Chapter-2

Interest and Time Value of Money

Content;
1. Introduction to Time Value of Money
2. Simple Interest
3. Compound Interest
1.Nominal Interest rate
2.Effective Interest rate
3.Continuous Compounding
4. Economic Equivalence
5. Development of Interest Formulas
1.The Five Types of Cash flows
2.Single Cash flow Formulas
3.Uneven Payment Series
4.Equal Payment Series
5.Linear Gradient Series.
6.Geometric Gradient Series.
 Introduction to Time Value of Money
• Time value of money is define as the time
dependent value of money stemming both from
changes in purchasing power of money and from
the real earning potential of alternatives
investments over time.
• Time value of money is the relationship between
interest and time.
• Any investment decision also relation with
interest and time so, for investment we will have
to consider the three factors;
1. Liquidity
2. Risk premium
3. Inflation factor
 Interest
 Interest is the price paid for the use of borrowed money. As with any
financial transaction, interest is either something you pay (a
disbursement) or something you earn (a receipt) depending on
whether you are doing the borrowing or the lending.
 Interest earned/paid is a certain percentage of the amount
loaned/borrowed.
Type of interest;
1. Simple Interest
Simple interest is interest calculated on the principal portion of a loan or
the original contribution to a savings account. Simple interest does not
compound, meaning that an account holder will only gain interest on the
principal, and a borrower will never have to pay interest on interest
already accrued.
Future value(FV)= Principal amount(P) or Present Value(PV)+ Earned
Interest(I)
Simple Interest (earned)I= (P*iN)
FV or F = P+P*i= P(1+iN)
Or, F= P(1+iN) where; i= interest rate, N= Time period
 2. Compound Interest
 Compound interest (or compounding interest) is interest
calculated on the initial principal, which also includes all of the
accumulated interest from previous periods on a deposit or loan.
 The rate at which compound interest accrues depends on the
frequency of compounding, such that the higher the number of
compounding periods, the greater the compound interest.
 The compounding frequency is the number of times per year (or
rarely, another unit of time) the accumulated interest is paid out,
or capitalized, on a regular basis. The frequency could be yearly,
half-yearly, quarterly, monthly, weekly, daily, or continuously (or
not at all, until maturity).
 For example, monthly capitalization with interest expressed as
an annual rate means that the compounding frequency is 12, with
time periods measured in months.
 Compound Interest
 The general compound interest formula is:
F = P * (1 + i)N
where,
F = Future value (how much P will be worth in the future)
P = Present value (money invested today)
i = interest rate
N = number of interest periods
 The standard symbol for the above formula is:
F = P(F/P,i,N)
 Interest factor is (F/P, i, N)
where, F represents what is unknown
P represents what is known
i and N represent input parameters;
can be known or unknown depending upon the problem
 Example: (F/P,6%,20) is read as:
To find F, given P when the interest rate is 6% and the number of time
periods equals 20.
Economics Equivalence
 If the interest rate is 6% per year, Rs 100 today (present
time) is equivalent to Rs 106 one year from today.
 The concept of economic equivalence is different sums
of money at different times are equal in economic
value
 The time value of money and the interest rate helps to
develop the concept of economic equivalence.
General Principles of Equivalence Calculation;
 Equivalence calculations made to compare alternatives
requires a common time basis.
 Equivalence depends on interest rate.
 Equivalence calculations may require the conversion of
multiple payment cash flows to a single cash flow.
 Nominal and Effective Interest Rate;
Consider the situation where a person deposits Rs 100 into a
bank that pays 12% interest rate compounded semiannually.
How much would be interest earned and total saving account at
the end of one year.
 Interest earned during 1st six months = Rs 100* .12/2= Rs 6
 Total amount after 6 month= 100+6= Rs 106
 Interest earned during 2nd six month= Rs 106*.12/2= Rs 6.36
 Total interest after 1 yr = 6+6.36=12.36
 Total amount =112.36
So, Interest rate for the entire year= (12.36/100)* 100= 12.36%
From this example; we have two type of interest rate i.e. 12%
and 12.36%.
{From this two interest rate; which one is Nominal and which
one is Effective?}
 Nominal and Effective Interest Rate;
Nominal Interest rate(annual percentage rate);
 Nominal interest rate is the annual interest rate without
considering the effect of any compounding.it is denoted
by r and commonly stated as r% compounded m-ly
where, r = annual nominal interest rate
m = compounding frequency per year
r/m= interest rate per compounding period
For above example 12% is Nominal Interest rate.
Example expressing nominal interest rate;
 r= 12% compounded semiannually; m=2 i.e 12/2=6%
per 6 month.
 r= 12% compounded quarterly, m=4, i.e. 12/4= 3% per
3 month.
 When, m= ∞ , compounded continuously.
 Nominal and Effective Interest Rate;
Effective Interest rate (annual percentage
yield);
Is the annual interest rate taking into account
the effect of any compounding during the year.
It is denoted by i.
Effective interest rate are always expressed on
annual basis unless specifically stated
otherwise.
For above example; 12.36% is Effective
interest rate.
Relation between Nominal(r)and
Effective(i) interest rate
If Rs 1 deposit were made to an account that compounded
interest m times per year and paid a nominal interest rate per
year is r, the interest rate per compounding sub period would be
r/m, and the total in the account at the end of one year would be;
total amount= Rs 1* (1+r/m)m [F = P * (1 + i)N ]
or simply (1+r/m)m
total interest earned= (1+r/m)m -1
Effective annual interest rate (i)= (1+r/m)m -1
Let i’= r/m
i= (1+i’)m -1 or i’ = (1+i)1/m- 1
For Compounded continuously m=∞ and (1+i)= er
Eff. Annual interest rate i= er -1
 Continuous Compounding
 For Compounded continuously
m=∞ and (1+i)= er
 Eff. Annual interest rate i= er -1
 Compound interest formula becomes;
F=P(1+i)n = Pern , F= Pern
Example;
How long will it take for money to double at 10%
nominal interest, compounded continuously?
Soln ;
F= Pern ; 2=1*e.01*n ; e.01*n = 2
0.01n = ln2; n= 6.93≈ 7 years
Example
What is the effective interest rate of the nominal
interest rate 9% per year if the compounding is a)
yearly, b) quarterly c) Monthly d) Daily
e) Continuously
Soln ; i= (1+ r/m)m -1
 for compounded yearly, i= (1+.09/1)1 -1= 0.09= 9%
 For compounded quarterly, i=(1+ 0.09/4)4 -1=
0.09308= 9.308%
 For compounded monthly, i= (1+0.09/12)12 -1=
0.0938= 9.38%
 For compounded daily, i= (1+ 0.09/365)365 -1=
0.0941= 9.41%
 For compounded continuously, i= (1+0.09/∞)∞ -1=
er -1= e0.09 -1=9.417%
 Development of Interest Formula
Types of Cash Flow
1. Single Cash Flow; simplest case involves only a
single present amount(P) and its future worth(F)

