THE COPPERBELT

UNIVERSITY
SCHOOL OF BUSINESS

BF 224:Corporate Finance

Session 2: Basic Concepts in Finance

Dr Young Kafwembe
2024/25
Lecture Objectives
• Distinguish between simple and compound interest.
• Calculate the present value and future value of a single
amount for both one period and multiple periods.
• Calculate the present value and future value of multiple cash
flows.
• Calculate the present value and future value of annuities.
• Compare nominal interest rates (NIR) and effective annual
interest rates (EAR).
• Distinguish between the different types of loans and calculate
the present value of each type of loan.
Time Value of Money: Example
Which would you prefer – $10,000 today or
$10,000 in 5 years?

Obviously, $10,000 today.

You already recognize that there is

TIME VALUE TO MONEY!!
Why Time?
• Why is TIME such an important element in your
decision?

• TIME allows you the opportunity to postpone

consumption and earn INTEREST.
Time Value
• The notion that a dollar today is worth more than a
dollar tomorrow
Time Value Terminology
• Future value (FV) is the amount an investment is worth after one or more
periods.

• Present value (PV) is the amount that corresponds to today’s value of a

promised future sum.

• The number of time periods between the present value and the future
value is represented by ‘t’.

• The rate of interest for discounting or compounding is

called ‘r’.

• All time value questions involve four values: PV, FV, r and t. Given three
of them, it is always possible to calculate the fourth.
Time Value Terminology
• Compounding is the process of accumulating interest in an investment over
time to earn more interest.

• Interest on interest is earned on the reinvestment of previous interest

payments.

• Discount rate is the interest rate that reduces a given future value to an
equivalent present value.

• Compound interest is calculated each period on the principal amount and on

any interest earned on the investment up to
that point.

• Simple interest is the method of calculating interest in which, during the entire
term of the loan, interest is computed on the original sum borrowed.
Types of Interest
• Interest is the cost of funds
• Simple Interest
• Interest paid (earned) on only the original amount, or
principal, borrowed (lent). Simple Interest - Interest
earned only on the original investment.
• Compound Interest
Interest paid (earned) on any previous interest earned,
as well as on the principal borrowed (lent).
Simple Interest
Simple Interest Example
• Assume that you deposit $1,000 in an
account earning 7% simple interest
for 2 years. What is the accumulated
interest at the end of the 2nd year?

• SI = P(R)(T)
= $1,000(0.07)(2)
= $140
Simple Interest: Future Value
• What is the Future Value (FV) of the
deposit?
FV = Principal + Simple
Intrest = $1,000 +
$140 =
$1,140
• Future Value is the value at some future
time of a present amount of money, or a
series of payments, evaluated at a given
interest rate.
Simple Interest: Present Value
• What is the Present Value (PV) of the
previous problem?
The Present Value is simply the
$1,000 you originally deposited.
That is the value today!
• Present Value is the current value of a
future amount of money, or a series of
payments, evaluated at a given
interest rate.
Compound Interest
• Interest earned on interest
• You invest $100 in a savings account that earns 10 per
cent interest per annum (compounded) for five years.

After one year: $100  (1 + 0.10) = $110

After two years: $110  (1 + 0.10) = $121
After three years: $121  (1 + 0.10) = $133.10
After four years: $133.10  (1 + 0.10) = $146.41
After five years: $146.41  (1 + 0.10) = $161.05
 Future
Future Value
Value
Single
Single Deposit
Deposit (Graphic)
(Graphic)
Assume that you deposit $1,000
at a compound interest rate of 7%
for 2 years.

0 1 2
7%

$1,000
FV2
Future Value of a Lumpsum: Formula
• In general, the future value, FVt, of $1 invested today at
r per cent for t periods is:

FVt $1 1  r 

t

• The expression (1 + r)t is the future value interest factor

(FVIF).
 Using
Using Future
Future Value
Value Tables
Tables
FV2 = $1,000 (FVIF7%,2) =
$1,000 (1.145) = $1,145 [Due to Rounding]

Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
Future Value of a Lumpsum:
Example
• What will $1000 amount to in five years time if interest
is
6 per cent per annum, compounded annually?
FV $1000 1  0.06
5

$1000  1.3382
$1338.22

• From the example, now assume interest is 6 per cent

per annum, compounded monthly.
• Always remember that tFVis$1000
the 1number
 0.005
60
of compounding
periods, not the number of years.
$1000  1.3489
$1348.90
 Present Value:
Discounting
Assume that you need $1,000 in 2 years.
Let’s examine the process to determine how
much you need to deposit today at a discount
rate of 7% compounded annually.

