Chapter 4
Equivalent rates
This Chapter does not introduce any new theory, but rather develops what you have learned thus far
into the concepts of the time value of money and equivalent rates.
You will recall that we discussed, in Chapter 0, that an amount of money, at a particular time, has
different values at different times due to the impact of inflation. The impact of this inflation is then
compensated for in the interest rates we use to either grow or discount an amount of money over
time.
For example, the pizza costing R100 today will cost R120 in a years’ time and hence a loan of R100
made today will require a repayment of at least R120 in one year’s time. In other words R100 today
has a value, if invested for one year at 20% interest, of R120 in one years’ time due to the effect of
interest applied to that R100. This is what is meant when we use the expression “the time value of
money”.
Time value of money (TVM) is the basic principal that money can earn interest - so money worth
R100 today will be worth more in the future, if invested.
This is represented in the formula
The time value of money implies that investors would rather have money today than in the future,
because the earlier they receive it, the sooner they can invest it to earn interest on the money and
grow it to a larger future value.
Example 4.1
Consider an amount of R 1000 due on 1 January 2020. Suppose money earns interest at 12% per
annum.
The accumulated value of the R1000 on 1 January 2021 is
The discounted value of the R1000 on 1 January 2019 is
Therefore, the time value of R1000 on 1 January 2020 is equivalent to R1120 on 1 January 2021 and
equivalent to R892.86 on 1 January 2019. This relationship between amounts is called the “principle
of equivalence of amounts”.
The principle of equivalence of amounts implies that if we are to compare different amounts of
money payable at different dates, we must compare their values all at a single date using a single
rate of interest (called the settlement rate).
Example 4.2
Determine, at an interest of 6%p.a., whether you would rather have
a) R931.55 at 1 January 2019
b) R1000.00 at 1 January 2020
c) R1090.84 at 1 January 2021 or
d) R 1123.60 at 1 January 2022.
In order to compare these amounts, the principle of equivalence says we must compare the values
of these amounts at a single date, using the same settlement rate. Let’s select 1 January 2020 as out
single date.
We can show the equivalent amounts of the four options on this date of the four on a timeline as
follows :
INSERT TIMELINE
So,
a) The equivalent amount at 1 January 2020 of R931.55 at 1 January 2019 using a settlement
rate of 6% is R987.44.
b) The equivalent amount at 1 January 2020 of R 1000 at 1 January 2020 is, obviously, R1000
c) The equivalent amount at 1 January 2020 of R1090.84 at 1 January 2021 using a settlement
rate of 6% is R1029.09
d) The equivalent amount at 1 January 2020 of R1123.60 at 1 January 2022 using a settlement
rate of 6% is R1000
Therefore the most valuable option is option c) as this gives us the highest value at 1 January 2020,
and we would be indifferent between options b) and d) but would not choose option a)
Note: In the above example, we have compared the different amounts at the single date of 1
January 2020. We could just as well have compared all the amounts at a different date, say 1
January 2019, 1 January 2021 or 1 January 2020 (or even some other selected date). We would then
just accrue or discount the amounts with interest to that particular date and compare them.
Example 4.3
Use the principle of equivalence of amounts to solve the following problem:
A borrower needs to repay a loan from an institution by way of the following three amounts:
R18 400 after 2 years from now
R 23 800 after 5 years from now
R 35 400 after 8 years from now
This person has approached the bank and advised that he wishes to settle his debt with one single
payment after 4 years from now. What will be the amount he will need to pay after four years using
a settlement rate of 5.5% per annum?
We could solve this in two ways.
Method 1. Discount the value of the repayments to the present using the settlement rate, and then
find the equivalent value of this amount in 4 years’ time. This is the amount required to be paid to
settle the loan.
INSERT TIMELINE
Present Value of amounts due =
Value of this amount at Time 4 =
Method 2. Discount or accrue each of the required repayments to time 4 (the new settlement date)
using the settlement rate, and this amount is then the amount required to be paid to settle the loan.
INSERT TIMELINE
Value of amounts due at Time 4 =
