Chapter Three-Time Value of Money

CHAPTER – THREE
TIME VALUE OF MONEY
By Honelign E. (Ph.D)
Department of Accounting and Finance,
Bahir Dar University
INTRODUCTION
Which would you prefer-Br 10,000 today or Br
10,000 five years from today? Why?
 Time Value of money deals with an individual’s
preference for possession of a given amount of
money now, rather than the same amount at
some future time.
 Three reasons may be attributed to the
individual’s time preference for money:
 risk
 investment opportunities
 preference for consumption
Dr. Honelign E,BDU. 2

 The time preference for money is generally
expressed by an interest rate.
 This rate will be positive even in the absence of any
risk.
 It may be therefore called the risk-free rate.
 An investor requires compensation for assuming
risk, which is called risk premium.
 The investor’s required rate of return is:
Risk-free rate + Risk premium.

3.1. Terminologies in Time
Value of Money
i. Interest: Money paid (earned) for the use of
money for a period of time.
ii. Simple interest is the interest that is calculated
only on the original amount (principal), and thus,
no compounding of interest takes place.
iii. Compound interest is the interest that is
received on the original amount (principal) as
well as on any interest earned but not withdrawn
during earlier periods.

Terminologies in Time Value of Money
iV . Present value of a future cash flow (inflow or

outflow) is the amount of current cash that is of
equivalent value to the decision-maker .
v. Future Value: The value at some future time
period of a present amount of money or a series
of payments evaluated at a given interest rate.
Vi. Compounding is the process of finding the
future values of cash flows by applying the
concept of compound interest

Terminologies ...
vii. Discounting—the process of calculating
present values of cash flows.
viii. Annuity is a fixed payment (or receipt) each
year for a specified number of years.
ix. Perpetuity is an annuity that occurs indefinitely.
X. Uneven Cash flows:- a series of Cash flows that
varies from period to period
Xi. Time line:- A graphical representation used to show
the timing of cash flows.
0 2 3
i% 1
CF0 CF1 CF2 CF3

3.2. MATHEMATICS OF TIME VALUE
OF MONEY
 The mathematics of time value of money has
three major applications:
a) Single Sum
b) Annuities ,and
c) Uneven cash f lows
 Hence, we will determine the present and
future values of these cash flows using
 a regular calculator.
 Financial tables.
 financial calculator.
A. SINGLE SUM
i. Future Value of a Single Sum
Suppose you deposit Br. 100 in a bank that
pays 10% rate of interest each year.
What will the balance after each of the following
3 years?
Interest can be calculated as :INT= PV. i. n

Maturity value :FV = PV +INT
FV = PV + PV. i. n., N=1

After 1 year:
FV1 = PV + INT1 = PV + PV(i)
= PV(1 + i)
= Br. 100(1.10)
= Br. 110.00.
After 2 years:
FV2 = PV(1 + i)2
= Br. 100(1.10)2
= Br. 121.00.
After 3 years:
FV3 = PV(1 + i)3
= 100(1.10)3
= Br. 133.10.
In general,
FVn = PV(1 + i)n.

Future Value of a Single Sum...
 The general form of equation for calculating

the future value of a lump sum after n periods
may be written as follows:
F n  P (1  i ) n 3.1
 The term (1 + i)n is the compound value
factor (CVF) of a lump sum of Br. 1, and it
always has a value greater than 1 for positive
i, indicating that CVF increases as i and n
increase.
Fn =P  CVFn,i
Example: FV of a single Sum
Suppose you deposit Br. 100 in a bank that

pays 5% rate of interest each year.
a) How much would you have at the end of one
year.
b) how much would the deposit grow at the
end of five years?
Solution:
F n  P (1  i ) n
a) 100*(1.05)1 = Br 105
b) 100* (1.05)5 = 100(1.2763) =Br 127.63
ii. Present Value of a Single Sum
 The following general formula can be employed to
calculate the present value of a lump sum to be
received after some future periods:
Fn
P  F 
n  (1  i ) n
 3.2
(1  i ) n
 The term in parentheses is the discount factor or

present value factor (PVF), and it is always less
than 1.0 for positive i, indicating that a future amount
has a smaller present value.
PV  Fn  PVFn ,i

Example-Present Value of a Single Sum
Suppose that an investor wants to find out the

present value of Br. 50,000 to be received
after 15 years. Her interest rate is 9 per
cent.
Find out the present value factor of this birr
50,000.
Solution
PV= 50,000* (1.09)-15
= 50,000(0.275) =Br 13,750

iii. Solving for time and Interest rate
• It is possible to compute time and interest
rate from the previous compounding and
discounting formulas.
• Solve for the fourth unknown variable if all
the other three is known, using the following
formulas.
F n  P (1  i ) n 3.1
Fn 3.2
P  F 
n  (1  i ) n

(1  i ) n

Example: Solving for time and Interest rate
a) What interest rate would cause Br 100 to

grow to Br125.97 in 3 years?
b) Find the number of years by which a br

78.35 saving will grow to br 100 when interest
rate is 5%.

