The eminent writer W Somerset Maughan once said quote money is the sixth sense, which enables you to enjoy the other five unquote. Of course many people are motivated by money and money does buy you things. But as clichéd as this might sound it's true that money doesn't buy time, happiness, health, or even a good night sleep. In this segment we continue to talk about money but focus on why the time value of money is universally considered one of the most important concepts in finance, and how it is central to so many of the financial decisions that we make at home at work, and elsewhere. But before we explore the why and the how about the time value of money, just what does this expression mean anyway? Whether it is ice cream or iPhones, electric cars, or education, we've already learned that people in various situations assign a value to things. Buyers and sellers determine a price which changes over time, sometimes appreciating, other times depreciating for many different reasons. But it is this principle of assigning a value, in this case to money, with changes over time. So in other words, the time value of money refers to a process that determines how money is valued over time. By getting acquainted with this process, it's easy to learn how to calculate the value of money as it changes over time. So before we start a few calculations, let's think about how money grows in value over time. We know that money may not always be worth more in the future because this is going to depend on how much money was invested, how much was earned, whether there was inflation, and a host of other factors. But we can all agree on how to calculate the way money is compounded, which in fact, grow exponentially into the future. Similarly, it's just as important to understand the process in reverse. That is we need to convert the future amount to their equivalent present amount today. This process is known as discounting which reflects a loss in value. In fact, most financial decisions try to look into the future with respect to money flows but since this decisions are being made in the present we must convert the future amounts into their equivalent present values. So let me summarize this, the value of money changes over time. Think of it as planting seeds to produce grapes which you might use to make and sell juice or jelly or wine or whatever you make out of this fruit. The seeds have the potential to grow and bear fruit and gain in value, but not all of them will. What we can do today is to imagine the possibilities and this involves agreeing on how to measure and calculate the possible future values. And it's corollary of converting those future amounts into their present values today, so let me work through an example to help you to quickly understand compounding and future values as well as discounting and present values. And as a practical matter, most people are going to think about providing money for their futures and most often for their children and for people they care about. Financial planners of course advise us about how much money we could have in the future through wise investing so let's keep it simple. Lets say you have $100 today which the present value. Also assume a interest rate of 10% and ask what is the future value of this $100 three years from now? The math really is quite easy. We will start with $100 and let me show you how that will grow. So we have various time periods, today, one year, two years, let's say three years. We have an amount to work with which will grow. These are amounts. We're going to start of course with $100. I'm assuming an interest rate in this case to be 10%. And of course then I can compute the future values. This is where I'm going with this problem. So $100 on a 10% interest obviously gives me interest of $10 by the end of the year right? So I took 100 and multiplied it by 10%. Now what's the future value? The future value is 100 plus the interest earned which is $110. So this time I'm going to start with $110 which will again on 10% interest 10% of 110 now is going to be of course $11 and the future amount 110 plus 11 gives me the 121 which again Is my beginning amount for my last year, the third period. Again, I'm going to earn on 121, 10% which is $12.10. And so if I add up the future value, it works out to be 133.10. So this is the future value of $100 that growing at an interest rate of 10% compounded annually. So note the interest rate of 10% also we can refer this to as the the annual percentage rate. APR, that is the rate that we are applying to the original investment, and of course to any of the subsequent interests that we've earned. In other words, we're running interest on interest. And this is the process of compounding, since the interests will compound over time. What had the interest rate of 10% earned the same amount, the same interest based on the original investment of 100, this would be known as simple interest. So if we had earned simple interest of $10 each year, of course our future value would be lower, it would be $130 instead of $133.10. So for compound interest if we had to depict this over time, if we draw our timeline here for three years, 0, 1, 2, and 3, we can see we started with 100. I'll use some different colors here. So that you can clearly see the impact of compounding 100 grew to 110. 