TOPIC TWO

𝑻𝒊𝒎𝒆 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑴𝒐𝒏𝒆𝒚 (𝑰)

Contents Page
Relevant Reading and References 9
Lecture Notes 10
Workshop 2 Topic 2 Questions 24
Practice Questions on Topic 2 (incl. solutions) 28

BUS140 Topic 2 - Time Value of Money I 9

 Relevant Reading (See Custom Text)
1. “The Time Value of Money – The Basics,” Chapter 5 in Titman et al. (2019)
Financial Management: Principles and Applications, 8th Edition, Pearson
Australia

Additional References (Mathematics refresher - if required)

2. “Mathematical Preliminaries” Chapter 1 in Bradley, T. (2008) Essential
Mathematics for Economics and Business, 3rd Edition John Wiley & Sons Ltd,
West Sussex, England.

3. “Basic Mathematics” Chapter 1 in Lynch, P., (2012) Perform Financial

Calculations, 3rd Edition, Better Teams Publications, Australia.

The ‘additional references’ are optional. The books are available in the Reserve
section of Murdoch University Library. The relevant chapters are also available
from eReserve.

Lecture Notes: Topic 2 The Time Value of Money (TVM) I

An appreciation of the time value of money (TVM) concept is essential to an understanding of

both personal and business financial management at basic and advanced levels. This topic is
crucial in terms of understanding the concepts and computations that underpin many financial
decisions both personal and business. TVM concepts are particularly important for valuation.

As you work through the topic it is a good idea to solve the problems as they are presented. A
successful approach to learning in this unit is described by the ancient Chinese philosopher Lao
Tse:
You read and you forget;
You see and you remember;
You do and you learn.

While it is always important to understand the concepts and mathematics underlying the
calculations, it is also helpful to streamline the practical application of routine financial
calculations by using a financial calculator. The ability to solve problems with the aid of a
calculator, however, does not necessarily reflect a conceptual understanding of the material –
which is the objective of this unit and the basis for assessment. You are therefore strongly urged
to make sure that you understand the basic underlying concepts before relying on your financial
calculator to streamline computations.1
1
Appendix I provides you with an easy and quick reference guide introducing the BA II Plus TM calculator and some
of the most commonly used financial and statistical functions. Before trying any solutions using the financial
10 BUS140 Topic 2 - Time Value of Money I
Learning Objectives

After studying topic 2 you should be able to:

• explain the time value of money concept,
• explain the distinction between simple and compound interest rates,
• explain the distinction between nominal and effective interest rates,
• compare interest rates quoted over time (for example calculating the effective annual rate
when a monthly interest rate is given),
• calculate present values and future values, and know how to distinguish between a present
value (PV) versus a future value (FV) problem, and
• use your financial calculator to solve Time Value of Money problems.

functions on your calculator you will find it useful to read the section on ‘Getting Started’ in Appendix I. This
will help you initialise the settings on your BA II Plus TM calculator and the material is also covered in your week
1 workshop. Additional notes regarding your BA II Plus TM calculator use are identified using the icon displayed
in the right hand margin of your lecture notes where appropriate.
BUS140 Topic 2 - Time Value of Money I 11
The Time Value of Money

A dollar in the hand today is worth more than a dollar to be received in the future because if you
had it now you could invest that dollar and earn interest. All valuation techniques, such as
debenture and share pricing and capital budgeting, rely on this time value of money concept.

Cash flows occurring in different time periods, and therefore investments, are not directly
comparable unless adjusted for time value by converting all the cash flows to values at the same
point in time. This is usually the present time or a common future date. To do this adjustment
for time value we use the basic tools of financial mathematics presented in this topic.

There are four variables in basic time value of money equations. In most problems, three of the
four variables are known and you are required to solve for the value of the fourth variable. 2 The
four variables are:
• present value (PV),
• future value (FV),
• the interest rate, and
• number of time periods.

Simple Interest

Interest is the cost of using money for a certain period of time.

Simple interest is paid on the principal amount only.
The principal (PV) is the original amount borrowed or invested.3
The rate of interest (r) is the percentage of the principal that is charged for its use for one
period of time.
For each time period the simple interest is the same, and equal to PV.r.
For ‘t’ time periods the total simple interest is then: (PV.r) t
The future (or accumulated) value at the end of the period is the principal plus interest.
So the future value of a deposit, at the end of “t” periods using simple interest is:

FV = PV + PVrt = PV (1+ rt )

Where FV = Future Value,

PV = Present Value (or Principal sum deposited),
r = simple interest rate per period, and
t = number of periods.

