Chapter 3

Time Value of Money and

Security valuation
• Concept of time vale of money
• Interest rate determinants
• Future/present value of single sum
• Future/Present value Annuities
• Rates of return
• Amortization 6-1
 Concept of TVM
Time value of money represents the fact that $1 today is more
valuable than $1 in the future, say one year from now.
 The factors that make money to have time value:

 Consumption preference: - Individuals prefer current

consumption to future consumptions. So people would have to

be offered more in the future to give up current consumption.
 Inflation: - general increase in prices (inflation) erodes the

purchasing power of money. Hence, the value of money

decreases with time when there is inflation.
 Uncertainty (Risk): - As compared to today’s money future cash

flows have risks (default risk) Hence, delaying cash collection

means assuming greater risks. Individuals want to be rewarded
for this additional risk assumed n future cash flows.
 Investment opportunities: - cash received today could be

invested and fetch additional income.

6-2
 Concept of TVM…
 Therefore, as money has time value, the same cash flows
in different periods have different values. This makes
aggregation and comparison of cash flows at different
times illogical unless adjusted for the above factors. This
adjustment is made using discount rates.
 Discount rate: - rates at which present and future cash
flows are traded-off. It incorporates the above factors.
 Greater present consumption….higher discount rates.
Individuals with greater present consumption require higher
rewards for giving it up.
 Higher expected inflation ….. . higher discount rates.
 Higher risks …….. higher discount rates.
 Higher expected return on the present cash flows……higher
discount rates.
6-3
 Concept of TVM…
 Discounting: - the process of moving cash flows that are
expected to occur in the future back to the present using
discount rates. It converts future cash flows to present
value terms.
 Compounding: - the process of moving present cash
flows to future using discount rates.

6-4
 Determinants of Interest rate
 Interest Rate Levels
 Refers to the shift in demand and supply for funds and the
related change in the interest rate level (equilibrium).Like
any commodity capital is allocated by its price (interest
rate) which, in a pure market economy, is determined by
the forces of demand and supply. Increase in the demand
of debt capital pushes interest rates up, and decreases in
the demand of capital, in times of recession, pulls it lower.
Increase in the total supply of debt capital reduces
interest rates. A decrease in the supply creates shortage
of funds in the market and those firms with profitable
investment tend to attract capital away from less
profitable firms by paying higher interest rates.

6-5
 Determinants of Interest rate
 Determinants of Interest Rates
 The quoted interest rate on a debt security, K, is
composed of a real risk free rate of interest plus
premiums for inflation, risk and liquidity.
 K =K* + IP + DRP + LP + MRP
 Where:
 K*= the real risk free rate.
 IP = inflation premium (the average expected inflation
rate over the life of the security)
 DRP = Default risk premium
 LP = Liquidity or marketability premium
 MRP = maturity risk premium (the risk related to price
declines) 6-6
 Determinants of Interest rate
 The Real Risk-Free Rate (K*)
 This is the interest rate that would exist on a risk less
security if no inflation is expected. This is a no risk no
inflation interest rate. This rate changes over time
depending on economic conditions:
 Rate of return expected by businesses and other
borrowers expect to earn on a productive assets. This is
the upper limit borrowers can afford.
 People’s time preferences for current versus future
consumptions. Determines the amount of income savers
are ready to defer, hence the amount of funds available.
(Supply of funds)

6-7
 Future values and present
values and the Time lines
0 1 2 3
i%

CF0 CF1 CF2 CF3

 Show the timing of cash flows.

 Tick marks occur at the end of periods, so
Time 0 is today; Time 1 is the end of the
first period (year, month, etc.) or the
beginning of the second period.
6-8
 Drawing time lines:
$100 lump sum due in 2 years;
3-year $100 ordinary annuity

$100 lump sum due in 2 years

0 1 2
i%

100
3 year $100 ordinary annuity
0 1 2 3
i%

100 100 100

6-9
 Drawing time lines:
Uneven cash flow stream; CF0 = -$50,
CF1 = $100, CF2 = $75, and CF3 = $50

Uneven cash flow stream

0 1 2 3
i%

-50 100 75 50

6-10
 What is the future value (FV) of an initial
$100 after 3 years, if I/YR = 10%?

 Finding the FV of a cash flow or series of

cash flows when compound interest is
applied is called compounding.
 FV can also be solved by using the
arithmetic, financial calculator, and
spreadsheet methods.
0 1 2 3
10%

100 FV = ?
6-11
Solving for FV:
The arithmetic method
 After 1 year:
 FV = PV ( 1 + i ) = $100 (1.10)
1
= $110.00
 After 2 years:
2
 FV = PV ( 1 + i ) = $100 (1.10)
2
2
=$121.00
 After 3 years:
3
 FV = PV ( 1 + i ) = $100 (1.10)
3
3
=$133.10
 After n years (general case):
 FV = PV ( 1 + i )
n
n 6-12
Solving for FV:
The calculator method
 Solves the general FV equation.
 Requires 4 inputs into calculator, and will
solve for the fifth. (Set to P/YR = 1 and
END mode.)

