UNIT 3: THE TIME VALUE OF MONEY

3.1 INTRODUCTION

Many decisions in finance involve choices of receiving or paying cash at different time
periods. The concept of the time value of money is that money received now is generally
better than the same amount of money received some time later. This is because there is
an opportunity to invest the money we have now and earn a return on it. For example, if
you have Br. 1,000 today, you could save it in a bank and earn interest.

The time value of money is a very important concept in financial management. It has
many applications in financial decisions like loan settlements, investing in bonds and
stocks of other entities, acquisition of plant and equipment. Therefore, understanding the
time value of money concept is essential for a financial manager to achieve the wealth
maximization goal of a firm.

The first basic point in the concept of the time value of money is to understand the
meaning of interest.
Interest is the cost of using money (capital) over a specified time period. There are two
basic types of interest: simple interest and compound. Simple interest can be understood
in two different ways. One is that simple interest is an interest computed for just a period.
If interest is computed for one period only, the interest is always simple interest. Another
way to understand simple interest is that it is an interest computed for two or more
periods whereby only the principal (original) value would earn interest. In simple interest
the previously earned interests do not produce another interest..

Compound interest, on the other hand, is an interest computed for a minimum of two
periods whereby the previous interests produce another interest for subsequent or next
periods. Here both the principal and previous interests bring additional interest.

Though we have discussed both simple and compound interest, in financial management
we are largely interested on compound interest. So in the sections that follow we shall
discuss the concepts and techniques of the time value of money in the context of
compound interest.

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3.2 FUTURE VALUE

To understand future value, we need to understand compounding first. Compounding is a

mathematical process of determining the value of a cash flow or cash flows at the final
period. The cash flow(s) could be a single cash flow, an annuity or uneven cash flows.
Future value (FV) is the amount to which a cash flow or cash flows will grow over a
given period of time when compounded at a given interest rate. Future value is always a
direct result of the compounding process.

3.2.1 Future Value of a Single Amount

This is the amount to which a specified single cash flow will grow over a given period of
time when compounded at a given interest rate. The formula for computing future value
of a single cash flow is given as:

FVn = PV (1 + i)n
Where:
FVn = Future value at the end of n periods
PV = Present Value, or the principal amount
i = Interest rate per period
n= Number of periods
Or
FVn = PV (FVIFi,n)
Where:
(FVIFi, n) = The future value interest factor for i and n

The future value interest factor for i and n is defined as (1 + i)n and it is the future value
of 1 Birr for n periods at a rate of i percent per period.

Example: Hana deposited Br. 1,800 in her savings account in Meskerem 1990. Her
account earns 6 percent compounded annually. How much will she have in Meskerem
1997?

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To solve this problem, let’s identify the given items: PV = Br, 1,800; i = 6%; n = 7
(Meskerem 1990 – Meskerem 1997).
FVn = PV (1 + i)n
= Br. 1,800 (1.06)7
= Br. 2,706.53

The (FVIFi,n) can be found by using a scientific calculator or using interest tables given
at the end of this material. From the first table by looking down the first column to period
7, and then looking across that row to the 6% column, we see that FVIF6%,7 = 1.5036.
Then, the value of Br. 1,800 after 7 years is found as follows:
FVn = PV (FVIFi,n)
FV7 = Br. 1,800 (FVIF6%, 7)
= Br. 1,800 (1.5036) = Br. 2,706.48
Example: Mr x place $800 in saving account paying 6% interest compounded annually.
He want to know how much money will be in the account at he end of year 5?

3.2.2 Future Value of an Annuity

An annuity is a series of equal periodic rents (receipts, payments, withdrawals, deposits)

made at fixed intervals for a specified number of periods.

For a series of cash flows to be an annuity four conditions should be fulfilled.

First, the cash flows must be equal.
Second, the interval between any two cash flows must be fixed.
Third, the interest rate applied for each period must be constant.
Last , interest should be compounded during each period. If any one of these conditions is
missing, the cash flows cannot be an annuity.

Basically, there are two types of annuities namely ordinary annuity and annuity due.
Broadly speaking, however, annuities are classified into three types:
1. ordinary annuity,
2. annuity due, and
3. deferred annuity

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i) Future value of an Ordinary Annuity – An ordinary annuity is an annuity for which
the cash flows occur at the end of each period. Therefore, the future value of an
ordinary annuity is the amount computed at the period when exactly the final (n th) cash
flow is made. Graphically, future value of an ordinary annuity can be represented as
follows:

0 1 2 ------------------ n

PMT1 PMT2 ---------------PMTn

The future value is computed at point n where PMTn is made.

FVAn = PMT

Where:
FVAn = Future value of an ordinary annuity
PMT = Periodic payments
i = Interest rate per period
n = Number of periods
Or
FVAn = PMT (FVIFAi,n)
Where:
(FVIFAi, n) = the future value interest factor for an annuity

Example: You need to accumulate Br. 25,000 to acquire a car. To do so, you plan to
make equal monthly deposits for 5 years.
years. The first payment is made a month from today,
in a bank account which pays 12 percent interest, compounded monthly. How much
should you deposit every month to reach your goal?

