CHAPTER 3:

TIME VALUE OF MONEY

THE CONCEPT OF TIME VALUE OF MONEY

A dollar on hand today is worth more than a dollar to be received in the future because the dollar
on hand today can be invested to earn interest to yield more than a dollar in the future. The Time
Value of Money mathematics quantifies the value of a dollar through time. This, of course,
depends upon the rate of return or interest rate which can be earned on the investment.

The Time Value of Money has applications in many areas of Corporate Finance including
Capital Budgeting, Bond Valuation, and Stock Valuation. For example, a bond typically pays
interest periodically until maturity at which time the face value of the bond is also repaid. The
value of the bond today, thus, depends upon what these future cash flows are worth in today's
dollars.

The Time Value of Money concepts will be grouped into two areas: Future Value and Present
Value. Future Value describes the process of finding what an investment today will grow to in
the future. Present Value describes the process of determining what a cash flow to be received in
the future is worth in today's dollars

REASONS FOR TIME VALUE OF MONEY

Money has time value because of the following reasons:
1. Risk and Uncertainty: Future is always uncertain and risky. Outflow of cash is in our control
as payments to parties are made by us.
There is no certainty for future cash inflows. Cash inflows are dependent out on our Creditor,
Bank etc. As an individual or firm is not certain about future cash receipts, it prefers receiving
cash now.
2. Inflation: In an inflationary economy, the money received today, has more purchasing power
than the money to be received in future.
In other words, a rupee today represents a greater real purchasing power than a rupee a year
hence.
3. Consumption: Individuals generally prefer current consumption to future consumption.
4. Investment opportunities: An investor can profitably employ a rupee received today, to give
him a higher value to be received tomorrow or after a certain period of time.
Thus, the fundamental principle behind the concept of time value of money is that, a sum of
money received today, is worth more than if the same is received after a certain period of time.

TECHNIQUES OF TIME VALUE OF MONEY

There are two techniques for adjusting time value of money.
1. Compounding Techniques/Future Value Techniques
2. Discounting/Present Value Techniques
The value of money at a future date with a given interest rate is called future value. Similarly, the
worth of money today that is receivable or payable at a future date is called Present Value.

Compounding Techniques/Future Value Technique

In this concept, the interest earned on the initial principal amount becomes a part of the principal
at the end of the compounding period.

FOR EXAMPLE:
Suppose you invest Br1,000 for three years in a saving account that pays 10 percent interest per
year. If you let your interest income be reinvested, your investment will grow as follows
First year: Principal at the beginning 1,000
Interest for the year (` 1,000 × 0.10) 100
Principal at the end 1,100
Second year: Principal at the beginning 1,100
Interest for the year (` 1,100 × 0.10) 110
Principal at the end 1210
Third year: Principal at the beginning 1210
Interest for the year (` 1210 × 0.10) 121
Principal at the end 1331
This process of compounding will continue for an indefinite time period.
The process of investing money as well as reinvesting interest earned there on is called
Compounding. But the way it has gone about calculating the future value will prove to be
cumbersome if the future value over long maturity periods of 20 years to 30 years is to be
calculated.
A generalized procedure for calculating the future value of a single amount compounded
annually is as follows:
Formula: FVn = PV (1 + r)n
In this equation (1 + r) n is called the future value interest factor (FVIF).
Where,
FVn = Future value of the initial flow n year hence
PV = Initial cash flow
r = Annual rate of Interest
n = number of years
By taking into consideration, the above example, we get the same result.
FVn = PV (1 + r)n
= 1,000 (1.10)3
FVn = 1331
To solve future value problems, we consult a future value interest factor (FVIF) table. The table
shows the future value factor for certain combinations of periods and interest rates. To simplify
calculations, this expression has been evaluated for various combinations of ‘r’ and ‘n’.
Discount Rate: Discount rate is the rate at which present and future cash flows are traded-off.
It incorporates the above factors. Greater present consumption entails higher discount rates.
Individuals with greater present consumption require higher rewards for giving their present
consumption up. Higher expected inflation also requires application of higher discount rates as
lenders (savers) want to be compensated for the expected decline in the purchasing power of
their money. Higher risks would as well necessarily lead to higher discount rates.
Discounting: Discounting is the process of moving cash flows that are expected to occur in the
future back to their present worth using discount rates. It converts future cash flows to present
value terms.
Compounding: Compounding is the process of moving present cash flows to their future
worth, using discount rates.

Interest and Interest Rate

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—simple interest and compound interest.

Simple interest can be understood in two different ways. One is that simple interest is an interest
computed for just a period. If interest is computed for one period only, the interest is always
simple interest. Another way to understand simple interest is that it is an interest computed for
two or more periods whereby only the principal (original) value would earn interest. In simple
interest the previously earned interests do not produce another interest.

