UNIT 3: TIME VALUE OF MONEY
3.1 INTRODUCTION
This unit aims at providing basic concepts on the time value of money. This is very important for
making any financial decision. In a business we are investing huge amounts of money today in
anticipation of uncertain future returns or revenues. You have already learned that capital is not
only scarce but also has cost. Cost in simple terms is nothing but the interest. Suppose you would
like to borrow Birr 1, 000 today and return the same after a month without any interest. Do you
think someone is going to lend you Birr 1, 000? Definitely no. If you are prepared to pay interest
of 3% for a month on the borrowed money, people will come forward to lend you money. The
reason is simple money is not available freely and it is capable of earning interest i.e., Birr 30. It
is evident that today’s Birr 1, 000 is equivalent to Birr 1, 030 after a month. Here Birr 30 is
called cost of capital in financial management.
5.2 TIME VALUE OF MONEY
By experience, we all know that the value of a sum of money received today is more than its
value received after some time this is called time value of money. Conversely, the sum of money
received in future is less valuable than it is today. The present worth of birr received after some
time will be less than a birr received today. Since, a birr received today has more value,
individuals, as rational human beings would naturally prefer current receipt to future receipts.
The time value of money is also known as time preference for money. The time preference for
money in business unit normally expressed in terms of rate of return or more popularly as a
discount rate. In a business revenues are spread over a period of time i.e., the life of the project.
It is nothing but we are trying to calculate the present value versus future value.
5.3 Techniques of present value Vs future value
Future Value and Compounding
The first thing we will study is future value. Future value (FV) refers to the amount of money
an investment will grow to over some period of time at some given interest rate. Put another
way, future value is the cash value of an investment at some time in the future. We start out by
considering the simplest case: a single-period investment.
INVESTING FOR A SINGLE PERIOD
Suppose you invest $100 in a savings account that pays 10 percent interest per year. How much
will you have in one year? You will have $110. This $110 is equal to your original principal of
$100 plus $10 in interest that you earn.
We say that $110 is the future value of $100 invested for one year at 10 percent, and we simply
mean that $100 today is worth $110 in one year, given that 10 percent is the interest rate.
In general, if you invest for one period at an interest rate of r, your investment will grow to (1 +
r) per dollar invested. In our example, r is 10 percent, so your investment grows to
1
1 + .10 =1.1 dollars per dollar invested. You invested $100 in this case, so you ended up with
$100 x 1.10 = $110.
INVESTING FOR MORE THAN ONE PERIOD
Going back to our $100 investment, what will you have after two years, assuming the interest
rate doesn’t change? If you leave the entire $110 in the bank, you will earn $110 x.10 =$11 in
interest during the second year, so you will have a total of $110 + 11 = $121.
This $121 is the future value of $100 in two years at 10 percent. Another way of looking at it is
that one year from now you are effectively investing $110 at 10 percent for a year. This is a
single-period problem, so you’ll end up with $1.10 for every dollar invested, or $110 x 1.1 =
$121 total.
This $121 has four parts. The first part is the $100 original principal. The second part is the $10
in interest you earned in the first year, and the third part is another $10 you earn in the second
year, for a total of $120. The last $1 you end up with (the fourth part) is interest you earn in the
second year on the interest paid in the first year: $10 x .10 = $1.
This process of leaving your money and any accumulated interest in an investment for more than
one period, thereby reinvesting the interest, is called compounding. Compounding the interest
means earning interest on interest, so we call the result compound interest. With simple
interest, the interest is not reinvested, so interest is earned each period only on the original
principal.
Interest on interestXAMPLE5.1
Suppose you locate a two-year investment that pays 14 percent per year. If you invest
$325, how much will you have at the end of the two years? How much of this is simple interest?
How much is compound interest?
At the end of the first year, you will have $325 x (1 + .14) = $370.50. If you reinvest this entire
amount and thereby compound the interest, you will have $370.50 3x1.14 = $422.37 at the end
of the second year. The total interest you earn is thus $422.37 - 325 = $97.37.
Your $325 original principal earns $325 x .14 = $45.50 in interest each year, for a two-year total
of $91 in simple interest. The remaining $97.37 - 91 =$6.37 results from compounding.
You can check this by noting that the interest earned in the first year is $45.50. The interest on
interest earned in the second year thus amounts to $45.50 x.14 = $6.37, as we calculated.
Future/Compound value: where a sum of money deposited one time and earns interest for a
specified period. The interest is paid on principal as well as on an interest earned but not
withdrawn during earlier period is called compound interest.
