Chapter - 3

Time value of Money

 Factors that affects the value of
money are
Level of risk
Inflation
Timing of return (Interest)

The concept of interest is one of the

core ideas in financial management.
 Business
Cont’d…
organization deals with interest
rates when it makes both financing and
investment decisions.
A company can, therefore, earn a rate of
return on its invested funds and a rate of
interest on the funds it lent to borrowers.
The rate of return/interest can be
stated explicitly as it is the case for
commercial and mortgage loans
provided by banks.
 General Assumptions Needed in
Computing Interest
Certainty-all current and past data are
known.
Discrete Time Period-Time is divided into
yearly intervals
 Yearly Interest Computations-interest is
computed once a year and the computation is
made at the end of the year
Methods of Interest Computations

Simple interest
Compound interest- Which
is interest on interest.
 Approach of Deposit/payment
There are two ways of depositing payments
(money) into an interest bearing account.
These are
 single payment and
 series of payments (annuity).
 In
either of the above two approaches we need to
compute:
 Presentvalue (discounting) and
 Future value of the deposits or payments
(compounding)
 Future value of single payment
 The process of going from today's values, or present
values (PV) to future values (FV) is called compounding.

 FV1 = PV + I (interest)
 FV2 = FV1 (1+i)=PV (1+i) (1+i)=PV (1+i)2
 FVn= PV(1+I)n or = Pv (FV1Fi,n) using TVM tables

 To illustrate this, suppose you deposited 100 Birr

at the Commercial Bank of Ethiopia (CBE) that
pays 5 percent interest each yea. How much
would you have at the end of one year?
 Other Application of future value
amount of single payment
 The future value equation for single payment stated in this
material can also be used to find interest rates, as well as,
numbers of years that will be needed for the compounded
amount to equal the desired value.
 Finding the Interest rate: - Estimating the interest rate on the
deposited money is a recurring problem when it is not
explicitly stated.
 A useful approach is to treat the interest rate as an implicit
interest rate and find by using the interest table (future value
table of single payment).
Example
 Assume that you have invested 15,000 Birr
today at a bank where it can grow to the future
value of 17,000 Birr within three years from now
into the future.
 What is the interest rate that the bank should pay
for your account in order to fulfill your desire?
 FV3 = PV (1+i)3
 17900 = 15,000 (1+i)3
 (1+i)3 = FVIFi,3 =
Cont’d……

 The future value interest factor in the interest (future

value of single payment table) corresponding to the
unknown interest rate (i) and a period of 3 years n = 3) is
1.193.
 Hence, look up the three year (n=3) row and read horizontally
until you find the table value (future value interest factor) that
is equal or the closest to the computed value of 1.193.
 There is no table value that is exactly equal to 1.193.
 The table value of 1.191 is found to be the closest value to
1.193 and it corresponds to 6 percent.
 Thus, the interest that the bank actually has to pay to your
account is slightly greater than 6 percent.
Finding the number of years
 Assume, for example, a deposit of 1000 Birr is made in an
interest bearing account that pays 10 percent compounded
yearly. Your goal as a depositor is to collect 1,500 Birr after
an unknown number of years. How many years should you
wait for the desired amount to be realized?
 By substituting the values into the future value of single
payment equation, you get:
 FVn = 1000 (1+I)n
 1,500 =1000 (1+0.1)n =1000 (1.1)n
 (1.1)n = 1500 = 1.5, by using logarithm
 1000
 n = log1.1 1.5 = log 1.5 = 0.176 = 4.29 years
 log 1.1 0.041
 Present (Discount) value
 Finding the present value of the future cash receipts, or payment is
called discounting, and it simply the reverse of the compounding
process. If you know present value, PV, you compound it to find
the future value, FV.
 FVn= PV(1+I)n = Pv (FV1Fi,n)
 and by solving for PV in several equivalent form, we arrive at:
 PV =
 Suppose that you have some extra cash, you have a chance to buy a
low risk security which will pay 127.63 Birr at the end of 5 years.
 Assume that Awash International Bank (AIB) is currently offering 5
percent, on 5-year time deposit.
 How much should you deposit today in the time deposit account in
order to get the indicated amount of 127.63 Birr at the end of year 5
n=5).
Cont’d…..

