Chapter 3

The Time Value of Money

3.1. Introduction
Many decisions in finance involve choices of receiving or paying cash at different time periods. As
you recall from the discussions of the first unit, the goal of a firm is wealth maximization. This goal
recognizes the difference in the value of equal cash flows received at different time periods. So 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.
❖ Simple Interest Concept
Variables in Interest Computation
There are several terms that we need to understand.
1. Principal-the amount borrowed or invested on which interest is to be charged
2. Interest rate-the percentage that is applied to the principal
3. Time-the periods that the principal is outstanding
➢ Simple Interest
A paid interest is charge for a loan, usually a percentage of the amount loaned.
If we have borrowed money, from a bank or credit union, we have to pay them interest.

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An earned interest is a percentage of an amount that we receive from a bank or credit union for the
amount of money that we have deposited.
In this section we will discuss simple interest, simple interest over multiple years, and simple interest
over a fraction of a year.
- Computing Simple Interest
Simple interest is calculated on a yearly basis (annually) and depends on the interest rate.
The rate is often given per annum (p.a.) which means per year.
Simple interest is calculated on the original principal only.
Accumulated interest from prior periods is not used in calculations for the following periods. Simple
interest is normally used for a single period of less than a year, such as 30 or 60 days.
Simple Interest = p r t
Where:
p = principal (original amount borrowed or loaned) r = interest rate for one period
t = number of periods
Example 3.1: You borrow $10,000 for 3 years at 5% simple annual interest. What is the interest
amount? Interest = p r t = 10,000 x 0.05 x 3 = 1,500
Example 3.2: You borrow $10,000 for 60 days at 5% simple interest per year (assume a 365 day
year). Determine the interest amount.Interest = p r t = 10,000 x 0.05 x (60/365) = 82.1917
Amount of Simple Interest
Example 3.3: Ko.Co. Deposited $10,000 into saving account that pays 10% per quarter
a. what is simple interest for four quarters
b. what will be the future amount of the deposit after two years
c. compute total interest for two-years
Example 3.4: a credit union has issued a three year of loan of birr 5,000. Simple interest is charged at
a rate of 10% per year, the principal plus the interest is to be paid at the end of 3rd year.
a) Compute the interest for three year period.
b) What amount will be paid at the end of the 3rd year?
❖ Compound Interest Concept
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.

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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.
General Assumptions Needed in Computing Interest
In order to focus on interest rate and to avoid complications that would tend to hide the essential
concepts, the following three general assumptions are needed to be made. These are:
Certainty: - It is the most restrictive assumption.
All current and future data values are assumed to be known with certainty, or a set of techniques exists
for estimating all unknown variables.
Certainty also applies to the accuracy of future events and their occurrences.
This assumption is used for simplicity since uncertainty requires the introduction of techniques that
cannot be easily understood.
Discrete Time Period: - Time is divided into yearly intervals.
The time that elapses between the last days of two consecutive years is expressed as one year. For
example, year 3 is the time that elapses from the last day of year 2 to the last day of year 3. This
assumption doesn't require cash flows to occur on the last day of each year.
What is required is that cash flows have to occur only at points of time that are separated by one year
intervals.
The assumption, thus, allows us to abstract from specific calendar dates and to measure time from the
point at which a particular investment or financing program begins.
Yearly Interest Computations: - interest is computed once a year and the computation is made at the
end of the year.
This assumption is thus, consistent with the discrete time period assumption made above.
In reality, many situations involve monthly, daily, and even continuous interest computation where by
many commercial banks and savings and credit associations offer daily or continuous interest
compounding on depositors' money.
Compounding Method: There are two ways of depositing payments (money) into an interest bearing
account. These are single payment and series of payments.
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.
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 ➢ 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.
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

