CHAPTER THREE
TIME VALUE OF MONEY
3.1 The concept of time value of money and interest
The time value of money is a very important concept in financial management. 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, time value of money is the concept that an amount in hand
today is worth more than the same amount that will be received in future year. The basic concept of
financial management is that money has time value which is described either as present value or future.
Present value is the value of money today; future value is the value of money at some point in the future.
The first basic point in the concept of the time value of money is to understand the meaning of interest.
Interest is the cost of using money (capital) over a specified time period. Interest is the price paid for the
use of a sum of money over a period of time. It is a fee paid for the use of another’s money, just rent is
paid for the use of another’s house.
There are two basic types of interest: simple interest and compound. Simple interest can be understood in
two different ways. One is that simple interest is an interest computed for just a period. If interest is
computed for one period only, the interest is always simple interest. Another way to understand simple
interest is that it is an interest computed for two or more periods whereby only the principal (original)
value would earn interest. In simple interest the previously earned interests do not produce another
interest.
Simple interest I= principal x rate x time
Compound interest, on the other hand, If the interest, which is due, is added to the principal at the end of
each interest period (such as a month, quarter, and year), then this interest as well as the principal will
earn interest during the next period. In such a case, the interest is said to be compounded.
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
1
3.2 The future value (compounding)
Future value (FV) is the amount to which a cash or cash flows will grow over a given period of time when
compounded at a given interest rate. Future value is always a direct result of the compounding process.
To understand future value, we need to understand compounding first. Compounding is a mathematical
process of determining the value of a cash flow or cash flows at the final period. The cash flow(s) could
be a single cash flow, an annuity or uneven cash flows.
3.2.1. Future Value of a Single Amount
FVn = PV (1 + i)n
Where: FVn = Future value at the end of n periods
PV = Present Value, or the principal amount
i = Interest rate per period
n= Number of periods
Conversion period (m) Rate per compound period (i)
1. Annually (once a year) ----------------------------------- i = r/1
2. Semiannually (every 6 months) ------------------------ i = r/2
3. Quarterly (every 3 months) ----------------------------- i = r/4
4. Monthly --------------------------------------------------- i = r/12
Example : 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 three year. How much future sum would you receive?
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:
FVn = PV (1 + i)n
FVn = birr 10,000 (1 + 0.02)12
FVn = 12.682.42
Example: Find the compound amount and compound interest after 10 years if Br. 15, 000 were invested
at 8% interest;
If compounded annually
Compounding annually means that there is one interest payment period per year. Thus
t = 10 years
m=1
n = mt = 1 x 10 = 10
i = r/m = 8 %/1 = 8% = 0.08
2
The compound amount will be:
A = 15, 000 (1.08)10
= 15, 000 (2.158925) = Br. 32, 383.875
Compound Interest = compound amount (A) – Principal (P)
= 32, 383.875 – 15, 000
= Br. 17, 383.875
a) If compounded semiannually
Compounding semiannually means that there are two interest payment periods per year. Thus, the number
of payment periods in 10 years n = 2 x 10 = 20 and the interest rate per conversion period will be i = r/m
= 8%/2 = 4%. The compound amount then will be:
A = P (1 + i)n
= 15, 000 (1.04)20
= 15, 000 (2.191123
= Br. 32, 866.85
Compound Interest = A – P
= 32, 8666.85 – 15, 000
= Br. 17, 866.85
b) If Compounded quarterly
If compounding takes place quarterly (four times a year), then an 8% annual interest rate, the interest rate
per conversion period will be i = 0.08/4 = 0.02, there will be a total of n = 4 x 10 = 40 conversion periods
over the 10 years. The compound amount will be:
A = 15, 000 (1.02)40
= 15, 000 (2.208039) = Br. 33, 120.60
c) If compound monthly
p = 15, 000
t = 10 years
m = 12 (12 payment periods per year)
n = 12 x 10 = 120 payment periods over the 10 years
i = r/m = 8%/12 = 0.667% = 0.00667
Under these conditions:
A = 15, 000 (1. 00667)120
= 15, 000 (2.220522)
= Br. 33, 307.84
Interest = Br. 18, 307.84 = (33,307.84 – 15,000)
3
d) If compounded weekly
m = 52
n = 10 x 520 = 520
i = 8%/52 = 0.154% = 0.00154, then
A = 15, 000 (1.00154)520 = Br. 33, 362.60
Interest = 33,362.60 – 15,000 = 18362.60
When a number of conversion period within a year increases, the interest earned also increases
continuously toward an upper limit. The limiting case occurs where interest is compounded continuously.