Given: FVAn = Br. 25,000; i = 12%  12 = 1%; n = 5 x 12 = 60 months; PMT = ?

FVAn = PMT (FVIFAi, n)
 Br. 25,000 = PMT (FVIFA, 1%, 60)
 Br. 25,000 = PMT (81.670)

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  PMT = Br. 25,000/81.670
 PMT = Br. 306.11

ii) Future value of an Annuity Due.

Due. An annuity due is an annuity for which the
payments occur at the beginning of each period. Therefore, the future value of an
annuity due is computed exactly one period after the final payment is made.
made.
Graphically, this can be depicted as:
0 1 2 --------------------- n

PMT1 PMT2 PMT3 ----------------------- PMTn + 1

The future value of an annuity due is computed at point n where PMTn + 1 is made
FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i)
Or

= PMT ( 1 + i)

Example: Assume that pervious example except that the first payment is made today
instead of a month from today. How much should your monthly deposit be to accumulate
Br. 25,000 after 60 months?

FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i)

 Br. 25,000 = PMT (FVIFAi, n) (1 + i)
 Br. 25,000 = PMT (81.670) (1.01)
 PMT = Br. 25,000/82.487
 PMT = Br. 303.08

iii) Future value of Deferred Annuity is an annuity for which the amount is computed
two or more period after the final payment is made.
0 1 2 ------------------n --------------n + x

PMT1 PMT2 PMTn

The future value of a deferred annuity is computed at point n + x

FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i)x

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 = PMT (1 + i)x

Where x = The number of periods after the final payment; and X  2.

Example: Mr x has a savings account, which he had been depositing Br. 3,000 every
year on January 1, starting in 2000. His account earns 10% interest compounded
annually. The last deposit Mr x made was on January 1,2009. How much money will he
have on December 31, 2013? (No deposits are made after 2009 January).

The future value is computed on December 31, 2013 (or January 1, 2014).
Given: PMT = Br. 3,000; i = 10%; n = 10; x = 5
FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i)x
= Br. 3,000 (FVIFA 10%, 10) (1.10)5
= Br. 3,000 (15.937) (1.6105)
= Br. 76, 999.62

3.2.3 Future Value of Uneven Cash Flows

Uneven cash flow stream is a series of cash flows in which the amount varies from one
period to another. The future value of an uneven cash flow stream is computed by
summing up the future value of each payment.

Example: Find the future value of Br. 1,000, Br. 3,000, Br. 4000, Br. 1200, and Br. 900
deposited at the end of every year starting year 1 through year 5. The appropriate interest
rate is 8% compounded annually. Assume the future value is computed at the end of year
5.
0 1 2 3 4 5

1,000 3,000 4,000 1,200 900

FVIF8%, 4 Br. 1,000 (1,3605) = Br. 1,360.50
FVIF8%, 3 Br. 3,000 (1.2597) = 3,779.10
FVIF8%,2 Br. 4,000 (1.1664) = 4,665.60
FVIF8%, 1 Br. 1,200 (1.0800) = 1,296.00
Br. 900 (1.0000) = 900.00

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 FV = Br. 12,001.20

3.3 PRESENT VALUE

Present value is the exact reversal of future value. It is the value today of a single cash
flow, an annuity or uneven cash flows. In other words, a present value is the amount of
money that should be invested today at a given interest rate over a specified period so that
we can have the future value. The process of computing the present value is called
discounting.

3.3.1 Present Value of a Single Amount

It is the amount that should be invested now at a given interest rate in order to equal the
future value of a single amount.

PV =

Where:
PV = Present Value
FVn = Future value at the end of n periods
i = Interest rate per period
n = Number of periods
Or
PV = FVn (PVIFi, n)
Where:
(PVIFi, n) = The present value interest factor for i and n = 1/ (1 + i)n

Example: Zelalem PLC owes Br. 50,000 to ALWAYS Co. at the end of 5 years.
ALWAYS Co. could earn 12% on its money. How much should ALWAYS Co. accept
from Zelalem PLC as of today?

Given: FV5 = Br. 50,000; n = 5 years; i = 12%; PV = ?

PV = FV5 (PVIF12%, 5)
= Br. 50,000 (0.5674) = Br. 28,370

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Example: Mr x wish to find the present value of $1700 that will be received 8 years from
now. interest rate is 8%.

3.3.2 Present Value of an Annuity

i) Present value of an Ordinary Annuity is a single amount of money that should be

invested now at a given interest rate in order to provide for an annuity for a certain
number of future periods.
Or simply, it is the value of a serious of future payment or rent on a date one period
before the first payment or rent.