2. Uniform(Equal) series; amounts are arranged as a

series of equal cash flows at regular intervals.
 Types of Cash Flow
3. Linear gradient series; involve series of cash flows, the
amounts are not always uniform, they may vary in some
regular way. One common pattern of variation occurs
when each cash flow in a series increases or decreases by
a fixed amount.

4. Geometric gradient series; Series are formed by some

fixed rate, expressed as a percentage.

5. Uneven payment series; A series of cash flow may be

irregular. It doesn’t exhibit an overall regular pattern.
 Interest Formula
1. Single Cash Flow;
To find the single future sum(F) of the initial payment(P) with
interest rate i% and nth year,
 Interest after 1st year = Pi
 F after 1st year = P + Pi = P(1+i)
 Interest for 2nd year= P(1+i)*i
 F after 2nd year= P(1+i) + P(1+i)*i = P(1+i)2
After nth year
 F = P(1+i)n i.e. F = P(F/P, i,N)
or P= F (1+i)−n i.e. P = F(P/F, i,N)
 (1+i)n = Single payment compound factor
 (1+i)−n = Single Payment Present worth Factor
 Cont….
Example 1;
Suppose you deposit Rs 1000 in saving account that pays
interest at a rate of 8%, compounded annually. Assume that
you don’t withdraw the interest earned at the end of each
period(year), but let it accumulate. How much would you have
at the end of year 5?
Soln ; given: P= Rs 1000, N= 5yrs and i= 8% per year
Then, F= P(F/P, i%, N) or F= P(1+i)N
Or, F= 1000*(1+0.08)5 = Rs 1470

Example 2:
How much should be put in an investment with a 10%
effective annual rate today to have Rs 10,000 in five years?
Using the formula in the factor conversion table,
P = F/(1 + i) n = (10,000)/(1 + 0.1) 5 ) =Rs 6209
 Interest formula
2. Uniform(Equal) series;
To find F when A is given;
F= A (1+i)n-1 + A(1+i)n-2 +…
….+A(1+i) + A-------(1)
Multiplying both side by (1+i)
F(1+i) = A(1+i)n + A(1+i)n-1 +…….+ A(1+i)2 +A(1+i)-------(2)
Subtracting Eq. 1 and 2, we get,
F(1+i)-F = A(1+i)n – A
( 𝟏:𝒊 𝒏;𝟏 𝒊
F= A[ ] A= F[ ]
𝒊 𝟏:𝒊 𝒏;𝟏
𝒊
[ ]= Sinking fund factor
𝟏:𝒊 𝒏;𝟏

