CHAPTER THREE

THE TIME VALUE OF

MONEY
3.1 Why money has a time value?
The phrase “time value of money “ refers to the
fact that a birr in hands today is worth more than
a birr promised at some time in the future.
 One reason for this is that we could earn
interest while we waited the money with us.
 Inflation and uncertainty between today &
tomorrow are the other reason for the greater
value of today’s birr than birr in the future.
 So because of interest, uncertainty, inflation and
among other things money has a time value.
 3.2 Future Value of a Single Amount

 Is the value of a present amount at a future date,

found by applying compound interest over a specified
period of time.
 Compound interest
 Interest that is earned on a given deposit and has
become part of the principal at the end of a specified
period.
 Simple interest
 Interest earned only on the original principal amount
invested.
Principal amount
 The amount of money on which interest is paid or the
initial amount that were deposited.
 The Equation for Future Value
 The general equation for the future value at the
end of period n is

FVn=PV*(1+i)n

where
FVn= Future value at the end of period n
PV= Initial principal, or present value
i= Annual rate of interest paid.
n= Number of periods (typically years) that the
money is left on deposit
 Con…
 Fenet Tilahun places 800 birr in a savings
account paying 6% interest compounded
annually. She wants to know how much money
will be in the account at the end of 5 years.
 Given:
PV= 800 birr
i= 0.06
n= 5
 FV5= 800*(1+0.06)5
 = 800*(1.338)= 1,070.40 birr
3.3 Present Value of a Single
Amount

 Is the current birr 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 often useful to determine the value today
of a future amount of money.
 Discounting cash flows
 The process of finding present values.
 The Equation for Present Value
PV = FVn/(1+i) n

 Shawol wishes to find the present value of 1,700

birr that will be received 8 years from now.
Shawol’s opportunity cost is 8%.
 Given:
FV8= 1700 birr
n= 8
i= 0.08
 PV= 1,700/(1+0.08)8
 = 1,700/1.851
 = 918.42 birr
 Annuity
 An annuity is a stream of equal periodic cash
flows, over a specified time period.
Types of Annuities
 Ordinary annuity: An annuity for which the cash flow
occurs at the end of each period.
 Annuity due: An annuity for which the cash

flow occurs at the beginning of each period.

 3.4 future value of annuity
1. future value of an ordinary annuity: The value
that a stream of expected or promised future
payments will grow to after a given number of
periods at a specific compounded interest.
FVoa = PMT [(1+i)n-1]/I
Where:
FVoa = Future value of ordinary annuity
PMT= Amount of each payment
i= Interest rate per period
n= Number of period
 Con…
 What amount will accumulated if we deposit birr5,000
at the end of each year for the next 5 years? Assume
an interest of 6% compounded annually.
 Given:
 PMT= 5,000
 i= 0.06
 N= 5 years
 FVoa = PMT [(1+i)n-1]/I

 FVoa= 5,000 [(1+0.06)]5-1]/0.06

= 5,000(5.6371)
= 28,185.50
2. Future Value of An Annuity Due: is the same to
an ordinary annuity except that each payment occurs
at the beginning of the period rather than at the end.

FVad=FVoa(1+i)
What amount will accumulated if we deposit birr5,000
at the beginning of each year for the next 5 years?
Assume an interest of 6% compounded annually.
Given:
PV= 5,000 i= 0.06 n= 5 years
FVoa = 5,000 [(1+0.06)] 5-1]/0.06
= 5,000 (5.6371) = 28,185.50

