© Pearson Education 2013 4-1

Principles of Managerial Finance

Arab World Edition
Gitman, Zutter, Elali, Al Roubaie

Chapter 4: Time Value of Money

Lecturer: [Insert your name here]

© Pearson Education 2013 4-2

 Learning Goals

LG1: Discuss the role of time value in finance, the use of

computational aids, and the basic patterns of cash flow.
LG2: Understand the concept of future value and present
value, their calculation for single amounts, and the
relationship between them.
LG3: Find the future value and the present value of both an
ordinary annuity and an annuity due, and the present
value of a perpetuity.

(continued)

© Pearson Education 2013 4-3

 Learning Goals (cont’d)

LG4: Calculate both the future value and the present value of a
mixed stream of cash flows.
LG5: Understand the effect that compounding interest more
frequently than annually has on future value and the
effective annual rate of interest.
LG6: Describe the procedures involved in (1) determining
deposits needed to accumulate to a future sum, (2) loan
amortization, (3) finding interest or growth rates, and (4)
finding an unknown number of periods.

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 The Role of Time Value in Finance

• Most financial decisions involve costs & benefits that are

spread out over time.
• Time value of money allows comparison of cash flows from
different periods.
• Question: Your father has offered to give you some money
and asks that you choose one of the following two
alternatives:
– US$1,000 today, or
– US$1,100 one year from now.
• What do you do?

© Pearson Education 2013 4-5

 The Role of Time Value in Finance (cont.)

• The answer depends on what rate of interest you could earn

on any money you receive today.
• For example, if you could deposit the US$1,000 today at
12% per year, you would prefer to be paid today.
• Alternatively, if you could only earn 5% on deposited funds,
you would be better off if you chose the US$1,100 in one
year.

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 Future Value Versus Present Value

• Suppose a firm has an opportunity to spend US$15,000 today

on some investment that will produce US$17,000 spread out
over the next five years as follows:

Year Cash flow

1 US$3,000
2 US$5,000
3 US$4,000
4 US$3,000
5 US$2,000

• Is this a wise investment?

• To make the right investment decision, managers need to
compare the cash flows at a single point in time.

© Pearson Education 2013 4-7

 Future Value Versus Present Value:
Basic Concepts

Future Value: compounding or growth over time

Present Value: discounting to today’s value
Single cash flows & series of cash flows can be considered
Time lines are used to illustrate these relationships

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 Future Value Versus Present Value:
Time line

Figure 4.1
Time line depicting
an investment’s
cash flows

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 Future Value Versus Present Value:
Compounding and Discounting

Figure 4.2
Compounding
and
Discounting:
Time line showing
compounding to
find future value
and discounting to
find present value

© Pearson Education 2013 4-10

 Computational Tools

• Finding present and future values can involve time-

consuming calculations.

• Although you should understand the concepts and

mathematics underlying these calculations, financial
calculators and spreadsheets streamline the application of
time value techniques.

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 Basic Patterns of Cash Flow

• The cash inflows and outflows of a firm can be described by

its general pattern.
• The three basic patterns include a single amount, an
annuity, or a mixed stream:

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 Single Amounts:
Future Value of a Single Amount

• Future value is the value at a given future date of an amount

placed on deposit today and earning interest at a specified
rate. Found by applying compound interest over a specified
period of time.
• Compound interest is interest that is earned on a given
deposit and has become part of the principal at the end of a
specified period.
• Principal is the amount of money on which interest is paid.

© Pearson Education 2013 4-13

 Single Amounts:
Example: Future Value

If Fahmi Hamada places US$100 in a savings account paying 8

percent interest compounded annually, how much will he have
at the end of 1 year?
Future value at end of year 1 = US$100  (1 + 0.08) = US$108

If Fahmi were to leave this money in the account for another

year, how much would he have at the end of the second year?
Future value at end of year 2 = US$100  (1 + 0.08)  (1 +
0.08)
= US$116.64

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 Single Amounts:
The Equation for Future Value

• We use the following notation for the various inputs:

FVn = future value at the end of period n
PV = initial principal, or present value
i = annual rate of interest paid. (Note: On financial
calculators, I is typically used to represent
this
rate.)
n = number of periods (typically years) that the
money is left on deposit
• The general equation for the future value at the end of period n
is

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 Future Value of a Single Amount:
The Equation for Future Value

Jannett Maher places US$800 in a savings account paying 6

percent interest compounded annually. She wants to know how
much money will be in the account at the end of five years.

