CHAPTER 1

TIME VALUE OF MONEY

Learning objective:

Students should be able to:

1. Understand the concept of time value of money

2. Perform the computation of time value of money
3. Understand the impact of interest rates on time value of money
4. Understand the application of time value of money for financial decision making

3.1

Introduction

Time value of money (TVM) is important in financial management as the value of money
changes due to time and interest rates. A clear understanding on TVM helps financial
managers in making accurate correct decisions. Due to its importance, this chapter discusses
the concept and application of TVM for decision making.

3.2

Methods of Computation of Time Value of Money

There are 2 methods of computing value of money with regards to interest rates.

Simple Interest

Compounding Interest

3.2.1 Simple Interest Rate

Example: To determine how much would it be in your savings account after 3 years if you
deposited $100 today and bank pays simple interest rate of 5% per annum.

Interest Amount = Principle x Interest Charges x Number of Years

= 100 x 5% x 3 =15
Thus, after 3 years = $100 + $15 = $115

Example: You plan to buy a car, Proton Waja, selling at $61,000. Compute your monthly
payment on the car assuming EON Bank offers you 90% car loan financing with simple
interest rate of 3.0% per annum and payment period of 9 years.

Loan amount = $61,000 x 90% = $54,900

Interest amount = $54,900 x 9 years x 3.0% = $14,823
Total amount to be paid = $54,900 + $14,823 = $69,723
Monthly payment = $69,723 / (12x9) = $645.58

3.2.2 Compounding Interest Rate

In compounding interest, various methods of computation are involved which can be divided
as follows:-

Future Value (FV)

Present Value (PV)

Future Value Annuity (FVA)

Present Value Annuity (PVA)

Uneven Cash Flows

Future Value

Example: Determine the value after 1 year of $100 deposit today, earning 5% per year,
annual compounding.
FV = PV (1+i) n

= 100 (1+0.05)1 = 100 (1.05)1

= $105

Solve the followings.

a)

FV of $1 1 year from today if interest rates = 4% per year

b)

FV of $200 3 years from today if interest rates = 6% per year

c)

FV of $500 5 years from today if interest rates = 5% per year

d)

FV of $500 5 years from today if interest rates = 10% per year

Present value

Example: Encik Adam wants to have $115.76 in his account after 3 years. How much should
he deposits today if EON Bank pays him 5% annual compounding.
PV = FV/(1+i) n = $115.76/(1.05)3 = $115.76 / 1.1576 = $100

Solve the followings.

a)

PV of $100 in year 1 if interest rates = 4% per year

b)

PV of $200 in year 2 if interest rates = 5% per year

c)

PV of $300 in year 3 if interest rates = 6% per year

d)

PV of $500 in year 4 if interest rates = 4% per year

e)

PV of $500 in year 4 if interest rates = 8% per year

Future Value Annuity (FVA) Ordinary Annuity

Example: If you deposit $100 at the end of each year for 3 years in a savings account that
pays 5% annually, how much would you have at the end of 3 years?

5%

5%

$100

$100

5%

3
$100

Formulae:- FVA = PV (1+i)n

100 (1.05)2 = 110.25
100 (1.05)1 = 105.00
0

Alternatively, the following formula can be used to solve the computation above.
FVO

Pmt
(1 i) n 1
i

Example: To determine the FVO at the end of year 3 if you deposited $100 at the end of each
year for 3 years in a savings account that pays 5% compounded annually.
Pmt
(1 i) n 1
i
100
=
(1 0.05) 3 1 =
0.05

FVO

2000 (1.05) 3 1 = $315.25

Future Value Annuity (FVA) - Annuity Due

FVA

Pmt
(1 i) n 1 x 1 i
i

Example: To determine the FVA at the end of year 3 if your deposited $100 at the beginning
of each year for 3 years in a savings account that pays 5% compounded annually.

FV A

Pmt
(1 i) n 1 x 1 i
i

100
(1 0.05) 3 1 x 1 0 . 05
0.05
2000 (1.05) 3 1 x 1.05
= 2000 0.1576 x 1.05 = $331.01

Comparing between the values of annuity due and ordinary annuity, annuity due ($331.01) is
higher than the ordinary annuity ($315.25) because of the earlier cash flow occurred in
annuity due, that is the cash flow of annuity due starts in Year 0 while ordinary annuity starts
in Year 1.

