UNIT 04

TIME VALUE OF MONEY:

LEARNING OBJECTIVES:

This topic aims to enable students to:

• Understand how and why the money is affected by time.

• Understand the concept of compounding and discounting.

• Calculate the future values and present values using respective formulas as well as
tables.

• Find the number of payment period and the interest rate.

• Define and differentiate the types of annuities.

• Calculate the future value and present value of an ordinary annuity.

• Calculate the present value of an annuity due.

• Define perpetuities and calculate their present value.

• Calculate the present value of an uneven series of payments.

• Explain the amortization of loan and its schedule.

• Describe the calculation of effective annual rate from nominal rate.

• Compound amounts more than once per year.

• Explain the Rule of 72 to double the money.

Institute: QASMS,QAU
Subject: FM
Instructor: Noman Shafi

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 TIME VALUE OF MONEY

Time Value of Money is the idea that money available at the present time is worth more
than the same amount in the future, due to its potential earning capacity. This core
principle of finance holds that, provided money can earn interest, any amount of money is
worth more the sooner it is received, also referred to as "discounted cash flow analysis
(DCF)".

A Rupee in hand today is worth more than a promise of a Rupee tomorrow. This is one of
the basic principles of financial decision-making. Time value analysis helps answer
questions about how much money an investment will make over time and how much a
firm must invest now to earn an expected payoff later.

Why money has time value?

Interest rates are positive in part because people prefer to consume now rather than later.
Positive interest rates indicate that money has time value. When a person lends his money
to another, he requires compensation in exchange for reducing his current consumption.
The person who borrows the money is willing to pay to increase current consumption.
The cost paid by the borrower to the lender for reducing consumption, known as
opportunity cost, is the real rate of interest.

The real rate of interest reflects “the compensation for the pure time value of money.”
The real interest rate does not include the interest charged for expected inflation and for
other risk factors. The required rate of return on an investment reflects the pure time
value of money, an adjustment for expected inflation and other risk premiums.

Measuring the Time Value of Money:

Financial managers adjust for time value of money by calculating the future value and the
present value. Future value is the value of a starting amount at a future point in time,
given the rate of growth per period and the number of periods until that future date e.g.
Mr.Zaib has invested Rs.1000 at 10 percent per annum today for 10 years. What will be
the value of this investment after 10 years?

The present value is the value of a future amount today, assuming a specific required
interest rate for a number of periods until the future amount is realized e.g. How much
should we pay today to obtain a promised payment of Rs.100,000 in fifteen years if the
invested money today would yield a 10 percent rate of return per year?

Calculating Future Value:

Future value is the amount to which a payment or series of payments will grow over a
given future time period when compounded at a given interest rate. The process of
finding future values is called compounding.

Compounding is the arithmetic process of determining the future or final value of a

payment or series of payments when compound interest is applied.

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The formula to calculate future value is
FV= PV + I … (i)
As I = PV (k)
FV = PV + PV (k)
FV = PV (1 + k)
OR
FV2 = FV1 + I
FV2 = FV1 + FV1 (k)
FV2 = FV1 (1 + k)
FV2 = PV (1 + k) (1 + k)
FV2 = PV (1 + k) 2
OR
FVn = PV (1 + k) n … (ii)
Where:
PV: Present value or the beginning amount
k (i or r): Interest rate
I: Dollars of interest earned each year = k (PV)
FV: Future value or ending amount
n: number of years or periods involved in a transaction.

The formula (ii) indicates the future value at the end of n years.