Example 1. $100 invested for 2 years at a simple interest rate of 10% per annum will grow to:

Solution: FV = PV (1+ rt ) =100 (1 + 01

. ( 2)) = $120

2
A further variable (periodic payment) arises when we consider annuities.
3
Note that variable names commonly used in Finance may be more than one letter. For example PV is one variable
and not the product of two variables P and V.
12 BUS140 Topic 2 - Time Value of Money I
Try Topic 2 lecture Example A now.

Example A. Simple Interest (FV)

How much will I have in my bank account at the end of five years if I have $435 invested at a
simple interest rate of 7%?

The concept of present value is the reverse of future value and finding PVs is often referred to as
discounting. Present value is the cash equivalent today of an amount to be paid or received at
some future date. We can rearrange the FV equation to find the amount of principal originally
invested (present value) if FV, r and t are all known:

Example 2. Son Limited promises to pay $5000 in a year’s time. When the market simple
interest rate for a loan is 12% pa how much has the company borrowed?

FV 5000
Solution:4 PV = = = $4,464.29
(1 + rt ) [1 + 012
. (1)]

Try Topic 2 lecture Example B now.

Example B. Simple Interest (PV)

How much do I need to invest now, at a simple interest rate of 5% per annum, in order to repay a
debt of $2000 in two years time?

4
Note that the interest rate should be input as a decimal in all equations.
BUS140 Topic 2 - Time Value of Money I 13
Situations where the simple interest concept is used include short-term commercial notes and
fixed interest bearing deposits with banks. An appreciation of the concept is also helpful for
understanding compound interest.
In practise we assume compound interest is appropriate unless simple interest is indicated.

Compound Interest

Compound interest occurs when interest earned or paid on an investment during the first period
is added to the principal and then, during the second period interest is earned or paid on the new
sum ie previous interest earned plus the original principal.
The future (or compound) value after one period5 is FV1 = PV (1+ i).
Similarly for two periods FV2 = [PV (1 + i)] (1 + i) = PV (1 + i)2

Example 3. $100 deposited at a rate of 10% pa will grow to $100 (1.1) = $110 after 1 year.
The money, including interest earned so far, reinvested for a second year will earn interest and
grow to $110(1.1) = $121 OR Mathematically in one step this is FV2 = $100(1.1)2 = $121.

Generalising, if the interest rate is “i” per period and the money is invested for “n” periods, then
n
the value of the money at time “n” will be given by: 6 FVn = PV (1 + i)

5
The FV subscript is used to indicate the number of periods into the future. For example, the general term FV n
would indicate the future value after n periods.
6
Although some of the variable names used may be different, the equations in your BUS140 Lecture Notes
correspond to the same concept and equation in your chapter reference in the BUS140 Custom Text.
14 BUS140 Topic 2 - Time Value of Money I
 Calculator Notes7: ALL NOTES PROVIDED REFER TO THE BA II PlusTM

TVM calculations can be made much simpler with the aid of your financial calculator.8 In solving
TVM problems with a financial calculator you will often be given three of four variables and will
have to solve for the fourth. The five most common function keys on your BA II Plus TM are:
N - stores, or calculates, the total number of compounding periods (or payments),
I/Y - stores, or calculates, the annual (nominal) interest or discount rate,
PV - stores, or calculates, the present value of a future cash flow (or a series of cash flows),
FV - stores (or calculates) the future value; that is, the accumulated value of a single initial cash
flow (the present value) or a series of cash flows. (FV can also be used for final cash flow.)
PMT - stores, or calculates, the dollar amount of each annuity payment deposited or repaid at the
end of each period.
RCL To display a stored TVM value, press RCL and the relevant TVM key. Helpful when
checking for errors!
There are several points to keep in mind:
• In general each problem will have cash flows with two signs – outflows with a negative value
and inflows with a positive value. Use the +/- key to input negative values.
• It is a good idea to ‘clear’ the calculator of previous values before attempting a problem. If
you do not take this step it is necessary to enter a zero for any of the five variables not
included or used in the problem in order to clear that variable.

At this stage there are generally three steps to a TVM solution using a financial calculator:
1. Set up your calculator for the problem by checking:
• cleared previous values from TVM worksheet
• correct compounding and payment periods (C/Y and P/Y)
• number of decimal places, and
• end or beginning of period payment.
2. Enter the input values of the known variables.
3. Compute the value of the unknown variable.

