Unit 4 - Time Value of Money (3-9-16)

Is a dollar today worth more than a dollar tomorrow?

• Yes, because opportunity cost and inflation, this is the reason for charging and paying interest.

v = future value of $
p = present value of $
r = real interest rate (nominal - inflation rate)
n = years
k = number of times interest is credited per year

Simple Interest Formula: V = (1 + r)^n * p

Compound Interest Formula: V = (1 + r/k)^nk * p

Example

Assume inflation is expected to be 3% and nominal interest rate on simple interest savings is 1%. Calculate value of $ after  1 year. 

Step 1: Calculate real interest rate. (r% = i% - n%) = (1 - 3 = -2%) OR (-.02)

Step 2: Use simple interest formula to calculate future value of $1
V = (1 + r)^n *p
V = .98 * 1
V = $0.98