ILLUSTRATION No. 1:
Suppose a person had Rs.100 that he deposited in bank savings account that paid 5 %
interest compounded annually. How much would he have at the end of five years?
In this example
PV = Rs.100
k = 0.05 or 5%
n=5
As FVn = PV (1 + k) n
FVn = 100(1 + 0.05) 5
FVn = Rs.127.63
This future value takes into account the interest factors for year 1,2,3,4 & 5.
FV1 = PV (1 + k)…..(a)
FV1 = 100(1 + 0.05) 1 = 105
FV2 = FV1(1 + k)
Substituting (a) in above equation, we get
FV2 = PV (1 + k) (1 + k)
FV2 = PV (1 + k) 2
FV2 = 100(1 + 0.05) 2 = 110.25
Or FV2 = FV1 + FV1 (k)
FV2 = FV1(1 + k)
= 105 (1.05) = 110.25

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Likewise,
FV3 = 100(1 + 0.05) 3 = 115.76
Or FV3 = FV2(1 + k) = 115.76

FV4 = 100(1 + 0.05) 4 = 121.55

Or FV4 = FV3(1 + k) = 121.55

FV5 = 100(1 + 0.05) 5 = 127.63

Or FV5 = FV4(1 + k) = 127.63

If we analyze the above problem on a timeline, we find that:

t 0 (today) t1 t2 t3 t4 t5

Rs.100 Rs.105 Rs.110.25 Rs.115.76 Rs.121.55 Rs.127.63

Compound Interest Tables:

To find the future value, we can use compound interest tables. The term future value
interest factor for k, n (FVIFk, n) is defined as the future value of Re.1 left in an account
for n years paying k percent interest per period, which equals to (1 + k)n.

Tables have been constructed for values of (1 + k)n for a wide range of k and n values.
The equation (ii) using the future value interest factor can be written as

FVn = PV (FVIFk, n)

Interest factors can easily be found by using Interest Factor Tables (Appendix A). For
example, if the interest rate is 5% for 5 year as given in Illustration No.1, we have to
look down in the period column to 5 and then across this row to 5% column to find the
interest factor which will be 1.2763. Then, this interest factor shall be multiplied with
Rs.100 (PV) to find the future value of Rs.100 i.e. 100*1.2763=Rs. 127.63.

PRESENT VALUE:
Present value is the today’s value of a future payment or series of payments discounted at
an appropriate discount rate.
Discounting is the process of finding the present value of a payment or series of future
cash flows. It is the reverse of compounding.

In Illustration No.1, the future value of Rs.100 in 5 years at 5% interest rate is Rs.127.63.
This Rs.100 is the present value. In general, the present value of a sum due in the future
is the amount which, if were on hand today, would grow to equal the future sum.

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The formula for discounting is the reverse of compounding.
FVn = PV (1 + k) n
This formula when solved for PV gives;

PV = FVn = FVn (1 + k) -n

(1 + k) n
Present Value Interest Factor:
PVIF k, n is defined as the present value of Re.1 due n periods in the future discounted at
k percent per period. This is equal to (1/1+k) n. For the above-mentioned example we
look down the 5 percent column to the fifth row. The figure shown there is 0.7835, which
is used to find the present value of Rs127.63.

PV = FV n (PVIF k, n)
PV = FV 5 (PVIF 5%, 5 years)
PV = 127.63 (.7835)
PV = Rs.100

Relationship between Future Value and Present Value:

The Present Value Interest factor (PVIF k, n) is found to be the reciprocal of Future Value
Interest Factor (FVIF k, n) for the same k and n combination.
PVIF k, n = 1/ FVIF k, n
Therefore, since the future value interest factor for 5% over 5 years is 1.2763, the present
value interest factor for 5% over 5 years must be
PVIF 5%, 5 years = 1/ 1.2763 = 0.7835
The reciprocal nature of the relationship between present values and future values permits
us to find present values in two ways-by multiplying or dividing. Thus the present value
of Rs.1000 due in 5 years and discounted at 5 % may be found as
PV = FV n (FVIF k, n) = FV 5 (1/1+k) 5 = 1,000*0.7835 = Rs783.5
Or as
PV = FV n / FVIF k, n = FV5/ (1+k) 5 = 1,000/1.2763 = Rs783.5
Finding the Interest Rate (k):
Financial managers frequently have to solve for the interest rate k, when firms make
long-term investments. They need to determine how much periodic return an investment
has generated over time.