These steps are clearly set out in the calculator quick guide in appendix I of this publication. To
minimise repetition in these notes it is assumed that you will clear previous values when
beginning a new problem and that you have adjusted your calculator to the default settings
suggested. The calculator solutions provided emphasise steps 2 & 3. For example, using the
default settings suggested in the calculator quick guide would mean that, provided you are happy
to round your final answer to two decimal places, you should only need to clear previous values
for the next example (4).

You should use a financial calculator in this subject, including in the tests and exams. The
calculator is more accurate and can do easily many things that are very difficult or cumbersome
via tables or equations. All relevant formulas will still be provided in test and exam papers. While
it is not necessary that you rewrite formulas when attempting a question in an exam or test, a
good “audit” trail is highly desirable. All workings (eg a time line) should be shown so that marks
for method can be allocated. This becomes especially important when minor computational
errors are made. It is not sufficient for students to simply draw calculator buttons and place
values besides the buttons that they have drawn. A brief explanation of how you arrived at the
input values may be important. Worked solutions in the lecture notes provide some guidance as
to the amount of information required. Displaying one number as the answer, with no indication
as to how you arrived at your answer, is unlikely to gain more than half marks.

7
Refer to your BA II Plus Guidebook if you wish to ‘store’ numbers or use memory functions (see Guidebook p12& p80).
8
There are financial tables available that can be used in TVM calculations. However no table can contain all interest
values so it is better to compute values directly using formulae or your financial calculator.
BUS140 Topic 2 - Time Value of Money I 15
 Example 4. Future value using compound interest.
If we invest $500 in a bank where it will earn 8% compounded Calculator
annually, how much will it be worth at the end of 7 years? Solution
DATA INPUT FUNCTION KEY
Solution: 7 N
FVn = PV (1+ i )n = 500(1 + 0.08)7 = $856.91
8 I/Y

500 +/- PV
Remember that the interest rate must be expressed as a
decimal when used in the equation/formulae. This is not FUNCTION KEY ANSWER
required for the calculator, which assumes that the interest CPT FV 856.91
input is a percentage.

Try Topic 2 lecture Example C now.

Example C. Compound Interest (FV)

Calculate the value in three years of $1000 deposited in an account that pays 8% interest pa.

Example 5. Comparing simple interest and compound interest.

If a $100 investment earned 7% simple interest over 5 years the accumulated simple interest
would be the future value less the initial investment, ie $100 [1 + (0.07 x 5 years)] - $100 = $35.
With compound interest the interest earned would be equal to the future value less the initial
investment, ie $100(1 + 0.07)5 - $100 = $40.26.

Thus, FV is greater for compound interest with an additional $5.26 earned from the interest
earned on the interest as a result of compounding.

16 BUS140 Topic 2 - Time Value of Money I

Try Topic 2 lecture Example D now.

Example D. Compound Interest (FV)

Use your calculator and fill in the blank cells with future values of $1 compounded over various
periods in the table below.

Future value of $1 at the end of n years at i % pa

Years 2% 5% 10% 15%
5 1.1041
10 1.6289
15 8.1371
20 6.7275
30
40 7.0400
60 4,383.9987
80 2,048.4002
100 7.2446

What relationship can you infer between the time period and the interest rates?
What do these numbers suggest to you about the value (or purchasing power) of money that will
be received in 40 years’ time? About alternatives that provide income for retirement?

Present value is the value today of an amount to be received in the future. Finding the present
value (called discounting) is simply the reverse of compounding or accumulating. Using the
same FV equation we are simply solving for a different variable (PV).

n FVn
FVn = PV (1 + i) becomes PV =
(1 + i)n
Present value terminology
• The value today of a future cash flow is called the present value.
• The interest rate used to compute the present value of future cash flows is called the
discount rate.
• The expression 1 or (1+i)-n is called the discount factor.
(1+i ) n
• For convenience, and to facilitate comparisons with current prices, present value is often
used for decision-making purposes rather than a common future value.
• Remember, unless otherwise stated, we assume that cash flows occur at the end of the
period.9 (This is also the default setting on your financial calculator.)

9
This is a fairly arbitrary assumption that simplifies TVM calculations. Can you see why this is regarded as a
conservative assumption from a decision-making perspective?
BUS140 Topic 2 - Time Value of Money I 17
Example 6. What is the present value of $1338.23, to be
received in 5 years, discounted at an interest rate of 6 percent? Calculator
Solution
FV n 1338.23 DATA INPUT FUNCTION KEY
PV = = = $1000.00
(1+ i ) (1 + 0.06)
n 5 5 N

6 I/Y

Note that the calculator solution is negative, representing 1338.23 FV

a negative cash flow or outflow. The idea is that we
need to pay out $1000 now in order to receive $1338.23 FUNCTION KEY ANSWER
in five year’s time. When using your financial calculator you
CPT PV -1000.00
must remember that outflows are regarded as negative
numbers.

