CHAPTER 4

THE TIME VALUE OF MONEY

LECTURER:PROF O.A. ONI
Chapter outline
• Introduction
• Interest rates
• Future value and compounding of lump sums
• Compounding interest more frequently than annually
• Nominal and effective interest rates
• Present value and discounting
• More on present and future values
• Valuing annuities
• Perpetuities
• Amortising a loan
• Sinking funds
• Conclusion
Learning outcomes

By the end of this chapter, you should be able to:

• use various computation tools to analyse the role of
time value in finance
• calculate, interpret and explain the future value and
present value of single amounts or lump sums, and
investigate the relationship between them
• calculate, interpret and explain the future value and
present value of annuities (ordinary annuities, annuities
due and ordinary deferred annuities)
• calculate, interpret and explain the present value of a
perpetuity
Learning outcomes (cont.)

By the end of this chapter, you should be able to:

• calculate and interpret the present value and future
value of a mixed stream of cash flows
• determine deposits needed to accumulate a future
sum, calculate installments to amortise a loan and
calculate an interest rate or growth rate
• calculate the present value, future value, interest rate
and time period using discounting and compounding
principles.
Introduction
• The value of an investment depends on:
 size
 timing of cash flows
• The larger the cash inflows, and the sooner the
receipt of these cash flows, the more valuable
the investment
• Time value of money:
 Cash flows to be received in the near future are
more valuable than ones to be received in the
distant future
Interest rates

• Simple interest
 Interest earned on the principal amount only –
interest earned is not reinvested
• Compound interest
 All interest earned is reinvested together with
principal amount – interest is earned on original
principal as well as on interest that has been
reinvested
Example 4.1 Simple interest
Sibusiso receives a R1 000 bonus. He invests the R1 000 in a
savings account that offers a simple interest rate of 10% p.a. for
a period of five years. How much money will Sibusiso have after
five years?

Initial principal Interest

Year 1: 10% of R1 000 = R100
Year 2: 10% of R1 000 = R100
Year 3: 10% of R1 000 = R100
Year 4: 10% of R1 000 = R100
Year 5: 10% of R1 000 = R100

Initial principal: R1 000

Total interest earned over this period: R 500
Final amount after five years: R1 500
Example 4.1 Compound interest
Sibusiso invests R1 000 in a savings account offering interest at
10% p.a. but the interest earned will be re-invested. How much
money will Sibusiso have after five years?

Initial Previous
Principal Interest Principal New amount
Year 1: 10% of R1 000,00 = R100,00 R1 000,00 R1 100,00
Year 2: 10% of R1 100,00 = R110,00 R1 100,00 R1 210,00
Year 3: 10% of R1 210,00 = R121,00 R1 210,00 R1 331,00
Year 4: 10% of R1 331,00 = R133,10 R1 331,00 R1 464,10
Year 5: 10% of R1 464,10 = R146,41 R1 464,10 R1 610,51

Initial principal: R1 000,00

Final amount after five years: R1 610,51
Total interest earned over this period: R 610,51
Future value and compounding of
a lump sum
• Future value (FV): determine accumulated
value of all cash flows at end of a project (T n)
• Present value (PV): discounts all cash flows to
start/beginning of a project (time zero, T 0)

FVn = PV0 × (1+i)n

Example 4.2

Sibusiso invests his money for a period of one

year at an interest rate of 10%. What will the FV
of his investment be at the end of the year?
Example 4.3

Sibusiso invests his money for two years at 10%.

Calculate the FV of his investment after two years.
Compounding interest more
frequently than annually
• Interest often computed more frequently than
once a year
• Terminology for different frequencies of
compounding:
 Nominal annual rate compounding annually (NACA)
 Nominal annual rate compounding semi-annually
(NACSA)
 Nominal annual rate compounding quarterly (NACQ)
 Nominal annual rate compounding monthly (NACM)
Semi-annual, quarterly and
monthly compounding
• Formula when interest is compounded more
than once per period: nm
 i 
FVn = PV0 × 1  
 m

• FV increases when frequency of compounding

the interest payments is increased
Example 4.6

Sibusiso invests his money for a period of two years at an

interest rate of 10%, compounded semi-annually. What will
the FV of his investment be at the end of this period?
Continuous compounding

• Interest sometimes computed continuously

FVn = PV0 × e i × n
Let’s reconsider Sibusiso’s deposit of R1 000 in the
savings account for a period of two years at an annual
interest rate of 10%, but let’s now assume that the interest
is compounded continuously. Calculate the FV.

Using the formula:

FV2 = PV0 × ei × n
= R1 000 × 2,7183 0,10 × 2
= R1 221,40
Nominal and effective interest
rates
• Nominal (stated) interest rate: contractual
annual percentage rate of interest charged by a
lender or promised by a borrower
• Effective (true) annual rate: annual rate of
interest actually paid or earned.
 Effective annual rate includes effects of
compounding frequency; nominal rate does not
m
 i 
EAR = m   1
1 
 
Example 4.10
• What is the effective annual rate of interest if
an annual nominal rate of 8% is compounded
quarterly?
Using the formula:
m
 i 
EAR = 1   1
 m
4
 8% 
= 1  4   1
= (1,02)4 − 1
= 0,0824
= 8,24%
Present value and discounting

• Present value (PV)

 Amount of money invested today at given interest
rate for specified period to equal future amount
• Alternatively: PV is amount today that is
equivalent to future payment that has been
discounted by appropriate interest rate
• Since money has time value: PV of future amount
is worth less longer you have to wait to receive it
• Process of finding PVs: discounting
Present value and discounting
• PV
 Amount of money that would have to be invested today at given interest rate over
specified period to equal future amount

PV0 =

FVn
1  i n
Example 4.11

Fikile wishes to find the current value (PV) of an

amount of R1 700 that will be received eight
years from now, assuming that the annual
interest rate is 8%.