110 grew to 121 and we finally ended up with 13310, right? What I want to show you is that in fact this process, this growth. We can derive a very powerful and useful formula from it. So we started with 100, the 100 grew at 10% which became 110. The 110 of course then grew again at 10%. This became 121. I'll do it one more time. 121 grew again. That became 133 10. In other words, to calculate the future value of 13310 you must know the present value. You must know the interest rate, and you must know the time period. The rest is really easy, right? But what's important in deriving the formula is what we did was we took the present value of 100, we multiplied it by the interest rate three times, to get our future value of 133.10. Notice what we've done here is we've come up with a very important formula for future value. Which is present value, this amount here, multiplied by 1 plus the interest rate. Which is what you see here. And for three periods we denoted for time period t. And that is our fundamental future value equation, okay? Of course, we can play with this equation. As long as we know one, two, three values, we can compute the the fourth. Now I also mentioned to you that it's really important we do the reverse process, and that's what most financial decisions makers do, they work with future amounts, and convert them into the present. So we want the present value isolated on the left-hand side. For that to happen, we just cross multiply. Present value is going to be equal to future value divided by 1+r raised to the power t. So this is our equation for present value. So once we rearrange the equation for our future value into present value, what we're doing now, of course, is we're discounting these amounts. And in the above example, we can of course plug the numbers in, and we have a future amount already of 133.10. If we divide that by the present value factor, in this case it would be 1/1 plus the interest rate raised to the power 3. Not surprisingly, we're going to get the result of the original amount we started with, which is $100. Now let's introduce a couple of variations. First, we're going to look at how the frequency of compounding can dramatically change values over time. In this example we assumed an annual percentage rate, or APR, that corresponded to 10%. Now 10% is per year, per annum, so it implies it has a frequency of one. But what happens if that frequency changes? If interest was compounded every six months, or semiannually? The frequency would be two because there are two six month periods in a year. If interest was compounded each day the frequency would be 365 since there are 365 discrete periods in a year. So if M denotes this frequency, how would this change our future value equation? Lets assume in this example, monthly compounding. So if it's monthly, the frequency M is going to equal to 12, as there are 12 months in a year. There's a rule, whenever M is greater than one, T is going to increase and R is going to decrease by a factor of M. In our case, in this example, T is going to be, it was a three year problem, 12 months in each year, and that gives us 36 periods. However, for the interest rate, R, which was 10%, we now want to show how this can be divided up into 12 periods. So we must divide this by 12, which works out to be 0.0083. So notice all we have to do now is to reflect a different interest rate and a different time period. And if we do that in our example, we see the answer of course is going to be different. The future value, this time, is going to equal to the present value which is still 100. But this time we're going to multiply this by 1+R 0.0083 raised to the power, not 3 years but 36 periods, and that's going to work out to a higher number, about $135 if I round up. So we do earn more interest on interest. So this is the impact of frequency. So I'm going to summarize. Whenever compounding is greater than 1, meaning whenever there's M, whenever M is greater than 1, then we're going to have to introduce this within the formula. So if I denote that here future value equals to present value multiplied by 1 plus adjust the interest rate by M, multiply the time period by M. That becomes our adjusted formula for frequencies greater than once a year. Now this helps us to understand a second important variation of trying to understand the relationship between nominal rates and effective rates. So here we had the annual percentage rate. But if that rate is being compounded monthly, what does that do effectively to the annual rate? Now this conversion is very important because it's going to help you to understand how compounding can make or break your financial health. Take for example something as common as your credit cards or your retail cards. Now these of course are backed up by agreements, the small fine print where you know the advertised rate, but in fact, if you read that small print, they're charging you a different rate. These days most type of credit cards will advertise rates that range anywhere from, I don't know, 10, 12, 13%, all the way up to 20, 23, 24%. That's quite a variation. And in addition to that, they will legally charge up to 30% in terms of penalty rates if you don't pay on time. So this appears to be really exorbitant in times when you are earning close to 0% on your deposits in the bank. But that disparity is another question and we'll take that up later on in one of our activities. But for now, in terms of calculations, let's assume your credit card has an annual percentage rate of 18.5% compounded daily. So let's put that information down. We've read our credit card agreement. It says rate is 18.5% compounded daily. What does that mean? Compounded daily means a frequency of 365 periods within a year. So what does this frequency do in terms of converting this annual percentage rate? This is an annual percentage rate we want to convert this into an effective annual rate. And this effective annual rate, of course, using this formula here, we can derive the effective annual rate to equal to 1 plus the annual percentage rate divided by M raised to the power M minus 1. Here it is. So in our particular example here, all we have to do is plug the numbers in. We have the effective annual rate equal to 1. Plus the nominal rate, in this case 1 + 0.185. That's 18.5%. We have to now divide this by M, which is 365. Raise it to the power m 365 and then subtract 1 to get the answer, and it does work out to 20.32%, okay? So what's the