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Chapter 3

Chapter Three discusses the time value of money, emphasizing that money's value changes over time due to interest rates, making present money worth more than future money. It explains the differences between simple and compound interest, as well as the concepts of future and present values in investment decisions. Techniques for calculating future and present values are illustrated through examples and exercises.

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3 views3 pages

Chapter 3

Chapter Three discusses the time value of money, emphasizing that money's value changes over time due to interest rates, making present money worth more than future money. It explains the differences between simple and compound interest, as well as the concepts of future and present values in investment decisions. Techniques for calculating future and present values are illustrated through examples and exercises.

Uploaded by

GUDATA ABARA
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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CHAPTER THREE

THE TIME VALUE OF MONEY


Introduction
To make it a valuable as possible to stack holders; an enterprise must choose the best
combination of decisions on investment, financing and dividends. In any economy in which
individuals, firm and government have the time preference, the time value of money is an
important concept. The decision to purchase new plant and equipment or to introduce a new
product in the market requires using capital allocating or capital budgeting techniques.
Essentially, we must determine whether future benefits are mathematical tools of the time value
of money as the first step towards making capital allocating decisions.

3.1.The Concept of Time Value of Money

The value of money depends on time. The value of a given amount of money at one point in time
is not the same as the value of the same face amount at another time. Thus, the value of money is
dependent on the point of time it occurs at payment or receipt. It is the expression of the fact that,
if the rate of interest is positive, the money in hand now is worth more than money to be received
at a date in the future. It refers to the value derived from the use of money over time as a result of
investment and reinvestment. It is the concept that an amount in hand today is worth more than
the same amount that will be received in future year. This is because; the amount could be
deposited in an interest-bearing bank account (or otherwise invested) from now to time "t" and
yield interest. Similarly, it means that, cash paid out later is worth less than a similar sum paid at
an earlier date.
3.2.Simple Interest Versus Compound Interest
Interest is the growth in a principal amount representing the fee charged for the use of money for
specified time period.
3.2.1. Simple Interest: is the return on a principal amount for one period time. It is based on the
assumption that interest it self does not earn a return, but this kind of situation occurs rarely in
the business world.
Simple interest I= principal x rate x time
3.2.2. Compound Interest: is the return on a principal amount for two or more time periods,
assuming that the interest for each time is added to the principal amount at the end of each period
and earns interest in all subsequent periods.
Exercise 3.1
Suppose that Br. 200,000 is invested at 20% simple interest per annum. The following table
shows the state of the investment, year by year.

Year Principal Interest Earned Amount Cumulative Amount


1 200,000 40,000 (20% of 200,000) 240,000
2 200,000 40,000 (20% of 200,000) 280,000
3 200,000 40,000 (20% of 200,000) 320,000

Assuming the above case, the compounded amount would be as indicated on the following table.

Year Principal Interest Earned Amount Cumulative Amount


1 200,000 40,000 (20% of 200,000) 240,000
2 240,000 48,000 (20% of 240,000) 288,000
3 288,000 57,600 (20% of 288,000) 345,600

3.3. Future Values Versus Present Values


When correctly applied, both techniques will result in the same decisions but they view the
decision from opposite angles. Future value techniques are used to find the future values of the
amount (s) involved at some future time, usually at the end of the life of the project whereas,
present value techniques are used to find the today's equivalent (present values) of amounts
expected at some time in the future. Present values are measured at the start of the project's life
(time zero). Future value computation techniques use compounding to find the future value of each
cash flow at the end of the investment's life and then sums them to find the investment's future
value, on the other hand, the present value techniques uses discounting to find the present value of
each cash flow at time zero and then sums them to find the present value of the investments.

3.3.1. Future Value of Single Amount

The accumulated amount of a single amount invested, at compound interest may be computed
period by period by a serious of multiplications.
Exercise 3.2

2
Suppose your father gives you 10,000 on your eighteenth birthday. You deposited this amount in a
bank at 8 per cent compounded quarterly for one year. How much future sum would you receive
after one year?
Solution
If n is used to represent the number of periods that interest is to be compounded, i is used to
represent the interest per period, and p is the principal amount invested, the series of
multiplications to compute the amount is:
a = P (1+i) n
a= birr 10,000 (1 + 0.02)4
a= 10,824.32

3.3.2. Present Value of Single Amount


It is a method of assessing the worth of an investment by investing the compounding process to
give the present value of future cash flows. This process is "discounting".
The present value of "P" of the amount "A" due at the end of "n" conversion periods at the rate
"i" per conversion period. The value of "P" is obtained as follows:
P= A or P= A (1+i) -n
(1+i) n

Exercise 3.3
Ato Asfaw has been given the opportunity to receive birr 10,000 four years from now. If he can
earn 6 % on his investment, what is the amount that would make him indifferent if he is to
receive the amount as of today?
Solution
P= A = 10,000 = 10,000 = 7,921
(1+i) n (1+0.06)4 1.26428

This means that, if Asfaw deposited birr 7,921 in to the bank at interest rate of 6 per cent, he will
get birr 10,000 at the end of 4 years.

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