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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.
E.g.3.5: X deposited Br. 1,800 in her savings account in January 2023. Her account earns 6 percent
compounded annually. How much will she have in January 2030?
To solve this problem, let’s identify the given items: PV = Br, 1,800; i = 6%; n = 7 (January 2023 –
January 2030).
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 FVIF 6%,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 3.6: Assume that we have deposited 5,000 birr in CBE which pays interest of 6% per year
compounded semi-annually. Assume that you want to determine the amount of money we will have on
deposit at the end of two years, if all interests left in the saving account.
Finding the Interest Rate:
E.g.3.7. Assume that you have invested 15,000 Birr today at a bank where it can grow to the future value
of 17,900 Birr within three years from now into the future. What is the interest rate that the bank should
pay for your account in order to fulfill your desire?
Solution FV3= PV (1+i)3
17900 = 15,000 (1+i)3
(1+i)3 = FVIFi,3 =
The future value interest factor in the interest (future value of single payment table) corresponding to the
unknown interest rate (i) and a period of 3 years n = 3) is 1.193. Hence, look up the three year (n=3) row
and read horizontally until you find the table value (future value interest factor) that is equal or the
closest to the computed value of 1.193. There is no table value that is exactly equal to 1.193.
The table value of 1.191 is found to be the closest value to 1.193 and it corresponds to 6 percent. Thus,

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the interest that the bank actually has to pay to your account is slightly greater than 6 percent.
Example 3.8: if in 12 years, birr 600 accumulates to birr 882 what is the compound interest rate provided
it is converted annually.
Finding the number of years:-
E.g.3.9 Assume, for example, a deposit of 1000 Birr is made in an interest bearing account that pays 10
percent compounded yearly. Your goal as a depositor is to collect 1,500 Birr after an unknown number of
years. How many years should you wait for the desired amount to be realized?
By substituting the values into the future value of single payment equation, you get:
FVn = 1000 ((1+i)) n
1,500 =1000 ((1+0.1)) n =1000 ((1.1))n
((1.1)) n = 1500 = 1.5, by using logarithm
1000
n = log 1.5 = 0.176 = 4.29 years
log 1.1 0.041
Again it is possible to look up the 10 percent column in the future value interest factors (future
value) table and read vertically until you find a table value that is equal to 1.5 or closest to it. The closest
table value is 1.611, which corresponds to five years (n =5). That means if the 1000 Birr is kept in the
account that pays 10 percent for five years; the resulting compounding amount will be 1,611 Birr. This
amount exceeds the desired amount of 1,500 Birr. If the 1000 Birr is kept in the account only for four
years, the table value is 1.464 Birr. Hence, the 1000 Birr has to be kept in the account for a period
slightly greater than 4 years.
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.
It 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.

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
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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 3.10: ABC PLC owes Br. 50,000 to XYZ Co. at the end of 5 years. XYZ Co. could earn 12%
on its money. How much should XYZ Co. accept from ABC 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
E.g.3.11 On January 1, 2023, Moon Corporation sold a motor vehicle to Sun Company. Sun signed a Br.
200,000 non-interest bearing promissory note due on January 1, 2026. The prevailing interest rate for a
similar note on January 1, 2023, was 9%. How much is the selling price of the motor vehicle for Moon
Corporation?
Solution: The selling price of the motor vehicle is the present value of the promissory note.
Given: FV3 = Br. 200,000; i = 9%; n = 3 (Jan. 1, 2023 to Jan. 1,2026); PV = ?
PV = FV3 (PVIF9%, 3)
= Br. 200,000 (0.7722) = Br. 154,440
Finding the Interest Rate: Although the term of contract may clearly state that all the relevant cash
flows, the problem of determining the interest rate or the rate of return to the lender, or investor may still
remain unsolved.
When single payments are involved, the implied interest rate approach used for compounding problem
can be adopted for use in determining the interest rate in the present value table.

E.g.3.12: Suppose that you have taken a loan of 1200 Birr today which is to be paid after three years
together with its interest by making a payment of 1500 Birr. What is the rate of interest on the loan that
you have taken?
Solution: The present value, PV is equal to 1,200 Birr;
The future value, FV is 1500 Birr;
The period of the loan, n is equal to 3 years.
Then you substitute the given variables into the equation and solve for the table value: Pv = 1200 =
Looking at the year three (n=3) row in the present value table; try to locate the present value interest

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factor (table value) that is equal to or closest to 0.80. The resulting table values are 0.816 corresponding 7
percent and 0.794 corresponding to 8 percent. Thus, the interest rate is between 7 percent and 8 percent.

Finding the Number of Years: - The present value table and the present value equation for single
payment can be used to determine the number of years required for the present value to equal its future
value at a given rate of yearly compounding.