For example, suppose that a company purchased a land twenty years ago. For Rs.40,000.
Recently it sold the property for Rs.106,131. What average annual rate of return did the
firm earn on its twenty-year investment?
Here
FV = Rs. 106,131 PV = Rs.40,000 n = 20 years
Now:
FV = PV * (FVIF k, n)

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 106131 = 40000 * (FVIF k=?, n=20)
106131/40000 = (FVIF k=?, n=20)
(FVIFk=?, n=20)= 2.6533

Now we find the FVIF in the compounding table.

As n=20, find n=20 in rows on the left hand side of the table. As FVIF= 2.6533, move
across the n=20th row until you find (or come close to) the value 2.6533. The value lies
in the column where k=5%. Thus the interest rate the company’s investment has earned is
5 percent.
FVIF table only works well (for finding interest rate (k)), if the interest rate is a whole
number. However, it does not work well, when the interest rate is non-whole
number/fractional number. In such case we have to use another method to find interest
rate (k), which is as follow:
FV n = PV (FVIF k, n) as
FV n = PV (1 + k) n
k= (FV/PV) 1/n - 1
Using the data of the example:
k= (FV/PV) 1/n – 1
= (106131/40000) 1/20 – 1
= 2.6532750.05 – 1
= 1.05-1= 0.05 or 5%
This equation will find any interest rate given a starting value, PV, an ending value, FV,
and number of compounding periods, n.

Finding the number of periods:

Suppose an investment offers a return of 6 percent per year. How long would it take to
double the money?
In this problem, we are looking for n, the number of compounding periods it will take for
a starting amount, PV, to double in size. Suppose PV=Rs.100 It means that future value is
twice as much as present value i.e. FV = 2 * PV. Now, solving the FV formula for
number of periods ‘n”, we get

FV n = PV (FVIF k, n)
2*PV = PV * (FVIF 6%, n=?)
2*100=100*(FVIF 6%, n=?)
200=100*(FVIF 6%, n=?)
200/100 = FVIF 6%, n=?
2.0 = FVIF 6%, n=?
As k=6%, so scan across the top row to find the k=6% in columns. As FVIF=2, move
down k=6% column until you find (or come close to) the value 2. It occurs in the row

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where n = 12. Thus the number of periods it would take for the value of an investment to
double at 6% interest per period is 12(approx).

Rule of 72: Doubling the Money:

The Rule of 72 is useful to handle compound interest problems’ involving doubling the
money. The rule states that if the number of years, n, that an investment will be held is
divided into the value 72, we will get the approximate interest rate, k, required for the
investment to double in value. Thus,
72/n = k

The number of years the money will take to get doubles is:

72/k = n

For example, a firm bought a machine for Rs.10 million and sold it after five years later
at Rs.20 million. The firm doubled its money in 5 years. The interest earned is: 72/5 =
14.4%

Suppose the firm had taken its initial investment and deposited it in a saving account
earning 6% compound interest, the firm would have to wait for approximately 12 years
for the money to get doubled: 72/6 = 12 years

For most interest rates we encounter, the rule of 72 gives approximation of the interest
rate-or the number of years-required to double the money. But the answer is not exact.
For example, money doubling in five years would have to earn at a 14.87% compound
annual rate [(1+0.1487) 5 = 2], the rule of 72 says 14.4%. Also money invested in 6%
interest would require only 11.9 years to double [(1+0.06) 11.9= 2]; the rule of 72 suggests
12. This shows that Rule of 72 gives approximate answers. Can be used to get and idea
about the answer.

ANNUITY:
An annuity is defined as a series of payments of an equal, or constant, amount of money
at fixed intervals for a specified number of periods. There are two types of annuities.

Ordinary Annuity:
If the payments occur at the end of each period, as they typically do, the annuity is
called ordinary or deferred annuity. E.g. monthly salary

Due Annuity:
If the payments are made at the beginning of each period, the annuity is called
annuity due. E.g. house rent

Future value of ordinary annuity:

Financial managers often plan for the future. When they do, they often need to know how
much money to save on a regular basis to accumulate a specific amount of cash at a
specified period of time. The future value of an annuity is the amount that a given

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number of annuity payments, n, will grow to at a future date, for a given periodic interest
rate, k.
For instance suppose company A plans to invest Rs. 500 in a money market account at
the end of each year for the next four years, beginning one year from today. The business
expects to earn a five percent annual rate of return on this investment. How much will the
company have in the account at the end of five years?