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 Future Value of a Single Amount:
The Equation for Future Value

Jannett Maher places US$800 in a savings account paying 6

percent interest compounded annually. She wants to know how
much money will be in the account at the end of five years.

This analysis can be depicted on a time line as follows:

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 Present Value of a Single Amount

• Present value is the current dollar value of a future

amount—the amount of money that would have to be
invested today at a given interest rate over a specified
period to equal the future amount.
• It is based on the idea that a dollar today is worth more than
a dollar tomorrow.
• Discounting cash flows is the process of finding present
values; the inverse of compounding interest.
• The discount rate is often also referred to as the opportunity
cost, the discount rate, the required return, or the cost of
capital.

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 Present Value of a Single Amount:
An Example

Bader Hassan has an opportunity to receive US$300 one year

from now. If he can earn 6 percent on his investments, what is
the most he should pay now for this opportunity?

PV  (1 + 0.06) = US$300

PV = US$300/(1 + 0.06) = US$283.02

© Pearson Education 2013 4-19

 Present Value of a Single Amount:
The Equation for Present Value

The present value, PV, of some future amount, FVn, to be

received n periods from now, assuming an interest rate (or
opportunity cost) of i, is calculated as follows:

© Pearson Education 2013 4-20

 Present Value of a Single Amount:
The Equation for Present Value

Pola Abdo wishes to find the present value of US$1,700 that

will be received 8 years from now. Pola’s opportunity cost is 8
percent.

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 Present Value of a Single Amount:
The Equation for Present Value
Pola Abdo wishes to find the present value of US$1,700 that will be received 8 years from now.
Pola’s opportunity cost is 8 percent.

This analysis can be depicted on a time line as follows:

© Pearson Education 2013 4-22

 Annuities

• Annuities are equally-spaced cash flows of equal size.

• Annuities can be either inflows or outflows.
• An ordinary (deferred) annuity has cash flows that occur
at the end of each period.
• An annuity due has cash flows that occur at the beginning
of each period.
• An annuity due will always be greater than an otherwise
equivalent ordinary annuity because interest will compound
for an additional period.

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 Types of Annuities:
An Example

Fadia Ibrahim is choosing which of two annuities to receive.

Both are 5-year US$1,000 annuities; annuity A is an ordinary
annuity, and annuity B is an annuity due. Fadia has listed the
cash flows for both annuities as shown in Table 4.1 on the
following slide.

Note that the amount of both annuities totals US$5,000.

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 Types of Annuities:
An Example (cont’d)

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 Finding the Future Value of an Ordinary Annuity:
An Example
Fadia Ibrahim wishes to determine how much money she will
have at the end of 5 years if he chooses annuity A, the ordinary
annuity and it earns 7 percent annually. Annuity A is depicted
graphically below:

© Pearson Education 2013 4-26

 Finding the Future Value of an Ordinary Annuity:
An Example
Fadia Ibrahim wishes to determine how much money she will have at
the end of 5 years if he chooses annuity A, the ordinary annuity and
it earns 7 percent annually. Annuity A is depicted graphically below:

This analysis can be depicted on a time line as follows:

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 Finding the Future Value of an Ordinary
Annuity

• You can calculate the future value of an ordinary annuity that

pays an annual cash flow equal to CF by using the following
equation:

• As before, in this equation i represents the interest rate

and n represents the number of payments in the annuity (or
equivalently, the number of years over which the annuity is
spread).