FV = PV + (interest X principal) For example you deposit
Birr 100 @10% interest
After one year = 100 + (100 x .10)
= 110
After two years = 110 + (110 x .10)
= 121
After three years = 121 + (121 x .10)
= 133.10
FV1 = P(1+i)
FV2 = P(1+i) FV2 = FV1 + F1i P(1+i)2
2
2
FV3 = P(1+i)3 FV2 = F1(1+i)P
FV2 = P
Fn = P(1+i)n
Here the term (1+i)n is the compounded value factor (CVF) of a lump sum of birr 1. The values
may be directly traced from the present value tables. You have already learned the calculation of
present value factors in financial accounting II. Hence, you can directly apply the present value
factors and find out the values.
The same may be written as below:
FV = P(CVFn . i)
FV = Future value
P = Present value
CVFn = Compounded value factor year
i = rate of interest
Suppose you deposit Br. 55, 650 in a bank which will pay you 12 percent interest for a period of
10 years. How much would the deposit grow at the end of ten year?
FV = P(CVFn . i)
FV = 55, 650 (CVF10 . 12)
FV = 55, 650 (3 . 106)
= 172, 849.90
Future/Compound value of Annuity: An annuity is a fixed payment (or receipt) each year for a
specified number of years. Assume that a sum of birr 1 is deposited at the end of each year for
four years at 6% interest. This implies that
1(1+.06)3 1.191 Birr 1 deposited at the end of year 1 grow for 3 years.
1(1+.06) 1.124
2
Birr 1 deposited at the end of year 2 grow for 2 years.
1(1+.06) 1.06
1
Birr 1 deposited at the end of year 3 grow for 1 year.
1 Birr 1 deposited at the end of year 4 grow for no interest.
4.375
FV4 = A(1+i)3 + A(1+i)2 + A(1+i) + A
FV4 = A[(1+i)3 + (1+i)2 + (1+i)+1
FVn = A
[
( 1+i )n −1
i ]
The same may be written as below
FV = A(CVAFn i)
FV = Future value
A = Annuity
CVAFn = Compounded Value Annuity Factor to year
1 = rate of interest
Assume that you deposit a sum of birr 5, 000 at the end of each year for four years at 6% interest.
How much would this annuity accumulate at the end of fourth year.
FV = A(CVAFn i)
3
= 5, 000 (CVAF4 .06)
= 5, 000 (4.375)
= 21, 875
Sinking Fund: This is going to be in reverse to the compounded value annuity factor. Here we
proceed that to create certain sum of money, how much we have to set aside every year for a
specified period.
FV = A(CVAFn.i)
[
1
A = FV CVAFn. i
]
A = FV (SFFn i) SFF = Sinking Fund Factor
[ i
n
A = F (1+i) −1
]
For instant to clear off a loan of birr 21, 875 after four years, how much we have to set aside?
FV = A(CVAFn .1)
[
1
A = FV CVAFn. i
]
[ ]
1
= 21, 875 FV 4 .375
= 21, 875 x .2286
= 5, 000
Present Value: here, we calculate the present value of future earnings at a particular rate of
interest. This may be further classified into two
I) Present value of a lump sum. The present sum of money to be invested today in order to get
birr 1 at the end of year 1, 2, 3 so on and so forth at the rate of 10% interest.
We know F1 = P(1+i) at the end of year 1.
1 = P (1+10)
1
P= (1+i)
1
=
(1+. 10)
1
=
1.10
= 0.909
F3 = P(1+i)3
1 = P(1+.10)3
1
P= (1+10)3
4
1
= 1.331
= 0.751
Fn = P(1+I)n
Fn
P= (1+i)n
=
[ ]Fn
(1+i)n
= Fn [(1+i)n]
You wanted to know the present value of birr 50, 000 to be received after 15 years at the rate of
interest 9%
PV = FV (PVFn i)
= 50, 000 (PVF15 .09)
= 50, 000 (.275) present value table
= 13, 750
Present value of Annuity: An investor sometimes may receive constant amount for a certain
number of years. We may have to calculate the present value of such annuity to be received each
year for a specific period.
A A A An
P= + + +
(1+i ) (1+i)2 (1+i)3 (1+i)n
=A
1
[ +
1
2
+
1
3
+
1n
(1+i ) (1+i) (1+i) (1+i)n ]
[ ]
1
1−
(1+i)n
P= A
i
P= A
[
(1+i)n −1
i(1+i)n ]
A company receives an annuity of birr 5, 000 for four year at the interest of 10 percent. Then the
present value would be
[ ]
1
1−
(1+i)n
P=A
i
[ ]
1
1−
(1.10)4
P = 5, 000
.10 simply, you can refer to the PV tables for PV factor.