INPUTS 3 10 -100 0
N I/YR PV PMT FV
OUTPUT 133.10

6-13
 What is the present value (PV) of $100
due in 3 years, if I/YR = 10%?
 Finding the PV of a cash flow or series of
cash flows when compound interest is
applied is called discounting (the reverse of
compounding).
 The PV shows the value of cash flows in
terms of today’s purchasing power.
0 1 2 3
10%

PV = ? 100
6-14
Solving for PV:
The arithmetic method
 Solve the general FV equation for PV:
 PV = FVn / ( 1 + i )n

 PV = FV3 / ( 1 + i )3
= $100 / ( 1.10 )3
= $75.13

6-15
Solving for PV:
The calculator method
 Solves the general FV equation for PV.
 Exactly like solving for FV, except we
have different input information and are
solving for a different variable.

INPUTS 3 10 0 100
N I/YR PV PMT FV
OUTPUT -75.13

6-16
Solving for N:
If sales grow at 20% per year, how long
before sales double?
 Solves the general FV equation for N.
 Same as previous problems, but now
solving for N.

INPUTS 20 -1 0 2
N I/YR PV PMT FV
OUTPUT 3.8

6-17
 Annuities: an ordinary annuity and an
annuity due?

Ordinary Annuity
0 1 2 3
i%

PMT PMT PMT

Annuity Due
0 1 2 3
i%

PMT PMT PMT

6-18
The arithmetic method for Annuities
 Future value Formulae for annuities:
1. Ordinary annuities
 FV = PMT [(1+i) n - 1)]
 i
 Where: PMT is the periodic cash flows,
 i is the discount rate, and
 n is the number of periods
 Example : ABC co has planned to acquire machinery after
five years. To that end, the company deposits Birr $
3000.00 at the end of each year at a deposit rate of 12%.
How much is the terminal (future value) of the deposits at
the end of the fifth year? How much is the terminal value if
deposits are made semi-annually? 6-19
The arithmetic method for Annuities
2. Annuity Due
 FV = PMT (1+ r) [(1+i) n - 1]
 I

 Example : How much will the terminal value of the a

cash flow we used to illustrate ordinary annuity if the
deposit is made at the beginning of each year?

6-20
The arithmetic method for Annuities
 Present value Formulas for annuities:
1. Ordinary annuities
 PV = PMT [1- (1/(1+i)n]
 i
 Example 5: If in previous example , ABC co. has the option
of paying $10,000.00 at the time of purchase, which option
will ABC take at the discount rate of 12%.
 PV = $3,000.00[1-1/(1+12%)5]
 12%
 = $10,814.00

6-21
The arithmetic method for Annuities
 Present value Formulas for annuities:
2. Annuity Due
 PV = PMT + PMT (1-1/(1+i) n-1
 i

6-22
The arithmetic method for Perpetuities
 Present value Formulas for perpetuities:
A. Perpetuity: - a constant cash flow that is paid (received) at
a regular time interval forever.
PV = A/i
Where: A is the periodic cash flow, and
i is the discount rate
B. Growing perpetuities: - a cash flow that is expected to
grow at a constant rate forever.
 PV = CF1
 r-g
Where: CF1 is cash flow after one period,
r is the discount rate, and 6-23
Solving for FV:
3-year ordinary annuity of $100 at 10%

 $100 payments occur at the end of

each period, but there is no PV.

INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 331

6-24
Solving for PV:
3-year ordinary annuity of $100 at 10%

 $100 payments still occur at the end of

each period, but now there is no FV.

INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -248.69

6-25
Solving for FV:
3-year annuity due of $100 at 10%

 Now, $100 payments occur at the

beginning of each period.
 Set calculator to “BEGIN” mode.

INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 364.10

6-26
Solving for PV:
3 year annuity due of $100 at 10%

 Again, $100 payments occur at the

beginning of each period.
 Set calculator to “BEGIN” mode.

INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -273.55

6-27
 What is the PV of this uneven cash
flow stream?

0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV how about FV?
6-28
Solving for PV:
Uneven cash flow stream
 Input cash flows in the calculator’s “CFLO”
register:
 CF0 = 0
 CF1 = 100
 CF2 = 300
 CF3 = 300
 CF4 = -50
 Enter I/YR = 10, press NPV button to get
NPV = $530.09. (Here NPV = PV.) 6-29
Solving for I:
What interest rate would cause $100 to
grow to $125.97 in 3 years?
 Solves the general FV equation for I.

