CHAPTER THREE

TIME VALUE OF MONEY

3. An Introduction

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. Business decisions often involve receiving cash
or other assets now in exchange for a promise to make payments after one or more
periods. A common example is a decision to borrow money. Another important group of
business decisions involves investing cash now in order to receive cash, goods, or services in
future periods. Inflows of birr on various future dates should not be added together as if they
are of equal value and also for outflows. The future cash inflows and outflows must be
restated at their present value before they are aggregated. The concept of the time value
of money tells you that more distant cash inflows have a smaller present value than cash
inflows to be received within a short time span.

3.1 The concept of time value of money

The time value of money is the concept according to which a sum of money owned in the present
has a greater value than the value of the same sum received at a moment in the future. Thus, it is
taken into account the opportunity of the one presently owning the sum of money to invest it and
to obtain future gains such as interest or profit. 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 techniques used in order to make possible comparing and calculating the time value of
money include: Compounding, Discounting.

3.2 The Concept of Interest

The first basic point in the concept of the time value of money is to understand the meaning of
interest. The first basic point in the concept of the time value of money is to understand the

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meaning of interest. Interest is a return earned by or the amount paid to someone who has
forgone current consumption or alternative investment opportunities and rented money
in a creditor relationship. Interest is the growth in a principal amount representing the fee
charged for the use of money for a specified time period. Interest is the price paid for the use of
a sum of money over a period of time. Interest is the cost of using money (capital) over a
specified time period.

1. Simple Interest: The simple interest describes that the interest itself does not earn interest
over the periods of time. The interest is earned on the principal only. The principal is the
amount of money borrowed or invested.

I=PxRxT

Where:
I is interest,
P is the principal at time zero,
R is the interest rate per time period,
T is number of the time period

What is the simple interest on birr 10,000 at 10 percent per annum for a
year.

I = 10,000x0.1x1

= Br. 1,000
Example
If you bought a house and borrowed Br. 1000,000 at a 10 percent annual interest rate,
what would be your first month interest payment? And what will be the total value after a
month?
1
I = 1000,000x0.1x /12

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 = Br. 8,333.3
Fv = 1000,000 + 8,333.3

=Br. 1,008.3
2. Compound Interest: 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.

Fv = P +( P x i) = P(1+i)

Hence, for n periods: Fv = P (1+i)n

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 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. Compound interest to indicate that the amount of
interest earned on a given deposit has become part of the principal at the end of a specified
period. The term principal refers to the amount of money on which the interest is paid. Annual
compounding is the most common type. The future value of a present amount is found by
applying compound interest over a specified period of time.

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3.3.1. 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
5. Weekly………………………………………………i = r/52

For example, you have deposited birr 1,000 in a saving account paying 7 percent interest
compounded annually, the future value of your account at the end of the first year is
calculated as:
Fv = 1,000(1+0.07)
= Br.1070
If you place Br. 800 in a savings account paying 6% interest compounded monthly. You want to
know how much money will be in the account at the end of 5 years.

Pv=800

t = 5years
m = 12
n = 60
i = r/m = 6 %/12 =0. 5% = 0.005
Fv = 800(1+0.005)60
=Br.1,079.

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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
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

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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)
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.

3.4. The present value (discounting)

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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. The current dollar 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.

3.4.1 Present Value of Single Payments

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: If you have been given the opportunity to receive birr 120,000 ten years from now. If
you can earn 10 % on your investment, what is the amount that would make you indifferent if
you are to receive the amount as of today?
Solution
Pv= 120,000 = 120,000 = 46,265.
(1+0.1)10 2.593742

This means that, if you deposited birr 46,265 in to the bank at interest rate of 10 per cent, you
will get birr 120,000 at the end of 10 years.
Suppose the CBE jinka, branch manager offers to pay you Br. 100,000 in 7 years if you
deposit an X amount of birr today at annual 7 percent interest rate. Whether the investment is
worthwhile depends on how much money you must deposit. The amount of money that you
are going to deposit today is the present value.

Pv = 100,000

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 (1+0.07)7

= Br. 62,274.97

3.5 ANNUITY

An annuity is a stream of equal periodic cash flows, over a specified time period. The relevant
point is annuity could be a payment or receipt. Importance is series of equal. Financial
Management cash flows occurring over equally spaced periods, in time. The classical example
for annuity is the installment amount in a recurring deposit with a bank. Here, the installment is
fixed and the same amount is paid over a period, at regular intervals.

