Time Value of Money

1
 Introduction
• Time value of money is the concept used to
revalue payments from different time periods.
• Money has time value – meaning one pula today
is worth more than one pula in future.
• Money like any commodity it has a price. The
money can be ‘rent’ to someone else for example
a bank and earn interest.
• The interest will be a compensation for;
– inflation
– personal consumption preference
– risk
2
 Contin…..

• Inflation – Under inflationary conditions, the

value of money, expressed in terms of its
purchasing power over goods and services,
declines.
• Interest rates should therefore at least equal
inflation rate to preserve the value of money
over time.

3
 Contin…
• Personal consumption preference---majority of
people have a strong preference to immediate
rather than delayed consumption.
• Risk--- one pula now is certain, whereas one pula
receivable next year is less certain. “A bird in the
hand is better than the one flying”
• NOTE: PULAS FROM DIFFERENT TIME PERIODS
MUST BE TRANSLATED INTO THE SAME TIME
VALUE BEFORE THEY CAN BE COMPARED.
• USE EITHER FUTURE VALUE OR PRESENT VALUE
COMPUTATIONS.
4
 Future & Present Values
• Future value (FV) is how much your money today
(Present Value) will be worth in the future after
growing it by a certain interest rate.
• The process of going to future values is called
compounding.
• Present value (PV) is how much your expected
money in the future (FV) is worth today if you were
to use it now.
• The process of getting PV from future values is called
Discounting.
5
 Contin…

• Money today that can be compounded

(grown) or money in the future that can be
discounted (reduced) to today’s values can
be:
• Lump sum amount (a once off amount) e.g
value of P100 today in 5 years time. Or value
of P500 today that will be received in 5 years
from now
• A series of amount over time called Cash flows
6
 Determining FVs & PVs

• There are four procedures that can be used to

solve time value problems.
– Time lines (step-by-step approach)
– Formula approach
– Financial calculators &
– Spread sheets
– Financial tables

7
 Using Time Line
• A time line help you to visualise what is happening in a particular
problems. See an illustration below.

0 1 2 3
Periods 6%

Cash PV = P200 FV = ?

• Using a time line is a step-by-step approach in which FV & PV can

be obtained depending on what information you have been given.
• In the time line illustration above we are given times, interest rate
(6%), PV(200) and we are required to calculate FV in period 3.

8
 Contin…
• To get the FV for period three you have to get
the FV for period 1 and 2 first.
• Basically you multiply the initial amount at
each period with (1+ i) to get the FV for the
next period until you get to the last FV. See
the figure below.
0 1 2 3
Periods 6%

Cash P200.00 P212.00 P224.72 P238.20

9
 Contin…

• For example to get FV for Period 1-3 you compute:

FV1= P200(1+0.06) = P212.00
FV2= P212(1+0.06) = P224.72
FV3 = P224.72(1+0.06) = P238.20
• Therefore the required FV3 = P238.20
• Interest earned each period increases because the
beginning balance is higher each successive year.
• Total interest earned (P38.20) is reflected in the final
balance (P238.20).

10
 Formula Approach
• The formula for calculating FV is given as follows:
FVn=PV(1+i)n
• Where:
– FV= Future value
– PV=Present value
– i= interest rate
– n= Number of periods

• Calculate FV from the earlier example using the

above formula given PV=200, i=6% and n=3

11
 Solution

FV3=PV(1+i)n
FV3 = 200(1+0.06) 3

Therefore: FV3 = 200(1.06)3 = P238.20

Note: the formula can be used with any calculator that has an
exponential function to help find any FV given any number of
years “n”.

12
 Understanding Interest tables
– In the last example where we used the Formula
FVn=PV(1+i)n
– The (1+i)n is called the FV interest factor (FVIF). The
factor that multiplies the PVn to get the FVn.
• The FVIF can be obtained from interest tables and
used directly to calculate the FV given the PV, i
and n.
• From the interest table the FVIF is represented as
FVIF(i,n) and is a rounded figure.
• From our example we look for FVIF(6%,3)

13
 Contin…

• FVIF(6%,3) = 1.191
• To get our FV we use FV=PV*FVIF(6%,3)
• FV3= 200*1.191 = P238.20

14
 Using Financial Calculators
• Financial calculators can easily help calculate FVs
• You need to be familiar with the keys to strike in
your calculator:
• The most commonly used calculator is the BA II
plus Texas Instruments Calculator with the
following keys:
– N : representing number of periods
– I/YR: Interest rate per period
– PV = present value
– FV: Future value
– PMT: Payments

15
 Spread Sheets
• Refer to class exercise that we will do in class.
• But you basically have to be familiar with the following
notation to be used in the excel function.
– PV = use this function for calculating Present Value
– FV = used for calculating Future Value
– RATE = used when determining the interest rate
– NPER = used when determining the number of periods
– PMT =used when determining constant periodic payments
• Example: to find FV used the function below in excel
• =FV(rate,nper,pmt,[pv])

16
 Present Values

• To find PV you simply do the reverse of finding FV.

– Essentially solve for PV from the previous equation
we used for FVs: (FVn=PV(1+i)n)
• So PV = FVn/(1+i)n
• Finding PV is called discounting
• All the four method discussed earlier (step-by-step
approach, formula, Financial calculator and spread
sheets can be used to solve PV problems.

17
 Contin…

• Use a step by step approach and formula

approach to solve for the PV of P238.20
expected 3 years from now given the discount
rate of 6%.

18
 Solution

1. Step-by-step approach
• To get the PV for period zero(now) you have
to get the PV for period 2 and 1 first.
• Basically you divide the Ending amount at each
period with (1+ i) to get the PV for the
previous period. See the figure below.3
Periods
0 1 2
6%

Cash P200.00 P212.00 P224.72 P238.20

19
 Contin…

• For example to get PV for Period 2-0 you

compute:
PV2= P238.20/(1+0.06) = P224.72
PV1= P1224.72/(1+0.06) = P212.00
PV0 = P212.00/(1+0.06) = P200.00
• Therefore the required PV0 = P200 and we
have successfully discounted FV3 to the
present (PVo).
20
 Example Contin…

2. Formula Approach
• PV = FVn/(1+i)n
Therefore: PV0 = 238.20/(1+0.06) 3
PV0 = 238.20/1.063
PV0 = P200

21
 Using Interest Table

• PVIF(6%,3)= 0.840

PV= FV*PVIF
PV = 238.20 * 0.840
PV= P200

• Note that you don’t divide by the PVIF but rather you multiply
by the factor. Whenever you use the interest table you will
always multiply by the interest factor whether it’s a FV or PV
interest factor.

22
 Finding (i) and (n)

• Once you know the formula for PV and Future value

you can always find missing items from the formula.
• E.g from our previous example assume in a FV
calculation you know both your FV, PV and (n) to be
P238.20, P200 and 3 years respectively, thus
FV3=PV(1+i)3
238.20= 200(1+i)3
• Calculate (i)

23
 Solution

• 238.20= 200(1+i)3
• 238.20/200 = (1+i)3
• 1.191= (1+i)3
• 3√(1.191)=3√(1+i)3

• 1.06 = 1+i
• Therefore i = 0.06 = 6%

24
 Contin….

• Assume now that you are given everything but

(n) in our previous example, thus
• 238.20= 200(1+0.06)n
• Calculate (n), the number of years.

25
 Solution
• 238.20= 200(1+0.06)n
• 1.191= 1.06n
• Ln1.191=(n)Ln1.06
• 0.1748=(n)0.0583
• Therefore: n= 2.998 = 3 years

26