INPUTS 3 -100 0 125.97

N I/YR PV PMT FV
OUTPUT 8

6-30
 The Power of Compound
Interest
A 20-year-old student wants to start saving for
retirement. She plans to save $3 a day. Every day,
she puts $3 in her drawer. At the end of the year,
she invests the accumulated savings of $1,095
(3*365days) in an online stock account. The stock
account has an expected annual return of 12%.

How much money will she have when she is 65

years old? Note it is ordinary annuity of 1095 every
year.
she will have $1,487,261.89 when she is 65. 6-31
Solving for FV:
Savings problem
 If she begins saving today, and sticks to
her plan, she will have $1,487,261.89
when she is 65.

INPUTS 45 12 0 -1095
N I/YR PV PMT FV
OUTPUT 1,487,262

6-32
Solving for FV:
Savings problem, if you wait until you are
40 years old to start
 If a 40-year-old investor begins saving
today, and sticks to the plan, he or she will
have $146,000.59 at age 65. This is $1.3
million less than if starting at age 20.
 Lesson: It pays to start saving early.

INPUTS 25 12 0 -1095
N I/YR PV PMT FV
OUTPUT 146,001

6-33
Solving for PMT:
How much must the 40-year old deposit
annually to catch the 20-year old?
 To find the required annual contribution,
enter the number of years until retirement
and the final goal of $1,487,261.89, and
solve for PMT.

INPUTS 25 12 0 1,487,262

N I/YR PV PMT FV
OUTPUT -11,154.42

6-34
 Will the FV of a lump sum be larger or
smaller if compounded more often,
holding the stated I% constant?
 LARGER, as the more frequently compounding
occurs, interest is earned on interest more often.
0 1 2 3
10%

100 133.10
Annually: FV3 = $100(1.10)3 = $133.10
0 1 2 3
0 1 2 3 4 5 6
5%

100 134.01
Semiannually: FV6 = $100(1.05)6 = $134.01
6-35
 Classifications of interest
rates
 Nominal rate (iNOM) – also called the quoted or
state rate. An annual rate that ignores
compounding effects.
 iNOM is stated in contracts. Periods must also be
given, e.g. 8% Quarterly or 8% Daily interest.
 Periodic rate (iPER) – amount of interest
charged each period, e.g. monthly or quarterly.
 iPER = iNOM / m, where m is the number of
compounding periods per year. m = 4 for
quarterly and m = 12 for monthly compounding.
6-36
Classifications of interest
rates
 Effective (or equivalent) annual rate (EAR =
EFF%) – the annual rate of interest actually
being earned, taking into account
compounding.
 EFF% for 10% semiannual investment
EFF% = ( 1 + iNOM / m )m - 1
= ( 1 + 0.10 / 2 )2 – 1 = 10.25%
 An investor would be indifferent between
an investment offering a 10.25% annual
return and one offering a 10% annual return,
compounded semiannually.
6-37
Why is it important to consider
effective rates of return?
 An investment with monthly payments is different
from one with quarterly payments. Must put
each return on an EFF% basis to compare rates of
return. Must use EFF% for comparisons. See
following values of EFF% rates at various
compounding levels.

EARANNUAL 10.00%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%
6-38
Can the effective rate ever be
equal to the nominal rate?
 Yes, but only if annual compounding
is used, i.e., if m = 1.
 If m > 1, EFF% will always be greater
than the nominal rate.

6-39
When is each rate used?
 iNOM written into contracts, quoted by banks
and brokers. Not used in calculations or
shown on time lines.
 iPER Used in calculations and shown on time
lines. If m = 1, iNOM = iPER = EAR.
 EAR Used to compare returns on
investments with different payments per
year. Used in calculations when annuity
payments don’t match compounding
periods.
6-40
What is the FV of $100 after 3 years under
10% semiannual compounding? Quarterly
compounding?

i NOM m n
FV n  PV (1  )
m

0.10 2 3
FV 3S  $100 (1  )
2
FV 3S  $100 (1.05)
6
 $134.01
FV 3Q  $100 (1.025)
12
 $134.49
6-41
 What’s the FV of a 3-year $100 annuity,
if the quoted interest rate is 10%,
compounded semiannually?
1 2 3
0 1 2 3 4 5 6
5%

100 100 100

 Payments occur annually, but compounding

occurs every 6 months.
 Cannot use normal annuity valuation
techniques.