These situations are considered annuities if all the following conditions met:
i) The periodic cash flows are equal in amount

ii) The time period between payments or receipts is constant such as a year, a quarter of a
year, month etc;

iii) The interest rate per time period remains constant and

iv) The interest is compounded at the end of each time period.

Types of Annuities

There are two basic types of annuities. For an ordinary annuity, the cash flow occurs at the end
of each period. For an annuity due, the cash flow occurs at the beginning of each period.

3.5.1 Future value of an annuity

The future value of an annuity is the value of a series of payments, like payment of insurance
premium at regular intervals, over time. The term "annuity" refers to a series of payments of
constant amounts.

[Link]. Future Value of Ordinary Annuity

When payments are paid or received at the end of each period and the total amount on deposit
is determined at the time the final rent is made, it is considered as ordinary annuity. In an
ordinary annuity the first payment is not considered in interest calculation for the first period

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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.

[ ]
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

Here are the time lines for a $1000 3-year, 5% ordinary annuity and for an annuity due. With the
annuity due, each payment is shifted to the left by one year. A $1000 deposit will be made each
year.

The first payment earns an interest for three 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-2) 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.

0 1 2 3

1000 1000 1000

Example
1. Where you deposit Br.100 at the end of each year for 3 years and earn 10% per year. How
much will you have at the end of the five year?

FVoA = 100 ¿ = 610.51

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2. Suppose you receive a three year ordinary annuity of Br. 10,000 per year and deposits the
money in a saving account at the end of each year. The account earns an interest rate of 8
percent compounded quarterly. What is the amount your friend will have in his account at the
end of the third year?

Given Solution

PMT=10,000 FVoA = 10,000 ¿

t= 3 10,000[ 13.41208973 ] =134,120.897

m=4

n=mt=4×3=12 i= 8% /4 =0.02

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?

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[Link]. Future Value of Annuity due

Annuity due is the one in which payments or receipts occur at the beginning of each
period. The amount of an annuity due is the total amount on deposits one period after the
final payment or receipt. 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
[ (1+i)n − 1
i ] ( 1 + i) or .
FVAD= PMT[(1+i) n+1 - 1] - PMT
i

0 1 2 3

1000 1000 1000

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1. Suppose 20,000 birr is set aside in a saving account at the beginning of every year for 5
years. If the saving account pays 8% interest what is the balance of account at the beginning
of the period?
Solution

Given= 20,000
[
(1+0 .08 )5 − 1
0 . 08 ]
(1 + 0.08)
P=20,000 =126,718.58

n= 5

i=8%

2. Assume that pervious example, 2 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

FVAD= 10,000 ¿ (1+ 0.02)

= 136,803.3

3.5.2. Present Value of an Annuity

[Link]. Present Value of an Ordinary Annuity
The present value of an ordinary annuity is the amount of money today, which is equivalent to
the sum of a series of equal payment in the future. It is the sum of the present values of the
periodic payments of an annuity, each discounted to the beginning of an annuity. The present
value represents the amount that must be invested now to purchase the payment due in the future.
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

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 Example

1. What is the PV of an annuity if the size of each payment is Birr 200 payable at the end of each
quarter for one year and the interest rate is 8% compounded quarterly?

Given Solution.

R = Birr 200 r = 8%/4

m=4
P =?
r = 8%

m=4 = 200 [1 – (1+0.02)-4]

t = 1yr 0.02

P =? = 200 (3.08773)

= Birr 761.55

[Link] much should you deposit in an account paying 6% compounded quarterly in order to be
able to withdraw Birr 1000 every 3 months for the next 3 years?

Solution.
R = Birr 1000 PV = 1,000 [1- (1+0.015)-12]
0.015
t = 3years
m=4 = 1000(10.9075)
r = 6% = Birr 10, 907.50
PV =?

[Link]. Present value of Annuity Due

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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.
Present value of an annuity due can be calculated with the following formula:

PVAD = PMT i [
1 −(1+i)−n
]
(1 + i)

Example
Suppose you borrowed Br. 10,000 from your recent bank. The loan is for a period of four
years at an interest rate of 10 percent. It requires that you make four equal, annual, at the
beginning of year payments that include both the principal and the interest on the
outstanding balance.

PVAD = 10,000
[
1 −(1+0 . 1)−4
0.1 ]
(1 + 0.1)
= 34,868.5

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