0 1 2
7%

$1,000
PV0 PV1
 Using Present Value Tables
PV2 = $1,000 (PVIF )
7%,2 =
$1,000 (.873) = $873 [Due to Rounding]

Period 6% 7% 8%
1 0.943 0.935 0.926
2 0.890 0.873 0.857
3 0.840 0.816 0.794
4 0.792 0.763 0.735
5 0.747 0.713 0.681
Present Value of a Lump Sum:
Discounting
You need $1000 in five years time. If you can earn
10 per cent per annum, how much do you need to
invest now?

Discount one year: $1000 (1 + 0.10) –1 = $909.09

Discount two years: $909.09 (1 + 0.10) –1 = $826.45
Discount three years: $826.45 (1 + 0.10) –1 = $751.32
Discount four years: $751.32 (1 + 0.10) –1 = $683.02
Discount five years: $683.02 (1 + 0.10) –1 = $620.93
Present Value of a Lump Sum
• In general, the present value of $1 received in t periods
of time, earning r per cent interest is:
PV $1 1  r 
t

$1

1  r t

• The expression (1 + r)–t is the present value interest

factor (PVIF).
Present Value of a Lump Sum:
Example
Your uncle promises to give you $100 000 in 10
years time. If interest rates are 6 per cent per annum,
how much is that gift worth today?

PV $100 000  1  0.06

 10

$100 000  0.5584

$ 55 840
Annuities
• An Annuity represents a series of equal
payments occurring over a specified
number of equidistant periods.
• Ordinary Annuity: Payments or
receipts occur at the end of each
period.
• Annuity Due: Payments or receipts
occur at the beginning of each period.
Examples of Annuities
• Student Loan Payments
• Car Loan Payments
• Insurance Premiums
• Mortgage Payments
• Retirement Savings
 Parts of an Annuity

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today
Equal Cash Flows
Each 1 Period Apart
 Parts of an Annuity

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows
Each 1 Period Apart
Ordinary Annuity – FVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .

CF CF CF

CF = Periodic
Cash Flow

FVAt = CF(1 + r)t-1 + CF(1 + r)t-2 + FVAn

... + CF(1 + r)1 + CF(1 + r)0
 Formula for
Ordinary Annuity – FVA
Future value of an annuity:
Fva = a [(1+r)t – 1]
r
or
FVa = a (FVIFA r,t)

Where a = the equal annuity payment

FVa = future value of a annuity
Example:Ordinary Annuity – FVA

Find the Future Value of an annuity for

$1000 paid at the end of each year for
3 years assuming interest is compounded
annually at 7%?
 Example of an
Ordinary Annuity – FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%

$1,000 $1,000 $1,000

$1,070

$1,145

FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000(1.07)0$3,215 = FVA3
= $1,145 + $1,070 + $1,000
= $3,215
 Valuation Using Table
III = CF(FVIFA )
FVA t FVA = $1,000
r%,t 3
(FVIFA7%,3) = $1,000 (3.215) = $3,215

Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
 Hint on Annuity
Valuation
The future value of an ordinary
annuity can be viewed as
occurring at the end of the
last cash flow period,
whereas the future value of
an annuity due can be viewed
as occurring at the beginning
of the last cash flow period.
 Overview View of an
Annuity Due – FVAD
Cash flows occur at the beginning of the period
0 1 2 3 t–1 t
i% . . .

CF CF CF CF CF

FVADt = CF(1 + r)t + CF(1 + r)t-1

+ ... + CF(1 + r)2 +
FVADn
CF(1 + r)1 = FVAt (1 + r)
 Formula for
Annuity Due – FVAD

FVa due = a (FVIFA r,t)x(1+r)

FVa due= a [(1+r)t – 1] X (1+r)
r

Where : a (FVIFA r,t) = a ((1+r)t – 1)/r

Example:
Annuity Due – FVAD

Find the future value of an annuity due

where $1000 is paid at the beginning
of each year for 3 years at 7%?