Chapter-3

The Time Value of Money

Introduction
 A dollar in the hand today is worth more than a dollar to be received in the
future because,
 If you had it now, you could invest that dollar and earn interest.
 In business terms, interest is defined as the cost of using money overtime.
 Interest represents the time value of money.
 We would all prefer to receive a specific amount of money now rather than on
some future date.
 This preference rests on the time value of money.
 Inflows of dollars on various future dates should not be added together as if
they were of equal value.
 These future cash inflows must be restated at their present values before
they are aggregated.
 The concept of the time value of money tells us that more distant cash
inflows have a smaller present value than cash inflows to be received
within a shorter time span.
 Similar reasoning applies to cash outflows. To add together cash outflows on
various future dates, we must restate these outflows at their present values.
 As a simple example of this concept of present value,
 Assume that you are trying to sell your car and you receive offers from
three prospective buyers.
 Buyers A offer you Br. 8000 to be paid immediately. Buyer B offers
you Br. 8,200 to be paid one year from now. Buyer C offers the highest
price, Br. 9,200 but this offer provides that payment will be made in
five years. Assuming that the offers by B and C involves no credit risk
and that money may be invested at 5% interest compounded annually,
 Which offer would you accept?
 You should accept the offer of Br. 8000 to be received immediately, because
the present value of the other two offers is less than Br. 8000.
 If you were to invest Br. 8000 today, even at the modest rate of interest of
5%, your investment would be more than Br. 8200 in one year and
considerably more than Br. 9,200 in five years.
* This example suggests that the timing of cash receipts and payments has an
important effect on the economic worth and the accounting values of both
assets and liabilities.
* Consequently, investment and borrowing decisions should be made only
after a careful analysis of the relative present values of the prospective cash
inflows and outflows.
Simple Interest and Compound Interest

 Interest is the excess of resources (usually cash) received or paid over the
amount of resources loaned or borrowed at an earlier date.
 Business transactions subject to interest state whether simple or compound
interest is to be calculated.
1. Simple interest
 Is the return on a principal amount for one time period.
 We may also think of simple interest as a return for more than one time
period if we assume that the interest itself does not earn a return
The formula for simple interest is:
I = p.r.t (interest = principal x annual rate of interest x number of
years interest accrues).
For example, interest on Br. 10,000 at 8% for one year is expressed as follows:
I = p.r.t
I = Br. 10,000 x 0.08 x 1
I = Br. 800
2. Compound interest
 Is the return on a principal amount for two or more time periods, assuming
that the interest for each time period is added to the principal amount at the
end of each period, and earns interest in all subsequent periods.
For example, if interest at 8% is compounded quarterly for one year on a
principal amount of Br. 10,000 the total interest (compound interest) would be
Br. 824.32, as computed below:
Period Principal x Rate x Time = Compound Interest Accmul.
Amounts
1st quarter-------- Br. 10,000 x 0.08 x ¼ Br. 200.00 Br. 10,200.00
2nd quarter ----------10,200 x 0.08 x ¼ 204.00 10,404.00
3rd quarter -----------10,404 x 0.08 x ¼ 208.08 10,612.08
4th quarter ------- --10,612.08 x 0.08 x ¼ 212.24 10,824.32
Interest 824.32

N.B, in the computation of compound interest, the accumulated amount at the

end of each period becomes the principal amount for purposes of computing
interest for the following period.
Future and Present Values
 Future value involves a current amount that is increased in the future as a result
of compound interest accumulation.
 Present value, in contrast, involves a future amount that is decreased to the
present as a result of compound interest discounting.
 Present value in general refers to dollar (birr) values at the starting point of an
investment, and future value refers to end-point dollar (birr) values.
Future value of a single sum
 The accumulated amount of a single amount invested at compound interest may
be computed period by period by a series of multiplication.
 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 accumulated
amount FV in the example above may be determined as flows:
FV = p (1 + i) n
FV = Br. 10,000 (1.02)4
FV = Br. 10,000 (1.02) (1.02) (1.02) (1.02)
FV =Br. 10,824.32
Example:- If on the day her daughter was born, Bethel deposited Br. 10,000 in a
savings account that guarantees to accumulate interest quarterly at 10% a year.
 What will be the amount in the savings account on her daughter’s 18th
birthday?
Solution:
FV = 10,000 (1 + 0.025)72.
= 10,000 (5.91723)
= 59,172.28
Present Value of a single sum
 The present value represents the discounted amount (interest excluded) that
will accumulate to the future amount (interest included).
 The present value of a future amount is always less than that future amount.
 The computation of the present value of a single future amount is a reversal
of the process of finding future value of a single sum.
 We know that FV = p (1 + i)n,
FV
p=
1  i n
Example: If we want an amount of Br. 30,000 after 12 years by making a
single deposit in a saving account which will pay 16% interest compounded
quarterly,
 what should the amount of initial deposit be?
Solution: The present value is Br. 30,000 discounted at 4% for 48 periods.
The present value is;
P= FV = Br.30,000 Br.30,000
1  i 
n  = Br. 4565.84
1  0.0448 6.570528
Annuities
 An annuity is a series of uniform payments or receipts occurring at uniform
intervals over a specified investment time frame, with all amounts earning
compound interest at the same rate.
 When payment or receipt made at the end of each period and the total
amount paid or receipt is determined at the time the final payment or receipt
is made, the annuity is an ordinary annuity.
 When payment or receipt made at the beginning of each period, and the
total amount of payment or deposit is determined one period after the final
payment or receipt is made, the annuity is annuity due(annuity in advance).

