Chapter 3

The Time Value of Money

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 The Time Value of Money
• A concept that says one birr received
today worth more than a birr to be
received any time in the future. Why?
Because
➢ You can invest it now and make it bigger in
the future.
• Moreover, since we are living in the world of
Inflation and Risk, it is better to receive
one birr today instead of receiving it any time
in the future.

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 The Time Value of Money
• The four corner stones of TVM:
1. The future value of a single
payment
2. The present value of a single
payment
3. The future value of an annuity
4. The present value of an
annuity
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Future Value of a Single Sum

• How large the value of a current

investment will come to be if it grows
at given rate into the future is the
Future Value of an investment.
• When interest in one period is made
to earn interest in the following
period, the process is compounding
interest.

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Future Value of a Single Sum

• The future value of a lump sum

investment made today for N period
with interest rate i is given by:
FVn= PV(1+i)(1+i)…(1+i)
FVn =PV(1+i)n
• Example: What is the future value
of Br 5,000 deposited in a saving
account that pays 5% interest for
three years?
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Future Value of a Single Sum

• Using the above formula:

FV3= 5,000(1.05)3
=5,000(1.1576)=5,788
• You can use Future Value Interest
Factor Table for Single Sum, Table
A-1. You get the same answer.
• One can also use a business
calculator.
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Future Value of a Single Sum

Activity

You invest Br 12,000 today. If it

pays 10% per year, how large
your investment will be after 10
years?

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Present Value of a Single Sum
• The Value today of a future cash flow
is the present value.
• The process of converting a future
value to a present value is known
discounting.
• It is given by:
PV= FVn =FVn [1/(1+i)n]
(1+i)n

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Present Value of a Single Sum

• Example: If some one offered to

pay you Br 250,000 after five years
in exchange for your car today. What
price received today will make you
equally happy as the above offer if
the appropriate interest rate is 8%?
PV= 250,000 [1/(1.08)5]
= 250,000(0.6806)=170,150
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Present Value of a Single Sum
• Check your answer using Present
Value Interest Factor Table for a
single sum, Table A-2.
Activity:
• In the above example, what will be
the price today that will make you
indifferent if
1) i=10% or
2) n= 10 years?
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 Expected Rate of Return, i
• Example: You purchased a land today at
a price of Br 100,000 and expected to be
sold at Br 126,250 after four years. What
is the expected rate of return on your
investment?
FVn = PV(1+i)n , therefore
126,250 = 100,000(1+i)4
(1+i)4=126,250/100,000=1.2625
That is, (1+i)4=1.2625, then solve for i?

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 Expected Rate of Return, i
• (1+i)4=1.2625
i= (1.2625).25 – 1
i= 1.06 – 1=0.06 or 6%

• Check your answer using your

Interest Table.

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Continuous Compounding and
Discounting

• Continuous Compounding: the

process of compounding interest on a
continuous basis. It is given by:
FVn=PV(ein), where e=2.7183

Given, PV=100, i=5%, and n=5

FV5= 100(2.71830.05*5)=128.4

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 Continuous Compounding and
Discounting

• Continuous Discounting: It is discounting in

continuous basis or a reverse of continuous
compounding.
• It is given by:

FVn − in 1
PV = in = FVn (e ) = FVn  in 
e e 

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Continuous Compounding and Discounting
WHAT IS THE PV OF BR 20,000 TO BE
RECEIVED AFTER 5 YEARS AT INTEREST
RATE OF 8% WITH CONTINUOUS
DISCOUNTING?

20,000 20,000
PV = .08*5
= = 13, 406.62
2.7183 1.4918

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 Value of An Annuity
• Definition: An annuity is a series of equal
payments made at fixed intervals of time
for a specified number of periods.
• An annuity Can be:
1. Ordinary- End of period payments
2. Annuity Due -Beginning of period payments
3. Deferred Annuity- An ordinary annuity the
first payment of which is deferred for some
time in the future.

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Future Value of Ordinary Annuity
• Example: You plan to set aside Br
5,000 at the end of each year over
the coming five years to support
your son’s college education. If the
amount is kept in an account that
pays 9% per year, how much will
be available after five years (with
no withdrawal in between)?

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Future Value of Ordinary Annuity
• A mathematical model is given as:
FVAn= PMT [(1+i)n – 1]/i
FvA5= 5,000[(1.09)5 -1]/.09
= 5,000(5.9847)=29,923.50
• We should get the same answer using
Table A-3: Future Value Interest Table
for an annuity.

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 Future Value of Annuity Due
• What if the deposits are to be made at the
beginning of each year? Annuity Due!
• Future value of annuity due is greater than
future value of ordinary annuity, keeping
other things equal, because the deposits are
compounded for one more period. Thus,
FVAD= FVOA (1+i)
=29,923.50(1.09)=32,616.62
OR FVAD=PMT[(FVIFAi,n+1)-1]
=5,000[(FVIFA9%,5+1)-1]
=5,000[7.5233-1]
=32,616.50

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Present Value of Ordinary Annuity
• The value today of a series of constant
future cash flows is the PV of an
annuity.
Example:
The net-after tax annual cash inflow of
a new vending machine is Br12,000
over its life of 5 years. What is the
maximum price you would offer to buy
it if your desired rate of return is 10%?

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Present Value of Ordinary Annuity
• Mathematically,
PVOA=PMT[1-(1/(1+i))n]/i
=12,000[1-(1/(1.1))5]/0.1
= 12,000(3.7908)=45,489.60

• Check your answer using Table A-4,

Present Value Table for an annuity.