© Pearson Education 2013 4-28

 Finding the Future Value of an Ordinary Annuity:
An Example
Fadia Ibrahim wishes to determine how much money she will have at
the end of 5 years if he chooses annuity A, the ordinary annuity and
it earns 7 percent annually. Annuity A is depicted graphically below:

This analysis can be depicted on a time line as follows:

© Pearson Education 2013 4-29

 Finding the Future Value of an Annuity Due:
An Example

• You can calculate the present value of an annuity due that

pays an annual cash flow equal to CF by using the following
equation:

• As before, in this equation i represents the interest rate and n

represents the number of payments in the annuity (or
equivalently, the number of years over which the annuity is
spread).
• The FV in case of annuity due = $6153.29

© Pearson Education 2013 4-30

 Finding the Present Value of an Ordinary
Annuity

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 Finding the Present Value of an Ordinary
Annuity: An Example
Rasha Company, a small producer of plastic toys, wants to
determine the most it should pay to purchase a particular
annuity. The annuity consists of cash flows of US$700 at the
end of each year for 5 years. The required return is 8 percent.

© Pearson Education 2013 4-32

 Finding the Present Value of an Ordinary
Annuity: An Example
Rasha Company, a small producer of plastic toys, wants to
determine the most it should pay to purchase a particular
annuity. The annuity consists of cash flows of US$700 at the
end of each year for 5 years. The required return is 8 percent.

© Pearson Education 2013 4-33

 Present Value of an Ordinary Annuity:
An Example (cont’d) - The Long Method

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 Finding the Present Value of an Ordinary
Annuity

• You can calculate the present value of an ordinary annuity that

pays an annual cash flow equal to CF by using the following
equation:

• As before, in this equation i represents the interest rate and

n represents the number of payments in the annuity (or
equivalently, the number of years over which the annuity is
spread).

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 Finding the Present Value of an Annuity Due

• You can calculate the present value of an ordinary annuity that

pays an annual cash flow equal to CF by using the following
equation:

• As before, in this equation r represents the interest rate and n

represents the number of payments in the annuity (or
equivalently, the number of years over which the annuity is
spread).
• In case of annuity due: PV=$3,018.49

© Pearson Education 2013 4-36

 Exercise 1

• Find the following

1. Future value of single amount of $900, for 3 years, at 25%
interest compounding rate.
2. Present value of single amount of $900, for 3 years, at 25%
discount rate.

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 Exercise1 answer:

• Find the following

1. Future value of single amount of $900, for 3 years, at 25%
interest compounding rate.
• Answer $1757.81

2. Present value of single amount of $900, for 3 years, at 25%

discount rate.
• Answer: $460.80

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 Exercises 2

• Find the following

1. Future value of the annuity $900, for 3 years, at 25% interest
compounding rate.
a) In case of ordinary annuity
b) In case of annuity due
2. Future value of the annuity $900, for 3 years, at 25% interest
compounding rate.
a) In case of ordinary annuity
b) In case of annuity due

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 Exercises 2 Answer

• Find the following

1. Future value of the annuity $900, for 3 years, at 25% interest
compounding rate.
a) In case of ordinary annuity : $3431.25
b) In case of annuity due: $4289.06
2. Future value of the annuity $900, for 3 years, at 25% interest
compounding rate.
a) In case of ordinary annuity : $ 1756.80
b) In case of annuity due : $ 2196.00

© Pearson Education 2013 4-40

 Finding the Present Value of a Perpetuity

• A perpetuity is an annuity with an infinite life, providing

continual annual cash flow.
• If a perpetuity pays an annual cash flow of CF, starting one
year from now, the present value of the cash flow stream is:

© Pearson Education 2013 4-41

 Mixed Streams

• Two basic types of cash flow streams are possible: the annuity
and the mixed stream.
• Whereas an annuity is a pattern of equal periodic cash flows, a
mixed stream is a stream of unequal periodic cash flows that
reflect no particular pattern.

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 Future Value of a Mixed Stream:
An Example

Steel Industries, a cabinet manufacturer, expects to receive the

following mixed stream of cash flows over the next 5 years
from one of its small customers.
If Steel Industries expects to earn at least 8 percent on its
investments, how much will it accumulate by the end of year 5
if it immediately invests these cash flows when they are
received?

© Pearson Education 2013 4-43

 Future Value of a Mixed Stream:
An Example (cont’d)

If Steel Industries expects to earn at least 8 percent on its

investments, how much will it accumulate by the end of year 5 if
it immediately invests these cash flows when they are received?
This situation is depicted on the following time line.

