Financial Management

Lecture 2
Concepts of Time, Value and Return in Financial
management
Course leader : Dr. Asnake Minwyelet (Ph.D.))
 Concepts of Time, Value and Return in
Financial Management
2.1 Time Preference for Money
2.2 Required Rate of Return
2.3 Future Value, Present Value, Net Present Value
2.4 Yield
 Time Value Of Money

A Birr today is higher than a Birr tomorrow!

Time preference for money
• It is 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
• preference for consumption
• investment opportunities
• 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
Time Value Adjustment

• Two most common methods of adjusting

cash flows for time value of money:
• Compounding—the process of
calculating future values of cash flows
and
• Discounting—the process of calculating
present values of cash flows.
Simple Interest

• It is another concept in which interest

is computed only on the principal
amount in each period. No interest is
provided on interest.
• Periodic interest is computed as I=P*r
• Amount at the end of the period will be
A=P+I=P+P*r=P(1+r)
Compound Interest
• It involves computing interest on both
the principal and previous interests
(interest on interest).
üFuture value of a single sum / lump sum
T h e ge n e ra l fo r m o f e q u at i o n fo r
calculating the future value of a lump
sum after n periods is written as follows:
n
Fn  P(1  i )
 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
Ex. If you deposited Br.55,650 in a bank,
which was paying a 15 per cent rate of
interest on a ten-year time deposit, how
much would the deposit grow at the end of
ten years?(Br. 225, 159.90)
Future Value of an Annuity
• Annuity is a fixed payment (or receipt)
each year/period 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  C V F A n , i
Example on future value of
annuity

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? We first find CVFA
which is 4.3746. If we multiply 4.375 by
Br. 5,000, we obtain a compound value
of 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 afte r 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). Where A is required periodic
deposit. A = F
 i 
n  (1  i ) n
 1 

Present Value
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.
Discounting is the process of determining
present value of a series of future cash
flows.
The interest rate used for discounting cash
flows is also called the discount rate.
Present Value of a Single Cash Flow
The following general formula can be employed to
calculate the present value of a lump sum to be received
or paid after some future periods:
Fn
P n
 Fn  (1  i )  n 
(1  i )

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 on present value of a lump sum
• Suppose that an investor wants to find
out the present value of Br.50,000 to
b e rec ei ved after 1 5 years . H e r
interest rate is 9 per cent. First, we will
find out the present value factor,
which is 0.275. Multiplying 0.275 by Br.
50,000, we obtain Br. 13,750 as the
present value.
Present Value of an Annuity

The computation of the present value of an

annuity can be written in the following
general form:
1 1 
P  A  
 i i 1  i  
n

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.
P = A × P V A Fn, i
Capital recovery/Loan
Amortization
Capital recovery is the annuity of an investment
made today for a specified period of time at a
given rate of interest. Capital recovery factor helps
in the preparation of a loan amortisation (loan
repayment) schedule i.e. Computing the periodic
payments of an annuity in a loan to be found now.
 1 
A= P 
 P V A F n ,i 

A = P × CRFn,i
The reciprocal of the present value annuity factor
is called the capital recovery factor (CRF).
Present Value of an Uneven Periodic Sum

Investments made by 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 value factors for an
annuity cannot be used. The procedure is
to calculate the present value of each cash
flow and aggregate all present values.
 Present Value of Perpetuity
• Pe r p e t u i t y i s a n a n n u i t y t h at o c c u rs
indefinitely. Perpetuities are not very
common in financial decision-making:
Perpetuity
Present value of a perpetuity 
Interest rate
Present Value of Growing
Annuities
The present value of a constantly growing
annuity is given below:
A   1  g n
P= 1    
ig   1  i  

Present value of a constantly growing perpetuity

is given by a simple formula as follows:
A
P =
i – g
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
Fn = A  CVFA n ,i × (1  i )

Present Value of an Annuity Due

P = A × PVFA n, i × (1 + i )
Multi-Period Compounding

If compounding is done more than once a

year, the actual annualised rate of interest
would be higher than the nominal interest
rate and it is called the effective interest
rate.
n m
 i 
E IR = 1   –1
 m
Chapter End Exercise - 1
• Al m az i s a b o u t to e nte r co l l e ge . W h e n s h e
graduates 4 years from now, she wants to take a trip
to Europe that she estimates will cost Br. 5,000. How
much should she invest now at 7% to have enough
for the trip if interest is compounded:
a.Quarterly (3,788.08)
b.Continuously (3,778.92)
Chapter End Exercise - 2
• Given
• P=1,000 invested at i=6% (annual)
• Required
Compute the balance after 10 years if the interest is
compounded
a. Annually (?)
b. Quarterly (1,814.02)
c. Monthly (1,819.40)
d. Daily (365 days a year) (1,822.03)
e. Continuously (1,822.12)
End of Lecture