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 Present Value of Annuity Due
• Present value of annuity due worth
more than that of ordinary annuity,
all other things being equal
because cash flows occur sooner or
one period earlier.
That is,
PVAD= PVOA(1+i)

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Present Value of Annuity Due
FOR THE EARLIER EXAMPLE, ASSUMING
beginning OF YEAR PAYMENTS,

PVAD= 45,489.60(1.1)=50,038.56

OR PVAD=PMT[(PVIFAI,N-1)+1]
=12,000[(PVIFA10%,5-1)+1]
=12,000[3.1699+1]
=50,038.8

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 Special Case Annuities
1. Perpetuities
• Perpetuities are annuities that go on
indefinitely, or perpetually. That is,
PV (Perpetuity) = InterestRa
Payment
te
=
PMT
i
For example, a payment $10,000 in
perpetuity will have PV of
PV(P) = 0.05 = 200,000 ,(if i=5%)
10,000

PV(P) = 0.1 = 100,000 ,(if i= 10%)

10,000

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 Special Case Annuities
2. Deferred Annuity
• A deferred annuity is an ordinary
annuity the first cash flow of which
does not occur before certain
period, deferral period, has elapsed.
PVDA= CF* [PVIFA (i, entire time period)] – CF [PVIFA (i, deferred period)]

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 Special Case Annuities
Example:
You have an investment that is expected
to generate a uniform annual cash
inflows of Birr 500 beginning the end of
Year 3 till end of Year 6. How much
money would you put in the investment
today if your required rate of return is
10%?

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 Special Case Annuities
• PVDA= CF* [PVIFA (i, six periods)] – CF
[PVIFA (i, two periods)]
OR
PVDA= CF*[PVIFA (i, six periods) - PVIFA(i, two periods)]

= 500(4.353-1.7355) =1309.90

• Note that you can check this solution

using a time line.

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 Uneven cash Flow Streams
• Uneven cash flow stream is a series of
cash flows in which the amount varies from
period to period
• This topic is important because many
financial decisions involve uneven or non-
constant cash flows (for example dividends
on common stock & investment in fixed
assets may result uneven cash flows)

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 Uneven Cash Flow Streams
a) Present value of an uneven
cash flow stream:

The PV of an uneven cash flow is

found as the sum of the PVs of the
individual cash flow of the stream.

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Uneven cash Flow Streams
• Thus, the formula to find the PV is:
1 2 n
 1   1   1 
PV = CF1   + CF2   + ... + CFn  
1+ i  1+ i  1+ i 

t
n
  1 n

PV=  CFt   =  CFt ( PVIFi ,t )

t =1  1 + i  t =1

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Uneven cash Flow Streams
Example: You have an investment project
with cost of capital of 6% and expected
net cash flows of the following. What is
the value of the investment today?
Y1 100 Y4 200
Y2 200 Y5 0
Y3 200 Y6 1000
Use Time Line. Solution: PV=1,303.78

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Uneven cash Flow Streams
b) Future value of an uneven cash flow
stream
– The future value of an uneven cash flow
stream (sometimes called the terminal
value) is found by compounding each
payment to the end of the stream and then
summing the future values
n n
FVn =  CFt (1 + i ) n −t
=  CFt ( FVIFi ,n −t )
t =1 t =1
n −1 n−2 n −t
FVn = CF1 (1 + i) + (CF2 (1 + i) + ... + (CFn (1 + i)
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Uneven cash Flow Streams

• It is the sum of the future

value of individual cash flows
• Time Line is very useful tool
for this purpose.
Solution: FV= 1,849.24

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 More Frequent Compounding or
Discounting
• More frequent compounding increases
future value of a stream of cash flows.
• More frequent discounting decreases
present value of a stream of cash flows.
• Example: You deposit Br 500 at the end
of each month for three years in a saving
account that pays interest of 12%. If
interest is compounded monthly, how
much will you have in your account after
three years?
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 More Frequent Compounding
or Discounting
• FVOA= 500[(1.01)36 -1]/0.01
= 500(43.077)=21,538.5
Activity:
o What will be the future value if you
deposit Br 3,000 end of every six-month
with semi-annual compounding, keeping
other things the same as above?
o How much should you deposit today in
order to receive these cash flows over
the coming three years?
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 Effective Annual Rate (EAR)
• EAR is what you are actually paying or
receiving as interest on a loan per
year.
• EAR is different from Annual
Percentage Rate (APR).
• APR is the sum of periodic rates (paid
or received on a loan) in a year.
• When interest is compounded more
than once in a year, EAR is greater
than the APR.
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 Effective Annual Rate (EAR)
• EAR= (1+periodic rate)m -1
• Example: A local bank offered to give
you a loan at 12% interest to be
compounded quarterly. What is the
effective annual rate of your loan?
EAR= (1+ i/m)m - 1
= (1 + .12/4)4 – 1
= (1.03) 4 - 1= 1.126 -1
=0.126 or 12.6%

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 Amortized Loans
• Amortized loans are loans that are
paid off in installments overtime.
Included in this category are
automobile loans, home mortgages,
student loans and some business
debts.
• The periodic payment (or installment)
is composed of interest and principal
(or capital) payments.
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 Amortized Loans
• The periodic interest payment is computed
by applying the interest rate on the
outstanding balance of the loan at the
beginning the year in question.
• The principal payment = PMT less interest
payment for the period or year.
• As time goes on towards the end of the
term of the loan, the interest payment
portion of the PMT declines whereas the
principal portion increases.

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 Amortized Loans
• Example: A university professor
purchased an automobile from ABC Auto
Supplier Plc for Br 2 million payable in four
annual installments with interest rate of
12%.
• Required:
1) Compute the annual payment (or PMT)
2) Prepare a loan amortization schedule
3) Compute the nominal aggregate payment over
four years and show the composition of interest
and principal payments.

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Amortized Loans

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This Chapter is Over.
Thank You.

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