From the Desk of Dr.

Imran Omer
THE MECHANICS OF VALUATION
Time Value of Money
Introduction

Time Value of Money (TVM) is an important concept in financial management. It can be used to compare
investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities.

TVM is based on the concept that a dollar that you have today is worth more than the promise or expectation
that you will receive a dollar in the future.

Interest
Interest is the cost of borrowing money. An interest rate is the cost stated as a percent of the amount
borrowed per period of time, usually one year.

 Simple Interest
Simple interest is calculated on the original principal only. Accumulated interest from prior periods is not
used in calculations for the following periods.

Simple Interest = p * i * n

where:
p = Principal (original amount borrowed or loaned)
i = Interest rate for one period
n = Number of periods

Example 1: You borrow $10,000 for 3 years at 5% simple annual interest.

Interest = p * i * n = 10,000 * .05 * 3 = 1,500

Example 2: You borrow $10,000 for 60 days at 5% simple interest per year (assume a 365 day year).

Interest = p * i * n = 10,000 * .05 * (60/365) = 82.1917

 Compound Interest

Compound interest is calculated each period on the original principal and all interest accumulated during
past periods. Although the interest may be stated as a yearly rate, the compounding periods can be yearly,
semi-annually, quarterly etc.

For Annually:
Compound Interest = P (1 + i)n

For Compounding Periods (Semi-annually, Quarterly etc.):

Compound Interest = P (1 + i/m)nm

where:
p = Principal (original amount borrowed or loaned)

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 From the Desk of Dr. Imran Omer
i = Interest rate for one period
n = Number of periods
m = No. Of Compounding periods in a year

Future Value of a Single Amount

Future Value is the amount of money that an investment made today (the present value) will grow to by
some future date. Since money has time value, we naturally expect the future value to be greater than
the present value. The difference between the two depends on the number of compounding periods involved
and the going interest rate.
The relationship between the future value and present value can be expressed as:

FV = PV (1 + i)n
Where:
FV = Future Value
PV = Present Value
i = Interest Rate Per Period
n = Number of Periods
Example: You can afford to put $10,000 in a savings account today that pays 6% interest compounded
annually. How much will you have 5 years from now if you make no withdrawals?

PV = 10,000
i = 0.06
n=5

FV = 10,000 (1 + .06)5
FV = 10,000 (1.3382255776)
FV = 13,382.26

Example 2: Another financial institution offers to pay 6% compounded semi-annually. How much will your
$10,000 grow to in five years at this rate?

Interest is compounded twice per year so you must divide the annual interest rate by two to obtain a rate
per period of 3%. Since there are two compounding periods per year, you must multiply the number of
years by two to obtain the total number of periods.

PV = 10,000
i = i/m = 0.06 / 2 = 0.03
n = n*m = 5 * 2 = 10

FV = 10,000 (1 + .03)10
FV = 10,000 (1.343916379)
FV = 13,439.16

Present Value of a Single Amount

Present Value is an amount today that is equivalent to a future payment, or series of payments, that has been
discounted by an appropriate interest rate. The relationship between the present value and future value can
be expressed as:
PV = FV (1 + i)-n
Where:
PV = Present Value

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 From the Desk of Dr. Imran Omer
FV = Future Value
i = Interest Rate Per Period
n = Number of Periods

Example: You want to buy a house 5 years from now for $150,000. Assuming a 6% interest rate
compounded annually, how much should you invest today to yield $150,000 in 5 years?

FV = 150,000
i =.06
n=5

PV = 150,000 (1 + .06)-5
PV = 150,000 (1.3382255776)
PV = 112,088.73

Example 2: You find another financial institution that offers an interest rate of 6% compounded semi-
annually. How much less can you deposit today to yield $150,000 in five years?

Interest is compounded twice per year so you must divide the annual interest rate by two to obtain a rate
per period of 3%. Since there are two compounding periods per year, you must multiply the number of
years by two to obtain the total number of periods.