The problem is illustrated in the following timeline.

Annuity Time line:
t 0 (today) t1 t2 t3 t4

Rs500 Rs500 Rs500 Rs500

FV at k=5% for 1 year

FV at k=5% for 2 year

FV at k=5% for 3 year

 = FVA =?

The t values in the timeline represent the end of each period. Thus, t 1 is the end of first
year; t 2 is the end of the second year and so on. The symbol t 0 is now, the present point in
time.
As Rs.500 is single payment amount per year, we can solve this problem one step at a
time. The first step is to calculate the future value of t 1, t 2, t 3, and t 4 using the future value
formula for a single amount. The next step is to add the four values together. The sum of
those values is the annuity’s future value.

Future Value of Company A Annuity:

t 0 (today) t1 t2 t3 t4

Rs500 Rs500 Rs500 Rs500

FVA

FV =500*(1+0.05) 1 525

FV =500*(1+0.05) 2 551.25

FV =500*(1+0.05) 3 578.8

 = FVA =Rs.2155.05

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The sum of the future values of the four single amounts is the annuity’s future value.
However, this step-by-step process is time consuming even in this simple example.
Calculating the future value of a twenty or thirty year annuity would take an enormous
amount of time as it happens in cases of bonds.,

Future Value of an Annuity Formula (Algebraic Method)

Annuity Formula is used to calculate Future Value of an Annuity to avoid time wastage.

FVA = PMT * (1 + k)n - 1

k

Where:
FVA = Future Value of an Annuity
PMT = Amount of each annuity payment
k = Interest Rate per period
n = Number of annuity payments.

The bracketed term in this equation is the result of adding the corresponding (1 + k)n
values from the future value of a single amount formula. This is the same as the sum of
the FVIF values from the table. For example, the sum of individual FVIF for each of the
Rs.500 payments is as follows;
1.1576 (n = 3)
1.1025 (n = 2)
1.0500 (n = 1)
1.0000 (n = 0)
4.3101
Now we solve the future value of annuity at 5 percent interest with four Rs.500 payments
(n=4 and PMT=Rs.500)

FVA = PMT * (1 + k)n - 1

k

FVA = 500 * (1 + .05)n - 1

.05

= 500*4.3101
= Rs.2155.05
Thus 4.3101 can be found by solving the terms in bracket or summing up the future
values of the single amount computation.
To find the future value of an annuity with the table method, we must find future value
interest factor for annuity (FVIFA). FVIFA is the value of [(1 + k) n – 1]/k for the
different combinations of k and n.

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Future Value of an Annuity Formula (Table Method)

FVA = PMT * FVIFA k, n

Where:
FVA = Future Value of an Annuity
PMT = Amount of each Annuity Payment
FVIFA k, n= Future Value Interest Factor for Annuity
k = Interest Rate per Period
n = Number of Annuity Payments.

The table for FVIFA k, n shows that FVIFA k=5%, n=4 is 4.3101. Using the table method,
we find the future value for the Rs.500 annuity.

FVA = 500 * FVIFA 5%, 4

= 500 * 4.3101
= Rs.2155.05

Present Value of an Ordinary Annuity:

Because annuity payments are often promised (as with interest on a bond payment) or
expected (as with cash inflows from an investment in new plant and equipment), it is
important to know how much these investments are worth to us today.
This worth is found by computing PVAn that is the present value of an annuity for n
periods.
For example, assume that a financial manager of firm X learns of an annuity that
promises to make four annual payments of Rs.500, beginning one year from today. How
much should the company be willing to pay to obtain that annuity?
The answer is the present value of the annuity. Since the annuity is nothing more than a
series of single amounts, we could calculate the present value of an annuity with the
present value formula of single amount (discounting formula) and sum the totals, but that
would be a cumbersome process. It would be very difficult and time consuming to
calculate present value of a twenty or greater-year annuity.
However, we calculate the present value of an annuity by the use of the formula:

