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Time Value of Money To Students

CCCD

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7 views4 pages

Time Value of Money To Students

CCCD

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Warriors Cyber
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We take content rights seriously. If you suspect this is your content, claim it here.
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Lecture 3:

Time Value of Money.


The concept attempts to explain why individuals prefer cash now rather than in the future. By the
virtue of passage of time, the value of money will change.
Significance of time value of money
i. Evaluation of business performance
ii. Selection of the best source of finance
iii. Determination of effective cost borrowing
iv. Loan repayment arrangements determination
v. Determination of true rate of return
Compound value of a single amount
Compound value refers to the future value of an amount called the principle. The computation is
only done on the principle, over a specified number or period at a particular interest rate.
Compound refers to the inclusion of the interest earned at the end of the period as part of the
principle in the next period.
𝐅. 𝐕 = 𝐏𝐕(𝟏 + 𝐫)𝐧
The function (1 + 𝑟)𝑛 is known as future value interest factor (F.V.I.F) expressed as FVIF r% n
Example
An investor deposits 100,000 shillings in a bank for 4 years. The interest rate is 15%. Compute the
future value/ compound value of the investment
F.V = 𝑃(1 + 𝑟)𝑛 = 100,000(1 + 0.15)4 = 174,900
Multi-period compounding
❖ Annually
❖ Semi-annually
❖ Quarterly
❖ After four months
❖ Weekly
❖ Continuously
𝐅𝐕 = 𝐏𝐕𝐞𝐫.𝐭

Alternative for continuous compounding: FV = A(1+r/f) n*f

Present Value of a Single Amount


Refers to the amount to be deposited today and be invested over a specified number of periods at
a particular interest rate.
The process of computing the present value is called the discounting rate or the required rate of
return, opportunity cost or cost of capital.
𝐹.𝑉 1
𝑃𝑉 = (1+𝑟)𝑛; 𝑃𝑉 = 𝐹𝑉 ∗ (1+𝑟)𝑛; 𝑃𝑉 = 𝐹𝑉(1 + 𝑟)−𝑛
1
The function (1+𝑟)𝑛 is known as present value interest factor PVIF r%,n
Example
Jane expects to receive 40,000 shillings in 4 years’ time. The discount rate is 14%. Compute the
amount to deposit today.
𝐹. 𝑉 40,000
𝑃𝑉 = = = 23,683
(1 + 𝑟)𝑛 (1 + 0.14)4
Annuities

1
Equal payment or receipts at equal intervals over a period of time
1. Future Value of an Annuity
a) Annuity due => Cash flows at the beginning of the year e.g. rent, fees
(1+𝑟)𝑛 −1
𝐴[ ] (1 + 𝑟); the expression is future value interest factor of an annuity
𝑟
b) Ordinary annuity => Cash flows at the end of year e.g. salaries
(1 + 𝑟)𝑛 − 1
𝐴[ ]
𝑟
The table method
Assume a salary of 1000 at the beginning of every year for 3 years
Year Cash FVIF FV of Cash
Flows Flows
1 1000 1.1 1100
2 1000 1.21 1210
3 1000 1.331 1331
Total 3.641 3641

Financial Tables Method


FVA = a. FVIFA r%, n
3,641 = 1,000*3.641

2. Present Value of an Annuity

a) PV of an annuity due:

1− (1+𝑟)−𝑛
𝐴[ ] (1 + 𝑟) ; assume we are to receive 1,000 at the end of every year.
𝑟
b) P.V of ordinary annuity:
1− (1+𝑟)−𝑛
𝐴[ ]
𝑟

The table method:


year Cash PVIF PV of Cash
Flows Flows
1 1000 0.9091 909.1
2 1000 0.8264 826.4
3 1000 0.7513 751.3
2.4868 2486.8

c) Financial Table Method:


PVA = aPVIFr r%, n

2
Areas of Further Studies: Make notes with examples:
1. Present Value of a growing annuity
In this case the annuity will be growing at a constant rate for a specified number of years:

2. Present Value of a growing annuity into perpetuity


In this case annuity growing at a constant rate until infinity:

3. Present value of a perpetuity


Perpetuity is a constant amount receivable or payable until infinity:

3
Application of Time Value of Money:
Loan amortization
X took Shs. 100,000 from Coop Bank at 20% for 3 years. Determine annual repayments. Construct
amortization schedule.
Solution
PVA = 100,000
n=3
r = 20%
𝟏− (𝟏+𝒓)−𝒏 𝟏− (𝟏+𝟎.𝟐)−𝟑
𝑨[ ] = 𝑨[ ]
𝒓 𝟎.𝟐
𝑨[𝟐. 𝟏𝟎𝟔𝟒]
PVA = a*PVIFAr%, n
100,000 = a*2.1064
100,000 = 2.1064a
a = 47,472
year annuity Interest Principal Balance
Repaid
0
- - - 100,000.00
1
47,472.00 20,000.00 27,472.00 72,528.00
2
47,472.00 14,505.60 32,966.40 39,561.60
3
47,472.00 7,911.28 39,560.72 -

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