Finding the Interest Rate – Using

TVM table
Finding the Numbers of Years –
Using logarithm
{Log(PV/FV)}/{Log(1/1+i)} = n
See example on page 33 of your
handout
 Annuities
 An annuity is an equal amount of Birr payment
for specified number of years.
 Such an example in finance is bond interest
payments
 Theannuity payments can occur at either the
beginning or the end of period.
 If the payments are made at the beginning of each
period, the annuity is known as annuity due.
 If the payments occur at the end of each period, as
they typically do, the annuity is called an ordinary
Application of Annuity

Finding the Interest Rate – Using

TVM table
Finding the Numbers of Years –
Using TVM Table only
See example on page 38 of your
handout
Uneven, or Un equal Cash flows
 Although many financial decisions do involve annuities,
some important decisions involve unequal, or non-
constant payments, or receipts, or cash flows.
 For example. common stock as you know, pay
fluctuating level of dividends overtime, and fixed assets
investments such as machinery do not generate constant
cash flows over their lives as they depreciate.
 As a result, it is very necessary to extend the time value
of money analysis to include unequal payments, or
receipts, or cash flows.
 See example on page 43-45 of your handout
Semi-annual and Other Compounding
Periods
 Whenever payments occur more frequently than
once a year, or if interest is stated to be
compounded more than once a year, then you must
convert the stated interest rate per annum into a
'periodic rate' and the number of years in to 'the
number of periods' as follows.
 Periodic rate = Stated rate/Number of
payment per year.
 Number of periods = Number years x
compounding periods per year.
 Perpetuities
A perpetuity is an annuity that continues
for ever; that every year from its
establishment this investment pay the
same birr amount.
The very good example of a perpetuity
is a preferred stock that yields a constant
dividend birr dividend infinitely as the
life of the preferred stock is unlimited.
Bond Valuation
 When the bond is purchased, the holder (owner)
of the bond receives two things:
 (1) interest payments, which are a series of equal
payments usually made semiannually, and
 (2) repayment of the full principal at its maturity,
regardless of the price the bondholder paid for the
bond.
 Generally speaking, the bond worth the present value of the
cash flows it provides. Thus, whenever the market discount
rate, or interest rate changes, the value of the bond changes.
 When the market interest rate is above the coupon arte, the
bond value will decline,
Generally speaking, the bond worth the present value of the
cash flows it provides. Thus, whenever the market discount
rate, or interest rate changes, the value of the bond changes.
Let us now examine the value of this bond assume three cases: medium, low and high
market interest rates say10 percent, 6 percent and 14 percent respectively.
Case 1: Bond Value at 10 percent Market Interest Rate:
The present values are computed by using the market interest rate of 10 percent paid
semiannually in this case.
 
Bond value at Present value of Present value of10% compounded =
interest payment the repayment of semiannually annuity
bond's principal

Bond value (using table values) = (PMT) (PVIFAi,n) + (FV) PVIFi,n)

Before you use the present value of annuity and single payment equations, you need to
convert the annual interest rate to the semiannual rate, or periodic rate and the twenty
year bond life into payment periods
Bond value (present value of cash flows) = (45) (PVIFA5%, 40) + (1000) (PVIF5%,
40)
= (45) (17.1591) + (1000) ( 0.1420)
= 772.16 + 142.00
= 914.16 Birr
Hence, the value of the bond that pays 45 Birr of interest
semiannually when the market interest (discount) rate is 10
percent per annum is 914.16Birr.
Since the bond carries a coupon rate of 9 percent per annum of
4.5 percent per six months,
• It will be sold at discount when the market interest rate is
greater than this coupon rate.
• (i.e 10 percent market interest rate, which is 5 percent per six
months).
• If the market interest rate drops from 10 percent to 6
percent, the value of the bond will climb from 914.16 Birr
to 1,346.77 Birr.
• If the market interest (discount) rate climbs
from 10 percent up to 14 percent, the value of
the bond will drop from 914.16Birr down to
666.73 Birr.
• This clearly shows that there is an inverse
relationship between the market interest
(discount) rate and the value of the bond.
• When the market interest (discount) rate
goes up, the value of the bond value goes
down, and vice versa.