FV = 150,000
i = i/m = 0.06 / 2 = 0.03
n = n*m = 5 * 2 = 10

PV = 150,000 (1 + .03)-10
PV = 150,000 (0.744093914)
PV = 111,614.09

Annuity
An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental
payments are examples. The payments or receipts occur at the end of each period is called ordinary
annuity while they occur at the beginning of each period is an annuity due.

Future Value of Annuities

 Future Value of an Ordinary Annuity

The Future Value of an Ordinary Annuity (FVoa) is the value that a stream of expected or promised
future payments will grow to after a given number of periods at a specific compounded interest.

FVoa = I (1 + i)n – 1
i
Where:
FVoa = Future Value of an Ordinary Annuity
I = Investment/Annuity amount
i = Interest Rate Per Period
n = Number of Periods

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 From the Desk of Dr. Imran Omer
Example: What amount will accumulate if we deposit $5,000 at the end of each year for the next 5 years?
Assume an interest of 6% compounded annually.

I = 5,000
i = 0.06
n=5

FVoa = 5,000 [(1.3382255778 - 1) /.06]

FVoa = 5,000 (5.637092)
FVoa = 28,185.46

 Future Value of an Annuity Due (FVad)

The Future Value of an Annuity Due is identical to an ordinary annuity except that each payment occurs at
the beginning of a period rather than at the end. Since each payment occurs one period earlier, we can
calculate the present value of an ordinary annuity and then multiply the result by (1 + i).

FVad = I (1 + i)n – 1 (1+i)

i

Example: What amount will accumulate if we deposit $5,000 at the beginning of each year for the next 5
years? Assume an interest of 6% compounded annually.

I = 5,000
i = 0.06
n=5

FVoa = 5,000 [(1.3382255778 - 1) /.06] (1.06)

FVoa = 5,000 (5.637092) (1.06)
FVoa = 29,876.59

Present Value of Annuities

 Present Value of an Ordinary Annuity

The Present Value of an Ordinary Annuity (PVoa) is the value of a stream of expected or promised future
payments that have been discounted to a single equivalent value today. It is extremely useful for comparing
two separate cash flows that differ in some way.

PVoa = I 1- (1 + i)-n
i
Where:
PVoa = Present Value of an Ordinary Annuity
I = Investment/Annuity amount
i = Discount Rate Per Period
n = Number of Periods

Example 1: What amount must you invest today at 6% compounded annually so that you can withdraw
$5,000 at the end of each year for the next 5 years?

FV = 5,000
i = .06
n=5
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 From the Desk of Dr. Imran Omer
PVoa = 5,000 [(1 - (1 + .06)-5) / .06]
PVoa = 5,000 (4.212364)
PVoa = 21,061.82

 Present Value of an Annuity Due (PVad)

The Present Value of an Annuity Due is identical to an ordinary annuity except that each payment occurs
at the beginning of a period rather than at the end. Since each payment occurs one period earlier, we can
calculate the present value of an ordinary annuity and then multiply the result by (1 + i).

PVad = I 1- (1 + i)-n (1+i)

i

Example: What amount must you invest today a 6% interest rate compounded annually so that you can
withdraw $5,000 at the beginning of each year for the next 5 years?

FV = 5,000
i = .06
n=5

PVad = 5,000 [(1 - (1 + .06)-5) / .06] (1.06)

PVad = 5,000 (4.212364) (1.06)
PVad = 22,325.53

Effective Rate (Effective Yield)

The effective rate is the actual rate that you earn on an investment or pay on a loan after the effects of
compounding frequency are considered.

Effective Rate = (1 + i / m)m - 1

Where:
i = Nominal or stated interest rate
m = Number of compounding periods per year

Example: What effective rate will a stated annual rate of 6% yield when compounded semi-annually?

Effective Rate = (1 + .06 / 2)2 - 1

Effective Rate = 0.0609
Effective Rate = 6.09%

Present Value of a Perpetuity

A constant stream of identical cash flows with no end. The formula for determining the present value of
perpetuity is as follows:

Cash Flow
PV Prep =
Rate

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