CHAPTER THREE

THE TIME VALUE OF MONEY AND THE CONCEPT OF INTEREST

Chapter objectives:
After studying this chapter, students should be able to:
1. Understand the concept of time value of money
2. Compute the method of calculating future value (Compounding)
3. Compute the method of calculating present value (Discounting)

3.1 The concept of time value of money

Time value of money is a critical consideration in financial and investment decisions. For example,
compound interest calculations are needed to determine future sums of money resulting from an
investment. Discounting, or the calculation of present value, which is inversely related to
compounding is used to evaluate future cash flow associated with capital budgeting projects. There are
plenty of applications of time value of money in finance.
In accounting (finance), the term “time value of money” is used to indicate a relationship between
time and money. The saying is “A bird in hand is worth too in the bush.” The value of a birr received today is
worth more than a birr received a year from now. Why? Money received now can be invested and earn
interest, or it could be consumed. Investing is trading birr today for birr in the future. Borrowing is trading
future birr for birr today.
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. Therefore; the value of money is dependent on the point of time it occurs
as payment or receipt. It shows the relationship between time, money, a rate of return and earnings
growth.
Individual investors generally prefer possession of a given amount of cash now, rather than the same
amount at some future time. There are four reasons that might be attributed to the individual’s time
preference for money. These are:
1. Uncertainty of cash flows,
2. Subjective preference for consumption,
3. Availability of investment opportunities and
4. Inflation

Required rate of return

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. In reality, an investor
will be exposed to some degree of risk. Therefore, investors would require a rate of return, called risk
premium, from the investment which compensates him/her for both time and risk. Investor’s required
rate of return will be the sum of risk free rate o return and risk premium.

Required rate of return= Risk free rate +Risk premium

Financial Management I teaching material Page 1

 3.2 The future value (Accrued/Maturity value)
A birr in hand today is worth more than a birr to be received tomorrow because of the interest it could
earn from putting it in a savings account or placing it in an investment account. Compounding interest
means that interest earns interest.
Future value techniques are used to find the future value of the amount(s) involved at some future
time, usually at the end of the life of the project. It uses compounding to find the future value of each
cash flow at the end of investment’s future value. It measures how much you get now grows to, when
compounded at a given rate.
The amount of interest involved in any financial transactions is a function of three variables.
Principal (P): the amount borrowed or invested.
Interest rate (i): is a percentage (rate) that to be applied on the outstanding principal.
Time (t or n): the number of years or fraction of a year that a principal is outstanding.
Simple interest: It is the interest that is calculated only on the original amount (principal), and thus no
compounding of interest takes place.
Simple interest is paid only on the initial principal and not on interest accumulated. It is expressed as
follows:
I=P*i*n/ or P*r*n
Future sum amount= Principal + interest on principal

For example, suppose that Birr 200,000 is invested at 20% simple interest per year. 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
…
…etc

Compound interest: It is the interest that is received on the original amount (principal) as well as on
any interest earned but not withdrawn during earlier periods. Compounding is the arithmetic process of
determining the final value of a cash flow or series of cash flow or series of cash flow when compound interest
is applied. Compound interest includes interest on previously computed and recorded interest. Consider
the above example to shows the state of the investment, year by year in compounding interest, if the invested
amount is invested on compound interest.

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
…
…etc

Financial Management I teaching material Page 2

Future value (FV) is the amount to which a cash flow or series of cash flows will grow over a given
period of time when compounded at a given interest rate. The future value of cash flow for n periods
computed as follows:
Where;-
F v = p v [1+i] n
FV=Future value
PV= Principal (or present value)
I=FV-PV
I= Interest
i= Interest rate
n= number of years (periods)

The Future Value Interest Factor for i and n (FVIF i, n) is defined as (1 + i) n, and these factors can
be found by using a regular calculator and then put into tables. Since (1 + i) n is FVIFi, n, the above
equation can be rewritten as follows:
FVn = PV (FVIFi, n).
Example: suppose you have deposit Birr 5,000in a bank that pays 5 percent interest each year. How
much you will have at the end of the 5th year?
Answer:
Fv= PV (1+i) n or using FVIF table = 5,000(FVIF0.05, 5).
= 5,000(1+0.05)5 =
5,000(1.276)
= 5, 000(1.05)5 = Birr 6,381.41
=
5,000(1.276)
= Birr 6,381.41

ANNUITY
Annuity is a sequence of fixed equal payments (or receipts) made over uniform time interval.
An annuity by definition requires that:
i. The periodic payments or receipts called rents always been the same amount.
ii. The interval between such rents always has been the same.
iii. The interest be compounded ones each interval.

The future value of an annuity is the sum of all accumulated compound interest on them.