Solve the followings.

a)

FV in year 2 of $1 deposited every year if interest rates = 4% per year

b)

FV in year 4 of $100 deposited every year if interest rates = 6% per year

c)

FV in year 4 of $100 deposited every year if interest rates = 12% per year

d)

FV in year 6 of $500 deposited every year if interest rates = 5% per year

Present Value Annuity (PVA) Ordinary Annuity

Example: What is the PV of 3 year annuity with deposit of $100 at the end of each year in a
savings account that pays 5% annually?

5%

5%

$100

2
$100

5%

3
$100

Formulae:- PVA = FVA / (1+i)n

100 / (1.05)1 = 95.238
100 / (1.05)2 = 90.7029
100 / (1.05)3 = 86.3838

Alternatively, the following formula can be used to solve the computation above.
PVO

Pmt
1
1

i (1 i) n

= PVO

PVO

100
1
1

3
0.05 (1 0.05)

100
1
1
= 2000(0.136 1) $272.32

0.05 1.1576

Present Value Annuity (PVA) Annuity Due

Example: To determine PVA of 3 year annuity with deposit of $100 at the beginning of each
year in a savings account that pays 5% compounding interest annually.

To apply the following formula,

PVA

Pmt
1
1
x 1 i

i (1 i) n

= PVA

PVA

100
1
1
x 1 0.05

0.05 (1 0.05) 3

100
1
1
x 1.05 = 2000(0.136 1) x 1.05 $285.81

0.05 1.1576

Comparing between the values of annuity due and ordinary annuity, the value of annuity due
($285.81) is higher than the ordinary annuity ($272.32) because of earlier cash flow occurred
in annuity due i.e. the cash flow of annuity due starts in Year 0 while ordinary annuity starts
in Year 1.

Solve the followings.

a)

PV of $100 deposited every year for 2 years if interest rates = 4% per year

b)

PV of $100 deposited every year for 2 years if interest rates = 8% per year

c)

PV of $500 deposited every year for 5 years if interest rates = 6% per year

Uneven Cash Flows

Unlike our earlier discussions where cash flows are fixed or are same amount, here we will
discuss on cash flows which are uneven (not fixed). Uneven cash flows are a series of cash
flows in which amount varies from one period to the next period.
Example: Determine the PV of the expected uneven cash flows that you will receive for the
next 7 years given interest rates of 6% per annum?

6%

0
PV?

6%

6%

6%

6%

6%

6%

$100

200

200

200

200

7
0

PV = FV / (1+i) n

100 / (1.06)1 = 94.34

200 / (1.06)2 = 178
200 / (1.06)3 = 167.92
200 / (1.06)4 = 158.42
200 / (1.06)5 = 149.45

The PV of $748.13 (in Year 0) is derived by discounting the future

uneven cash flows with a discount rate of 6% per year.

Example: Determine the FV of the expected uneven cash flows that you will receive for the
next 7 years given interest rates of 6% per annum?
6%

100

200

200

200

200

FV?

The FV of $1124.92 (in Year 7) is derived by compounding future

uneven cash flows with interest rates 6% per year.

FV = PV (1 + i)n
100 (1.06)6 =
200 (1.06)5 =
200 (1.06)4 =
200 (1.06)3 =
2
200 (1.06) =

141.85
267.65
252.50
238.20
224.72

Solve the followings.

a)

PV of $200 in year 1 and $300 in year 2 if interest rates = 5% per annum

b)

PV of $500 in year 1, $300 in year 2 and $100 in year 3 if i = 6% per annum

c)

FV in year 5 of $200 in year 1,$300 in year 2 and $100 in year 3 if i = 4% per year

3.3

Interest Rates

There are 3 types of interest rates.

(1)

Nominal Rates or Annual Percentage Rates (APR) or Quoted Rates rates which are
based on per year basis, example - 10% per year.

(2)

Periodic Rates rates which are based on periodic basis, example 10%
semiannually, 10% quarterly, 10% monthly or 10% daily.

(3)

Effective Annual Rates (EAR) refers to the effective (actual) rates earned on certain
investment or effective (actual) rates being charged on certain loan.

3.4

Effective Annual Rates (EAR)

Assuming you deposit your money in a bank, and the bank quotes 10% interest rate per year
to be paid to you semiannually. In this case, since you receive the interest payment twice a
year, the actual interest rate that you earn obviously must be higher than the nominal rate or
quoted rate that is 10% interest rate per year as quoted by the bank.
Now, how to convert from nominal rates to EAR?
EAR (%) = (1 + i nom/m)m - 1
where inom = nominal interest rates, m=number of compounding periods per year

The following are the examples of EAR with different compounding periods.

