UNIT 3: THE TIME VALUE OF MONEY

3.1. INTRODUCTION

Many decisions in finance involve choices of receiving or paying cash at different time
periods. As you recall from the discussions of the second unit, the goal of a firm is wealth
maximization. This goal recognizes the difference in the value of equal cash flows received at
different time periods. So the concept of the time value of money is that money received now
is generally better than the same amount of money received some time later. This is because
there is an opportunity to invest the money we have now and earn a return on it. For example,
if you have Br. 1,000 today, you could save it in a bank and earn interest.

The time value of money is a very important concept in financial management. It has many
applications in financial decisions like loan settlements, investing in bonds and stocks of
other entities, acquisition of plant and equipment. Therefore, understanding the time value of
money concept is essential for a financial manager to achieve the wealth maximization goal
of a firm.

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. 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 interest.

Though we have discussed both simple and compound interest, in financial management we
are largely interested on 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.

3.2. FUTURE VALUE

To understand future value, we need to understand compounding first. Compounding is a
mathematical process of determining the value of a cash flow or cash flows at the final
period. The cash flow(s) could be a single cash flow, an annuity or uneven cash flows. 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.

3.2.1. 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 (FVIFi, n)

Where:

(FVIFi, 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: Galgalo deposited Br. 1,800 in his savings account in Fulbana 1990. His account
earns 6 percent compounded annually. How much will he have in Fulbana 1997?

To solve this problem, let’s identify the given items: PV = Br, 1,800; i = 6%; n = 7 (Fulbana
1990 – Fulbana 1997).

FVn = PV (1 + i) n
 = Br. 1,800 (1.06)7

= Br. 2,706.53

The (FVIFi, n) can be found by using a scientific calculator or using interest tables given at
the end of this material. From the first table by looking down the first column to period 7, and
then looking across that row to the 6% column, we see that FVIF6%, 7 = 1.5036. Then, the
value of Br. 1,800 after 7 years is found as follows:

FVn = PV (FVIFi, n)

FV7 = Br. 1,800 (FVIF6%, 7)

= Br. 1,800 (1.5036) = Br. 2,706.48

3.2.2. Future Value of an Annuity

An annuity is a series of equal periodic rents (receipts, payments, withdrawals, 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. First, the cash flows must be equal. Second, the
interval between any two cash flows must be fixed. Third, the interest rate applied for each
period must be constant. Last but not least, interest should be compounded 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 (n th) cash flow is made.
Graphically, future value of an ordinary annuity can be represented as follows:

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

PMT1 PMT2 ---------------PMTn

The future value is computed at point n where PMTn is made.

[ ]
n
(1+i) − 1
FVAn = PMT i

Where:

FVAn = Future value of an ordinary annuity

PMT = Periodic payments

i = Interest rate per period

n = Number of periods

Or

FVAn = PMT (FVIFAi, n)

Where:

(FVIFAi, n) = the future value interest factor for an annuity

(1+i)n −1
= i

Example: You need to accumulate Br. 25,000 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: FVAn = Br. 25,000; i = 12%  12 = 1%; n = 5 x 12 = 60 months; PMT = ?

FVAn = PMT (FVIFAi, n)

 Br. 25,000 = PMT (FVIFA, %, 60)

 Br. 25,000 = PMT (81.670)

 PMT = Br. 25,000/81.670

 PMT = Br. 306.11

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 ----------------------- PMTn + 1

The future value of an annuity due is computed at point n where PMTn + 1 is made

FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i)

Or

= PMT
[
(1+i)n − 1
i ]
(1 + i)

Example: Assume that previous example except that the first payment is made today instead
of a month from today. How much should your monthly deposit be to accumulate Br. 25,000
after 60 months?

FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i)

 Br. 25,000 = PMT (FVIFAi, n) (1 + i)

 Br. 25,000 = PMT (81.670) (1.01)

 PMT = Br. 25,000/82.487

 PMT = Br. 303.08

iii) Future value of Deferred Annuity is an annuity for which the amount is computed two or
more period after the final payment is made.

0 1 2 ------------------n --------------n + x

PMT1 PMT2 PMTn

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

 FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i)x

= PMT
[
(1+i)n − 1
i (1 + i)x
]
Where x = The number of periods after the final payment; and X  2.

Example: Henock has a savings account, which he had been depositing Br. 3,000 every year
on January 1, starting in 1990. His account earns 10% interest compounded annually. The last
deposit Hencok made was on January 1, 1999. How much money will he have on December
31, 2003? (No deposits are made after 1999 January).

Jan.

1990 1991 1992 93 94 95 96 97 98 99 2000 2001 02 03 2004

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, 2003 (or January 1, 2004).

Given: PMT = Br. 3,000; i = 10%; n = 10; x = 5

FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i)x

= Br. 3,000 (FVIFA 10%, 10) (1.10)5

= Br. 3,000 (15.937) (1.6105)

= Br. 76, 999.62

3.2.3. 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. 4000, Br. 1200, 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

3.3. PRESENT VALUE

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.

3.3.1. 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
= FVn
PV = ( 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 (PVIFi, n)

Where:
 (PVIFi, n) = The present value interest factor for i and n = 1/ (1 + i)n

Example: Zelalem PLC owes Br. 50,000 to ALWAYS Co. at the end of 5 years. ALWAYS
Co. could earn 12% on its money. How much should ALWAYS Co. accept from Zelalem
PLC 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

3.3.2. 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−

PVAn = PMT
( 1+i )n
i
= PMT [
1− ( 1 + i )−n
i ] = PMT (PVIFAi, n)

Where:

PVAn = The present value of an ordinary annuity

(PVIFAi, n) = The present value interest factor for an annuity

1− ( 1 + i )−n
= i

Example: Ato Mengesha retired as general manager of Tirusew Foods Company. But he is
currently involved in a consulting contract for Br. 35,000 per year for the next 10 years. What
is the present value of Mengesha’s consulting contract if his opportunity costs is 10%?

Given: PMT = Br. 35,000; n = 10 years; i = 10%; PVAn = ?

PVA10 = Br. 35,000 (PVIFA10%, 10)

 = Br. 35,000 (6.1446) = Br. 215,061. This means if the required rate of return
is 10%, receiving Br. 35,000 per year for the next 10 years is equal to receiving Br. 215,061
today.

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 PMTn

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.

PVAn = (Annuity due) = PMT i [

1 −(1+i)−n
]
(1 + i) = PMT (PVIFAi, n) (1 + 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%; PVAn (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.

PVAn (Deferred annuity) = PMT i [

1 −(1+i)−n
]
(1 + i)-x = PMT (PVIFAi, n) (1 + i)-x

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: Sefa Chartered Accountants has developed and copyrighted an accounting
software program. Sefa 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

PVAn = ? 5,000 5,000 5,000 5,000 5,000 5,000

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

3.3.3. 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

3.3.4. Present Value of a 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:

PV (Perpetuity) = Payment = PMT

Interest rate 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) =?

PV (Perpetuity) = PMT = Br. 7,000 = Br. 100,000.

i 7%

This means that receiving Br. 7,000 every year forever is equal to receiving Br. 100,000 now.