TYPES OF ANNUITIES
For calculation of annuities, you must decide whether the payments are made at the beginning of each
time period, or at the end. So, based on this; annuities are classified in to two types .These are:
i. Ordinary annuity: It is an annuity for which the payments occur at the end of each period. It
is common type of annuity.
ii. Annuity due: It is an annuity where the payments occur at the beginning of each period.

Financial Management I teaching material Page 3

 Future value of ordinary annuity(FV-OA)

The future value of annuity of a given amount is just the aggregate sum of the future value of each
individual payment. It is computed by the formula

Fv-OA = PMT [(1+i)n -1/i]

OR using FVIFA table Fv-OA = PMT (FVIFA, i,n)

Where:
PMT- is the periodic payment or receipt

This annuity has its own characteristics:

* Payments or receipts are made at the end.

* The first payment will not earn interest because; it is made at the end of the period.

Example: Assume that, you wish to determine the sum of money , if you will have in a saving
accounts at the end of seven years by depositing birr 1,000 at the end of each year for the next 7 years
in to an account paying 10% interest annually.
Required; Determine the future value.
Answer:
FV- OA =PMT ((1+i) n -1)/i
= 1,000((1+0.1)7-1/0.1
=1,000((1.9487)-1)/0.1
=1,000(0.948717)/0.1
= Birr 9,487.17

Future value of annuity due (annuity in advance) (FV-AD)

An annuity due assumes periodic rents occur at the beginning of each period. This mean an annuity
due will accumulates interest during the first period, where as an ordinary annuity rent (deposit) will
not earn interest during the first period, because the rent is not received or paid before the end of the
period.
Therefore; the significant differences between the two types of annuities were in the number of
interest accumulation period involved. That is why, the total amount of future value of annuity due is
higher than total amount of future value ordinary annuity .(i.e. FV-AD has n- number of interest
accumulation period which is the same with given period, but FV-OA has n-1 number of interest
accumulation period.
Future value of annuity due has the following unique characteristics:
Periodic rent (deposit) is made at the beginning.
The first rent is interest earning.

It is computed as;
FV-AD = PMT [(1+i)n -1/i] * (1+i)
OR using FVIFA table Fv-OA = PMT (FVIFA, i,n (1+i)

Financial Management I teaching material Page 4

Example: Let us use the above illustration with little modification as per the annuity’s approach;
assume other things remain the same, but the payment (receipt) was made at the beginning.
Required; Determine the future value.
Answer:
FV- AD =PMT ((1+i) n -1)/i *(1+i)
= 1,000((1+0.1)7-1/0.1 * (1+0.1)
=1,000((1.9487)-1)/0.1* (1.1)
=1,000(0.948717)/0.1* (1.1)
= Birr 10,435.88

UNEVEN CASH FLOW STREAMS

Uneven cash flow is a series of cash flows in which the amount varies from one period to the next.
Although many financial decisions do involve constant payments, other important decisions involve
uneven or non constant, cash flows; for example, common stocks typically pay an increasing stream of
dividends over time, and fixed asset investments such as new equipment normally do not generate
constant cash flows.

FUTURE VALUE OF AN UNEVEN CASH FLOW STREAM

The future value of an uneven cash flow stream (sometimes called the terminal value is found by
compounding each payment to the end of the stream and then summing the future values:

FV = CF1 (1/1+i) n-1 +CF1 (1/1+i) n-2+---+ CFn

Example: Consider the following cash flows for four year with 10% interest rate.

CF1 = Birr 100 CF2 = Birr 300

CF3 = Birr 300 CF4 = Birr -50

Required: Compute the future value of the cash flows

Answer:
FV = CF1 (1/1+i) n-1 +CF1 (1/1+i) n-2+---+ CFn
= 0(1/ 1.1) 4-0 +100 (1/1.1) 4-1+ 300 (1/ 1.1) 4-2+ 300 (1/ 1.1) 4-3+ -50
= 0 +75.13 + 247.93 + 272.73 + -50
= Birr 545.79
3.3 The present value (Discounting)
Present value techniques are used to find the today’s equivalent (present values) of amounts expected
at some time in the future. It is measured at the beginning of project’s life (time zero) and uses
discounting to find the present value of each cash flow at time zero and then sums them to find the
present value of investment. It also measures how much you get now. Discounting is the process of
finding the present value of a cash flow or a series of cash flows; discounting is the reverse of
compounding.

