TIME VALUE OF MONEY
By Jared M. Ariemba
The process of finding present values is referred to as discounting. It is the inverse of
compounding and seeks to answer the question. “If I can earn k% on my money, what is
the most I will be willing to pay now for an opportunity to receive FV shillings n periods
from now?” The annual rate of return k% is referred to as the discount rate, required
rate of return, cost of capital, or opportunity cost.
The present value as the name suggests, is the value today of a given future amount.
Recall the basic compounding formula for a lump sum;
FVn = Po (1+k)1 Therefore making P the subject
Po = FVn
(1+ k)n
FV
n
1
PV FV
(1 k ) (1 k )
k ,n n n n
Example:
Assume you were to receive sh. 172,800 three years from now on an investment and the
required rate of return is 20 %. What amount would you receive today to be indifferent?
Solution.
Recall previous example on FV
PV20%, 3yrs= 172,800/ (1 + 0.20)3 =172,800/1.728 = Sh.100, 000
PV=Sh.100, 000
FV5 = Sh.172800
Using Present Value Interest Factor (PVIF) Tables
, or (1 K )
1 n
The factor denoted by as above is called the present value
(1 k )
n
interest factor (PVIF). The PVIF is the multiplier used to calculate at a specified discount
rate the present value of an amount to be received at a future date. The PVIFk,n is the
present value of one shilling discounted at k% for n-periods.
Therefore the present value (PV) of a future sum ( FVn ) can be found by
PV = FVn x (PVIFk, n).
In the preceding example the PV could be found by multiplying Sh. 172,800 by the
relevant PVIF. Table A - 1 Present Value of $1 Due at the End of n Periods gives a
factor of 0.5787for 20% and 3 years.
PV = 172800 x 0.5787 = Sh.99, 999.36
= sh. 100,000
Present Value of a Mixed Cashflows
We determine the PV of each future amount and then add together all the individual
PVs
Example
The following is a mixed stream of cash flows occurring at the end of year
Year Cash flow
sh.000
1 400
2 800
3 500
4 400
5 300
If a firm has been offered the opportunity to receive the above amounts and if it’s
required rate of return is 9% what is the most it should pay for this opportunities?
Solution.
Year (n) Cash flow PVIF9%, n PV
1 400,000 0.917 366,800
2 800,000 0.842 673,600
3 500,000 0.775 386, 000
4 400,000 0.708 283,200
5 300,000 0.65 195,000
PV 1,904,600
Present Value of an Annuity
The method for finding the PV of an annuity is similar for that of a mixed stream but
can be simplified using present value interest factor of an annuity (PVIFA) tables.
The present value interest factor of an annuity with end–of-year cash flows that are
discounted at k per cent for n period are
n
n
1 1 1
PVIFAK,n = = 1
t 1 1k n
k
1k
Table A - 2 Present Value of an Annuity provides the PVIFAk,n, which can be used in
calculating the present value of an annuity (PVA) as follows:
PVA = PMT × PVIFAk n
Example
Assume that a project will give you sh. 1000 at the end of each year for 4 years .What
is the maximum amount would you be willing to pay for that project if the required rate
of return is 10%.
Solution
The PVIFA at 10% for 4 years (PVIFA10%, 4yrs) from Table A-2 is 3.1699.
Therefore, PVA = 3.1699X 1000 = Sh.3, 169.9
Present Value of an Annuity Due. From the above example, assume that the project
gives you sh. 1000 at the beginning of each year for 4 years.
PVIFAk,n(annuity due) = PVIFk,n(ordinary annuity) x ( 1 +k)
= 3.1699 × (1+0.1)
=3.48689
Therefore present value of the annuity due = 1000 x 3.48689
=Sh.3, 486.89
Present Value of Perpetuity
Perpetuity is an annuity with an infinite life – never stops producing a cash flow at the
end of each year forever.
The PVIF for a perpetuity discounted at the rate k is
PVIFAk, α = 1/k
Example
Ongosi wishes to determine the PV of a Sh.1000 perpetuity discounted at 10%.
The present value of the perpetuity is 1000 x PVIFAk, α = 1000 x 1/0.1= Sh.10, 000.
This implies that the receipt of Sh.1,000 for an indefinite period is worth only Kshs
.10,000 today if Ongosi can earn 10% on her investments (If she had Sh.10,000 and
earned 10% interest on it each year, she could withdraw Sh.1000 annually without
touching the initial Sh.10,000).
Deposits to Accumulate a Future Sum.
It may be necessary to find out the periodic deposits that should lead to the built of a
needed sum of money in future.
We can use the expression below, which is a rewriting of FVn = Po × FVIFk,n.
PMT = FVAn/FVIFAk n
Where PMT is the periodic deposit, FVAn is the future sum to be accumulated, and FVIFAk
n is the future value interest factor of an n-year annuity discounted at k%.
Example
John needs to accumulate Sh. 5 million at the end of 5 years to purchase a company.
He can make deposits in an account that pays 10% interest compounded annually. How
much should he deposit in his account annually to accumulate this sum?
