UNIT 3: THE TIME VALUE OF MONEY

3.1 INTRODUCTION

 Money received now is generally better than the same

amount of money received some time later.

 This is because there is an opportunity to invest the

money we have now and earn a return on it.

 For example, if you have Br. 1,000 today, you could

save it in a bank and earn interest.
 CONT’D
 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.
 There are two basic types of interest:
1. simple interest 2. compound interest
 If interest is computed for one period only, the
interest is always simple interest.
 In simple interest the previously earned interests
do not produce another interest.
 Cont’d

Compound interest
 is an interest computed for a minimum of two periods.
 the previous interests produce another interest for
subsequent or next periods.
 Here both the principal and previous interests bring
additional interest.

So in the sections we will discuss the concepts and

techniques of the time value of money in the context of
compound interest.
 FUTURE VALUE
 Future value is the value of money at some point
in the future.
 Future value is always a direct result of the
compounding process of cash flow.
 The cash flow(s) could be a
- Single cash flow,
- An annuity or
- Uneven cash flows
 Future Value of a Single Amount

 Specified single cash flow will grow over a given period

of time when compounded at a given interest rate.
 Can be computing as:
FV = PV (1 + i)n
FV = Future value at the end of n periods
PV = Present Value, or the principal amount
i = Interest rate per period
n= Number of periods
Example: Hana deposited Br. 1,800 in her savings account in
Meskerem 1990. Her account earns 6 percent compounded
annually. How much will she have in Meskerem 1997?
 Future Value of an Annuity
 An annuity is a series of equal periodic rents (receipts,
payments, withdrawals, deposits) made at fixed intervals
for a specified number of periods.
 For a series of cash flows to be an annuity four
conditions should be fulfilled.
1. the cash flows must be equal.
2. the interval between any two cash flows must be fixed.
3. the interest rate applied for each period must be constant.
4. interest should be compounded during each period.
If any one of these conditions is missing, the cash flows
cannot be an annuity.
 Cont’d

 Broadly speaking, annuities are classified into

three types:
i) Ordinary Annuity
ii) Annuity Due.
iii) Deferred Annuity
 i) Future value of an Ordinary Annuity
 is an annuity for which the cash flows occur at the end of each
period.

 The future value is computed as:

 (1  i)  1
n

FVAn = PMT  
 i 

Where:
FVAn = Future value of an ordinary annuity
PMT = Periodic payments
i = Interest rate per period
n = Number of periods
 cont’d

Example1. What is the amount of an annuity if the size of

each payment is Br. 100 payable at the end of each quarter
for four year at an interest rate of 4% compounded
quarterly?
Example 2: You need to accumulate Br. 25,000 to acquire
a car. To do so, you plan to make equal monthly deposits
for 5 years. The first payment is made a month from
today, in a bank account which pays 12 percent interest,
compounded monthly. How much should you deposit
every month to reach your goal?
 ii) Future value of an Annuity Due.
 is an annuity for which the payments occur at the beginning of
each period.
 is computed exactly one period after the final payment is made.
0 1 2 --------------------- n

PMT1 PMT2 PMT3 ----------------------- PMTn + 1

 The future value of an annuity due is computed at point n where

PMTn + 1 is made
 (1  i) n  1
FVAn= PMT   ( 1 + i)
 i 

Example: Assume that pervious example except that the first

payment is made today instead of a month from today. How much
should your monthly deposit be to accumulate Br. 25,000 after
60 months?
 iii) Future value of Deferred Annuity
 is an annuity for which the amount is computed
two or more period after the final payment is
made.
0 1 2 ------------------n --------------n + x

PMT1 PMT2 PMTn

 The future value of a deferred annuity is

computed at point n + x
 (1  i) n  1 x
FVAn= PMT   (1 + i)
 i 
 Cont’d
 Example: Henock has a savings account, which he had been
depositing Br. 3,000 every year on January 1, starting in 1990.
His account earns 10% interest compounded annually. The last
deposit Hencok made was on January 1, 1999. How much money
will he have on December 31, 2003? (No deposits are made after
1999 January).
 Future Value of Uneven Cash Flows
 is a series of cash flows in which the amount
varies from one period to another.
 is computed by summing up the future value of
each payment.
Example: Find the future value of Br. 1,000, Br.
3,000, Br. 4000, Br. 1200, and Br. 900 deposited at
the end of every year starting year 1 through year
5. The appropriate interest rate is 8% compounded
annually. Assume the future value is computed at
the end of year 5.
 PRESENT VALUE
 Present value is the exact reversal of future value.
 It is the value today of :
i - single cash flow,
ii - an annuity or
iii - uneven cash flows
 The process of computing the present value is
called discounting.
 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.

PV =

Example: Zelalem PLC owes Br. 50,000 to ALWAYS Co.

at the end of 5 years. ALWAYS Co. could earn 12% on its
money. How much should ALWAYS Co. accept from
Zelalem PLC as of today?
 Present Value of an Annuity
Present value of an Ordinary Annuity:
 is 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.

PVAn =

Example: Ato Mengesha retired as general manager of

Tirusew Foods Company. But he is currently involved in a
consulting contract for Br. 35,000 per year for the next 10
years. What is the present value of Mengesha’s consulting
contract if his opportunity costs is 10%?
 Present value of an Annuity Due
is the present value computed where exactly the first
payment is to be made.

 1 (1  i)  n 
PVAn = (Annuity due) = PMT   (1 + i)
 i 

Example: Ruth Corporation bought a new machine

and agreed to pay for it in equal installments of Br.
5,000 for 10years. The first payment is made on the
date of purchase, and the prevailing interest rate that
applies for the transaction is 8%. Compute the
purchase price of the machinery.
 Present value of a Deferred Annuity
is computed two or more periods before the first
payment is made.
 1  (1  i)  n  -x
PVAn (Deferred annuity) = PMT   (1 + i)
 i 

Example: Sefa Chartered Accountants has developed

and copyrighted an accounting software program. Sefa
agreed to sell the copyright to Steel company for 6
annual payments of Br. 5,000 each. The payments are
to begin 5 years from today. If the annual interest rate
is 8%, what is the present value of the six payments?
 Present Value of Uneven Cash Flows

is found by summing the present values of

individual cash flows of the stream.
Example: Suppose you are given 400, 100, 300
three years cash flow stream where the
appropriate interest rate is 12% compounded
annually. What is the present value of the cash
flows?
 Present Value of a Perpetuity
 A perpetuity is an annuity with an indefinite cash flows.
 In a perpetuity payments are made continuously forever.
 The present value of a perpetuity is found by using the following
formula:
PV (Perpetuity) = Payment = PMT
Interest rate i
Example: What is the present value of a perpetuity of Br. 7,000 per year
if the appropriate discount rate is 7%?
Given: PMT = Br. 7,000; i = 7%;, PV (Perpetuity) = ?
PV (Perpetuity) = PMT = Br. 7,000 = Br. 100,000. This
means that
i =7%
receiving Br. 7,000 every year forever is equal to receiving Br. 100,000
now.
Th
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