PART 1:

INTEREST & ECONOMIC

EQUIVALENCE

CHAPTER 4
TIME VALUE OF MONEY

Interest
Interest

can be thought of as "rent of money".

Interest is a fee paid on borrowed assets.
It is the price paid for the use of borrowed
money,[1]
Money earned by deposited funds
Interest is a rental amount charged by financial
institutions for the use of money.
It is expressed on an annual basis.
For the lender, it consists, for convenience, of (1)
risk of loss, (2) administrative expenses, and (3)
profit or pure gain.
For the borrower, it is the cost of using a capital
for immediately meeting his or her needs.

Interest Rate

The percentage of money being borrowed that

is paid to the lender on some time basis
Interest Rate is a measure of the interest for given
loan during the loan period and usually denoted
by i and expressed in percentage (%)

Time Value Of Money

The

time-value of money is the relationship between

interest and time. i.e.

Figure 1 : Time-Value of Money

Money

has time-value because the purchasing

power of a ringgit changes with time.

RM
+
Interest

RM

0
Now

3
years

Figure 1

n-1

Power Of Money
Earning

Power Of Money

The earning power of money represents funds borrowed

for the prospect of gain.
Often these funds will be exchanges for goods, services,
or production tools, which in turn can be employed to
generate and economic gain.

Purchasing

Power Of Money

The prices of goods and services can go upward or

downward, and therefore, the purchasing power of
money can change with time.
Price Reductions : Caused by increases in productivity
and availability of goods.
Price Increases : Caused by government policies, price
support schemes, and deficit financing.

Cash Flow Diagrams

Cash flow diagrams are a means of visualizing

(and simplifying) the flow of receipts and
disbursements
The diagram convention is as follows:

Horizontal Axis : The horizontal axis is marked off in equal

increments, one per period, up to the duration of the
project.
Revenues : Revenues (or receipts) are represented by
upward pointing arrows.
Disbursements : Disbursements (or payments) are
represented by downward pointing arrows.
Net Cash Flow : The arithmetic sum of receipts (+) and
disbursements (-) that occur at the same point in time.

Cash Flow Diagrams

All

disbursements and receipts (i.e. cash flows) are

assumed to take place at the end of the year in
which they occur. This is known as the "end-of-year"
convention.

Arrow

lengths are approximately proportional to the

magnitude of the cash flow.

Expenses

incurred before time = 0 are sunk costs,

and are not relevant to the problem.

Since

there are two parties to every transaction, it is

important to not that cash flow directions in cash
flow diagrams depend upon the point of view
taken.

Symbols

= The interest rate per interest period.

= The total number of interest periods.

P
= a sum of money at a time chosen for purposes of analysis
as time zero, sometimes referred to as the present value or
present worth.

F
= A future sum of money at the end of the analysis period.
This sum may be specified as Fn.

A
= An end of period payment or receipt in a uniform series
that continues for N periods. This is a special situation where
A1 = A2 = = AN.

Cash Flow Diagrams

RM 1120

RM 1000

RM 120 RM 120 RM 120 RM 120

0

5
0

RM 120 RM 120 RM 120 RM 120

Lender point of view

Borrower point of view

RM 1120

RM 1000

Example 1: Figure 2 shows cash flow diagrams for a transaction spanning

five years. The transaction begins with a RM1000.00 loan. For years two,
three and four, the borrower pays the lender RM120.00 interest. At year five,
the borrower pays the lender $120.00 interest plus the RM1000.00 principal.

Methods of Calculating Interest

Simple Interest : the practice of

charging an interest rate only to
an initial sum (principal amount).
I = Pni.
P = Principal
i = Interest rate
n = Number of years (or periods)
I = Interest
Example 2 : Suppose that RM
1000 is borrowed at a simple
interest rate of 8% per annum.