Example: Solving for time and
Interest rate
Solution.
a) 100 (1 + i )3 = Br125.97
(1 + i )3 = Br125.97/100
i = 3 1.2597 - 1
= 8%
 B) 78.35 (1 .05 )n = Br 100
n= log(1+i) = FV/P
= log FV/P = log 1.276 = 0.10596 = 5
log(1+i) log 1.05 .021189
B. ANNUTIES
 There are two types of annuities:
1. Ordinary/ Differed annuity: consists of a
serious of equal payments made at the end
of each period.
2.Annuty due: consists of a serious of equal

payments made at the beginning of each
period.

i. Future Value of an Ordinary
Annuity
 Annuity is a fixed payment (or receipt) each
year for a specified number of years. If you rent
a flat and promise to make a series of
payments over an agreed period, you have
created an annuity.
 (1  i )n  1 
Fn  A  
 i 
 The term within brackets is the compound
value factor for an annuity of Br. 1, which we
shall refer as CVFA.
Fn =A CVFA n, i
Example
 Suppose that a firm deposits Br. 5,000 at the
end of each year for four years at 6 per cent
rate of interest.
 How much would this annuity accumulate at
the end of the fourth year?
 F4= 5000 (1.06)4 -1
0.06
= Br 5,000(4.375)
= Br 21,875.

Sinking Fund
 Sinking fund is a fund, which is created out of
fixed payments each period to accumulate to a
future sum after a specified period. For
example, companies generally create sinking
funds to retire bonds (debentures) on maturity.
 The factor used to calculate the annuity for a
given future sum is called the sinking fund
factor (SFF).  (1  i )n  1 
Fn  A  
From FV of Annuity:  i 
 i 
We can derive: A = Fn  
 (1  i )  1
n

Example –Sinking Fund
 How much money should be deposited in a
sinking fund at the end of each of the next 5
years to accumulate Br 10,000 if the fund
earns 8% per annum?
Solution
A = 10,000 (0.08)
(1.08)5 -1
= 800 / 0.46932
= Br 1,704.59
ii. Present Value of an Ordinary
Annuity
 The computation of the present value of an
annuity can be written in the following general
form:
PVAn= A 1- (1+i)-n
P = A × PVAFn, i
i
PVAn = A 1- 1/(1+i)n
i
 The term within parentheses is the present
value factor of an annuity of Br 1, which we
would call PVFA, and it is a sum of single-
payment present value factors.
Example
 Suppose that a firm deposits Br. 5,000 at the
end of each year for four years at 6 per cent
rate of interest.
 What is the present value of this annuity at
the beginning of the first year?
 P4= 5000 1- (1.06)-4
0.06
= Br 5,000(3.465106)
= Br.17,325.53

Value of an Annuity Due
 Annuity due is a series of fixed receipts or
payments starting at the beginning of each
period for a specified number of periods.
 Future Value of an Annuity Due
 (1  i )n  1 
Fn  A   (1+i)
 i 
 Present Value of an Annuity Due
 PVAn= A 1- (1+i)-n (1+i)
 i
Example- FV of this annuity Due
 What’s the FV of this annuity Due?
0 1 2 3
10%
100 100 100

Solution
FV= A (1+i)n -1 (1+i) = 100 (1.10)3 -1 (1.10)

i 0.10
= 100 (3.31) (1.10)

= 364.10

Example- PV of Annuity Due
 What’s the PV of this annuity Due?
0 1 2 3
10%
100 100 100

Solution
PVAn= A 1- (1+i)-n (1+i) = 100 1- (1.10)-3 (1.10)

i 0.10
= 100 (3.6410)(1.10)
= 400.50

Present Value of Perpetuity
 Perpetuity is an annuity that occurs
indefinitely. Perpetuities are not very common
in financial decision-making:
Perpetuity = A
Present value of a perpetuity 
Interest rate i
Example: A government sold a huge bond issue and

promised to pay Br 100 per year in perpetuity. What
would each bond be worth if the discount rate was 5%?
Solution: PV of perpetuity= Br 100/ .05

= Br 2,000
C. Value of an Uneven
Periodic Sum
 Investments made by of a firm do not
frequently yield constant periodic cash flows
(annuity). In most instances the firm receives
a stream of uneven cash flows. Thus the
present or future value factors for an annuity
cannot be used. The procedure is to
calculate the future or present value of each
cash flow and aggregate all the present or
future values.