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

Though we have discussed both simple and compound interest, in financial management we are
largely interested in compound interest. So in the sections that follow we shall discuss the
concepts and techniques of the time value of money in the context of compound interest.
The interest rate paid to lenders depends on the factors mentioned above. The size of the interest
rate depends on the following factors:
(a) The rate of return expected to be earned on the invested capital. If the borrower expects
to earn higher return from invested capital, they will be ready to pay higher interest rates.
On the other hand, when there are investment opportunities with higher expected returns,
lenders will have options to invest their money; hence they seek higher rates.
 (b) The lenders (savers) preference of current versus future consumptions. Lenders with
desperate needs for current consumption require higher rates to give it up. On the other
hand, those with higher needs for future consumption (such as retirement) require lower
interest rates.
(c) The riskiness of the loan. When the borrower is assumed to have higher probability of
default, lenders require higher interest rates.
(d) The expected future rate of inflation. As repeatedly discussed in this chapter, inflation
erodes the purchasing power of money and when expecting it lenders (savers) charge an
interest they believe would compensate them for the decline in value of their money.

3.1. The Future Value of Money

Future value (FV) is the amount to which a cash flow or cash flows will grow over a given
period of time when compounded at a given interest rate. Future value is always a direct result of
the compounding process.
A. Future Value of a Single Amount
This is the amount to which a specified single cash flow will grow over a given period of time
when compounded at a given interest rate. The formula for computing future value of a single
cash flow is given as:
FVn = PV (1 + i)n
Where:
FVn = Future value at the end of n periods
PV = Present Value, or the principal amount
i = Interest rate per period
n= Number of periods
Or
FVn = PV (FVIF i, n)
Where:
(FVIF i, n) = The future value interest factor for i and n
The future value interest factor for i and n is defined as (1 + i)n and it is the future value of 1 Birr
for n periods at a rate of i percent per period.
Example: Ayantu deposited Br. 1,800 in her savings account in September 2008. Her account
earns 6 percent compounded annually. How much will she have in September 2015?
To solve this problem, let us identify the given items: PV = Br, 1,800; i = 6%; n = 7
FVn = PV (1 + i)n
= Br. 1,800 (1.06)7
= Br. 2,706.53
The (FVIF i, n) can be found by using a scientific calculator or using interest tables given at the
end of financial management books. From such tables, by looking down the first column to
period 7, and then looking across that row to the 6% column, we see that FVIF 6%, 7 = 1.5036.
Then, the value of Br. 1,800 after 7 years is found as follows:
FVn = PV (FVIF i, n)
FV7 = Br. 1,800 (FVIF6%, 7)
= Br. 1,800 (1.5036) = Br. 2,706.48

B. Future Value of an Annuity

An annuity is a series of equal periodic rents (receipts, payments, withdrawals, or 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 in same manner during each period.
If any one of these conditions is missing, the cash flows cannot be an annuity.
Basically, there are two types of annuities namely ordinary annuity and annuity due. Broadly
speaking, however, annuities are classified into three types:
i) Ordinary Annuity,
ii) Annuity Due, and
iii) Deferred Annuity
(i) Future Value of an Ordinary Annuity:
An ordinary annuity is an annuity for which the cash flows occur at the end of each period.
Therefore, the future value of an ordinary annuity is the amount computed at the period when
exactly the final (nth) cash flow is made. Graphically, future value of an ordinary annuity can
be represented as follows:
0 1 2 ------------------ n

PMT1 PMT2 ----------------------- PMT n

The future value is computed at point n where PMT n is made.
 (1  i ) 1
n

FVA n = PMT  

 i 

Where:
FVA n = Future value of an ordinary annuity
 PMT = Periodic payment
i = Interest rate per period
n = Number of periods
Or
FVA n = PMT (FVIFA i, n)
Where:
(FVIFA i, n) = the future value interest factor for an annuity
(1  i ) n  1
=
i
Example 1:
Jitu Company has planned to acquire machinery after five years. To that end, the company
deposits Birr 3,000.00 at the end of each year at a deposit rate of 12%. How much is the terminal
(future value) of the deposits at the end of the fifth year?
Given: FVA n =? i = 12% n = 5; PMT = 3,000
FVA n = PMT (FVIFA i, n)
 FVA 5 = 3,000 (FVIFA, 12 %, 5)
 FVA 5= 3,000 (6.35284736)
 FVA 5 = Birr 19,058.54