Principle + Interest at end of

Year 1 = 1000 * 0.08 * 1 = RM 80
Year 2 = 1000 * 0.08 * 2 = RM 160

Year

Amount at
start of
year (RM)

Interest
at end of
year
(RM)

Principle
+
Interest

1,000

80

1,080

80

1160

80

1240

Methods of Calculating Interest

Compound Interest: the practice of charging an interest rate to an

initial sum and to any previously accumulated interest that has not
been withdrawn

Example 3

Year

P = RM1,000 i = 8% n = 3
years
Amount at start of
Interest at end
year (RM)
of year (RM)

Ending
Balance

1,000

80

1,080

1,080

86.40

1,166.40

1,166.40

93.31

1,259.71

Economic equivalence

EE exists between cash flows that have the same economic

effect and could therefore be traded for one another.
EE refers to the fact that a cash flow-whether a single
payment or a series of payments-can be converted to an
equivalent cash flow at any point in time.
Even though the amounts and timing of the cash flows may
differ, the appropriate interest rate makes them equal

RM1000

i = 8%

RM 1,259.71

Economic equivalence

Example 4: A loan of $1,000 is made at an interest of 12% for 5

years. The interest is due at the end of each year with the
principal is due at the end of the fifth year. The following table
shows the resulting payment schedule:

Principal
Year

P = $1000.00 Interest Rate i = 0.12. Number of years (or periods) n = 5.

Amount at start of Interest at end of
year
year

Owed amount
at end of year

Payment

1000

120

1120

120

1000

120

1120

120

1000

120

1120

120

1000

120

1120

120

1000

120

1120

1120

Economic equivalence
Example

5: A loan of $1,000 is made at an interest of

12% for 5 years. The principal and interest are due at
the end of the fifth year. The following table shows the
resulting payment schedule:
Year

Amount at start of
year

Interest at end of
year

Owed amount
at end of year

1000

120

1200

1000

134.40

1254.40

1000

150.53

1404.93

1000

168.59

1573.52

1000

188.82

1762.34

1762.34

Payment

Nominal And Effective Interest Rates

Nominal Interest Rate

Interest rate quoted based on an annual period
without adjustment for the full effect of compounding
Cannot be used for calculating the interest
An interest rate is called nominal if the frequency of compounding
(e.g. a month) is not identical to the basic time unit (normally a year).
Example, :
12% per year compounded monthly
What It Really Means?
Interest rate per month (i) = 12%/12 = 1% (One percent per month)
Number of interest periods per year (N) = 12
In words, bank will charge 1% interest each month on your unpaid
balance, if you borrowed money.
You will earn 1% interest each month on your remaining balance, if
you deposited mone

Nominal And Effective Interest Rates

Effective interest rate, ie

Actual interest earned or paid in a year or some other time period

with adjustment for the full effect of compounding
Application: to compare the annual interest between loans with
different compounding terms
Example :
12% per year compounded monthly
Effective interest rate per month = 1%
Effective interest rate per year = ?????

The effective rate is calculated in the following way

ie = ( 1 + r / M )M 1 ,
Where
ie = Effective interest rate,
r = Nominal interest rate
M = number of compounding periods (eg.how many months)
For example, :
12% per year compounded monthly
Effective interest rate per year = ieyear = ( 1 + r / M )M 1=

(1+[(12%/100)/12])12 -1 = 0.126%

For example, :
12% per year compounded monthly
Effective interest rate per year = ieyear = ( 1 + r /
M )M 1= (1+[(12%/100)/12])12 -1 = 0.126%

Another example (based on the above) :

Interest 1% per month, with the saving of 1k, so after
1 year, you will get 1,130 in total.
** Original Saving + Interest = 1,000 + 13 % = 1,130

NOMINAL AND EFFECTIVE INTEREST RATES

Effective Annual Rate Based on Frequency of Compounding
Nominal
Rate

SemiAnnual

Quarterly

Monthly

Daily

Continuous

1%

1.00%

1.00%

1.01%

1.01%

1.01%

5%

5.06%

5.10%

5.12%

5.13%

5.13%

10%

10.25%

10.38%

10.47%

10.52%

10.52%

15%

15.56%

15.87%

16.08%

16.18%

16.18%

20%

21.00%

21.55%

21.94%

22.13%

22.14%

30%

32.25%

33.55%

34.49%

34.97%

34.99%

40%

44.00%

46.41%

48.21%

49.15%

49.18%

50%

56.25%

60.18%

63.21%

64.82%

64.87%