Financial Management I teaching material Page 5

The present value is the amount that must be invested now to produce a known future value. Present
value concepts apply to personal finance and investment decision. In order to compute present value,
we will use the following formula:

PV =Fv 1/ [1+i] n

The Present Value Interest Factor for i and n (PVIF i,n ) is defined as (1 + i)n , and these factors can
be found by using a regular calculator and then put into tables. Since (1 + i) n is PVIFi,n, the above
equation can be rewritten as follows:

PV = FV (FVIFi,n).
Example: Mr. X has been given the opportunity to receive birr 5,000, five years from now. If he can
earn 8% on his investments, what is the amount that would he receive as of today?
PV = FV 1/(1+i)n
= 5,000 1/(1+0.08)5
=5,000 1/1.46
= Birr 3,402.92

Present value of ordinary annuity (PV-OA)

PV-OA is the discount value of a series of future rents on the date, one period before the first rents or
payments. It is an inverse of FV-OA.
It is computed as:
[[[[[[[

PV-OA = PMT [1-(1+i)-n]

i
OR using PVIFA table PMT (PVIFA,I,n)
Note; - This type of annuity most of the time used for purchase payment in installment pattern.
Example: Suppose you received an annuity of 5,000 for four years at the end of each year with the
rate of interest10 percent.
Required; Compute the present value of this annuity.
Answer:
PV-OA = PMT [1-(1+i)-n]
i
= 5,000 [1-(1+0.1)-4]
0.1
= 5,000 * 3.1699
= Birr 15,850

Present value of annuity due (PV-AD)

It is the discount value of a series of future rents on the date; the first rent is received or paid. In the
present value of ordinary annuity the final rent was discounted by the same number of periods that
there were received or paid.
In determining the PV-AD; there is always one period fewer discount period.

Financial Management I teaching material Page 6

It is computed as follows;-
PV-AD = PMT [1-(1+i)- n] * (1+i)
i
OR using PVIFA table PMT(PVIFA,I,n)* (1+i)
Example: Let us use the above example with a little modification as per the annuity’s approach;
assume other things remain the same, but the receipt was made at the beginning.

Required; Compute the present value of an annuity.

Answer:
PV-AD = PMT [1-(1+i)- n] * (1+i)
i
= 5,000 [1-(1+0.1)-4] * (1 + 0.1)
0.1
= 5,000 * 3.1699 * 1.1
= Birr 17,435

PRESENT VALUE OF AN UNEVEN CASH FLOW STREAM

The PV of an uneven cash flow stream is found as the sum of the PVs of the individual cash flows of
the stream. It is calculated by the following formula.
PV = CF1 (1/1+i) 1 +CF1 (1/1+i) 2+---+ CFn (1/1+i) n
Example: Consider you are an investor and you have an opportunity of receiving birr1, 000, birr 1,500,
birr 800, birr 1,100, and birr 400 respectively at the end of one through five years. Assume that the
required rate of return is 8%.
Required: Compute the present value of the cash flows
Answer:
PV = CF1 (1/1+i) 1 +CF1 (1/1+i) 2+---+ CFn (1/1+i) n
= 1,000(1+0.08)1 + 1,500(1+0.08)2+ 800(1+0.08)3+ 1,100(1+0.08)4+ 400(1+0.08)5
= 1,000 *.926 +1,500 * .857 + 800 *.794 + 1,100 * .735 + 400 * .681
=926+1,285.5+635.2+808.5+272.4
= Birr 3,927.60
Multi period compounding
Interest may be compounded frequently more than once a year. Some of the most common
compounding periods are semiannual, quarterly, monthly and daily. In these types of cases, the future
value’s formula should be adjusted to accommodate the compounding periods involved and it is given
by the following formula:
F v = Pv [1+i/m] n. m
Where:
m= is the number of times interest is compounded in a year.
n=the number of compounding periods.

Financial Management I teaching material Page 7

Example: Compute the compounded value of Birr 1,000 interest rate brings 12%. If the amount
compounded annually, half-year, quarterly and monthly, what will be its value for 2 years?

a. Annually
c. Quarterly
FV =1,000*(1.12)2
FV =1,000*(1+ 0.12/4)2*4
= 1,000 * 1.254
= 1,000 * 1.267
= Birr 1,254
= Birr 1,267
b. Half-year
FV =1,000*(1+ 0.12/2)2*2 d. Monthly
= 1,000 * 1.262 FV =1,000*(1+ 0.12/12)2*12
= Birr 1,262 = 1,000 * 1.270
= Birr 1,270

Continuous compounding
The future value, when interest is compounded continuously it is computed as follows;-
F v = p v [e i *n] where:
e = 2.71828
Note; - The future value reaches its maximum limit, when interest is compounded continuously.
Example: If the amount in the previous example compounding is done continuously, then the
compound value will be:
FV= 1,000 *e 0.12 *2
= 1,000 *1.2713
= Birr 1,271.30

Financial Management I teaching material Page 8