5
= 5, 000 x 3.170
= 15, 850
PV = A(PVAFn .i)
= 5, 000(3.170) from PV table or using the above formulae
= 15, 850
DETERMINING THE DISCOUNT RATE
We frequently need to determine what discount rate is implicit in an investment. We can do this
by looking at the basic present value equation:
PV = FV t / (1 + r) t
There are only four parts to this equation: the present value (PV), the future value (FV t), the
discount rate (r), and the life of the investment (t). Given any three of these, we can always find
the fourth.
Finding r for a single period investment
You are considering a one-year investment. If you put up $1,250, you will get back $1,350.
What rate is this investment paying?
First, in this single-period case, the answer is fairly obvious. You are getting a total of $100 in
addition to your $1,250. The implicit rate on this investment is thus $100/1,250 =8 percent.
More formally, from the basic present value equation, the present value (the amount you must
put up today) is $1,250. The future value (what the present value grows to) is $1,350.
The time involved is one period, so we have:
$1,250 =$1,350/(1 + r ) 1
1 +r = $1,350/1,250 = 1.08
r = 8%
In this simple case, of course, there was no need to go through this calculation. But as we
describe next, it gets a little harder with more than one period.
Finding r for more than one period investment
To illustrate what happens with multiple periods, let’s say we are offered an investment that
costs us $100 and will double our money in eight years. To compare this to other investments,
we would like to know what discount rate is implicit in these numbers.
This discount rate is called the rate of return, or sometimes just the return, on the investment.
In this case, we have a present value of $100, a future value of $200 (double our money), and an
eight-year life. To calculate the return, we can write the basic present value equation as:
PV = FV t / (1 + r) t
$100 = $200/ (1 + r) 8
It could also be written as:
(1 + r) 8 = $200/100 = 2
1+r =2
r =2-1 = 0.09 or 9%
Exercise
You estimate that you will need about $80,000 to send your child to college in eight years.
You have about $35,000 now. If you can earn 20 percent per year, will you make it? At what rate
will you just reach your goal?
6
Multi period Compounding: Till now, we have seen the cash flows will occur once in a year.
But, the cash flows may occur monthly, bi-monthly, quarterly, half yearly and yearly. In such
instances we have to apply the following formulae.
[ ]
n×m
i
1+
Fn = P m
You have deposited a birr of 1, 000 in Commercial Bank of Ethiopia at 12 percent interest per
annum. It compound annually, semi-annually, quarterly and monthly for two years. How much
does it grow?
1) Annual compounding
n=2 i = .12%
FV = P(CVFn .i)
= 1, 000 (CVF2 .12)
= 1, 000 (1.254)
= 1, 254
12
2) Half-yearly n = 2 x 2 = 4 i = 2 = 6%
FV = 1, 000 (CVF4 .06)
= 1, 000(1.262)
= 1, 262
12
3) Quarters n=4x2=8 i = 4 = 3%
FV = 1, 000 (CVF12 .03)
= 1, 000 (1.267)
= 1, 267
12
4) Monthly n = 12 x 2 = 24, i = 12 = 1%
FV = 1, 000 (CVF24. .01)
= 1, 000 (1.270)
= 1, 270
5.4 PROBLEMS AND SOLUTIONS
Future Value
Compound value of Lump sum
Future Value = Present value + (Rate of interest) (Present value)
1. You deposit Br. 100 in a bank at 10% interest what would be amount after 3 years.
FV = PV + (PV) (Rate of interest)
= 100 + 100 (.10)
= 100 + 10
= 110
= 110 + (110) (.10)
7
= 110 + 11
= 121
= 121 + (121) (.10)
= 121 + 12.10
= 133.10
Suppose Br. 1,000 are placed in SBA/C of a Bank at 5% interest what will be the future value
after 5 years.
Compound value factor – Table –A
FV = PV (CVF5 .5)
= 1,000 (1.266)
= 1,276
2. If you deposit Br. 55,650 in a Bank at 12% interest for a period of ten years what will be
the future value?
FV = 55,650 (CVF10 .12)
= 55,650 (3.106)
= 172, 848.90
Compound Value of Annuity
Suppose Br. 1,000 is invested in annuity for four years at the rate of 6%
0 1 2 3 4
1,000
1,060
Future sum = 1,124
F4 = A (1+I)3
1,191
Fn = A
[(1+I )n −1
I ] 4,375
Fv = A (CVAFn I)
(Compound value factor for annuity factor)
3. You deposit a sum of Br. 5,000 at the end of each year for four years at 6%. How much
would this annuity accumulate at the end of the fourth year?
FV = A (CVAF4, .06)
= 5,000(4.375)
= 21,875
4. Your father has promised to give you 100,000k, in cash on your 25 th birthday. Today is
your 16th birthday. He wants to know two things
a) He decides to make annual payments into a fund after one year, how much will
each have to be if the fund pays 8%.
