BBC406 Fundamentals of

Finance
Week 4 Time Value of Money 2

Learning Objectives
At the end of this chapter, you should be
able to:
Discuss the role of time value in finance and the
use of various calculation techniques
Understand the concept of future value and
present value and the components involved in
the calculations
Understand ordinary annuity and an annuity
due, in both present value and future value
calculations, as well as the concept of perpetuity

Learning Objectives (cont.)

Understand the calculation of
effective annual rate (EAR), annual
percentage rate (APR) and annual
percentage yield (APY)
Calculate other components in time
value of money such as periods,
interest rate and loan amortization

Nominal and Effective

Annual Rate
The nominal (stated) annual rate is the
contractual annual rate of interest charged by
a lender or promised by a borrower.
The effective (true) annual rate (EAR) is the
annual rate of interest actually paid or earned.
In general, the effective rate > nominal rate
whenever compounding occurs more than once
per year

Effective annual rate

The effective annual rate or simply effective
rate may also be defined as the interest rate
on a loan or financial product restated from the
nominal interest rate as an interest rate with
annual compound interest payable in arrears.
In other words, it is the equivalent annual rate
after adjusting for the frequency of
compounding that occurs within a year. It is
used to compare the annual interest between
loans with different compounding terms (daily,
monthly, annually, etc)

Example
Jay wishes to find the effective annual rate
associated with an 8% nominal annual rate (r =
0.08) when interest is compounded (1)
annually (m = 1); (2) semiannually (m = 2);
and (3) quarterly (m = 4).

Revision Future Value of

an Annuity
Jack has been faithfully depositing RM2,000 at
the end of each year since the past 10 years
into an account that pays 8% per year. How
much money will she have accumulated in the
account?

Revision Present Value of

an Annuity
Amin wants to make sure that he has saved up
enough money prior to the year in which his
daughter begins college. Based on current
estimates, he figures that college expenses will
amount to RM40,000 per year for 4 years
(ignoring any inflation or tuition increases
during the 4 years of college). How much
money will John need to have accumulated in
an account that earns 7% per year, just prior to
the year that his daughter starts college?

Ordinary Vs Due
Lets say that you are saving up for retirement
and decide to deposit RM3,000 each year for
the next 20 years into an account which pays a
rate of interest of 8% per year. By how much
will your accumulated nest egg vary if you
make each of the 20 deposits at the beginning
of the year, starting right away, rather than at
the end of each of the next twenty years?

Multiple Payment Streams

With unequal periodic cash flows, treat each of
the cash flows as a lump sum and calculate its
future value over the relevant number of
periods.
Sum up the individual future values to get the
future value of the multiple payment streams.

Future Value Uneven

Cash Flow
Jamal deposits RM3,000 today into an account
that pays 10% per year, and follows it up with
3 more deposits at the end of each of the next
three years. Each subsequent deposit is $2,000
higher than the previous one. How much
money will Jim have accumulated in his
account by the end of three years?

Present Value Uneven

Cash Flow
Jamilah has just purchased some equipment for
her beauty salon. She plans to pay the
following amounts at the end of the next five
years: RM8,250, RM8,500, RM8,750, RM9,000,
and RM10,500. If she uses a discount rate of 10
percent, what is the cost of the equipment that
she purchased today?

Loan Payment Methods

Discount vs Interest only vs Amortised loans
Rose wants to borrow $40,000 for a period of 5 years.
The lenders offers her a choice of three payment
structures:
Pay all of the interest (10% per year) and principal in one
lump sum at the end of 5 years;
Pay interest at the rate of 10% per year for 4 years and then
a final payment of interest and principal at the end of the
5th year;
Pay 5 equal payments at the end of each year inclusive of
interest and part of the principal.

Under which of the three options will Rose pay the least
interest and why? Calculate the total amount of the
payments and the amount of interest paid under each
alternative.

Method 1

Method 2

Method 3

Loan Payment Methods

Loan

Total Payment

Interest Paid

Discount

64,420.40

24,420.40

Interest only

60,000.00

20,000.00

Amortized

52,759.31

12,759.31

Amortisation Schedules
Tabular listing of the allocation of each loan
payment towards interest and principal
reduction. Helps borrowers and lenders figure
out the payoff balance on an outstanding loan.
Procedure:
Compute the amount of each equal periodic
payment (PMT).
Calculate interest on unpaid balance at the end of
each period, minus it from the PMT, reduce the loan
balance by the remaining amount,
Continue the process for each payment period, until
we get a zero loan balance.

 Prepare a loan amortisation schedule for the

amortized loan option given in Example above.
What is the loan payoff amount at the end of 2
years?

Amortisation Schedules
Year
1
2
3
4
5

Beg. Bal

Payment

Interest

Principal
Reduced

Ending
Balance