1 1

PVA = PMT * (1 + k) n
k

Where:
PVA = Present Value of an Annuity
PMT = Amount of each annuity payment
k = Interest (Discount) Rate per period
n = Number of annuity payments

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Using the example of a four-year ordinary annuity with payments of Rs.500 per year and
a five percent discount rate, we can solve for the present value of the annuity as follows:

1 1

PVA = 500 * (1 + .05) 4

.05
PVA = 500 * 3.54595
= Rs.1772.97
The present value of the four-year ordinary annuity with equal yearly payments of Rs.500
at a 5 percent discount rate is Rs.1772.97.

Present Value of an Annuity Formula (Table Method)

We can also use the financial table for the present value interest factor for annuity
(PVIFA) to solve the present values of the annuity problems.
The formula for the table method is:

PVA = PMT * PVIFA k, n

Where: PVA = Present Value of an Annuity

PMT = Amount of each Annuity Payment
PVIFA = Present Value Interest Factor for Annuity
k = Interest (Discount) Rate per Period
n = Number of Annuity Payments.

Applying this equation, we can find the present value of the four-year annuity as follows:

PVA = 500 * PVIFA 5%, 4

= 500 * 3.5460
= Rs.1773.001
1
The Rs.03 difference between the algebraic result and the table formula is due to differences in
rounding.

Finding the Interest Rate for a PVA problem:

Financial managers may need to find interest rate (k) for a PVA problem when they know
the starting amount (PVA), n and the annuity payment (PMT).
For example, suppose a company wanted a fifteen year, Rs.100,000 loan from a bank that
is to be paid off in equal amounts that include principal as well as interest. The payment
per year for fifteen years will be Rs.12,405.89. What interest rate the bank is charging on
the loan?
To solve the problem, we use the PVIFA formula;
PVA = PMT * (PVIFA k, n)
Rs100000 = Rs12405.89 * (PVIFA k=?, n= 15)
8.0607 = (PVIFA k=?, n= 15)

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 Now refer to the PVIFA values in the table. As n=15, find n=15 in rows on the left hand
side of the table. As PVIFA= 8.0607, move across the n=15th row until you find (or come
close to) the value 8.0607. The value lies at the k=9% column. Thus the interest rate on
the company’s loan is 9 percent.
*It should be noted that if you do not find the exact value from the table, you have to do
interpolation.

Future and Present Values of Annuity Due:

Sometimes we must deal with annuities where the annuity payments occur at the
beginning of each period. These are known as annuities due (e.g. Rent) in contrast to the
ordinary annuity where payments occurred at the end of each period.
Whenever we calculate the FVA or a PVA of an annuity due, the adjustment needed is
the same in both cases. The method is to use the FVA or the PVA of an ordinary annuity
formula and multiply the answer with (1+k).
The reason of multiplying the FVA or PVA formula with (1+k) is that annuities due have
annuity payments earning interest one period sooner. So, higher FVA and PVA result
with an annuity due. The first payment occurs sooner in the case of a future value of an
annuity due. In the problems of present value of annuity due, each annuity payment occur
one period sooner, so the payments are discounted less severely. Thus the formula for
Future Value of an Annuity Due is:

FVA (due) = PMT * FVIFA k, n* (1 + k)

FVA (due) = PMT * (1 + k) n – 1 * (1 + k)

k

In the example of company A., the future value of Rs.500 ordinary annuity with k=5%
and n=4, was Rs.2155.06. If these payments occur at the beginning of each period instead
of at the end, then the future value of this annuity due would be:

Rs.2155.06*(1+0.05) = Rs.2262.81

Present Value of an Annuity Due Formula

PVA (due) = PMT * PVIFA k, n * (1 + k) OR

1 1

PVA (due) = PMT* (1 + k) n * (1 + k)

k

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In the example of company X., the present value of Rs.500 ordinary annuity with k=5%
and n=4, was Rs.1772.97. If the Rs.500 payments occurred at the beginning of each
period instead of at the end, then the present value of this annuity due would be:

Rs.1772.97*(1+0.05) = Rs.1861.62

*In annuity due, each amount is compounded for one extra period of time or discounted
for one lesser period of time as compared to its respective amount in case of ordinary
annuity.