Try lecture Example E after reading ‘Evaluating Investments’ below.

Example E. Compound interest (PV)

Suppose that you can buy goods for $18,000 cash OR for a payment of $20,000 in two year’s
time. (a) If the interest rate is 6% which option is better for you?

(b) If the interest rate is 5% would your decision be any different? Why, or why not?

18 BUS140 Topic 2 - Time Value of Money I

Evaluating Investments

To give you an idea of how we use present and future values, consider the following simple
investment. If you propose to buy an asset for $670, and this investment is very safe. You
anticipate that you will sell the asset in three years for $800. You know that you could invest the
$670 elsewhere at 10% with very little risk. What do you think of the proposed investment?

This is not a good investment because we can invest the $670 elsewhere at 10%. With this
alternative after three years your initial outlay will grow to: FV3 = 670 (1.1)3 = $891.77.
(Check with your financial calculator.) Since the proposed investment only pays out $800, it is
not as good as other alternatives that you have.

Another way of saying the same thing is to notice that the present value of $800 in three years at
10% is: PV = 800 (1.1)-3 = $601.05. (Check this outcome with your financial calculator.)
This tells us that you really only need to invest about $600 to get $800 in three years, not $670.

Nominal and Effective Interest Rates

It is important for both consumers and businesses to be able to make objective comparisons of
interest rates. In order to compare loan costs or investment returns over different compounding
periods, we must compare effective interest rates.
The ability to differentiate between nominal and effective interest rates, and to translate from one
to the other, is also essential for computation purposes. Using the wrong rate in your
calculations could have disastrous implications for financial decision making.
So far our examples have used an interest period of one year. We assume annual compounding
unless the information presented indicates that a different compounding or payment period is
appropriate. However, there are many instances where interest is ‘compounded half-yearly’ or
‘payable quarterly.’ These rates, when expressed as rates per annum, are known as ‘nominal
rates.’

Nominal interest rate (j or I/Y)

Unless otherwise specified interest rates quoted will usually refer to the nominal interest rate.
A yearly nominal rate is meaningless until we specify the compounding frequency (m). Nominal
and effective rates are equivalent for annual compounding.
If compounding occurs more than once a year the effective annual interest rate (or yield) will be
higher than the nominal annual rate due to the ‘interest on the interest.’
Where a nominal rate is quoted and compounding occurs “m” times during the year, dividing the
nominal rate by “m” gives the effective interest rate (i) per compounding period. For example,
15% pa with quarterly payments. Divide the quoted interest rate by 4 to give the effective
interest rate of 3.75% per quarter. This is the rate appropriate for use in the formulas and the
appropriate number of periods (n) will then be mt where “t” is the number of years. This would
be 4 times the number of years in our example.

BUS140 Topic 2 - Time Value of Money I 19

Example 7. How much will I accumulate in five years if I
invest $1000 now at 12% pa compounded Calculator
monthly? Solution
NB:Change C/Y (& P/Y) to 12
j
Solution: j = 12%, m = 12  i = =1% per month DATA INPUT FUNCTION KEY
m
t = 5, m = 12  n = mt = 60 months 60 N

12 I/Y
Therefore FVn = PV (1 + i)n = $1000 (1.01) 60 = $1816.70
1000 +/- PV
The TVM equation requires the effective interest rate per
compounding period (here it is monthly), expressed as a FUNCTION KEY ANSWER
decimal, matched with the number of compounding periods
(monthly in this example). This is an important principle to CPT FV 1816.70
note and may be crucial for non-standard calculations.

Calculator Note: Remember when using your financial calculator that I/Y is always
the annual nominal interest rate. The calculator automatically converts I/Y to a ‘per
period’ rate (necessary for the calculations) based on the values of P/Y and C/Y.
When you enter a value for P/Y, the same value is automatically entered for C/Y.
(You can then change C/Y if necessary.)

Try Topic 2 lecture Example F now (see Appendix II).

Example F. Compound interest (FV, C/Y)

Find the compound interest earned on $5,000 invested for two years at 6% compounded half-
yearly.

