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119 views

Time Value of Money PDF

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Calvin Sandi
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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From Innovation to Cash Flows: Value Creation by Structuring High Technology Alliances

by Constance Lütolf-Carroll, Antti Pirnes and Withers LLP


Copyright © 2009 Constance Lütolf-Carroll with the collaboration of Antti Pirnes

APPENDIX 17.2
The Time Value of Money

he concept of interest, like taxes, has existed since earliest recorded history. Baby-
T lonian records dating back 2000 B.C. reveal people paying interest for the use of
borrowed grain or other commodities. The interest was paid in the form of extra
grain or other goods.1
The time value of money may be expressed either as simple interest or as a
compound interest (interest compounding on the interest). When simple interest is
applicable, the amount of interest earned or paid may be computed by this formula:

I = P ×n×i

where I = amount of interest earned (computed on a simple basis)


P = principal amount lent or borrowed, say $100
n = number of interest periods, say 3 years
i = simple interest rate (in % per interest period)

Numerical Example Using Simple Compounding


Say you loan $100.00 to a friend for three years at a simple interest rate of 5 percent
per annum. How much will be the total simple interest? Substituting the numbers
into the formula, we compute:

I = P ×n×i
I = $100 × 3 years × 5% per year
I = $15.00

Commercial banks do not use simple interest as it ignores the value of com-
pounding the interest on the interest. We won’t use it in this book, either. In real
life, compound interest may be computed either discretely or on a continuous basis.
(See definitions of both terms next.) Finance and economics textbooks teach students
about discrete compounding.2

From Innovation to Cash Flows: Value Creation by Structuring High Technology Alliances
Copyright 
C 2009 by Constance Lütolf-Carroll with the collaboration of Antti Pirnes. All rights reserved.

1
2 APPENDIX 17.2: THE TIME VALUE OF MONEY

DISCRETE COMPOUNDING

Discrete compounding means that the interest is compounded at the end of each
finite-length period, such as a year. The future value is the value of a sum of money
after investing it for a given amount of time at a set interest rate. The basic equation
of compound interest, where interest is compounded discretely, is:

F Vn = P V0 × (1 + i)n

where P V0 = present value (initial amount) at time t = 0


i = interest rate per period (compounded discretely)
n = number of compounding periods
F Vn = future value or the sum at the end of n periods.

Numerical Example Using Discrete Compounding


If a customer were to place $1,000 on deposit in a bank account for three years,
determine how much money would be in the account at the end of the three-year
period, assuming discrete compounding at a 10 percent rate of interest per annum.

F Vn = P V0 × (1 + i)n
= $1,000.00 × (1.10)3
= $1,000 × (1.10) × (1.10) × (1.10)
= $1,331.00

CONTINUOUS COMPOUNDING
In many business transactions and economic studies, interest is assumed to compound
at the end of discrete periods of time. Cash flows are assumed to occur either at the
beginning or at the end of such periods. Discrete compounding is the most common
practice when doing discounted cash flows, and is what students are accustomed to
seeing in finance or economics textbooks.
However, cash that is retained in the business is being compounded continu-
ously, every second of every day. In continuous compounding, we assume that cash
payments occur once per year (like dividend payments) but that compounding is con-
tinuous throughout the year (the interest on the dividends received is compounded
continuously from the moment they are paid).
We demonstrate how to convert from discrete compounding to continuous
compounding by using the generalized formula for within-the-year compounding.
(Within-the-year compounding means the compounding takes place semiannually,
monthly, quarterly, or daily.)
 
r
F Vn = P V0 × 1+ ×n×q
q
Appendix 17.2: The Time Value of Money 3

where P V0 = present value or the initial amount existing at time t = 0


r = stated nominal rate of interest per year (in other words, without com-
pounding)
q = frequency of compounding within the year (in other words, q = 2 times
a year for semiannual compounding)
n = number of years
F Vn = future value or amount of money at the end of n periods

Numerical Example Using Monthly Compounding


Using the above formula, what is the end-of-the-year wealth of a client who receives
a 24 percent rate of interest compounded monthly on a $100 investment? (Answer:
$126.82.) Thus the annual rate of return (or the effective annual interest rate) is
26.82 percent. Because of the more frequent compounding, the effective annual
interest rate will be greater than the stated annual interest rate of 24 percent.
Now let us allow the frequency of compounding, q, to go to infinity and de-
rive the continuous compounding formula. This means that when q = ∞, we are
compounding our money every infinitesimal second of every day. For continuous
compounding, the equation simplifies to this:

F VT = P V0 er T

where e = base of natural logarithms and equals the constant 2.71828 (to 5 digits)
r = represents the stated annual nominal interest rate
T = number of years over which the investment lasts. (We use the capital
letter T to distinguish that we are doing continuous compounding rather
than discrete compounding.)

Numerical Example Using Continuous Compounding


A wealthy client decides to invest $1,000 at a continuously compounded rate of
10 percent per year. (Note that a continuously compounded rate of 10 percent per
annum is equivalent to an annually compounded rate or effective annual interest rate
of 10.52 percent.) What is the value of her wealth at the end of one year?

$1,000 × e0.10 = $1,000 × e0.10 = $1,000 × 1.10517 = $1,105.17

What is the value of her wealth if she decides to keep the funds invested for two
years?

$1,000 × e0.10×2 = $1,000 × e0.20 = $1,000 × 1.2214 = $1,221.40

If we choose to solve for P V0 , then the continuous compounding equation


becomes the continuous discounting equation:

F VT
P V0 = = F VT e−r T
er T
4 APPENDIX 17.2: THE TIME VALUE OF MONEY

A Second Example of Continuous Compounding


Assume we want to know how much interest is earned if we put $100 into an
asset that is continuously compounding at the rate of r = 20 percent for three years.
Answer: We will earn $82.21 in interest at the end of three years for a total amount
of principal plus interest of $182.21.
If we had instead put the $100 into an account that compounds the interest only
one time per year (discrete compounding), how much interest would we have earned?
The answer is $72.80 at the end of three years for a total amount, principal plus
compound interest, of $172.80, which is (1.2)3 times $100. The positive difference of
$182.21 minus $172.80 equals $9.71 is due to the far greater frequency of continuous
compounding.
To convert from discrete compounding to continuous compounding, we note
that er T for continuous compounding corresponds to (1 + i)n for discrete compound-
ing. Therefore er corresponds to (1 + i). Rearranging terms, this means that:

i = er − 1

where i = discrete discount rate


r = continuously compounded rate.
What would be the discrete rate of interest, if the bank were offering 12 percent
continuously compounded? Using the previous formula, we input 12 percent in
decimal form for r , then solve for i the discrete rate of interest,

i = e0.12 − 1 = 1.127497 − 1 = 0.127497 or 12.7497%

Therefore, compounding a 12 percent nominal rate continuously, the equivalent


discrete rate is 12.7497 percent. We might add that the 12.7497 percent is the
effective annual interest rate, also called the annual percentage rate (APR). The APR
is always compounded once per year.

NOTES
1. See E. Paul DeGarmo, John R. Canada, and William G. Sullivan, Engineering Economy,
6th ed. (New York: Macmillan, 1979), p. 64, to learn more about history and early origins
of interest.
2. Readers unfamiliar with the concepts of present value may wish to consult a basic corporate
finance textbook and practice solving problems using present value techniques. Log onto
our book’s web site (www.innovationtocashflows.com) and go to the Resources section,
where we provide a list of recommended finance textbooks.

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