To find P when A is given;

we have, F= P(1+i)n
( 1:𝑖 𝑛;1) ( 𝟏:𝒊 𝒏;𝟏) (𝒊∗ 𝟏:𝒊 𝒏
P(1+i)n= A[ ] P= A[ ] A= P[ ]
𝑖 𝒊∗ 𝟏:𝒊 𝒏 𝟏:𝒊 𝒏;𝟏
(𝒊∗ 𝟏:𝒊 𝒏
[ ] = Capital recovery(annual equivalent cost of capital cost) factor
𝟏:𝒊 𝒏;𝟏
Summary of all interest formula
Summary of interest formula for
Continuous Compounding

 Cash flow at beginning of year

 Cash flow at end of year
Example
Q. Mr. Reyes borrows Rs 600, 000 at 12% compounded
annually, agreeing to repay the loan in 15 equal
annual payments. How much of the original principal
is still unpaid after he has made the 8 payment?
Solving for A;
(𝑖∗ 1:𝑖 𝑛
A= P[ ]
1:𝑖 𝑛;1
[P= 600000, i=0.12, n=15]
A= Rs 88,094.54
After 8th payment, remaining no of
payment= 7 so,
Solving for P at 8th year;
( 1:𝑖 𝑛;1)
P= A[ ] [ A= 88094.54, i=
𝑖∗ 1:𝑖 𝑛
0.12, n=7]
P= Rs 4,02, 042
 Example
Q. Mr. Ram wants to have Rs 10,00,000 for the studies
of his son after the period of 15 years. How much
rupees does he has to deposit each year for 10
continuous years in a saving account that earns 8%
interest annually.
Given; F= 10,00,000, n=15 years, i= 8% per
year, A=?
Discounting Rs 10,00,000 at the end of 10th
year ,
P = F/(1+i)n [ Functionally P= F (P/F, 8%, 5)]
P= 10,00000/(1+ 0.08)5 = Rs 680583.197
Using the sinking fund factor;
𝑖
A= F[ 𝑛 ] [ Functionally A= F( A/F, 8%,
1:𝑖 ;1
10)
0.08
A= 680583.197* [ ]
1:0.08 10;1
A= Rs 46980.31
Example;
Q. How many deposit of Rs 25,000 each should Mr.
Thakur make each month so that the final accumulated
amount will be Rs 10,00,000. if the bank interest rate is
12% per year?
Given; A= 25,000 per month, F= 10,00,000, i=12% per year
For monthly interest rate;
i= (1+i’)m- 1
i’ = (1+i)1/m- 1
i month = (1+iyear) 1/12 – 1, or, i month = (1+0.12) 1/12 – 1 or imonth = 0.0094=
0.94%
Using uniform series compound interest formula
( 1:𝑖 𝑛;1
F= A[ ] [functionally F= A(F/A, 0.94%, n)
𝑖
( 1:0.0094 𝑛;1
10,00,000= 25,000* [ ]
0.0094
0.376= (1.0094)n -1, or (1.0094)n = 1.376
Taking log on both side
Log (1.0094)n = log 1.376 or, nlog 1.0094 = log 1.376,
n= 34 (34 deposits)
 Example
Q. Determine the present worth and the accumulated amount
of an annuity consisting of 6 payments of Rs 1,20, 000 each,
the payment are made at the beginning of each year. Money
is worth 15% compounded annually.
Given: A = Rs 1,20, 000, n = 6, i = 15%
Required: P = present worth, F = future worth
We have;
_
( 𝟏:𝒊 𝒏 𝟏;𝟏)
P= A[ _ ] + A [ A= 120000, i= 0.15, n=6]
𝒊∗ 𝟏:𝒊 𝒏 𝟏
P= 5,22,259.00
Again,
( 𝟏:𝒊 𝒏;𝟏
F= A[ ]* (1+i)
𝒊
F= 12,08,016.00
Example
Q. What is the future worth of Rs 600 deposited at the
end of every month for 4 years if the interest is 12%
compounded quarterly?
Given;
A= 600
n=4*12= 48
F= ?
i= 12% compounded quarterly
For effective interest rate;
i= (1+r/m)m- 1
i= (1+ .12/4)4 -1= 0.1255=12.55%
For monthly interest rate;
iyear= (1+i month)m- 1
imonth = (1+i year)1/m- 1= (1+0.125)1/12 -1= 0.0098
i= 0.98%
Solving for future worth;
( 𝟏:𝒊 𝒏;𝟏 ( 𝟏:𝟎.𝟎𝟎𝟗𝟖 𝟒𝟖;𝟏
F= A[ ]= 600* [ ]
𝒊 𝟎.𝟎𝟎𝟗𝟖
F= Rs 36,641.32
Ans. F= Rs 36,641.32
Example
Example
Example
Example
Example
Example
Example
Suppose that one has cash flows as follows.
calculate the present equivalent at i=15%
End of year Net cash flow
1 -8000
2 -7000
3 -6000
4 -5000
Example
Example
THANK YOU