10% semiannually

= (1 + 0.10/2)2 1

= 10.25%

10% quarterly

= (1 + 0.10/4)4 1

= 10.38%

12

10% monthly

= (1 + 0.10/12) 1 = 10.47%

10% daily

= (1 + 0.10/365)365 1 = 10.515%
8

3.5

Determining FV (Compounding using different periods)

1.

You deposit $100 today; interest rate to be received is 10% per year. Determine FV of
your deposit after 1 year.

PV = 100; i%= 10%; n = 1

FV = PV (1+i)n = 100(1.10)1 = $110

2.

You deposit $100 today; interest rate to be received is 10% per year, compounded
semiannually. Determine FV of your deposit after 1 year.

PV = 100; i%= 5%; n = 2

FV = PV (1+i)n = 100(1.05)2 = $110.25

3.

You deposit $100 today; interest rate to be received is 10% per year, compounded
quarterly. Determine FV of your deposit after 1 year.

PV = 100; i%= 2.5%; n = 4

FV = PV (1+i)n = 100(1.025)4 = $110.38

4.

You deposit $100 today; interest rate to be received is 10% per year, compounded
monthly. Determine FV of your deposit after 1 year.

PV = 100; i%= 0.833%; n = 12

FV = PV (1+i)n = 100(1.0833)12 = $110.47

5.

You deposit $100 today; interest rate to be received is 10% per year, compounded
daily. Determine FV of your deposit after 1 year (365 days).

PV = 100; i%= 10%/365; n = 365

FV = PV (1+i)n = $110.515

From the computations, we can conclude that the more frequent the compounding, the higher
the FV (given same amount of deposit and year).
9

3.6

Real Purchasing Power

(1 + i nominal) = [(1+i real) x (1 + i inflation) -1] x 100

The above formula explains the real purchasing power which is influenced by inflation.
Assuming we deposited our money in a bank and earned a nominal rate of 6% per year. If
inflation is 2% per year, this means the real purchasing power is 3.92%.

3.7

Loan Amortization Schedule

Example: The following shows a loan amortization schedule on loan amount of $6,000, to be
paid at the end of each year for 6 years with interest rates of 10% per annum compounded
annually.

We first need to determine the yearly payment amount. The following PV Ordinary Annuity
is applied since the yearly payment is of equal amount and paid at the end of each year.

PVO

Pmt
1
Pmt
1
, 6000
1
1

n
i (1 i)
0.10 (1.10) 6

Pmt
1
Pmt

1
, 6000
1 - 0.564474 , 6000 Pmt 0.435526 ,

0.10 1.771561
0.10
0.10
600
Pmt
$1377.64
0.435526
6000

Loan Amortization Schedule

Year

0
1
2
3
4
5
6

(a)
Payment

(b)
Interest
=10% x Loan Balance

(c)
Principle
c=ab

1377.64
1377.64
1377.64
1377.64
1377.64
1377.64

600
522.24
436.70
342.60
239.10
125.24

777.64
855.40
940.94
1035.04
1138.54
1252.40

(d)
Loan Balance =
previous loan balance c
$6000
5222.36
4366.96
3426.02
2390.98
1252.44
0

10

3.8

Missing Cash Flows

In this section we are interested to determine the value(s) of missing cash flow(s).
Example:
Year 1
Year 2
Year 3
Year 4

???
$200
$100
$500

The present value for all cash flows above is $1000. Determine the missing cash flow in Year
1 given interest rates = 10% per annum.
1000 [100/(1.102) + 100/(1.103) + 500/(1.104)]
= 1000 [165.29 + 75.131 + 341.507] = 418.07
FV = PV (1+i)n = 418.07 (1.10) = $459.88 (cash flow for year 1)
Example:
Year 1
Year 2
Year 3
Year 4

???
???
$100
$500

The present value for all cash flows above is $1000. Determine the missing cash flows in
Year 1 and Year 2 (of equal amounts) given interest rates = 10% per annum.
1000 [100/(1.103) + 500/(1.104)]
= 1000 [75.131 + 341.507] = 583.362
PVO

Pmt
1
1

i (1 i) n

583.362

Pmt
1
1

0.10 (1.10) 2

583.362

Pmt
0.174
0.10

= 583.362 x 0.10 = 0.174 Pmt

= 58.336 = 0.174 Pmt
Pmt = 58.336/0.174 = $335.266 (cash flows of equal amounts in Year 1 and Year 2)
11

Example:
Year 1
Year 2
Year 3
Year 4

$100
???
???
$500

The present value for all the cash flows above is $1000. Determine the missing cash flows
(Year 1 and Year 2 of equal amounts) flows given interest rates = 10% per annum.
1000 [100/(1.10) + 500/(1.104)]
= 1000 [90.909 + 341.507] = 567.584
567.584 x 1.10 = 624.342

624.342

Pmt
1
1

0.10 (1.10) 2

624.342

Pmt
0.174
0.10

= 624.342 x 0.10 = 0.174 Pmt

= 62.434 = 0.174 Pmt
Pmt = 62.434/0.174 = $358.816 (cash flows of equal amounts for Year 2 and Year 3)

3.9

Summary

This chapter discusses the methods of computation for TVM, the function of interest rates in
TVM, the discounting and compounding factor in the TVM computation and missing cash
flows.