PERPETUITIES:
An annuity that goes for an indefinite period of time is called a perpetual annuity or
perpetuity. Perpetuities contain an infinite number of annuity payments. An example of
perpetuity is the dividends typically paid on a preferred stock issue.
The future value of perpetuity cannot be calculated, but we can find its present value. We
start with the present value of an annuity formula, that is

1 1

PVA = PMT * (1 + k) n
k

For perpetuity, the number of payments (n) gets larger and larger. So (1+k) n term will get
larger and larger and as it does, it will cause the 1/(1+k) n fraction to become smaller and
smaller. As ‘n’ approaches infinity, (1+k) n term becomes infinitely large, and 1/(1+k) n
term approaches zero.
The entire formula reduces to the following equation:

PVP = PMT * 1 - 0
k
Or

PVP = PMT * 1
k
Where:
PVP = Present Value of a Perpetuity
k = Discount Rate
Neither the table nor the financial calculator can solve for a present value of perpetuity.
This is because the PVIFA table does not contain values for infinity and the financial
calculator does not have an infinite key.
If an investor purchases a share of preferred stock that pays Rs.70 per year forever. If
your required rate of return is eight percent, what is the present value of the preferred
dividends? In other words, given the required rate of return, how much should you be
willing to pay for the preferred stock?

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The answer can be found by applying the above equation.
PVP = PMT * (1/k) = Rs70 * (1 / 0.08) = Rs.875
Thus the present value of the preferred stock with an 8% interest rate and a payment of
Rs.70 per year forever is Rs.875.

PRESENT VALUE OF AN UNEVEN SERIES OF PAYMENTS:

The definition of an annuity includes the words ‘constant amount’-in other words,
annuities involve situations in which cash flows are identical in every period. Although
many financial decisions do involve constant cash flows, some important decisions are
concerned with uneven flows of cash; for example, common stock are typically expected
to pay an increasing series of dividends over time. Also the capital budgeting projects do
not normally provide constant cash flows. When the periodic payments vary, we say that
the cash flow streams are uneven.
The PV of an uneven stream of future income is found as the sum of PVs of the
individual components of the stream.
Suppose we are trying to find the PV of the stream of payments discounted at 6%. We
multiply each payment by the appropriate PVIFk, n and then sum up these products to
obtain the PV of the stream.

Timeline for an uneven cash flow stream:

t0 t1 t2 t3 t4 t5 t6 t7

Rs.100 Rs.200 Rs.200 Rs.200 Rs.200 Rs.0 Rs.1000

Rs.94.34
178.00
167.92
158.42
149.46
0.00
665.10
PV=Rs.1413.24

Year Payment * PVIF6%, n =PV of individual payments

1 Rs. 100 0.9434 Rs.94.34

2 200 0.8900 178.00
3 200 0.8396 167.92
4 200 0.7921 158.42
5 200 0.7473 149.46
6 0 0.7050 0
7 1000 0.6651 665.10
PV=Rs.1413.24

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The PV of the payments from year 2 to 5 can also be found by using annuity equation.
This alternative solution process involves the following steps:

Step 1: find the PV of Rs100 during year 1:

Rs.100 (0.9434) = Rs.94.34

Step 2: Rs.200 as annuity payment will be received during years 2 through 5. We can
solve this by finding the present value for 5 year annuity, and then by subtracting present
value of 1 year annuity from this. The net amount will represent the present value of
annuity from year 2 to year 5 i.e. by subtracting the PVIFA for 1 year, 6% annuity from
that for a 5-year annuity and multiplying the difference by Rs.200.