relationship between 20.32% and 18.5%? So what this means is that compounding 18.5% daily is effectively equal to paying 20.32% annually. And you might say well, that's not a big deal. It's not a huge difference between the two. But in fact, this discrepancy is going to get worse and worse, especially if you don't have access to credit, you don't have a credit card, and you're not as well off. So people still need money, and when they need money and they cannot go through financial institutions to get it, they try and access whatever source there is available. So let's take a practical example to see how that might work and how these nominal rates can translate into dramatically high effective rates. Let's say it's okay to pay back $5 for using $100 for a week. So if you're going to pay, $5 over $100 for money you desperately need for something, so that would be 5 over 100 and that is 5%. You might say, hey, that's not bad. If I can use the money for a week, I'll pay this person back $105. What does the 5% mean, though, in terms of an APR? The 5% of course is for a week, and we know here m is equal to there are 52 weeks in a year. So we must multiply this weekly rate and convert it into an annual percentage rate, which is going to be 5 multiplied by 52 weeks. And that works out to you're in fact paying 260% for this particular loan. And if we use our formula here for the effective annual rate and convert the APR into an EAR, you're going to get an astounding 1,164%. Wow, suddenly the 5% loan, which is in fact 1,164%, is something that looks what you might pay a loan shark, or at least it should be considered illegal. And in fact, in some countries it is illegal. In Canada, for example, under Section 347 of the criminal code, it is a crime to charge interest rates exceeding 60% a year. And even 60% seems a lot. In an upcoming activity we're going to ask you to check out whether there is legislation to protect borrowers in your region. And if not, what are you willing to do about this? But that's an activity we'll get to in a moment. What's really hard for the borrower, of course, is wonderful for the lender. So if you were earning this $5 interest from several clients each week and earning an annual rate of over 1,000%, this would be too good to be true. And for lenders and investors, the magic of compounding, it's going to remain extremely significant even if you earn a very low rate. As long as we have long periods of time ahead of us, we can see the impact of compounding in the next video on time value of money. All right, so let's come back to our basic future value and present value equations and explore the concept of opportunity cost, a term that's used all the time in financial decision-making. Let's say you're working in an engineering firm negotiating a price with the government. Let's say it's for an infrastructure project that is going to be ready in five years. The price tag ranges anywhere from $10 million to $14 million, and the government is offering you $12 million right now or, it's giving you a choice, $15 million if you complete the project. What are you going to choose, the $12 million now or the $15 million in the future? So the opportunity cost is not having the money right now and getting a lower amount in five years. But think of it as taking the money now, investing it, and generating a higher value in five years. Clearly the key here is going to be the interest rate that converts these values over time. So we can use our trusted equation of future value, which equals present value into (1+r) raised to the power t. And we have all the information in this problem to plug it in. Future value of 15 million if we wait for five years, or take the money now, 12 million. And everything is going to depend on that interest rate, because we know the time period. So if you plug this into the financial calculator and get the value for r, it actually works out to 4.56%. In other words, if you think you can add more than 4.56% over the next five years, take the 12 million now, because its future value is going to be higher that 15 million. If you think you'll earn less than 4.56%, wait until five years. So this shows us by understanding and determining interest rates, it's really key to good financial decision making. Which is why we're going to spend a whole lecture on exploring just how interest rates are set, why they are continuously changing, and what impact they can have on the many decisions that we make. So let's summarize what we've learned. Time value is a process that explains how money is valued over time. And to compute these values over time, you can work with the basic future value equation and the present value formula. So all the formulas we need are right here. Future value is present value into (1+r) raised to the power t. And then we're going to see a lot of applications where we have to compute the present value, so we just cross-multiply future value divided by (1+r) raised to the power t. [COUGH] Now each of the formulas can be adjusted for the frequency of compounding, as we mentioned, with this variable m. So [COUGH] we can actually adjust these by dividing the interest rates by m, so r would be divided by m and t would be multiplied by m, right? [COUGH] This adjustment, of course, helps us to understand the relationship between annual percentage rates and effective annual rates. And here's our third formula to remember. Effective annual rate is equal to 1 plus the nominal annual percentage rate divided by m, raised to the power m minus 1. So it's actually just a couple of formulas that are in your calculators. You don't actually have to remember them. All you have to do is assign values over time. And so as you practice and as you will see in some of the upcoming video lectures, we'll learn more about using these financial calculators that are really going to make this a piece of cake, make this