E.g.3.13: how many years do you need to wait for your deposit of 1000 Birr to grow to 1,200 Birr in a
saving account that pays interest compounding yearly at 6 percent?
Solution: let the 1000Birr be the present value of the future value of 1200 Birr at an interest rate of 6
percent per year. By substituting into the present value equation for single payment and solving for the
desired table value, you get.
PV = FVn (PV1Fi,n)
1000 = 1200 (PV1F6%,n) it follows that PV1F6%,n = 1000 = 0.833
1200
Then look at the 6 percent column in the present value table of single payment and read down the present
value interest factors till you arrive at the value that is equal of falls below the computed table value,
0.8333. The table value that meets the stated requirement is 0.792, and it corresponds to 4 years, (n=4).
Therefore, the 1000 Birr will have to be kept in the saving account for 4 years (and compounded four
times) before it grows to the desired value of 1200 Birr.
3.4. Future Value of an Annuity
An annuity is a series of equal periodic rents (receipts, payments, withdrawals or 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.
1. The cash flows must be equal.
2. The interval between any two cash flows must be fixed.
3. The interest rate applied for each period must be constant.
4. 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:
i) ordinary annuity,
ii) annuity due, and

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iii) deferred annuity

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 (nth) 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 3.14: You need to accumulate Br. 25,000 to acquire a car. To do so, you plan to make equal
monthly deposits for 5 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, %, 60)
⟶ Br. 25,000 = PMT (81.670)
⟶ PMT = Br. 25,000/81.670
⟶ PMT = Br. 306.11
ii) Future value of an Annuity Due. An annuity due is an annuity for which the payments occur at the
beginning of each period.

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Therefore, the future value of an annuity due is computed exactly one period after the final payment is
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 3.15: Assume that previous 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: 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 1+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
= PMT (1 + i)x
Where x = the number of periods after the final payment; and X ≥ 2.
Example 3.16: Abel has a savings account which he had been depositing Br. 3,000 every year on
January 1, starting in 2023. His account earns 10% interest compounded annually. The last deposit Abel
made was on January 1, 2032. How much money will he have on December 31, 2036?
(No deposits are made after 2032 January.)
Jan.
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2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 2037
3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000
The future value is computed on December 31, 2036 (or January 1, 2037).
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

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 3.17: 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
FV = Br. 12,001.20

Examples 3.18
1. How much must you deposit now on January 1, 2023 to have a balance of Br. 10,000 on December 31,
2027? Interest is compounded at an 8% annual rate.
Solution
Given: FV5 = Br. 10,000; n = 5 (January 1, 2023 to December 31, 2027); i= 8%; PV = ?

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FV5 = PV (FVIF8%, 5)
⟶ Br. 10,000 = PV (1.4693)
⟶ PV = Br. 10,000 / 1.4693 = Br. 6,805.96
2. XYZ company plans to accumulate Br. 500,000 to retire its long-term debt on December 31, 2030. To
achieve the plan, the company has just deposited Br. 100,000 today January 1,2023. But the company
knows that this deposit alone would not enable to achieve the target and wants to make equal annual
deposits starting January 1,2025 until January 1,2030. Assuming the appropriate interest rate is 6%
compounded annually, how much should XYZ deposit every January so as to achieve its plan?
Solution
2023 2024 2025 2026 2027 2028 2029 2030 2031

Br. 100,000 PMT PMT PMT PMT PMT PMT Br. 500,000 Br. 100,000 (FVIF6%, 8) + PMT
(FVIFA6%, 6) (1.06) = Br. 500,000
⟶ Br. 100,000 (1.5938) + PMT (6.9753) (1.06) = Br. 500,000
⟶ Br. 159,380 + PMT (7.3938) = Br. 500,000
⟶ PMT (7.3938) = Br. 340,620
⟶ PMT = Br. 340,620 ÷ 7.33938 = Br. 46,068.33
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.
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 3.19: Ato Mengesha retired as general manager of Tirusew Foods 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 Mengesha’s consulting contract if his opportunity costs are 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.