Example 2:
You need to accumulate Br. 250,000 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?
Given: FVA n = Br. 250,000; i = 12%  12 = 1%; n = 5 x 12 = 60 months; PMT =?
FVA n = PMT (FVIFA i, n)
 Br. 250,000 = PMT (FVIFA, %, 60)
 Br. 250,000 = PMT (81.670)
 PMT = Br. 250,000/81.670
 PMT = Birr 3,061
(ii) Future Value of an Annuity Due:
An annuity due is an annuity for which the payments occur at the beginning of each period.
Therefore, the future value of an annuity due is computed exactly one period after the final
payment is made. Graphically, this can be depicted as:
0 1 2 --------------------- n

PMT1 PMT2 PMT3 ----------------------- PMT n+1

The future value of an annuity due is computed at point n where PMT n + 1 is made
FVA n (Annuity due) = PMT (FVIFA i, n) (1 + i)
Or
 (1  i ) n  1 
= PMT   (1 + i)
 i 
Example:
Assume example 1 for ordinary annuity except that the payments are made at the beginning
instead of end of each year. How much is the terminal (future value) of the deposits at the end of
the fifth year?
FVA n (Annuity due) = PMT (FVIFA i, n) (1 + i)
 FVA 5 = 3,000 (FVIFA 12%, 5) (1 + 12%)
 FVA 5 = 3,000 (6.35284736) (1.12)
 FVA 5 = Birr 21, 345.57

Comparing Future Values

For the same number of periods, same discount rate, and same amount of money involved; which
one, ordinary annuity or annuity due, always will have greater future value?
Key: Annuity due will always have greater future value as the last cash flow earns interest for
annuity due; but not for ordinary annuity.

(iii)Future Value of Deferred Annuity:

Deferred annuity is an annuity for which the amount is computed two or more period after the
final payment is made. When the amount of an ordinary annuity remains on deposit for a
number of periods beyond the final rent, the arrangement is known as a deferred annuity. When
the amount of an ordinary annuity continues to earn interest for one additional period, we have
an annuity due situation, when the amount of an ordinary annuity continues to earn interest for
more than one additional period, we have a deferred annuity situation.

0 1 2 -------------------n -------------- (n + x)
PMT1 PMT2 PMT n

The future value of a deferred annuity is computed at point n + x

FVA n (Deferred annuity) = PMT (FVIFA i, n) (1 + i)x
 (1  i ) n  1 x
= PMT   (1 + i)
 i 
Where x = the number of periods after the final payment; and x  2.
Example: Ebise has a savings account in which she had been depositing Br. 3,000 every year on
January 1, starting in 1999. Her account earns 10% interest compounded annually. The last
deposit Ebise made was on January 1, 2008. How much money will she have on December 31,
2012? (No deposits were made after January1, 2008).
January 1:

1999 2000 2001 02 03 04 05 06 07 08 09 2010 11 12

3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000

The future value is computed on December 31, 2012 (or January 1, 2013).
Given: PMT = Br. 3,000; i = 10%; n = 10; x = 5
FVA n (Deferred annuity) = PMT (FVIFA i, n) (1 + i)x
= Br. 3,000 (FVIFA 10%, 10) (1.10)5
= Br. 3,000 (15.937) (1.6105)
= Br. 76, 999.62

C. Future Value of Uneven Cash Flows

Uneven cash flow stream is a series of cash flows in which the amount varies from one period to
another. The future value of an uneven cash flow stream is computed by summing up the future
value of each payment.
Example: Find the future value of Br. 1,000, Br. 3,000, Br. 4,000, Br. 1,200, 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.
 0 1 2 3 4 5

1,000 3,000 4,000 1,200 900

FVIF8%, 4 Br. 1,000 (1.3605) = Br. 1,360.50
FVIF8%, 3 Br. 3,000 (1.2597) = 3,779.10
FVIF8%, 2 Br. 4,000 (1.1664) = 4,665.60
FVIF8%, 1 Br. 1,200 (1.0800) = 1,296.00
Br. 900 (1.0000) = 900.00
FV = Br. 12,001.20

3.2. Present Value of Money

Present value is the exact reversal of future value. It is the value today of a single cash flow, an
annuity or uneven cash flows. In other words, a present value is the amount of money that should
be invested today at a given interest rate over a specified period so that we can have the future
value. The process of computing the present value is called discounting.