12

Sample Questions

1.

Your child will be ready to go to college in 10 years, so you calculate that you will need
$20,000 to cover the educational expenses. If you start an installment plan at 4.5%
annual interest, how much should you deposit at the end of each month in order to
achieve your goal?
a
b
c
d
e

2.

Determine FV of the following cash flows; Year 0=$0, Year 1= $10, Year 2=$20, Year
3=30, Year 4=$50. Interest rate is at 5%.
a
b
c
d
e

3.

$115.12
$125.12
$135.12
$145.12
$94.71

You earned 6% per year on your savings deposit. Assuming inflation is 3% per year,
determine your real rate of return on your savings.
a
b
c
d

4.

$102.28
$112.28
122.28
$132.28
$142.28

2.91%
2.95%
2.98%
3.00%

The present value of the following stream of cash flows (including the missing one) is
$1,200. Find the missing cash flow (Year 4) if the opportunity cost is 10%.
Year 0=$0, Year 1 = $100, Year 2 = $500, Year 3 = $200, Year 4 =? Year 5 = $300
a
b
c
d
e

$524.09
$525.09
$526.09
$528.09
$529.09

13

5.

The present value of the following stream of cash flows (including the missing one) is
$1,500. Find the missing cash flows (Year 3 & Year 4) if the opportunity cost is 10%.
Year 0=$0, Year 1 = $400, Year 2 = $300, Year 3 = ?, Year 4 = ?, Year 5 = $600
a
b
c
d
e

6.

Assume that you will receive $2,000 a year in Years 1 through 5, $3,000 a year in
Years 6 through 8, and $4,000 in Year 9, with all cash flows to be received at the end of
the year. If you require a 14 percent rate of return, what is the present value of these
cash flows?
a
b
c
d
e

7.

RM11.37m
RM12.09m
RM12.58m
RM16.74m

Currently you are paying your monthly insurance premium at the end of each month.
Recently, the insurance operator notifies you to pay the same premium at the beginning
of the month. As a result of this, the present value of your insurance premium will
_____ and the future value will ______.
a
b
c
d

9.

$9,851
$13,250
$11,714
$15,129
$17,353

RBH plans to invest in an office building offering a payment of RM3 million at the end
of each year for the next 10 years, except for year 5 in which no payment will be made.
The required annual rate of return for the company is 20 percent on such an investment.
The present value of the investment will be closest to:
a
b
c
d

8.

$355.66
$356.66
$357.66
$358.66
$359.66

increase, decrease
decrease, increase
increase, increase
decrease, decrease

An investment pays RM350 at the end of every year over the next 5 years. However,
the interest is compounded monthly, at a nominal rate of 5%. Calculate the value of the
investment after 5 years.
a
b
c
d

RM1,837.50
RM1,938.46
RM1,933.97
RM2,040.18
14

10. An insurance company in its promotion promises to pay RM500,000 at maturity for
policy which requires one lump sum premium of RM99,000 today. If the term of the
policy is 25 years, what is the annual rate of return for this policy?
a
b
c
d
11.

4.9%
5.3%
6.7%
7.2%

Given the following cash flows, determine the missing one. The present value of all the
cash flows is $2,000. Discount rates (interest rates) = 10 percent per annum.
Year 1 = $400, Year 2 = $500, Year 3 = ???, Year 4 = $100
a
b
c
d

12.

$1487.69
$1507.39
$1537.09
$1577.29

Given the following cash flows, determine the missing one (same amount). The present
value of all the cash flows is $2,000. Discount rates (interest rates) = 10 percent per
annum.
Year 1 = $500, Year 2 = ???, Year 3 = ???, Year 4 = $ 1000
a
b
c
d

13.

The value of $5 today after 5 years if inflation equals 5% per year is

a
b
c
d

14.