Example: Value of Uneven cash flow
 Assume an interest rate of 10% and the

following uneven cash flow streams made at
the end of each Year.
Year Cash flow
1 100
2 300
3 300
4 (50)
a) Find the FV this cash flows.
b) Find the PV this cash flows
FV uneven cash flow stream?
0 1 2 3 4
10%
100 300 300 -50
X(1.10)1
330
X(1.10)2
363
X(1.10)3
133.10
FV = 776.10

PV uneven cash flow stream?
0 1 2 3 4
10%
100 300 300 -50
90.91
247.93
225.39
-34.15
530.08 = PV

Multi-Period Compounding
 Annual Compounding: is arithmetic process
of determining the future values of cash flows
when interest is added once a year.
 Semi-annual Compounding: is arithmetic
process of determining the future values of
cash flows when interest is added twice a
year.
 Time value calculations should be done using
number of periods and period rates, not
based on the number of years and stated
rates.
Multi-Period ....
Hence, when payments occur more frequently
than once a year, then stated interest rates
should be converted to a “periodic rate” as
follows:
Periodic rate = Stated rate

number of payments per year
Number of = (Number x ( Periods

periods of Years ) per year )
Multi-Period ....
 When payments occur more frequently than
once a year, we can use a modified version
of the equation for FV of a lump sum.
Annual compounding: FVn= PV (1+i)n
More frequent compounding:
FVn= PV 1+ iNom mn
m
Where: iNom is the nominal/Quated/Stated rate

m is the number of compounding per years
n is the number of years
Example -Multi-Period Compounding
 Assume you have placed Br. 500 into an
account at an interest rate of 12%. How much
would you have accumulated at the end of 5
years under the following conditions?
a) annually?
b) semi-annually?
c) quarterly?
d) Monthly?

Example -Multi-Period Compounding
 Solution
a) Annual compounding
Periodic rate = 12%/1 = 12%
No. of periods= (5) x(1) =5
Fv = PV (1+i ) n = 500(1.12 ) 5 = Br 881.17
b) Semi-annual compounding
Fv = PV (1+i ) n = 500(1.06 ) 10 = Br 895.42
Example -Multi-Period ...
c) Quarterly compounding
Fv = PV (1+i ) n = 500(1.03) 20 = Br 903.05
d) Monthly compounding
Fv = PV (1+i ) n = 500(1.01 ) 60 = Br 908.35

Multi-Period ....
Multi-period compounding can also used for
discounting and both lump sum and annuities.
Example:
Find the present value of an ordinary annuity of 3
years with an 8% interest rate for:
a) Birr 100 payment compounded annually.
b) Birr 50 payment compounded semi-annually.

Multi-Period ....
a) Periodic rate= 8%/1 ; no of periods = 1*3= 3
PVAn= 100 1- (1.08)-3 = Br. 257.71

0.08
b) Periodic rate= 8%/2= 4% ;no of periods = 2*3= 6
PVAn= 50 1- (1.04)-6 = Br. 262.11

0.04

Types of interest Rates
We will deal with 3 different rates:
iNom = nominal, or stated, or

quoted, rate per year.
iPer = periodic rate.
EAR = EFF% = effective annual .

rate

 Nominal, or stated (iNom)
 iNom is written into contracts, quoted by banks and
brokers. Not used in calculations or shown on time
lines, unless compounding occurs once a year,in
which case iNom = Periodic rate.
 Quated nominal rate should also include the number
of compounding per Year.
Examples:
 8%; Quarterly
 8%, Daily interest (365 days)

Interest Rates
Periodic rate ( iPer ) is the rate charged or paid by a

borrower each period.
Used in calculations, shown on time lines.
iPer = iNom/m,
where m is number of compounding periods per
year. m = 4 for quarterly, 12 for monthly, and 360
or 365 for daily compounding.
Examples:
8% quarterly: iPer = 8%/4 = 2%.
8% daily (365): iPer = 8%/365 = 0.021918%.
 Effective Annual Rate (EAR = EFF%):
The annual rate that causes PV to grow to the
same FV as under multi-period compounding.
 Used to compare returns on investments with
different payments per year.
Example: EFF% for 10%, semiannual:
FV = (1 + iNom/m)m
= (1.05)2 = 1.1025.
EFF% = 10.25% because
(1.1025)1 = 1.1025.
Any PV would grow to same FV at 10.25%
annually or 10% semiannually.

How do we find EFF% for a nominal rate of
10%, compounded semiannually?
m
 iNom 
EFF%  1   1
 m 
2
 0.10 
 1    1 .0
 2 
 1.05   1.0
2
 0.1025  10.25%.
Or use a financial calculator.

