TVM & Compounding

Time Value of Money
Let’s say that you are given a choice to receive $100 today or
$100 one year from now. Which choice will you prefer? The more
likely answer is that you will want to receive $100 today. You
could purchase something with that $100 today or you could
deposit it in a savings account. If you deposit it in a savings
account or any other form of investment, what you will get after
one year is likely to be more than the $100 that you started with.
This means that money is more valuable today than it is tomorrow
or after one year.
KEY POINTS
 The time value of money means that a sum of money is
worth more now than the same sum of money in the future.
 The principle of the time value of money means that it can
grow only through investing so a delayed investment is a
lost opportunity.
 The formula for computing the time value of money
considers the amount of money, its future value, the amount
it can earn, and the time frame.
 For savings accounts, the number of compounding periods
is an important determinant as well.
Inflation has a negative impact on the time value of money

because your purchasing power decreases as prices rise.
 PV = Present value of money
 FV = Future value of money
 i = Rate of interest or current yield on similar investment
 t = No. of years
 n = No. of compounding periods of interest each year
Example
A relative has offered to give you $8,000 and asks if you would rather
receive the money today or wait two years. To ensure that getting the
$8,000 today is worth more than if you waited, you can calculate its
future value. If you decide to take the $8,000 and invest in an account
at an annual rate of 6%, you would use the following calculation to
discover its worth in two years:
PV = $8,000
i = 6% or 0.06
n = 1, since the interest rate is applied once a year
t=2
The result would look like this:

FV = $8,000 x \[1 + (6%/1)\] ^ (1 x 2)
FV = $8,000 x (1 + 0.06) ^ 2
FV = $8,988.80
In two years, your $8,000 investment will be worth $8,988.80. You can
see that it is more valuable to take the $8,000 today rather than wait
two years to receive $8,000 because it gives you $988.80 more.
TIME VALUE OF MONEY IN CASE ON ANNUITY

An annuity is a series of equal cash flows.
 The future value of an annuity is a way of calculating how much

money a series of payments will be worth at a certain point in the
future.
 By contrast, the present value of an annuity measures how much
money will be required to produce a series of future payments.
 In an ordinary annuity, payments are made at the end of each
agreed-upon period. In an annuity due, payments are made at the
beginning of each period.
 To calculate the future value of an annuity, you must know the
annuity payment amount, number of periods, and projected rate of
return.
 Because annuity due payments often entail having an additional
compounding period, the future value of an annuity due will usually
be higher than the future value of an annuity.
 P = Value of each payment
 r = Rate of interest per period
 n = Number of periods
Example 1: Dan was getting $100 for 5 years every year at an interest rate of 5%. Find the future value
of this annuity at the end of 5 years? Calculate it by using the annuity formula.
Solution
The future value
Given: r = 0.05, 5 years = 5 yearly payments, so n = 5, and P = $100
FV = P×((1+r)n−1) / r
FV = $100 × ((1+0.05)5−1) / 0.05
FV = 100 × 55.256
FV = $552.56
Therefore, the future value of annuity after the end of 5 years is $552.56.
Example2: If the present value of the annuity is $20,000. Assuming a monthly interest rate of 0.5%,
find the value of each payment after every month for 10 years. Calculate it by using the annuity
formula.
Solution:
Given:
r = 0.5% = 0.005
n = 10 years x 12 months = 120, and PV = $20,000
Using formula for present value
PV = P×(1−(1+r)-n) / r
Or, P = PV × ( r / (1−(1+r)−n))
P = $20,000 × (0.005 / (1−(1.005)−120))
P = $20,000 × (0.005/ (1−0.54963))
P = $20,000 × 0.011...
P = $220
Therefore, the value of each payment is $220.

COMPOUNDING
Compounding is the process whereby interest is credited to an existing
principal amount as well as to interest already paid.
Compounding thus can be construed as interest on interest—the effect of

which is to magnify returns to interest over time, the so-called “miracle of
compounding.”
KEY POINTS
 Compounding allows interest on the overall amount, i.e., the principal

sum and the accumulated interest.
 The amount increases exponentially because the interest is not
withdrawn; it is reinvested to generate additional returns.
 The compound interest provides a higher return than simple interest.
The simple interest yields interest only on the principal sum
Formula for Compound Interest

Increased Compounding Periods
The effects of compounding strengthen as the frequency of compounding

increases. Assume a one-year time period. The more compounding periods
throughout this one year, the higher the future value of the investment, so
naturally, two compounding periods per year are better than one, and four
compounding periods per year are better than two.
To illustrate this effect, consider the following example given the above
formula. Assume that an investment of $1 million earns 20% per year. The
resulting future value, based on a varying number of compounding periods,
is:
 Annual compounding (m = 1): FV = $1,000,000 × [1 + (20%/1)] (1 x

1)
= $1,200,000
 Semi-annual compounding (m = 2): FV = $1,000,000 × [1 +
(20%/2)] (2 x 1) = $1,210,000
 Quarterly compounding (m = 4): FV = $1,000,000 × [1 + (20%/4)] (4 x
1)
= $1,215,506
 Monthly compounding (m = 12): FV = $1,000,000 × [1 + (20%/12)] (12
x 1)
= $1,219,391
 Weekly compounding (m = 52): FV = $1,000,000 × [1 + (20%/52)] (52 x
1)
= $1,220,934
 Daily compounding (m = 365): FV = $1,000,000 × [1 + (20%/365)] (365
x 1)
= $1,221,336
As evident, the future value increases by a smaller margin even as the

number of compounding periods per year increases significantly.
PRACTISE QUESTIONS
Q1. Jasmine deposits $520 into a savings account that has a
3.5% interest rate compounded monthly. What will be the
balance of Jasmine’s savings account after two years?
Q2. Calculate the interest rate for an account that started with
$5,000 and now has $13,000 and has been compounded
annually for the past 12 years.
Q3. Kristen wants to have $2,000,000 for retirement in 45
years. She invests in a mutual fund and pays 8.5% each year,
compounded quarterly. How much should she deposit into the
mutual fund initially.
ANSWERS..
1. 557.65
2. 8.288%
3. $45,421.08

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Time Value of Money

Inflation has a negative impact on the time value of money

n = 1, since the interest rate is applied once a year

The result would look like this:

TIME VALUE OF MONEY IN CASE ON ANNUITY

 The future value of an annuity is a way of calculating how much

The future value

Given: r = 0.05, 5 years = 5 yearly payments, so n = 5, and P = $100

FV = $100 × ((1+0.05)5−1) / 0.05

n = 10 years x 12 months = 120, and PV = $20,000

Using formula for present value

P = $20,000 × (0.005 / (1−(1.005)−120))

P = $20,000 × (0.005/ (1−0.54963))

Therefore, the value of each payment is $220.

Compounding thus can be construed as interest on interest—the effect of

 Compounding allows interest on the overall amount, i.e., the principal

Formula for Compound Interest

The effects of compounding strengthen as the frequency of compounding

 Annual compounding (m = 1): FV = $1,000,000 × [1 + (20%/1)] (1 x

As evident, the future value increases by a smaller margin even as the

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