© Pearson Education 2013 4-44

 Present Value of a Mixed Stream:
An Example

Faris Company, a shoe manufacturer, has been offered an

opportunity to receive the following mixed stream of cash
flows over the next 5 years.
If the firm must earn at least 9 percent on its investments,
what is the most it should pay for this opportunity?

© Pearson Education 2013 4-45

 Present Value of a Mixed Stream:
An Example (cont’d)

If the firm must earn at least 9 percent on its investments,

what is the most it should pay for this opportunity?
This situation is depicted on the following time line.

© Pearson Education 2013 4-46

 Compounding Interest More Frequently Than
Annually

• Compounding more frequently than once a year results in a

higher effective interest rate because you are earning on
interest on interest more frequently.
• As a result, the effective interest rate is greater than the
nominal (annual) interest rate.
• Furthermore, the effective rate of interest will increase the
more frequently interest is compounded.

© Pearson Education 2013 4-47

 Compounding Interest More Frequently Than
Annually: An Example

Fahmi Hamada has decided to invest US$100 in a savings

account paying 8 percent interest compounded semiannually. If
he leaves his money in the account for 24 months, he will be
paid 4 percent interest compounded over 4 periods.

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 Compounding Interest More Frequently Than
Annually: An Example (cont’d)

Fahmi Hamada has found an institution that will pay him 8

percent annual interest, compounded quarterly. If he leaves
the money in the account for 24 months (2 years), he will be
paid 2 percent interest compounded over 8 periods.

© Pearson Education 2013 4-49

 Compounding Interest More Frequently Than
Annually: An Example (cont’d)

• Table 4.5 compares values for Fahmi’s US$100 at the end of years
1 and 2 given annual, semiannual and quarterly compounding
periods at the 8 percent rate.
• As shown, the more frequently interest is compounded, the
greater the amount of money accumulated.

© Pearson Education 2013 4-50

 Compounding Interest More Frequently Than
Annually

A general equation for compounding more frequently than

annually:

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 Compounding Interest More Frequently Than
Annually

Recalculate the example for Fahmi Hamada, assuming:

(1) semiannual compounding and (2) quarterly compounding.

© Pearson Education 2013 4-52

 Continuous Compounding

• Continuous compounding involves the compounding of

interest an infinite number of times per year at intervals of
microseconds.
• A general equation for continuous compounding:

where e is the exponential function, which has a value of

2.7183.

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 Continuous Compounding:
An Example

Find the value at the end of 2 years (n = 2) of Fahmi Hamada’s

US$100 deposit (PV = US$100) in an account paying 8 percent
annual interest (i = 0.08) compounded continuously.

FV2 (continuous compounding) = $100  e0.08  2

= $100  2.71830.16
= $100  1.1735 = $117.35

© Pearson Education 2013 4-54

 Nominal & Effective Annual Rates of Interest

• The nominal (stated) interest rate is the contractual

rate of interest charged by a lender or promised by a
borrower.
• The effective (true) interest rate (EAR) is the rate
actually paid or earned.
• In general, the effective rate > nominal rate whenever
compounding occurs more than once per year.

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 Nominal & Effective Annual Rates of Interest:
An Example

Fahmi Hamada wishes to find the effective annual rate

associated with an 8 percent nominal annual rate (i = 0.08)
when interest is compounded (1) annually (m=1);
(2) semiannually (m=2); and (3) quarterly (m=4).

© Pearson Education 2013 4-56

 Special Applications of Time Value:
Deposits Needed to Accumulate to a Future
Sum
The following equation calculates the annual cash payment (CF)
that we’d have to save to achieve a future value (FVn):

Suppose you want to buy a house 5 years from now, and you
estimate that an initial down payment of US$30,000 will be
required at that time. How much would you need to deposit at the
end of each year for the next 5 years to accumulate US$30,000 if
you can earn 6 percent on your deposits?