6-42
 Compound each cash flow; or
method 2 is using financial
calculator
1 2 3
0 1 2 3 4 5 6
5%

100 100 100

110.25
121.55
331.80

FV3 = $100(1.05)4 + $100(1.05)2 + $100

FV3 = $331.80
6-43
Method 2:
Financial calculator
 Find the EAR and treat as an annuity.
 EAR = ( 1 + 0.10 / 2 )2 – 1 = 10.25%.

INPUTS 3 10.25 0 -100

N I/YR PV PMT FV
OUTPUT 331.80

6-44
Find the PV of this 3-year
ordinary annuity.
 Could solve by discounting each cash
flow, or …
 Use the EAR and treat as an annuity to
solve for PV.

INPUTS 3 10.25 100 0

N I/YR PV PMT FV
OUTPUT -247.59

6-45
 Loan amortization
 Amortization means retiring a debt in a given length of time
by equal periodic payments that include compound interest.
After the last payment, the obligation ceases to exist-it is
dead-and it is said to have been amortized by the payments.
 In amortization our interest is to determine the periodic
payment, R, so as to amortize (retire) a debt at the end of
the last payment. Solving the PV of ordinary annuity formula
for R in terms of the other variables, we obtain the following
amortization formula:

6-46
 Loan amortization
 Where:  i

R = P  
 R = periodic payment 1 -  1 + -n
 i 
 P = PV of loan
 i= interest rate per period
 n = number of payment periods

6-47
Loan amortization
 Amortization tables are widely used for
home mortgages, auto loans, business
loans, retirement plans, etc.
 Financial calculators and spreadsheets are
great for setting up amortization tables.

 EXAMPLE: Construct an amortization

schedule for a $1,000, 10% annual rate
loan with 3 equal payments.
note: first find periodic payment of 402 per year using
PV of ordinary annuity formula 6-48
Step 1:
Find the required annual payment
 All input information is already given,
just remember that the FV = 0 because
the reason for amortizing the loan and
making payments is to retire the loan.

INPUTS 3 10 -1000 0

N I/YR PV PMT FV
OUTPUT 402.11

6-49
Step 2:
Find the interest paid in Year 1
 The borrower will owe interest upon the
initial balance at the end of the first year.
Interest to be paid in the first year can
be found by multiplying the beginning
balance by the interest rate.

INTt = Beg balt (i)

INT1 = $1,000 (0.10) = $100
6-50
Step 3:
Find the principal repaid in Year 1
 If a payment of $402.11 was made at
the end of the first year and $100 was
paid toward interest, the remaining
value must represent the amount of
principal repaid.

PRIN = PMT – INT

= $402.11 - $100 = $302.11

6-51
Step 4:
Find the ending balance after Year 1
 To find the balance at the end of the
period, subtract the amount paid toward
principal from the beginning balance.

END BAL = BEG BAL – PRIN

= $1,000 - $302.11
= $697.89

6-52
 Constructing an amortization table:
Repeat steps 1 – 4 until end of loan
Year BEG BAL PMT INT PRIN END
BAL
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 366
3 366 402 37 366 0
TOTA 1,206.34 206.34 1,000 -
L
 Interest paid declines with each payment as
the balance declines. What are the tax
implications of this?
6-53
 Illustrating an amortized payment:
Where does the money go?
$
402.11
Interest

302.11

Principal Payments

0 1 2 3
 Constant payments.
 Declining interest payments.
 Declining balance.
6-54
 Mortgage Payments
 In atypical house purchase transaction, the home-buyer pays part of the
cost in cash and borrows the remained needed, usually from a bank or a
savings and loan association. The buyer amortizes the indebtedness by
periodic payments over a period of time. Typically, payments are monthly
and the time period is long-30 years is not unusual.


 Mortgage payment and amortization are similar. The only differences are
 The time period in which the debt/loan is amortized/repaid
 The amount borrowed.
 In mortgage payments m is equal to 12 because the loan is repaid from
monthly salary, but in amortization m may take other values.

6-55
Similarly

 In Mortgage payments we are interested in the determination of

monthly payments.
 Taking A = total debt
 R = monthly mortgage payment
 r = stated nominal rate per annum
 n = 12 x t
 R can be determined as follows:

 r/12
  i

R = A   (O R ) R = A  
1 -
-n 
 1 + r/12   1 - 1 +
-n 
i 
 
6-56
Similarly

1  1  i   n 
 Similarly, A R 
 i


 Example
 Mr. X purchased a house for Birr 115,000. He
made a 20% down payment with the balance
amortized by a 30 yr mortgage at an annual
interest of 12% compounded monthly.
 What is the amount that Mr. X should pay monthly so
as to retire the debt at the end of the 30th yr?
 Find the interest charged.


6-57