8
b) If he decides to invest a lump sum in the account after one year and let it
compound annually. How much will the lump sum?
A) FV = A (CVAFn .I)
100, 000 = A(12.488)
100 ,000
12,488 = A
8,007.69 = A
B) FV = PV (CVFn .2)
100,000 = PV (CVF9. .08)
100,000 = PV (1.999)
100 ,000
1.999 = PV
50,025 = P
5. CBE pays 12% interest and compounds quarterly. If Br. 1,000 are deposited initially,
how much shall it grow at the end of 5 years?
The quarterly interest will be 3%, number period will be 20
.12
FV = PV (1+ 4 )nxm
= 1,000 (1.03)20
= 1,000 x 1.806
= 1,806
6. How long will it take to double your money if it grows at 12% annually?
FV = PV (CVFn. .12)
Br. 2 = Br. 1 (CVFn .12)
From Table Br. 2 = CVFn .12) = 1.974 Therefore n = 6
7. Mohan bought a share 15 years age for Br. 10. It is now selling Br. 27.60. What is the
compound growth rate the price of share
FV = PV (CVFn .r)
27.60 = 10 (CVF15 .r)
27 .60
10 = CVF15 .r)
From Table 2.760 = 7%
8. X is borrowing Br. 50, 000 to buy a house. If he pays equal installments for 25 years and
4% interest on outstanding balances, what is the amount of installment?
FV = A(CVAFn .r)
50,000 = A (CVAF25 .04)
50,000 = A(15.622)
50,000
15,622 = A
3,200.61 = A
If it is quarterly payment
9
FV = A(CVAF100. .01)
50,000 = A (63.029)
50 , 000
63 .029 = A 793.28 = A
9. A company issued 5,000,000 bonds to be repaid after 7 years. How much should it invest
in sinking fund earning 12%, in order to repay bonds?
FV = A (CFAn .r)
5,000,000 = A (CFA7 .12)
5,000,000 = A (10.089)
5,000 ,000
10 .089 =A
495,589 = A
10. A company has to retire Br. 500, 000 debentures of 8% interest 10 years from today. The
company plans to put a fixed amount into a sinking fund each year for 10 years. A
separate fund is created for the purpose.
The first payment will be paid at the end of the current year. The company anticipates
that the fund will earn 6% a year. What should be the installments to accumulate 500,000
from now?
FV = A (CAF10. .06)
500,000 = A(CAF10. .06 i.e. 13.181)
500,000
13 ,181 = A
37,933.388 = A
11. A limited company borrows from commercial bank Br. 1,000,000 at 12% interest to be
paid in equal annual installments. What would be the size of the installment be? Assume
the repayment period is 5 years.
FV = A (CAF5 .12)
1,000,000 = A (3.605)
1,000 ,000
3 .605 = A
277,392.51 = A
12. A sum of Br. 50,000 deposited in a fund which will earn 12% compound semiannually
for the first 5 years and 8% interest compounded quarterly for the next 7 years. How
much will be amount after 12 years.
12
First 5 years n = 5 x 2 = 10 Interest 2 = 6%
8
Second 7 years n = 7 x 4 = 28 interest 4 = 2%
FV = 50, 000 (CVF10. .06)
= 50,000 (1.791)
10
= 89,542
FV = 89,542 (CVF14. .02)
= 89,542 (1.741)
= 155,895
If A wanted to deposit cash in a saving account at the beginning of year 1, so that he will have
Br. 45,000 at the end of 9 years. What is the money to be deposited by A at the beginning of the
year 1, if the interest rate for the first five years is 10% compounded semi-annually and the
interest rate for the last four years is 12% compounded quarterly?
12
Last 4% FV = PV = (CVFn .I) 4 = 3%
45,000 = PV (CVFn 16 .3)
45,000 = PV (1.605)
45 ,000
1.605 = PV
28,037 = PV
First 5 year
10
n = 10 interest = 2 = 5%
FV = PV (CVFn.1)
= PV (CVF10 .05)
28,037 = PV (1.629)
28 , 037
1.629 = PV
17,211 = PV
5.6 ANSWERS TO CHECK YOUR PROGRESS
2. FV = A (CVAFn .i)
1, 000, 000 = 80, 000 (CVAFn . 14)
1,000,000
80,000 = CVAFn .14
12.5
Look into the table for equal or nearest value you will find between 7 and 8 years = 7.72
or
1, 000, 000 = 80, 000 (CVAFn .14)
[ ]
n
1 .14 −1
= 80, 000 . 14
1,000,000
80,000 x 0.14 = 1.14n – 1
1.75 + 1 = 2.75 = 1.14n
log 2.75 = n log 1.14
11
0.4393 = n x .0569
. 4393
.569 = n
7.72 = years
12