An effective interest rate is one where the frequency of payment matches the time period
specified by the interest rate. For example 1% per month with monthly payments is the
‘effective’ rate per month. This is the actual rate charged or received each month. The effective
annual interest rate is most often used for comparison purposes.
 j m
The effective annual rate of interest is calculated using: i = 1 +  −1
m
Where ‘i’ is the effective annual interest rate for a nominal interest rate ‘j’ per year compounding
‘m’ times per year.

20 BUS140 Topic 2 - Time Value of Money I

Example 8. Find the annual effective rate of interest equivalent to a nominal rate of 5%
compounded daily.
m  0.05  365
 j
i = 1+  −1= 1 + −1= 0.051267 = 5.1267%
 m  365 

Calculator Solution to Example 8.

Press Display Explanation

2nd [I Conv] NOM (old contents) Select interest conversion worksheet
2nd [CLR Work] NOM = 0.0000 Clear worksheet
5 ENTER NOM = 5.0000 Enter nominal interest rate of 5 percent
  365 ENTER C/Y = 365.0000 Requires daily compounding ie 365 periods pa.
 CPT EFF = 5.1267* Computes effective annual interest rate (%)

Try Topic 2 lecture Example G now.

Example G. (a) What is the value in ten years of $10,000 invested at 12% simple interest?

(b) Fill in the blank spaces in the table below to evaluate the effect of compounding frequency
on the same investment of $10,000 after ten years at 12%.

Compounding Effective Annual Number of periods Future Value(ii)

Frequency Interest Rate(ii)
Annually 12.0000 %
Semi-annually $32,071.35
Quarterly 40
Monthly 12.6825 %
Daily 3650

Note: (i) At the same nominal interest rate of 12%, the future value depends on frequency of
compounding, increasing/decreasing in value with increased/decreased compounding.
(ii) The calculation for the effective interest rate is done using the IConv function. The
future value is calculated using the nominal interest rate (I/Y) of 12%.

BUS140 Topic 2 - Time Value of Money I 21

Solving for Interest Rate or Time

Sometimes three TVM variables are known and we need to solve for the fourth variable. Present
and future values are known but perhaps not the interest rate or the time period.
There are several possible ways to solve these problems
• using financial calculators,
n
• solve the problem directly by rearranging the equation FV = PV (1 + i) as shown, or
n
• use present value or future value tables. 10

Example 9. You will receive $12,000 five years from now if Calculator
Solution
you invest $6,000 today. What is the interest rate you would be
earning? DATA INPUT FUNCTION KEY

5 N
Solution: The same basic TVM relationship, FVn = PV (1 + i)n
can be rearranged to solve for i: 6000 +/- PV

1 1 12000 FV
 n  12,000  5
i =  FV  −1=  − 1= 0.148698 ie 14.8698%
 PV   6,000 
FUNCTION KEY ANSWER

CPT I/Y 14.8698

Calculator Note: In Example 9 we are assuming annual compounding again. Reset

C/Y (and P/Y) to 1 if necessary.

Where we need to know how long it will take for an amount invested today to grow to a certain
value, given that it earns a known interest rate, we can use the equation FVn = PV (1 + i)n and
rearrange it to solve for “n.” However this approach involves the use of logs and can be resolved
far more easily using your financial calculator.

Example 10. If you earn an annual rate of interest of 12% compounded semi-annually how
long will it take for your money to double if you start out with $1?

FVn = PV (1 + i )
n
Solution:  2 = 1(1+0.06)n ie 2 = 1.06n  ln 2 = n ln 1.06
 n = ln 2/ln 1.06 = 11.8957 six month periods = 5.95 years
The TVM equation assumes that the payment period and the compounding period coincide.
Thus N represents the number of six monthly periods because the interest rate is being
compounded semi-annually. The solution for N then needs to be converted to years.

10
As discussed earlier using tables is problematic due to the limited values available and is therefore not
recommended. Calculations based on tables are less accurate due to rounding and the use of interpolation. You
need to use your financial calculator or equations for assessment purposes to achieve the accuracy required.
22 BUS140 Topic 2 - Time Value of Money I
 Calculator
Solution
NB: Change C/Y (& P/Y) to 2 for semi-annual compounding
Note that the calculator
DATA INPUT FUNCTION KEY EXPLANATION TVM functions are
12 I/Y Nominal interest rate of 12% pa programmed so that
P/Y determines the unit of
1 +/- PV Current outlay of $1 measurement for N. If we set C/Y
and P/Y to 2 in this example the
2 FV Double initial investment calculator solution for the number
of periods then also needs to be
FUNCTION KEY ANSWER converted to years.
CPT N 11.8957* Six-monthly periods = 5.95 years

Try Topic 2 lecture Examples H & I now (see Appendix II).