FVad= 28,185.50 (1.06) = 19,876.63

 3.5 Present value of Annuity
PVAN: The present value of an annuity of N periods.
1. Present value of an ordinary annuity: The present value of a
stream of cash flows to be received in future periods.
PVoa= PMT[(1-(1/(1+i)n))]/i
Where:
Pvoa = Present value of an ordinary annuity
PMT= Amount of each payment
i= Discount period per period
n= Number of period
 Con…
 What amount must we invest today at 6%
compounded annually so that we can withdraw
Br5,000 at the end of each year for the next 5
years?
 Given:
 PV= 5,000 ,i= 0.06 ,n= 5 years
PVoa= PMT[(1-(1/(1+i)5))]/I
PVoa= 5,000[(1-(1/(1+0.06)5))]/0.06
= 5,000 (4.2124) = 21,062
2. Present Value of An Annuity Due: Is the same
to an ordinary annuity except that each payment
occurs at the beginning of a period rather than at
the end.
Pvad = Pvoa (1+i)
Where:
Pvad = Present value of an annuity due
Pvoa = Present value of an ordinary annuity
i= Discount rate per period
 Con…
 What amount must we invest today a 6% interest
rate compounded annually that we can withdraw
birr5,000 at the beginning of each year for the
next 5 years?
 Pvad = Pvoa (1+i)
 PVoa= PMT[(1-(1/(1+i)5))]/I
 PVoa= 5,000[(1-(1/(1+0.06)5))]/0.06
 = 5,000 (4.2124) = 21,062
 Pvad = 21,062 (1.06) = 22,325.72
 3.6 Special Case Annuities
3.6.1 perpetuities: Is an annuity with an infinite life—in
other words, an annuity that never stops
providing its holder with a cash flow at the end
of each year (for example, the right to receive birr500
at the end of each year forever).
So An important special case of an annuity arises
when the level stream of cash flows continues
forever.
The present value of a perpetuity is simply:
PV for a perpetuity = C/r
 Con…
 For example, an investment offers a perpetual
cash flow of birr500 every year. The return you
require on
such an investment is 8 percent. What is the value
of this investment? The value of this
perpetuity is:
Perpetuity PV = C/r = birr500/0.08 = birr6,250
 3.6.2 Deferred Annuity
A deferred annuity is a financial cash flow where
annuity payments are delayed until a certain
period of time has elapsed.
 3.7 Uneven Cash Flow Streams
Is a series of cash flows where the amount varies from
one period to the next.
There are two important classes of uneven cash
flows:
1) A stream that consists of a series of annuity payments
plus an additional final lump sum and
2) All other uneven streams.
We can find the PV of either stream by using Equation:
PV = CF1/(1 + i) 1 + CF2/ (1+i)2 + . . . CFN/(1+i)N =  CFt/(1+i)t
Where:
CFt = Cash flow ,t = No of period ,i = Interest rate
Con…
 Assume if we have a 5-year, 12% ordinary
annuity plus a final payment of the first year is
Br1,000, for the second year 300, for the third
year 300, for the fourth year again 300 and 500
for the fifth year. We can find the PV of the
annuity, then find the PV of the final payment and
sum them to obtain the PV of the stream.
 PV = CF1/(1 + i) 1 + CF2/ (1+i)2 + . . . CFN/(1+i)N =
 CFt/(1+i)t
 100/(1+0.12)1+ 300/(1+0.12)2 + 300/(1+0.12)3 +
300/(1+0.12)4 + 500/(1+0.12)5 = Br1,016.35
 So 1,016.35 is PV of cash flow stream
3.8 More Frequent Compounding
Compounding For Less Than A Year:
Interest is often compounded more frequently than
once a year. Savings institutions compound interest
semiannually, quarterly, monthly, weekly, daily, or
even continuously.
Semiannual Compounding: Compounding of
interest over two periods within the year.
Quarterly Compounding: Compounding of
interest over four periods within the year.
Con…
General Equation For Semiannual
Compounding And Quarterly Compounding:
FVn = PV* (1+i/m)m*n
Where:

Fv= Future value m= Compounding frequency

PV= Present value n= Number of years

i= Interest rate

But for semiannual m is must equal to 2 and 4 for quarterly

compounding

 Fred Moreno has found an institution that will pay him 8%

interest compounded semiannually and
 Con…

1. For semiannual compounding FV is:

FV2 = $100*(1 + 0.08/2)2*2 = $100 * (1+0.04)4 =
$116.99
2. For quarterly compounding FV is:
FV2 = $100*(1+0.08/4)4*2 = $100 * (1+0.02)8 =
$117.16
Effective Annual Rate And The Nominal
Rate
1. Nominal (stated) annual rate: Contractual
annual rate of interest charged by a lender or
promised by a borrower.
2. Effective (true) annual rate (EAR): The
annual rate of interest actually paid or earned.
 Fred Moreno wishes to find the effective annual rate
associated with an 8% nominal annual rate (i=0.08)
when interest is compounded (1) annually (m=1);
(2) semiannually (m=2); and (3) quarterly (m=4).
Con…
 For annual compounding:
EAR = ( 1+0.08/1)1 -1 = (1+0.08)1-1=1+ 0.08-1=
0.08 =8%
 for semiannual compounding:
EAR = ( 1+0.08/2)2 -1 = (1+0.04)2-1=1.0816-1=
0.0816 =8.16%
 for quarterly compounding:

EAR = ( 1+0.08/4)4 -1 = (1+0.02)4-1=1.0824-1=

0.08264=8.24%