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8 views

Unit 3 - 1

Uploaded by

eliasaliyi674
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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You are on page 1/ 15

UNIT 3: TIME VALUE OF MONEY

3.0 Aims and objectives

This unit will discuss the meaning of time value of money, it’s
importance in our day-to-day life.

After reading this unit, you will be able to:


 explain the meaning of time value of money

 understand future value and present value

 calculate the future and present values


3.2 Time value of money
By experience, we all know that the value of a sum of money received
today is more than its value received after some time.
This is called time value of money.
Conversely, the sum of money received in future is less valuable than
it is today.
The present worth of birr received after some time will be less than a
birr received today.
Since, a birr received today has more value, individuals, as a rational
human beings would naturally prefer current receipt to future receipts.
The time value of money is also known as time preference for money.
Conti---
 The time preference for money in business unit normally expressed in terms of rate of return or more
popularly as a discount rate.
 In a business revenues are spread over a period of time i.e., the life of the project.
 It is nothing but we are trying to calculate the present value versus future value.

3.3 Techniques of present value Vs future value


 Compound value: where a sum of money deposited one time and earns interest for a specified period.
 The interest is paid on principal as well as on an interest earned but not withdrawn during earlier
period is called compound interest.
FV = PV + (interest X principal)
For example you deposit
Birr 100 @10% interest
After one year = 100 + (100 x .10) = 110
After two years = 110 + (110 x .10) = 121
After three years = 121 + (121 x .10) = 133.10
FV1 = P(1+i)

FV2 = FV1 + F1i P(1+i)2

FV3 = P(1+i)3 FV2 = FV1(1+i)P

FV2 = P

Fn = P(1+i)n
 Here the term (1+i)n is the compounded value factor (CVF) of a lump sum of birr 1.
 The values may be directly traced from the present value tables.
 The same may be written as below:
FV = P(CVFn . i)
Where: FV = Future value
P = Present value
CVFn = Compounded value factor year
Suppose you deposit Br. 55, 650 in a bank which will pay you 12 percent
interest for a period of 10 years. How much would the deposit grow at the end
of ten year?
FV = P(CVFn . i)
FV = 55, 650 (CVF10 . 12)
FV = 55, 650 (3 . 106)
= 172, 849.90
Compound value of Annuity: An annuity is a fixed payment (or receipt) each year for a
specified number of years.
Assume that a sum of birr 1 is deposited at the end of each year for four years at 6%
interest. This implies that
1(1+.06)3 1.191 Birr 1 deposited at the end of year 1 grow for 3 years.
1(1+.06)2 1.124 Birr 1 deposited at the end of year 2 grow for 2 years.
1(1+.06)1 1.06 Birr 1 deposited at the end of year 3 grow for 1 year.
1. Birr 1 deposited at the end of year 4 grow for no interest.

FV4 = A(1+i)3 + A(1+i)2 + A(1+i) + A

FV4 = A[(1+i)3 + (1+i)2 + (1+i)+1


The same may be written as below

FV = A(CVAFn i)

FV = Future value

A = Annuity

CVAFn = Compounded Value Annuity Factor to year


Assume that you deposit a sum of birr 5, 000 at the end of each year for four years
at 6% interest. How much would this annuity accumulate at the end of fourth year.

FV = A(CVAFn i)

= 5, 000 (CVAF4 .06)

= 5, 000 (4.375)

= Br.21, 875

Sinking Fund: This is going to be in reverse to the compounded value annuity


factor.

Here we proceed that to create certain sum of money, how much we have to set
aside every year for a specified period.
FV = A(CVAFn.i)
 1 
 CVAFn.i 
A = FV
A = FV (SFFn i) SFF = Sinking Fund Factor
 i 
  1
(1  i ) n
A=F  
For instant to clear off a loan of birr 21, 875 after four years, how much we have to set aside?
FV = A(CVAFn .1)
 1 
 CVAFn.i 
A = FV
 1 
 4.375 
= 21, 875 FV
= 21, 875 x .2286
= 5, 000
Present Value: we can calculate the present value of future earnings at a particular
rate of interest.

This may be further classified into two

I) Present value of a lump sum. The present sum of money to be invested today in
order to get birr 1 at the end of year 1, 2, 3 so on and so forth at the rate of 10%
interest

1
(1  i)
1

(1  .10)
1

1.10
1
(1  10) 2
1
1.21

1
(1  10) 3
1
1.331

Fn
(1  i ) n
 Fn 
 n 
 (1  i ) 

You wanted to know the present value of birr 50, 000 to be received after 15 years at the rate of
interest 9%

= 50, 000 (.275) present value table


II) Present value of Annuity: An investor sometimes may receive constant amount for a certain
number of years.
 We may have to calculate the present value of such annuity to be received each year for a specific
period.
 Assume a company receives an annuity of birr 5, 000 for four year at the interest of 10 percent.
Then the present value would be:
 1 
1 
 (1  i) n 
 
 i 
 
 1 
1 
 (1.10) 4 
P = 5, 000   Simply, you can refer to the PV tables for PV factor.
 .10 
 

= 5, 000(3.170) from PV table or using the above formulae


Capital Recovery: The reciprocal of the present value annuity factor is called capital recovery
factor (CRF).
It will give the annuity to repay certain amount of borrowed loan at a particular interest for a
specified period.
A company borrows Birr 1, 000, 000 at an interest rate of 15 percent and the loan is to be repaid in
5 equal instalments payable at the end of each of the next 5 years. Prepare loan amortization table
and the annual instalment.
PV = A (PVAFn .i)
1, 000, 000 = A (PVAF5 .15)
1, 000, 000 = A (3.3522)
A=1, 000, 000/ 3.3522
A=298,311
Loan Amortization Table
Year Ope. Bala. Annu. Install. Interest Principa Clos. Balanc.
Birrs Birrs Birrs Birrs Birrs
1 1, 000, 000 298, 312 150, 000148, 312 851, 688
2 851, 688 298, 312 127, 753170, 559 681, 129
3 68, 129 298, 312 102, 169196, 143 484, 986
4 484, 986 298, 312 72, 748225, 564 259, 422
5 259, 422 298, 312 38, 913259, 399 23
Birr 23 left because annuity is taken as 298, 312 instead of 298, 311.
Multi period Compounding: we have seen the cash flows will occur once in a year.
 But, the cash flows may occur monthly, bi-monthly, quarterly, half yearly and
yearly.
 You have deposited a birr of 1, 000 in Commercial Bank of Ethiopia at 12 percent
interest per annum. It compound annually, semi-annually, quarterly and monthly for
two years. How much does it grow?
1) Annual compounding n=2 i = .12%
FV = P(CVFn .i)
= 1, 000 (CVF2 .12)
= 1, 000 (1.254)
FV = 1, 254
2) Half-yearly n = 2 x 2 = 4 i = = 6%
FV = 1, 000 (CVF4 .06)
= 1, 000(1.262)
FV = 1, 262
3) Quarter n = 4 x 2 = 8 i = = 3%
FV = 1, 000 (CVF12 .03)
= 1, 000 (1.267)
FV = 1, 267
4) Monthly n = 12 x 2 = 24, i = = 1%
FV = 1, 000 (CVF24. .01)
= 1, 000 (1.270)
FV = 1, 270
THE END

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