Example H. Compound interest (interest rate)

At what nominal interest rate, compounded monthly, will money triple itself in 12 years?

Example I. Compound interest (number of periods)

How many years will it take for an initial investment of $300 to grow to $545.82 if it is invested
at 6% compounded monthly?

BUS140 Topic 2 - Time Value of Money I 23

Brief numerical solutions to help you check you are on the right track for Topic 2 lecture
examples:

A $587.25
B $1,818.18
C $1259.71
D Compare with values in any future
value table (try an internet search).
E a) payment in 2 years is better,
b) payment now is better (Why?)
F $627.54
G FV using simple interest is $22,000.
H 9.1901%
I 10 years (120 months)

24 BUS140 Topic 2 - Time Value of Money I

 Workshop 2 Questions on Topic 2 Time Value of Money (TVM)

Bring your written attempts at answering these problems and questions to workshop 2.
Note that questions 1 to 3 focus on simple interest (refer notes pages 10-11). Try these questions
first, but don’t give up if you have difficulty with them as you will find the later questions (4–10)
using your calculator and compound interest easier.
1. Malakhi invests $1,000 for 3 years at 4 percent simple interest.
a) How much interest will you earn over the three years?
b) What will be the value of the investment at the end of the three years?

2. William borrowed $15,500 at an annual simple interest rate of 12.50 percent. He repaid
the loan by paying a lump sum of $15,894.93. What was the term of the loan?

3. A bank bill is bought for $91,107 and is sold 54 days later for $93,323.
a) What is the simple interest rate earned by the holder?
b) What is the effective annual interest rate earned by the holder?

4. To what amount will the following investments accumulate:11

a) $5,000 invested for 10 years at 10% compounded annually
b) $8,000 invested for 7 years at 8% compounded semi-annually
c) $775 invested for 12 years at 12% compounded monthly
d) $21,000 invested for 5 years at 5% compounded daily.

5. How many years will the following take:

a) $500 to grow to $1,039.50 if invested at 5% compounded annually
b) $35 to grow to $53.87 if invested at 9% compounded semi-annually
c) $100 to grow to $298.60 if invested at 20% compounded monthly
d) $53 to grow to $78.76 if invested at 2% compounded daily.

6. At what annual (nominal) rate would the following have to be invested:

a) $500 to grow to $1,948.00 in 12 years (assume annual compounding)
b) $300 to grow to $422.10 in 7 years (assume semi-annual compounding)
c) $50 to grow to $280.20 in 20 years (assume monthly compounding)
d) $200 to grow to $497.60 in 5 years (assume daily compounding)

7. What is the present value of the following future amounts:

a) $800 to be received 10 years from now and discounted back to the present at 10%
compounded annually.
b) $300 to be received 5 years from now and discounted back to the present at 5%
compounded semi-annually.
c) $1,000 to be received 8 years from now and discounted back to the present at 3%
compounded monthly.
d) $1,000 to be received 8 years from now and discounted back to the present at 20%
compounded daily.

11
Questions 4-7 have been adapted from questions in Titman et al (2019).
BUS140 Topic 2 - Time Value of Money I 25
8. You have $10,000 that you can deposit in any of three savings accounts for a three year
period. Bank A compounds interest on an annual basis; bank B compounds interest each
quarter; and bank C compounds interest daily. All three banks have a stated interest rate
of 4 percent.
a) What amount would you have at the end of the third year, leaving all interest paid on
deposit, in each bank?
b) What effective interest rate would you earn in each of the banks?
c) Based on your findings in a) and b) which bank should you deal with?
d) What effect does compounding interest calculated more often than annually have on i) the
future value generated by a beginning principal and ii) the effective interest rate? Why?

9. Find the nominal, or quoted, interest rate for each case:

Effective annual interest rate Compounding period
10.00% 1 month
6.09% 3 months
8.24% 6 months

10. Mei Lee invests $15,000 at an interest rate of 2.5 percent per quarter. How much is the
investment worth after two years?

Further problems and questions that you will attempt during Workshop 2.

11. Sally borrowed $8,000 and repaid the loan 90 days later with a single payment of $8,750.
a) What is the implied annual simple interest rate?
b) What is the 90 day implied simple interest rate?

12. If you earn 8 percent per year on your bank account how long will it take for an account
with $100 to double to $200?

13. What effects do increasing a) the required rate of return, ie the discount rate and b) time
periods have on the present value of a future amount? Why?