PV of the annuity = Rs.200 (PVIFA 6%, 5) – Rs.200 (PVIFA 6%, 1)

= Rs.200 (PVIFA 6%, 5 - PVIFA 6%, 1)
= Rs.200 (4.2124 – 0.9434)
= Rs.200 (3.2690) = Rs.653.8
This answer is the present value of the annuity component of uneven stream.
Step 3: Find the PV of the Rs1000 due in the year 7:

Rs.1000 (0.6651) = Rs.665.10

Step 4: Sum the components:

Rs.94.34 + Rs.653.80 + Rs.665.10 = Rs.1413.24

This method is an easy way to solve the PV problems if the annuity component runs for
many years.
Thus the present value of a stream of future cash flows can always be found by summing
the present values of each individual cash flow. However, the cash flow regularities
within the stream may allow the use of short cuts, such as finding the present value of
several cash flows that compose an annuity.

The future value of a series of uneven payments, often called the terminal value, is
found by compounding each payment and then summing the individual future values. We
are generally more interested in present value of stream of payments from an asset than in
future (terminal) value, because the PV is the current value and hence the market value of
the asset.

AMORTIZED LOANS:
One of the most important applications of the compound interest involves loans that are
to be paid off in equal installments over time. Amortized loan is a loan that is repaid in
equal payments over its life.
Included are the automobile loan, home mortgage loans and most business debt other
than the short-term loans.

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Suppose a firm borrows Rs.1500 to be repaid in 3 equal payments at the end of each of
the next three years. The lender is to receive 10 percent interest on the loan balance that is
outstanding at the beginning of each period.
The first task is to determine the amount the firm must repay each year, or the annual
payment. Rs.1500 is the present value of an annuity of PMT (installment) per year for 3
years, discounted at 10%. As it is shown on the time line:

t0 t1 t2 t3

Rs.1500 ? ? ?

Now, you have to find the equal payments i.e. Annual Payments or PMT for t1, t2 and t3.
This is annuity for three years which can be calculated by using Present Value Annuity
formula. The formula is given below:

PVA = PMT * (PVIFA k, n)

Here
PVA= Rs.1500
k=10%
n=3 years
PMT= ?
Now, using the formula we get

Rs.1,500= PMT (PVIFA10%, n=3)

PVIFA10%, n=3 from the table is found to be 2.4870, so
Rs.1,500= PMT (2.4870)
PMT = 1,500/2.4870 = Rs.603.14
t0 t1 t2 t3

Rs.1500 603.14 603.14 603.14

If the firm pays the lender Rs.603.14 at the end of each of next three years, the percentage
cost of the borrower, and the rate of return to the lender would be 10%.
Each payment consists partly of interest and partly of a repayment of principal. This
breakdown is given in the amortization schedule.
An amortization schedule is a schedule showing precisely how a loan will be repaid. It
gives the required payment on each specified date and a breakdown of the payment
showing how much constitutes interest and how much repayment of principal.
The interest component is the largest in the first year and declines as the outstanding
balance of the loan goes down. For tax purposes, a borrower reports interest as a

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deductible cost each year (shown in column 3 of the schedule below), while the lender
reports these same amounts as taxable income.

Loan Amortization Schedule:

Year Beginning Repayment of Remaining

a
Amount Payment Interest Principal b Balance
(1) (2) (3) (4) (5)
1 1500 603.14 150.00 453.14 1046.86
2 1046.86 603.14 104.686 498.454 548.406
3 548.406 603.14 54.8406 548.406 0.00
1809.42 309.5266 1500.00
a
Interest is calculated by multiplying the loan balance at the beginning of the year by the interest
rate. Therefore interest in year 1 is Rs1500 (0.10) = Rs.150; in year 2 it is Rs.1046.86 (0.10) =
Rs.104.686, and in the third year it is Rs.548.406 (0.10) = Rs.54.8406
b
Repayment of principal is equal to the payment of Rs.603.14 minus the interest for each year.