$500.25
$520.23
$545.22
$575.68

$3.87
$3.96
$5.60
$5.80

You owned plots of padi field in your village, Sungai Buloh. Your padi plots are
affected by a highway project and the government will pay you compensation
following the land acquisition meant for the highway project. If the government offers
compensation based on the following cash flows and year of payment, and you need to
decide today, which of the following offers is of your choice based on time value of
money. The savings rate is 4% per year.

15

Offer
Offer No. 1
Offer No. 2
Offer No. 3
Offer No. 4
a
b
c
d

15.

Year 0
RM100,000
RM90,000
RM80,000
RM60,000

Year 1

Year 2

Year 3

RM15,000
RM10,000
RM30,000

RM18,000
RM10,000

RM9,000

Offer No. 1
Offer No. 2
Offer No. 3
Offer No. 4

You plan to buy a house this year. You are looking for a terrace house with the price
ranging between $120,000 and $150,000. After making some search, you came across
an advertisement on property to be sold at a price of $120,000. Upon confirming with
the seller, you are now arranging a financing to purchase the property. There are three
banks offering financing to you as follows:
Loan Term

Bank A

Bank B

Bank C

Loan Amount
APR (%)
Loan Duration

$120,000
5.86
20 years

$120,000
6.15
18 years

$120,000
5.64
16 years

Determine your monthly payment to the bank based on the above information.

16.

You are now planning to buy a refrigerator on credit. You have gone for window
shopping and came across the following credit terms by three supermarkets.
Credit Details

Supermarket A

Supermarket B

Supermarket C

Sales Price
APR (%) Monthly
Payment Period

$1,500
1.60% per month
1 year

$1,580
1.50% per month
1 year

$1,620
1.40% per month
1 Year

(i)
(ii)

Show your calculation on the monthly installments of the credit purchase

offered by each of the supermarket.
Which supermarket would you choose if your credit purchase were based on
the lowest installments paid?

16

17.

Given the following, determine the missing cash flows assuming discount rates
(interest rates) equal 10%

18.

PV = $1,000
CF1 = $100

CF2 = $200

CF3 = $200

CF4 = $?

CF5 = $100

PV = $1,000
CF1 = $200

CF2 = $100

CF3 = $?

CF4 = $?

CF5 = $200

PV = $1,000
CF1 = $200

CF2 = $?

CF3 = $?

CF4 = $?

CF5 = $300

Given the following options, which cash flows would offer you the highest value?
$100 to be received today
$120 to be received 2 years from today, interest rates = 8%
$150 to be received 4 years from today, interest rates = 7%
$130 to be received in year 1 and $30 to be received in year 2, interest rates = 8%

19.

Determine the Effective Annual Rate (EAR) of 6% per year with monthly
compounding and 6% per year with quarterly compounding.
a
b
c
d

6.2004%; 6.1824%
6.1678%; 6.1364%
6.1455%; 6.1341%
6.1522%; 6.1500%

17

20.

Puan Maryamah aged 40, is currently working as an executive with an international

bank, Bank Americana. She contributes to Employees Provident Fund (EPF) and plans
to retire when she reaches 55 that is 15 years from now. Based on terms of contract
employment, her employer is to reward her RM100,000 if she manages to work with
the bank until she reaches age 55. In addition to that, based on her computation, she
estimates that her accumulated EPF savings will reach RM250,000 upon her reaching
age 55. After retirement, her plan is to settle down in her village. This is due to the
closeness of village environment to her heart as opposed to the citys hectic life. She
herself was originated from village and grew in a village environment surrounded with
padi fields and canals. She has a very strong interest in a bird species named burung
ayam-ayam that is abundance in the padi fields in her village. She owns assets
comprising of few plots of padi field and a house inherited from her family. The house
is located in the middle of the padi field and she is of the opinion that it is very suitable
for a chalet homestay. She strongly believes that her homestay will attract strong
demand especially from those who stay in the cities and want to experience home stay
in a middle of a padi field. She plans to rent the plots of padi field that she owns for
growing padi and to renovate the inherited house into a homestay chalet after her
retirement. She estimates that her padi plots and homestay chalet could generate rental
income of RM1,500 per month by the time she retires.
Based on the above information (use 4 decimals):
a

If her monthly expenses after retirement is estimated to be RM2,700 per month,

assuming her life expectancy is 15 years after retirement, is it possible for her to
meet the monthly expenses amount based on the total savings available at
retirement. Interest rate is at 4% per year. Suggest to Puan Maryamah the possible
solution if her total retirement savings is not sufficient to meet the monthly
expenses. Show your computation.

Determine the present value of her EPF savings that will become RM250,000
next 15 years. Interest rate is at 4% per year.

18