3.3. The present value (discounting)
Present value is the exact reversal of future value. It is the value today of a single cash flow, an annuity or
uneven cash flows. In other words, a present value is the amount of money that should be invested today
at a given interest rate over a specified period so that we can have the future value. The process of
computing the present value is called discounting.
3.3.1. Present Value of a Single Amount
It is the amount that should be invested now at a given interest rate in order to equal the future value of a
single amount.
( )
n
FVn 1
= FVn
PV = ( 1+i )
n 1+i
Where:PV = Present Value
FVn = Future value at the end of n periods
i = Interest rate per period
n = Number of periods
Example: 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= 10,000 = 10,000 = 7921
(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.
4
Example: What is the present value of a loan that will amount to Br. 5, 000 in 5 years if money is worth
3% compounded semi-annually?
Given: Solution:
A = Br. 5, 000 p = A (1 + i)-n
t = 5 years = 5, 000 (1.0015)-10
r = 3% / year = 5, 000 (0.985123)
m = 2 times = Br. 4925.62
n = mt = 2 x 5 = 10
i = r/m = 3%/2 = 1.5%
p =?
3.4. Future Value of an Annuity
An annuity is a bunch of structured payments or equal payments made regularly, like every month or
every week. Many measurement situations involve periodic deposits, receipts, withdrawals, or payments
(called rents), with interest at a stated rate compounded at the time that each rent is paid or received.
These situations are considered annuities if all the following conditions met:
1. The periodic rents are equal in amount.
2. The time period between rents is constant, such as a year a quarter of a year, or a month.
3. The interest rate per time period remains constant.
3.4.1. Future Value of Ordinary Annuity
An ordinary annuity is an annuity for which the cash flows occur at the end of each period. The concept
shows a series of equal periodic payments in which each payment is made at the end of the period. In an
ordinary annuity the first payment is not considered in interest calculation for the first period because it is
paid at the end of the first period for which interest is calculated. Similarly, the last payment does not
qualify for interest at all since the value of the annuity is computed immediately after the last payment is
received.
If we assume an investor who wants to know how much is the value of just birr 1 deposit to be
made at the end of each of the coming five years at 10 % compounded annually, the first
payment earns an interest for four years ( n-1) years because, it is made at the end of the first
year. So, it is late to earn anything in the first year. The second payment earns interest for 3 (n-
1) years. And the last payment does not earn anything because it is made just at the end of the
last year. Thus, for ordinary annuity of n payments, there is n-1 compounding periods.
5
Graphically, future value of an ordinary annuity can be represented as follows:
0 1 2 ------------------ n
PMT1 PMT2 ---------------PMTn
The future value is computed at point n where PMTn is made.
[ ]
n
(1+i) − 1
FVOA = PMT i
Where: FVOA = Future value of an ordinary annuity
PMT = Periodic payments
i = Interest rate per period
n = Number of periods
Example
1. Suppose 5000 birr is set aside in a saving account at the end of every year for 5 years. If the saving
account pays 9% interest what is the balance of account at the end of the period?
Solution
FVoA = 5000 [ (1+0.09)5−1
0.09 ]
= 29,923.55
2. Ato Abebe wish to determine the sum of money he will have in his saving account at the end of 6 years by
depositing birr 1,000 at the end of each year for the next 6 years at an annual interest rate of 8 per cent .