SEMIANNUAL AND OTHER COMPOUNDING PERIODS:

Nominal and Effective Annual Interest Rates:

The nominal or stated interest rate is the quoted or the contracted interest rate. It is
often called annual percentage rate (APR) when it is reported by banks or other lending
institutions.
The effective annual rate (EAR) is the annual rate of interest actually being earned as
opposed to the stated rate.
If Rs.1000 is put in a bank account that pays twelve percent annual interest rate, then the
nominal or stated rate will be 12%. However, the effective annual rate of interest can be
determined given the nominal interest rate by solving the following equation:
m*n

Effective Annual Rate (EAR) = 1 + k nom -1

m
Where:
k nom = Nominal or stated interest rate
m = number of compounding periods per year.

If nominal rate is 12%, and the compounding is semiannual-that is-interest is paid every
six months (m=2), EAR would be:

EAR = (1 + 0.12/2) 2 - 1 = (1.06) 2 - 1 = 1.1236 – 1 = 0.1236 = 12.36%

Compounding more than once per year:

Many investments pay interest that is compounded semiannually, quarterly or even daily.
Most banks, savings and loan associations, and credit unions pay compound interest on
their deposits more frequently than annually.

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For semiannual compounding, the annual interest rate is divided by 2, but twice as many
compounding periods are used because interest is paid twice a year.

Annual Compounding: FV n = PV (1+k)

m*n

More frequent compounding: FV n = PV 1 + k nom

m

The same treatment is used in annuities.

Consider that Rs.100 is deposited in a savings account at 12 percent for one year with
semiannual compounded interest. Because we want to find out what the future value of
the single amount will be, we use the compounding formula to solve for the future value
of the account after one year. Next, we divide the annual interest rate, 12% by 2. Then we
multiply number of years, n by 2. The calculation follows:
FV = PV * (1+k/2) n*2
FV = 100 * (1+ 0.12/2) 1*2
FV = 100 * (1+ 0.06) 2
FV = 100*1.1236 = Rs.112.36

The future value of Rs.100 after one year, earning 12 % annual interest compounded
semiannually is Rs.112.36.

The formula for the table method would be:

FV = PV * (FVIFk/2, n*2)
The amount grows faster under semiannual compounding because a 12 % semiannual
rate is better than 12% annual rate from a saver’s point of view. This is because
semiannual compounding earns interest on interest more frequently.

Continuous Compounding:
The effect of increasing the number of compounding per year is to increase the future
value of the investment. The more frequently interest is compounded, the greater the
future value. The smallest compounding period is used when we do continuous
compounding-compounding that occurs every tiny unit of time (the smallest unit of time
imaginable).
In the previous example, if Rs.100 is deposited in an account at 12% for one year with
annual compounding, the balance at the end of 1 year is Rs.112. However, with
semiannual compounding the amount raised to Rs.112.36.
When continuous compounding is involved, we cannot divide ‘k’ by infinity or multiply
‘n’ by infinity. Instead we use a term ‘e’.

e = limit h→ 0 (1+1/h) h = 2.71828 approx.

The value of e is the natural antilog of 1 and is approximately equal to 2.71828. Using e,
the formula for finding the future value of a given amount of money, PV, invested at
annual rate, k, for n years, with continuous compounding is as follows:

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 FV = PV * e (k*n)

*where ‘k’ and ‘n’ are expressed in annual terms.

Applying this equation to our example, we get the following balance:

FV = Rs100 * 2.71828(0.12 * 1) = Rs.112.75

The future value of Rs100, earning 12% annual interest compounded continuously is
Rs.112.75. Thus, the compounding frequency can impact the value of the investment.
Investors should look carefully at the frequency of compounding. Other things being
equal, the more frequently the interest is compounded, the more interest the investment
will earn.

.
Compiled by Qindeel Zafar (2003), T & RA, Reviewed/ Updated by Yasir Shahab (2008), T & RA,
Reviewed/2ndUpdate by Muhammad Usman (2021), T & RA , Last update (Mar 2024)

Supervised by: Noman Shafi, PhD

DAS (1995/9-2010)/QASMS(2010- to date)
Quaid-I-Azam University, ISB

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Appendix A: Time Value of Money Tables

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