Using the formula:

PV = FV × (1 + i)-n
= R1 700 × (1,08)-8
= R1 700 × 0,5402
= R918,46
More on present and future values
• Determining an interest rate
 Sometimes necessary to calculate the return on
investment
• Calculating the number of periods
 Sometimes necessary to work out the number of
time periods for an initial investment to accumulate
to a given FV
Valuing annuities

• Annuity
 Series of equal payments (cash outflows) or receipts
(cash inflows) occurring over specified time period
 Consists of constant payments made at regular
intervals (monthly, quarterly, annually, etc.)
• Two types of annuities
 Ordinary annuity (or annuity in arrears): payments or
receipts occur at the end of each period
 Annuity due (or annuity in advance): payments
occur at the start of each period
Example 4.14

You deposit R2 000 at the end of each of the next

five years in an account that pays 10% interest p.a.
What will the FV of your account be after five years?
Example 4.14
 1  i n  1
FVA = PMT ×  
 i 
FV of an annuity due

• Annuity due: each payment occurring is moved

ahead one period in order to convert the cash
flow stream into an ordinary annuity
 Achieved by multiplying PMT by (1+i)
 Resulting cash flows of R5 300 (5 000 × 1,06) at the
end of each period are similar to the cash flows of
R5 000 at the beginning of each period
Example 4.19

What amount will accumulate if you deposit R5 000 at

the beginning of each year for the next five years in an
account with an interest of 6% compounded annually?
PV of an ordinary annuity
• PVA: current value of a stream of expected or promised future
payments that have been discounted to a single equivalent value today

PVA = PMT ×

 1  1  i  n 
 
 i 
Example 4.20

Suppose you need an investment that will pay R2 000 at

the end of every year for the next five years at an annual
interest rate of 10%. How much should you invest today?
Example 4.22

What amount must you invest today at 6% interest

compounded annually so that you can withdraw R5 000
at the beginning of each year for the next five years?
Mixed stream of cash flows

• Annuity based on equal payments over a

number of periods
• During capital budgeting cash flows from initial
investment usually not in form of annuity
• Unequal cash flows will probably be generated
over project lifetime
 In some cases, positive as well as negative cash
flows may occur
 Mixed cash flow stream
 Not possible to use annuity formulae and calculator
solutions
Example 4.24

As a reward for taking care of your uncle he makes the

following payments into your account over a period of five
years:

Year Cash flow

1 R5 000
2 R5 000
3 R6 000
4 R6 000
5 R1 000
Assuming an interest rate of 10% per annum, calculate the
PV of the cash flows.
Example 4.24
Example 4.24

The calculation can also be computed with a

financial calculator by using the cash flow function
(Cfi):

Input Function
0 Cfi
5 000 Cfi
5 000 Cfi
6 000 Cfi
6 000 Cfi
1 000 Cfi
10 i
NPV = R17 904,58
Perpetuities

• Perpetuity: annuity in which periodic payments

begin on a fixed date and continue indefinitely
(perpetual annuity)
• Three types of perpetuities:
 Ordinary perpetuity: payments made at the end of
the stated periods
 Perpetuity due: payments made at the beginning of
the stated periods
 Growing perpetuity: periodic payments grow at a
given rate (g)
Perpetuities

• Formula used to calculate the PV of an

ordinary perpetuity (PV∞):
PMT
PV∞ = i

• Formula used to calculate the PV of a growing

perpetuity:
PMT
PV∞ = i g
Conclusion

• A lump sum refers to a single payment or receipt of

cash at a specific point in time. A distinction was made
between initial cash flows (occurring at time zero, i.e.
now) and future cash flows that occur somewhere in
future.

• An annuity can be defined as a stream of equal,

periodic cash flows over a specified period of time, in
equally spaced time intervals. These payments are
usually annual, but can occur at other intervals, such as
monthly (e.g. bond payments). Annuity formulae allow
complex problems to be resolved in a systematic
manner.
Conclusion (cont.)

• A perpetuity is a perpetual stream of constant or

constantly growing cash flows.

• A mixed cash stream consists of non-constant cash

flows, where different cash flows occur every period.

• The FVs and PVs of lump sum amounts, annuities and

mixed cash flows can be calculated by making use of
formulae, financial tables or a financial calculator.
Conclusion (cont.)

• Loan amortisation refers to the determination of equal

loan payments (the extinction of a debt by means of
equal periodic payments over a period of time).
Therefore, amortisation is a schedule showing the
repayment details for a loan, including the amount of
each payment that is apportioned to interest and to
capital (the principal debt).

• Sinking funds are used to accumulate money over time,

by depositing periodic payments in a fund. Examples of
sinking funds are to make provision for the replacement
of assets, or to make provision for a loan that needs to
be repaid.