Required: A. Determine the amount
B. Prepare fund accumulation table
Solution
A. FVoA= R [(1+i) n -1]
i
= 1000 [(1+ 0.08)6-1] = 7,336
0.08
B. Fund accumulation table
Date Annual Deposit Interest earned Increase in fund balance Fund balance
December 31
Year 1 1,000 - 1,000.00 1,000.00
Year 2 1,000 80.00 1,080.00 2,080.00
Year 3 1,000 166.40 1,166.40 3,246.40
Year 4 1,000 259.70 1,259.70 4,506.10
Year 5 1,000 360.50 1,360.50 5,866.60
Year 6 1,000 469.33 1,469.30 7,336.00
6
3. Hiwot deposits Br. 1, 000 at the end of every 3 months period in to an account for 5 years which earn 10%
interest compounded quarterly and then she stop her periodic payment and deposits it (total amount) for the next
5 years which earn 12% interest compounded monthly. How much is the account by the end of the time period
considered?
3.4. 2. Future Value of Annuity due
An annuity due is an annuity for which the payments occur at the beginning of each period. Therefore, the
future value of an annuity due is computed exactly one period after the final payment is made.
The future value of an annuity due is computed at point n
FVAD= PMT i [
(1+i)n − 1
]
(1 + i) or.
FVAD= R [(1+i) n+1 - 1] - R
i
Example: Assume that pervious example (example two of ordinary annuity) except that the first payment
is made today instead of end of the year. what is the balance of account at the end of the period??
= PMT
[
(1+i)n − 1
i ]
( 1 + i)
= 1000 ¿ ( 1 + 0.08)
= 7922.803
Because each payment occurs one period earlier with an annuity due, the payments will all earn interest
for one additional period. Therefore, the FV of an annuity due will be greater than that of a similar
ordinary annuity.
7
Exercise: Assume that Abera projected to deposit birr 5,000 on January 1 of each year for the coming
eight years in to an account paying 9 % compounded annually. How much will be in his account at the
end of the year 8?
Solution
FVAD= 5,000 [(1.09)8-1] * (1.09)
0.09
= 5,000 (11.0285) *(1.09) = 60,105.00
3.5. Present Value of an Annuity
3.5. 1. Present value of ordinary annuity
Present value of ordinary annuity refers a single amount of money that should be invested now at a given
interest rate in order to provide for an annuity for a certain number of future periods.
It can be calculated by using the following formula:
PVOA = R [1- (1+i)-n]
i
Where: PVOA = Present Value of Ordinary Annuity
R= Periodic Payments
i = Interest Rate
n= Periods for which Rent is Made
Example
ABC Corporation purchased Machinery on January 1, 2001 and agreed to pay for the purchase payment of
birr 5,000 each including principal and interest on December 31 of each of the next five-year beginning
December 31, 2001. The agreed interest rate is 6 per cent compounded annually. Compute the price of the
machinery and develop liability table.
Solution
PVOA= R [1- (1+i)-n]
i
= 5,000 [1-(1.06)-5] = 21,061.82
0.06
Therefore, the price of the machinery (present value) is birr 21,061.82
Debt Payment Program/liability table
Interest Payment at Net Reduction in Debt
Date 6 %/Year End of the year Debt Balance
8
Jan 1,01 - - - 21,061.82
Dec 31,01 1,263.71 5,000 3,736.29 17,325.53
Dec 31,02 1,039.53 5,000 3,960.47 13,365.06
Dec 31,03 801.90 5,000 4,198.10 9,166.96
Dec 31,04 550.02 5,000 4,449.98 4,716.98
Dec 31,05 283.02 5,000 4,716.98 0
3.5. 2. Present value of Annuity Due
Present value of Annuity Due is the present value computed where exactly the first payment is to be made
or it is the discounted value of a series of future rents on the date the first rent is received or paid.
PVAD = (Annuity due) = PMT i [
1 −(1+i)−n
(1 + i)
]
Example
XYZ Company acquired office equipment on January 1, 1999 and agreed to pay for the purchase with
three installments of birr 5,000 each including principal and interest, every year beginning January 1,
1999. The interest rate was 12 per cent compounded annually. Compute the acquisition cost of the
equipment.
PVAD= R [1- (1+i)-n] (1+i)
i = 5,000 [(1- (1.12)-3] (1.12) = 13,450.26
0.12