A. 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.
n
FVn  1 
PV =  FVn  
1  i  n
 1 i 
Where:
PV = Present Value
FVn = Future value at the end of n periods
i = Interest rate per period
n = Number of periods
Or
PV = FVn (PVIF i, n)
Where:
(PVIF i, n) = The present value interest factor for i and n = 1/ (1 + i)n
Example:
Bonsa Company owes Br. 50,000 to Adugna Co. at the end of 5 years. Adugna Co. could earn
12% on its money. How much should Adugna Co. accept from Bonsa Company as of today?
Given: FV5 = Br. 50,000; n = 5 years; i = 12%; PV =?
PV = FV5 (PVIF12%, 5)
= Br. 50,000 (0.5674) = Br. 28,370

B. Present Value of an Annuity

i) 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.
 1 
1 
 1  i n  1  1  i  n 
PVA n = PMT    PMT   = PMT (PVIFA i, n)
 i   i 
 
 
Where:
PVA n = the present value of an ordinary annuity
(PVIFA i, n) = the present value interest factor for an annuity
1  1  i 
n
=
i
Example 1:
On January 1, 2008, Tutu Company has borrowed Birr 500,000 by issuing an 8% note
compounded annually to one of its local banks, which is payable Br. 100,000 a year for five
years starting on December 31, year 1.
What is the present value of this debt on January 1, year 1? Prepare a loan amortization schedule.

Solution: The present value of the debt on January 1, year 1, is equal to the present value of an
ordinary annuity of five rents reported as Br. 399,271 (Br. 100,000 x 3.99271) in the accounting
records on January 1, year 1.
The repayment program (loan amortization table) for this debt is summarized below:
 Tutu Company
Repayment program for Debt of Br. 399,271 at 8% interest
Interest Expense Repayment at Net reduction Debt balance
Date at 8% a year end of year in debt
Jan. 1, year 1 ----- ------ ----- Br. 399,271
Dec. 31, year 1 Br. 31,942 Br. 100,000 Br. 68,058 331, 213
Dec. 31, year 2 26,497 100,000 73,503 257,710
Dec. 31, year 3 20,617 100,000 79,383 178,327
Dec. 31, year 4 14,266 100,000 83,734 92,593
Dec. 31, year 5 7,407 100,000 92,593 –0-
ii) Present Value of an Annuity Due: is the present value computed where exactly the first
payment is to be made. Graphically, this is shown below:

0 1 2 3 ---------------- n

PMT1 PMT2 ---------------- PMT n

The present value of an annuity due is computed at point 1 while the present value of an ordinary
annuity is computed at point 0.
1  (1  i )  n 
PVA n = (Annuity due) = PMT   (1 + i) = PMT (PVIFA i, n) (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.

Given: PMT = Br. 5,000; n = 10 years; i = 8%; PVA n (Annuity due) =?

PVA (Annuity due) = Br. 5,000 (PVIFA 8%, 10) (1.08)
= Br. 5,000 (6.7101) (1.08)
= Br. 36,234.54

So the cost of the machinery for Ruth is Br. 36,234.54. We have identified the case as an annuity
due rather than ordinary annuity because the first payment is made today, not after one period.

iii) Present value of a Deferred Annuity is computed two or more periods before the first
payment is made.
 1  (1  i )  n  -x -x
PVA n (Deferred annuity) = PMT   (1 + i) = PMT (PVIFA i, n) (1 + i)
 i 
Where x is the number of periods between the date when he first payment is made and the date
the present value is computed.
Example:
Lali Chartered Accountants has developed and copyrighted an accounting software program. Lali
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?

0 1 2 3 4 5 6 7 8 9 10

PVA n =? 5,000 5,000 5,000 5,000 5,000 5,000

x
Given: n = 6; PMT = Br. 5,000; X = 4; PVA6 (Deferred annuity) =?
i = 8% PVA6 (Deferred annuity) = Br. 5,000 (PVIFA8%, 6) (1.08)-4
= Br. 5,000 (4.6229) (0.7350)
= Br. 16,989.16

C. Present Value of Uneven Cash Flows

The present value of an uneven cash flow stream is found by summing the present values of
individual cash flows of the stream.
Example:
Suppose you are given the following cash flow stream where the appropriate interest rate is 12%
compounded annually. What is the present value of the cash flows?
Year 1 2 3
Cash flow Br. 400 Br. 100 Br.300
Br. 400 (0.8929) PVIF12%, 1
= Br. 357.16
Br. 100 (0.7972) PVIF12%, 2
= Br. 79.72
Br. 300 (0.7118) PVIF12%, 3
= Br. 213.54
Br. 650.42
D. Present Value of Perpetuity
Perpetuity is an annuity with indefinite cash flows. In perpetuity payments are made
continuously forever. The present value of perpetuity is found by using the following formula:
 Payment  PMT
PV (Perpetuity) =  
 Interest  i
Example:
What is the present value of perpetuity of Br. 7,000 per year if the appropriate discount rate is
7%?
Given: PMT = Br. 7,000; i = 7%; PV (Perpetuity) =?
 Payment  PMT Birr 7,000
PV (Perpetuity) =    = 
 Interest  i 7%
= Br. 100,000.
This means that receiving Br. 7,000 every year forever is equal to receiving Br. 100,000 now,
given that the market discount rate is 7%.