14. You have an opportunity to purchase any of the following investments. The purchase
price, amount of the single cash inflow and its year of receipt are given below for each
investment. Which purchase should you make, assuming that you can earn 10 percent on
your investments?
Investment Price ($) Single cash inflow ($) Year of receipt
A 18,000 30,000 5
B 600 3,000 20
C 3,500 10,000 10
D 1,000 15,000 40

15. You are offered $2,000 today, $10,000 in twelve years, or $25,000 in twenty-five years.
Assuming that you can earn 11% on your money, which should you choose?

16. If you require $7,000 in 5 years, and you can earn 4.5 percent compounded monthly on
your funds, how much will you need to invest today in order to reach your goal?

See further questions over page/…

26 BUS140 Topic 2 - Time Value of Money I

17. Calculate the amount of money that will be in each of the following accounts at the end
of the given deposit period:
ACCOUNT Amount Annual Interest Compounding Period Deposit
Deposited $ Rate % (Every _ months) Period (Yrs)
Mike Rabbit 1,000 10 12 10
Arthur Coles 95,000 12 1 1
Sue Elliott 8,000 12 2 2
Mai Nguyen 120,000 8 6 4
Peter Rossini 30,000 10 3 3
Matthew Lock 15,000 12 6 3
From Petty et al. (2012) Problem 4-5

18. Read the abridged article by Marc Terrano and Sarah Megginson from the Finder
website, reproduced below. (Accessed 5/02/21) What is the “comparison rate” and how
is it calculated? Is the “comparison rate” helpful to consumers?
Note: Further information on comparison rates is available from the following website: https://www.finder.com.au/home-loan-comparison-rates
What is a comparison rate?
A comparison rate can help you work out the true cost of your mortgage, but they're not always helpful.
Updated Dec 29, 2020. What changed?

A comparison rate is a rate that all lenders by law must display next to their advertised interest rates. It's a rate that takes into
account some of the fees and charges of a home loan, and it's designed to give you a more accurate representation of a loan's true
cost once all of the fees, charges and costs are taken into account.

Compare mortgages by interest and comparison rates

Comparison rates were made mandatory in an attempt to stop lenders from advertising very low interest rates that lured
unsuspecting borrowers into loans that actually cost them far more in the long run. For instance, a lender might have advertised a
low mortgage interest rate of 2.5%, but then charged $20 per month in account keeping fees and an annual $400 loan package fee.
Once these expenses are added in, the loan could be more expensive than a different bank that was charging 2.6%, but with no
fees.

A comparison rate on a home loan is legally mandated to be calculated based on:

• An example loan of $150,000
• A loan period of 25 years
• A principal and interest loan
Back when comparison rates were introduced in July 2003, these figures made much more sense. Today, the average loan size is
much more than $150,000: the latest stats put the current average loan size closer to $500,000.
The average loan term for the majority of borrowers is also 30 years, not 25 years.
It's important to be aware of this when looking at the comparison rate, because if your loan is more than $150,000, the comparison
rate won't be a true reflection of the actual costs of your loan. We'll explain more in a moment – but first, what is the difference
between the interest rate and the comparison rate?

What's the difference between the interest rate and comparison rate?
The interest rate is the percentage of interest that you will be charged on your loan. If your loan is $500,000 and the interest rate is
2.75%, you will be charged interest of around $13,750 in the first year of having the loan.
However, the interest rate you are charged doesn't consider all of your costs. There are other costs that your lender may charge,
such as:
• Account keeping fees
• Annual package fees
• Loan switch fees (when you move between variable and fixed rates)
• Rate lock fees (when you are first obtaining a loan)
• Government fees and charges
The comparison rate is a percentage amount that is calculated by adding together the interest rate, plus any additional fees and
charges that may apply to the loan. The total figure is then converted into a percentage rate to highlight the true cost of the loan.
Lenders are unable to hide any fees, charges or other costs, as these are reflected in the overall comparison rate.

How important is the comparison rate?

The example comparison rates on home loans are only guidelines for possible costs. The actual cost of your loan depends on many
factors and with legal comparison rates based on an amount of $150,000, there's an argument that they're not very helpful.

BUS140 Topic 2 - Time Value of Money I 27

 Workshop 2 Learning Objectives: Topic 2 TVM I

1. To understand the TVM concept, FV and PV and determine the PV or FV of a sum of

money.
2. Be able to explain the mechanics of compounding, how money grows over time when it is
invested.
3. To understand and use compound versus simple interest.
4. Be able to calculate the effective annual rate of interest and then explain how it differs from
the nominal or stated interest rate.
5. To understand the importance of financial calculator settings and check settings initialised.
6. To use the financial calculator to solve TVM problems involving single amounts.
7. To understand nominal versus effective rates and be able to use the I Conv Worksheet on
your calculator.