© Pearson Education 2013 4-57

 Special Applications of Time Value:
Loan Amortization

• Loan amortization is the determination of the equal

periodic loan payments necessary to provide a lender with a
specified interest return and to repay the loan principal over
a specified period.
• The loan amortization process involves finding the future
payments, over the term of the loan, whose present value at
the loan interest rate equals the amount of initial principal
borrowed.
• A loan amortization schedule is a schedule of equal
payments to repay a loan. It shows the allocation of each loan
payment to interest and principal.

© Pearson Education 2013 4-58

 Special Applications of Time Value:
Loan Amortization

• The following equation calculates the equal periodic loan

payments (CF) necessary to provide a lender with a specified
interest return and to repay the loan principal (PV) over a
specified period:

© Pearson Education 2013 4-59

 Special Applications of Time Value:
Loan Amortization – An Example (cont’d)

© Pearson Education 2013 4-60

 Special Applications of Time Value:
Finding Interest or Growth Rates

• It is often necessary to calculate the compound annual

interest or growth rate (that is, the annual rate of change in
values) of a series of cash flows.
• The following equation is used to find the interest rate (or
growth rate) representing the increase in value of some
investment between two time periods.

© Pearson Education 2013 4-61

 Special Applications of Time Value:
Finding Interest or Growth Rates – An Example

• Zamil Kareem wishes to find the rate of interest or growth

reflected in the stream of cash flows he received from a
real estate investment over the period from 2005 through
2009 as shown in the table below:

© Pearson Education 2013 4-62

 Special Applications of Time Value:
Finding Interest or Growth Rates – An Example

We can see that Zamil’s investment four years ago was

US$1,250. Now it is worth US$1,520. What compound annual
rate of return has Zamil earned on this investment? Plugging
the appropriate values into Equation 4.20, we have:

© Pearson Education 2013 4-63

 Special Applications of Time Value:
Finding an Unknown Number of Periods

• Sometimes it is necessary to calculate the number of time

periods needed to generate a given amount of cash flow from
an initial amount.
• This simplest case is when a person wishes to determine the
number of periods, n, it will take for an initial deposit, PV, to
grow to a specified future amount, FVn, given a stated interest
rate, i.

© Pearson Education 2013 4-64

 Special Applications of Time Value:
Finding an Unknown Number of Periods

• Amal Basil wishes to determine the number of years it will take

for her initial US$1,000 deposit, earning 8 percent annual
interest, to grow to equal US$2,500. Simply stated, at an 8
percent annual rate of interest, how many years, n, will it take
for Amal’s US$1,000 (PVn) to grow to US$2,500 (FVn)?

Calculator Use

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 Special Applications of Time Value:
Finding an Unknown Number of Periods

Spreadsheet Use

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 Time Value of Money in Islamic Finance

• In conventional finance, money is a commodity, the price of

which is the interest rate paid by users as a compensation for
the time involved, i.e. the time value of money is measured by
the amount of interest paid by borrowers for making use of other
people’s money.
• Islamic Shari’ah is against hoarding money and thus it cannot
function as a store of value. In the Islamic economy, the demand
for money is a derived demand needed to serve as a medium of
exchange for facilitating market transactions.
• In other words, money has no intrinsic value of its own and,
therefore, it cannot be used to earn more money in the form of a
fixed interest payment.
• Money becomes capital only when it is invested in creating value
but not when it is obtained as a business debt.

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 Time Value of Money in Islamic Finance

• In Islamic finance, both lenders and entrepreneurs share both

the profit and loss.
• In this respect, the return on investment comes from money
being actually realized and not paid in advance in the form of
predetermined fixed interest on an uncertain future outcome.
The return on investment is a product of money used in the
creation of real assets.
• This renders the time value of money irrelevant under the
system of Islamic financing.

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 Time Value of Money in Islamic Finance

• The prohibition of riba in Islam makes time’s monetary

valuation based on a predetermined fixed amount
unacceptable as a basis for computing return on investment.
• However, in contractual sales, Islamic finance allows the future
price of a commodity to differ from the spot price to
compensate for the time value involved.
• Islamic finance does not object to earning return from money
obtained through lending, but it objects to “making money’s
time value an element of any lending relationship that
considers it to have a predetermined value.”

© Pearson Education 2013 4-69

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