EAR = EFF% of 10%
EARAnnual = 10%.
EARQ = (1 + 0.10/4)4 – 1 = 10.38%.
EARM = (1 + 0.10/12)12 – 1 = 10.47%.
EARD(360) = (1 + 0.10/360)360 – 1 = 10.52%.

Can the effective rate ever be equal
to the nominal rate?
 Yes, but only if annual compounding is used,

i.e., if m = 1.
 If m > 1, EFF% will always be greater than
the nominal rate.

Amortization
Amortized loan is a loan that is repaid in equal

payments over its life.
Amortization tables are widely used--for home
mortgages, auto loans, business loans,
retirement plans, etc.
Example: Construct an amortization schedule for
a Br 1,000, 10% annual rate loan with 3 equal
payments.

Step 1: Find the required payments.
0 1 2 3
10%
-1,000 PMT PMT PMT
PVAn= A 1- (1+i)-n A= PVAn (i)

i 1- (1+i)-n
A= 1000 (0.10) A= 60 = Br 402.11
1- (1.10)-3 0.1638

Step 2: Find interest charge for Year 1.
INTt = Beg balt (i)

INT1 = Br 1,000(0.10) = Br 100.
Step 3: Find repayment of principal in Year 1.
Repmt = PMT – INT

= Br 402.11 – Br 100
= Br 302.11.

Step 4: Find ending balance after Year 1.
End bal = Beg bal – Repayment

= Br 1,000 – Br 302.11 = Br 697.89.
Repeat these steps for Years 2 and 3

to complete the amortization table.

BEG PRIN END
YR BAL PMT INT PMT BAL
1 Br 1,000 Br 402 Br 100 Br 302 Br 698

2 698 402 70 332 366
3 366 402 37 366 0
TOT 1,206.34 206.34 1,000
THE END

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CHAPTER – THREE

TIME VALUE OF MONEY

Dr. Honelign E,BDU. 2

Dr. Honelign E,BDU. 3

Dr. Honelign E,BDU. 4

iV . Present value of a future cash flow (inflow or

Dr. Honelign E,BDU. 5

CF0 CF1 CF2 CF3

Interest can be calculated as :INT= PV. i. n

Dr. Honelign E,BDU. 8

FVn = PV(1 + i)n.

Dr. Honelign E,BDU. 10

 The general form of equation for calculating

Suppose you deposit Br. 100 in a bank that

 The term in parentheses is the discount factor or

Dr. Honelign E,BDU. 13

Suppose that an investor wants to find out the

Dr. Honelign E,BDU. 14

Dr. Honelign E,BDU. 15

a) What interest rate would cause Br 100 to

b) Find the number of years by which a br

Dr. Honelign E,BDU. 16

2.Annuty due: consists of a serious of equal

Dr. Honelign E,BDU. 18

Dr. Honelign E,BDU. 20

Dr. Honelign E,BDU. 21

Dr. Honelign E,BDU. 24

100 100 100

FV= A (1+i)n -1 (1+i) = 100 (1.10)3 -1 (1.10)

= 100 (3.31) (1.10)

Dr. Honelign E,BDU. 26

100 100 100

PVAn= A 1- (1+i)-n (1+i) = 100 1- (1.10)-3 (1.10)

Dr. Honelign E,BDU. 27

Example: A government sold a huge bond issue and

Solution: PV of perpetuity= Br 100/ .05

Dr. Honelign E,BDU. 29

 Assume an interest rate of 10% and the

Dr. Honelign E,BDU. 31

Dr. Honelign E,BDU. 32

Periodic rate = Stated rate

Number of = (Number x ( Periods

Where: iNom is the nominal/Quated/Stated rate

Dr. Honelign E,BDU. 36

Dr. Honelign E,BDU. 38

Dr. Honelign E,BDU. 39

a) Periodic rate= 8%/1 ; no of periods = 1*3= 3

PVAn= 100 1- (1.08)-3 = Br. 257.71

b) Periodic rate= 8%/2= 4% ;no of periods = 2*3= 6

PVAn= 50 1- (1.04)-6 = Br. 262.11

Dr. Honelign E,BDU. 40

We will deal with 3 different rates:

iNom = nominal, or stated, or

EAR = EFF% = effective annual .

Dr. Honelign E,BDU. 41

Dr. Honelign E,BDU. 42

Periodic rate ( iPer ) is the rate charged or paid by a

Dr. Honelign E,BDU. 44

Dr. Honelign E,BDU. 45

EARQ = (1 + 0.10/4)4 – 1 = 10.38%.