Have you achieved the learning objectives for this workshop?

Practice Questions – Topic 2 Time Value of Money I

Instructions:

Here are some practice questions on Topic 2 for you to try. You should also be aware that these
and many of your workshop questions are suitable test or examination questions.

You may use the formulae provided below to assist you in answering the questions. These
formulae will be reproduced on your test or examination paper. You should show all workings
to gain credit for partly correct answers in your assessments. NOTE: when using your financial
calculator, full working is considered to be the inclusion of the ‘skeleton’ or listing all values
inputted in to your calculator, including the values of P/Y and C/Y.

Formulae

FV = PV (1 + rt )
n FVn
FVn = PV (1 + i) PV =
(1 + i)n
 j m
i = 1 +  −1
m
28 BUS140 Topic 2 - Time Value of Money I
Practice Questions for Topic 2
1. You are faced with the choice of a three year investment yielding 11 percent in simple
interest versus the same investment yielding 11 percent compound interest. Which
investment should you choose and why?

2. Scarlett earns $300 in interest over 4 years on her investment of $1,000. What simple
interest rate does this represent?

3. If an investment earning simple interest of 6% pa is today worth $1,770, what was it worth 3
years ago?

4. How much would you have to invest today at 12% compounded annually to have $30,000 to
buy a new car in 4 years?

5. Your grandfather placed $10,000 in a trust fund for you. In 10 years you will be able to
withdraw $35,000. What is the rate of return on the trust fund?

6. Congratulations! You have just won the lottery. You are offered the choice of any ONE of
the following prizes. Which should you choose if your discount rate is 8%? Show all
workings.
a) $10,000 now
b) $5,000 now and $7,000 in 5 years time
c) $16,000 in 6 years time
d) $30,000 in 15 years time

7. How much interest is earned in the tenth year on a $1,000 deposit that earns 8% interest
compounded annually?

8. A credit card account that charges interest at the rate of 1.15% per month would have an
annually compounded rate of __________________ and a nominal rate of ___________.

9. What is the present value of the following payment stream, discounted at 8% annually:
$1,000 at the end of year 1, $3,000 at the end of year 2, and $5,000 at the end of year 4?

10. Briefly explain the distinction between simple and compound interest rates.

11. You received a $1000 savings account earning 6% compounded daily on your 8th birthday.
How much will you have in the account on your 18th birthday if you don’t withdraw any
money before then?

12. You need $25,000 to buy a new car. If you have $7,000 to invest at 12% compounded
annually, how long will you have to wait to buy the car?

13. You have $900 in a savings account that earns 8% simple interest annually. How much
additional interest would you earn in 2 years if you moved the $900 to an account that earns
8% compounded?

BUS140 Topic 2 - Time Value of Money I 29

14. Your bank has agreed to loan you $500,000. You will repay the loan in five years with one
lump sum of $816,000 (covering both principal and interest). What is the implied interest
rate on the loan?

15. What will be the approximate population of the United States, if its current population of 270
million grows at a compound rate of 1% annually for 60 years?

16. If the effective annual rate of interest is known to be 15.87% on a debt that has quarterly
payments, what is the annual nominal interest rate (compounded quarterly)?

17. What simple interest rate per annum is equivalent to 9% compounded semi-annually if the
money is invested for three years? (Hint: compare the FVs of $1 at the end of 3 years.)

18. You have $1000 that you would like to invest. You have 2 choices: Savings Account A that
earns 7% compounded annually or Savings Account B that earns 6.8% compounded
monthly. Which account should you choose and why?

19. How much more would you be willing to pay today for an investment offering $10,000 in
four years rather than the normally advertised five-year period? Your discount rate is 8%.

Solutions to Numerical Topic 2 Practice Questions

2. 7.50%
3. $1,500
4. $19,065.54
5. 13.3462%
6. a) $10,000.00
b) $9,764.08
c) $10,082.71 Choose the maximum PV for the best value.
d) $9,457.25
7. $159.92
8. 14.7072%, 13.8000%
9. $7,173.09
10. See lecture notes
11. $1,822.03
12. 11.2325 years
13. $5.76
14. 10.2920%
15. 490,508,109
16. 15.0044%
17. 10% pa simple interest
18. Choose Account B Why?
19. $544.47

30 BUS140 Topic 2 - Time Value of Money I