PVAn = PMT = PMT (PVIFAi, n)

Where:
PVAn = The present value of an ordinary annuity
(PVIFAi, n) = The present value interest factor for an annuity

Example: Mr y is retired as general manager of ABC Company. But he is currently

involved in a consulting contract for Br. 35,000 per year for the next 10 years. What is
the present value of MR y’s consulting contract if the interest rate is 10%?

Given: PMT = Br. 35,000; n = 10 years; i = 10%; PVAn = ?

PVA10 = Br. 35,000 (PVIFA10%, 10)
= Br. 35,000 (6.1446) = Br. 215,061.
215,061.
This means if the required rate of return is 10%, receiving Br. 35,000 per year for the
next 10 years is equal to receiving Br. 215,061 today.

Example: ABC co has outstanding of Br 500,000 non-interest-bearing debt (loan)

payable Br 100,000 a year for 5 years starting Dec 31, year 1. What is the present value
of this debt on Jan 1 year 1. If interest is 8% compounded annually.

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Example: You just recently borrowed $50,000 from a bank for five (5) years to purchase
a new car. The loan has a fixed annual payment at the end of each year over the next 5
years. The loan has annual interest rate of 12 percent with compounding annually.
Required: Prepare an amortization schedule

ii) Present value of an Annuity Due – is the present value computed where exactly the
first payment is to be made. Graphically, this is shown below:

0 1 2 3 ---------------- n

PMT1 PMT2 PMTn

The present value of an annuity due is computed at point 1 while the present value of an
ordinary annuity is computed at point 0.
Therefore, the present value falls on the date the first payment is made.
made.

PVAn = (Annuity due) = PMT (1 + i)

= PMT (PVIFAi, n) (1 + i)

Example: XYZ Corporation purchase a new machine and agreed to pay for it in equal
installments of Br. 5,000 for 10years. The first payment is made on the date of purchase,
and the prevailing interest rate that applies for the transaction is 8%. Compute the
purchase price of the machinery.

Given: PMT = Br. 5,000; n = 10 years; i = 8%; PVAn (Annuity due) =?

PVA (Annuity due) = Br. 5,000 (PVIFA 8%, 10) (1.08)
= Br. 5,000 (6.7101) (1.08) = Br. 36,234.54.
So the cost of the machinery for XYZ co is Br. 36,234.54. We have identified the case as
an annuity due rather than ordinary annuity because the first payment is made today, not
after one period.

iii) Present value of a Deferred Annuity is computed two or more periods before the first
payment is made.

PVAn (Deferred annuity) = PMT (1 + i)-x

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 = PMT (PVIFAi, n) (1 + i)-x

Where x is the number of periods between the date when the present value in ordinarily
computed and the date the present value is computed for present value of due.

Example: Star Chartered Accountants has developed and copyrighted an accounting

software program. Star agreed to sell the copyright to Steel company for 6 annual
payments of Br. 5,000 each. The payments are to begin 5 years from today. If the annual
interest rate is 8%, what is the present value of the six payments?

0 1 2 3 4 5 6 7 8 9 10

PVAn = ? 5,000 5,000 5,000 5,000 5,000 5,000

X

Given: n = 6; PMT = Br. 5,000; X = 4; PVA6 (Deferred annuity) = ?

i = 8% PVA6 (Deferred annuity) = Br. 5,000 (PVIFA8%, 6) (1.08)-4
= Br. 5,000 (4.6229) (0.7350)
= Br. 16,989.16

3.3.3 Present Value of Uneven Cash Flows

The present value of an uneven cash flow stream is found by summing the present values
of individual cash flows of the stream.

Example: Suppose you are given the following cash flow stream where the appropriate
interest rate is 12% compounded annually. What is the present value of the cash flows?

Year 1 2 3
Cash flow Br. 400 Br. 100 Br.300

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Br. 400 (0.8929) PVIF12%, 1
= Br. 357.16
Br. 100 (0.7972) PVIF12%, 2
= Br. 79.72
Br. 300 (0.7118) PVIF12%, 3
= Br. 213.54
Br. 650.42

3.3.4 Present Value of a Perpetuity

A perpetuity is an annuity with an indefinite cash flow. In perpetuity payments are made
continuously forever. The present value of a perpetuity is found by using the following
formula:
PV (Perpetuity) = Payment = PMT
Interest rate i
Example: What is the present value of a perpetuity of Br. 7,000 per year if the
appropriate discount rate is 7%?

Given: PMT = Br. 7,000; i = 7%;, PV (Perpetuity) = ?

PV (Perpetuity) = PMT = Br. 7,000 = Br. 100,000.
100,000. This means that
i 7%
receiving Br. 7,000 every year forever is equal to receiving Br. 100,000 now.

SUMMARY OF IMPORTANT RELATIONSHIP IN TVM

For a given interest rate:

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  The longer the time period, The higher the future value
For a given time period:
 The higher the interest rate, The larger the future value

For a given interest rate:

 The longer the time period, The lower the present value
For a given time period:
 The higher the interest rate, The smaller the present value

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