Future Value of an ordinary Annuity

 An ordinary consists of a series of equal payment made at the end of each
period.
 Example:- If you deposit 100 Birr at the end of each year for three years in
a saving account that pays 5 percent per year,
 How much will you have at the end of year three (n=3)?.
 To answer this question, you must find future value of an annuity, FVAn.
 Each payment has to be compounded out to the end of period (n), and the
sum of the compounded payments gives you the future value of an annuity,
FVAn.
 This can be shown by using the following time line

0 1 2 3
100 Birr 100 Birr 100 Birr
105.00 Birr = (100) (1.05)1

110.25 Birr = (100) 1.05)2

For last year FVA3 = 315.25 Birr

FVAn = PMT(1+i)0 + PMT(1+i)1 + PMT(1+i)2+----+ PMT (1+i)n

The above equation can further be simplified to:

 (1  i ) n  1 
FVAn = (PMT)  
 i 
 Using this future value of an annuity equation, the future value of the 100 Birr
deposits made at the end of each year for three years at an interest rate of 5
percent would be:
FVA3= (100)  (1  0 .05 ) 3
 1 = (100) (3.1525) = 315.25Birr

 0 . 05 
Example:- Compute the amount of an ordinary annuity of 16 year rents of Br. 100
at 2%
 1  0.02   1  1.372786  1 
16
 0.372786 
    100   Br.1863.93
Solution: FVAn = 100  0. 02   0 . 02   0. 02 

Present (Discounted) value of ordinary Annuity:

Example: assume that you would like to deposit 100 Birr at the end of each
year over the coming three years in the saving account at Dashen Bank that pays
5 percent interest rate compounded yearly.
 How large should the Lump-sum payment today in order for it be equivalent
to the annuity?
To answer this question, let us start-up with the aid of the time line.

0 1 2 3
100 100 100
95.24

90.70

86.38
PVS3=272.32

The general mathematical equation that can be used to find the present
value of an ordinary annuity is shown below:
1 2 n
 1   1   1 
PVAn = (PMT)   PMT 
        PMT  
 1  i   1  i   1  i 
Since PMT is common for all terms, the above equation can be re-written
as:
 1 
1
  1 1  1  2  1 
n

PVAn = (PMT)                
 1  i    1  i   1  i   1  i  
Again the equation can be rewritten as:
 n  1 
t

PVAn = (PMT)    
 t 1 
 1  t  

 1 
 1  
 1  (1  i )  n  (i ) n
PVAn = (PMT)   , or PMT  
 i   i 
 

We can also calculate the present value of the previous example by using this
mathematical formula;
 1 
 1 
3
 1  (1  0.05)  (1  0.05)3 
PVA3 = (100) 
0 .05
 , or (100) 
0.05

   
 

= (100) (2.7232)
= 272.32 Birr
Future value of Annuity Due
 The amount of an annuity due (or annuity in advance) is the total amount on
deposit/payment one period after the final deposit/payment. Similar to
ordinary annuities except that payment/deposits are made at the beginning
of each deposit/payment periods.

Example. If the cooperative unions deposit 100 Birr interest of 10% for 3 years
Solution;

FVAd= 100 (1+i) n-1 × (1+i)

i

(1.1)3-1
FVAd= 100 0.1 × (1+01)

= 100 (3.31)*(1.1)
= Birr 364.10
Present value of annuity due
Present value of ordinary annuity is the discounted value of a series of future
rents on a date one period before the first payment/deposit.

Example
An individual makes rental payments of $1,200 per month and wants to
know the present value of their annual rentals over a 12-month period.
The payments are made at the start of each month. The current interest
rate is 8% per annum.
Using the formula above:
PV of the Investment = $1,200 x 11.57
PV of the Investment = $13,886.90
 A deferred annuity is a financial transaction where annuity payments
are delayed until a certain period of time has elapsed. Usually the
annuity has two stages, as depicted in this figure.

1.Accumulation Stage. A single payment is allowed to earn interest for a

specified duration. There are no annuity payments during this period of
time, which is commonly referred to as the period of deferral.
2. Payments Stage. The annuity takes the form of any of the four annuity
types and starts at the beginning of this stage as per the financial
contract.
 Note that the maturity value of the accumulation stage is the same as
the principal for the payments stage.
 The interest rate on deferred annuities can be either variable or fixed

Payment PMT
Interest = rate k
Present Value of Uneven Cash Flow
You may often get uneven cash flow streams. The example is dividend on equity
shares.
Illustration 5 : Aman makes an investment in a mutual fund which promises
following cash flows for five years. The discount rate is 10%. Find the present
value.
Effective Interest Rates and Nominal Interest Rates

 Nominal interest rate is the annual interest rate (per year) for a
certain compounding period. Nominal interest rate can be applied to
the advertised or stated interest rate on a loan, without taking into
account any fees or compounding of interest. The nominal interest
rate can be calculated using the formula:
 r = im
where:
•i is the periodic interest rate
•r is the nominal/stated rate
•m is the number of compounding periods
 The effective interest rate (f), (or simply effective rate) is the annual
interest rate compounded annually. It may be seen on a loan or financial
product restated from the nominal interest rate and expressed as the
equivalent interest rate if compound interest was payable annually in
arrears. It can be calculated with the following formula: f=(1+i)m-1
where:
•i is the periodic interest rate
•m is the number of compounding periods
•f is effective interest rate
 The effective rate is calculated in the following way,
where ; f is the effective rate, r the nominal rate , “m” the number of
compounding periods per year :
f = (1 + r/m)m - 1
The end of
chapter - three