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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.
Examples 3.20: How large must each annual payment be for a Br.100, 000 loans to be repaid in equal
installments at the end of each of the next 5 years? The interest rate is 10%, compounded annually.
Solution: The loan of amount of Br. 100,000 is the present value of the five equal annual payments.
Given: PVA5 = Br.100,000; n = 5; i = 10%; PMT = ?
PVA5 = PMT (PVIFA10%, 5)
⟶ Br. 100,000 = PMT (3.7908)
⟶ PMT = Br. 100,000 ÷ 3.7908 = Br. 26,379.66
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:
01 2 3 n

PMT1 PMT2 PMTn

Note: 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.
PVAn = (Annuity due) = PMT (1 + i) = PMT (PVIFAi, n) (1 + i)
Example 3.21: Ruth Corporation bought 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 Ruth 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.

E.g.3.22: Assume the above example except that the first payment is to be made after 1 year from the
date of purchase. How much would be the cost of the machinery now for Ruth Corporation? Solution
Given: PMT = Br. 5,000; n = 10; i = 8%; PVAn = ?
When the payment is to start one year from the date of purchase, the cost of the machinery would be the
present value of an ordinary annuity rather than annuity due.

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PVA10 = Br. 5,000 (PVIFA8%, 10)

= Br. 5,000 (6.7101) = Br. 33,550.50
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 = PMT (PVIFAi, n) (1 + i)-x
Where x is the number of periods between the date when the first payment is made and the date the
present value is computed.
Example 3.23: Sefa Chartered Accountants has developed and copyrighted an accounting software
program. Sefa 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 =? X 5,000 5,000 5,000 5,000 5,000 5,000

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
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 3.24: 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?
Solution Year 1 2 3

Cash flow Br. 400 Br. 100 Br.300 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

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Br. 650.42

Present Value of Perpetuity

Perpetuity is an annuity with indefinite cash flows.
In perpetuity payments are made continuously forever.
The present value of perpetuity is found by using the following formula:
PV (Perpetuity) = Payment = PMT
Interest rate i
Example 3.25: What is the present value of perpetuity of Br. 7,000 per year if the appropriate discount
rate is 7%?
Solution
Given: PMT = Br. 7,000; i = 7%;, PV (Perpetuity) = ?
PV (Perpetuity) = PMT = Br. 7,000 = Br. 100,000.
i 7%
This means that receiving Br. 7,000 every year forever is equal to receiving Br. 100,000 now.
Nominal and Effective Interest Rate
Nominal and effective interest rates, which have the same basic relationship.
The difference here is that the concepts of nominal and effective are used when interest is compounded
more than once each year.
Two types of interest quotation
1. Quotation using a Nominal Interest Rate
2. Quoting an Effective Periodic Interest Rate
Nominal and Effective Interest rates are common in business, finance, and engineering economy Each
type must be understood in order to solve various problems where interest is stated in various ways.
Conversion of Effective interest rate
It is a simple interest rate that would produce the same amount in one year is the same principal used at
simple interest rate without compounding.
Amount at simple interest = Amount at compound interest
P (1+in) = p (1+r/m)m.t let i = re (effective rate). Here i is nominal interest rate in one year
P (1+ren) = p (1+r/m)n
P (1+re1) = p (1+r/m)n divide both side by “p”
(1+re) = (1+r/m)n

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Compiled by Tefera B. (PhD Candidate)
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re = (1+r/m)n - 1
Example 3.26: What is the true, effective annual interest rate? If the nominal rate is 18%. r = 0.18/12
= 0.015 = 1.5% per month. 1.5% per month is an effective monthly rate. The effective annual rate is:
Given: “18%/year, comp. Monthly”
(1 + 0.18/12)12 – 1 = 0.1956 = 19.56%/year
If we allow compounding to occur more and more frequently, the compounding period becomes shorter
and shorter. Then m, the number of compounding periods increases. This situation occurs in businesses
that have a very large number of Cash Flow every day.
re = e r – 1
Where “r” is the nominal rate of interest compounded continuously. This is the max. Interest rate for any
value of “r” compounded continuously.
Example 3.27: What is the true, effective annual interest rate if the nominal rate is given as: r = 18%,
compounded continuously or, r = 18% c.c.
Solution: e0.18 – 1 = 1.1972 – 1 = 19.72%/year
The 19.72% represents the MAXIMUM i for 18% compounded anyway you choose!
Example 3.28: An investor has an opportunity to purchase two different notes. Note ‘A’ pays
15% compounded monthly and note ‘B’ pays 15.5% compounded semi- annually. Which is the better
investment?

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Compiled by Tefera B. (PhD Candidate)