Solution
PMT = FVAn/FVIFAk n = 5,000,000/6.105 = Sh.819, 000
Example
Suppose you want to buy a house in 5 years from now and estimate that the initial down
payment of Sh. 2 million will be required at that time. You wish to make equal annual
end of year deposits in an account paying annual interest of 6%. Determine the size of
the annual deposit.
FVAN = PMT X FVIFAK, N
PMT = FVAn/ FVIFAk n
PMT = 2,000,000/5.637= Sh.354,799
Finding unknown Interest Rate
A situation may arise in which we know the future value of a present sum as well as the
number of time periods involved but do not know the compound interest rate implicit
in the situation. The following example illustrates how the interest rate can be
determined.
Example
Suppose you are offered an opportunity to invest Sh.100’000 today with an assurance of
receiving exactly Sh.300, 000 in eight years. The interest rate implicit in this question
can be found by rearranging FVn = Po × FVIFk,n as follows.
FV8 = P0 (FVIF k, 8 )
300,000 = 100,000 (FVIFKk,8)
FVIFk, 8 = 300,000 / 100,000 = 3.000
Reading across the 8-period row in the FVIFs table (Table A-3) we find the factor that
comes closest to our value of 3 is 3.059 and is found in the 15% column. Because 3.059
is slightly larger than 3 we conclude that the implicit interest rate is slightly less than
15 percent.
To be more accurate, recognize that
FVIFk,8 = (1+k)8
(1+k)8 = 3
(1+k) = 31/8 = 30.125
1+k = 1.1472
k = 0.1472 = 14.72%
Amortizing a Loan
An important application of discounting and compounding concepts is in determining the
payments required for an installment – type loan. The distinguishing features of this loan
is that it is repaid in equal periodic (monthly, quarterly, semiannually or annually)
payments that include both interest and principal. Such arrangements are prevalent in
mortgage loans, auto loans, consumer loans etc.
Amortization Schedule.
An amortization schedule is a table showing the timing of payment of interest and
principal necessary to pay off a loan by maturity.
Example
Determine the equal end of the year payment necessary to amortize fully a Sh.600, 000,
10% loan over 4 years. Assume payment is to be rendered (i) annually, (ii) semi-annually.
Solution
(i) Annual repayments
First compute the periodic payment using Equation
PMT = PVAn /PVIFAk,n.
Using tables we find the PVIFA10%,4yrs = 3.170, and we know that PVAn = Sh.600,000
PMT = 600,000/3.170 = Sh.189, 274 per year.
Loan Amortization schedule
Payments
End of year Loan Beg. Of year Interest Principal End of year
payment principal principal.
[10%x (2)] [ (1) – (3) [ (2) – (4)]
(1) (2) (3) (4) (5)
1 189,274 600,000 60,000 129,274 470,726
2 189,274 470726 47,073 142,201 328,525
3 189,274 328525 32,853 156,421 172,104
4 189,274 172104 17,210 172,064 -
(ii) Semi-annual repayments
For semi-annual repayments the number of periods, n, is 8 and the discount rate is 5%.
Let’s compute the periodic payment using Equation
PMT = PVAn /PVIFAk,n.
Using tables we find the PVIFA5%,8periods =6.4632, and we know that PVAn = Sh.600,000
PMT = 600,000/6.4632 = Sh.92, 833 per year.
Loan Amortization schedule
Payments
End of Loan Beg. Of year Interest Principal End of
period payment principal period
(6months) principal.
[5%x (2)] [ (1) – (3) [ (2) – (4)]
(1) (2) (3) (4) (5)
1 92833 600,000 30,000 62,833 537,167
2 92,833 537,167 26,858 65,975 471,192
3 92,833 471,192 23,559 69,274 401918
4 92,833 401, 918 20,096 72,737 329,181
5 92,833 329,181 16,459 76,374 252,807
6 92,833 252,807 12,481 80,192 172,615
7 92,833 172,615 8,631 84,202 88,413
8 92,833 88,413 4,421 88,412 -0-
Determining Interest or Growth Rate
It is often necessary to calculate the compound annual interest or growth rate implicit
in a series of cash flows. We can use either PVIFs or FVIFs tables. Let’s proceed by way
of the following illustration.
Example
Roy wishes to find the rate of interest or growth rate of the following series of cash
flows
Year Cash flow (Sh.)
2004 1,520,000
2003 1,440,000
2002 1,370,000
2001 1,300,000
2000 1,250,000
Solution
Using 2000 as base year, and noting that interest has been earned for 4 years, we
proceed as follows:
Divide amounts received in the earliest year by amount received in the latest year.
1,250,000/1,520,000 = 0.822. This is the PVIF k , 4 yrs
. We read across row for 4
years for the interest rate corresponding to factor 0.822. In the row for 4 years in table
of Table A-3 of PVIFs, the factor for 5% is .823, almost equal to 0.822. Therefore,
interest or growth rate is approximately 5%.
Note that the FVIF k , 4 yrs
(1,520,000/1,250,000) is 1.216. . In the row for 4 years in
table of Table A-1 of FVIFs, the factor for 5% is 1.2155 almost equal to 1. [Link]
estimate the growth rate to be 5% as before.