Chapter –Three
Time Value of Money
3.1. Definition
A birr that we have today is more worth than
the promise or expectation that you will receive
in the future.
TVM is also described as discounted cash flow
(DCF).
✓ DCF is a technique used to determine the
present value of a certain amount of money
received at a future date.
3.2. Simple Interest and Compound Interest
• Interest is the excess of resources (usually cash)
received or paid over the amount of resources loaned
or borrowed at an earlier date.
• Business transactions subject to interest state whether
simple or compound interest is to be calculated.
1) Simple interest is the return on a principal amount
for one time period.
Simple interest is usually applicable only to short-
term investment and borrowing transactions
involving a time span of less than one year.
…con’t
• Interest is expressed in terms of an annual rate.
• The formula for simple interest is:
I = p * r * t (Interest = principal x annual rate of interest x
number of years).
• For example, interest on Br. 10,000 at 8% for one year is expressed
as follows:
I = p.r.t
I = Br. 10,000 x 0.08 x 1
I = Br. 800
• The amount to be repaid at the end of the year is the maturity
(future) value of the specified money.
Accordingly, F = P + I
F = 10000 + 800
F = Br. 10,800
…con’t
2) Compound interest For example, if
is the return on a interest at 8% is
principal amount for compounded
two or more time quarterly for one year
periods. on a principal
• Is calculated on the amount of Br. 10,000
principal amount and the total interest
on the accumulated (compound interest)
interest of previous would be Br. 824.32,
period (and therefore as computed below:
be regarded as
…con’t
• Compound interest formula:
I= P(1+i)n
• Where;
I = compound interest
P = Principal or Face amount
i = rate of interest
n= number of periods
…con’t
• Period Principal x Rate x Time = Compound Interest
Accumulated Amounts
1st quarter----Br. 10,000 x 0.08 x ¼ Br. 200 Br.
10,200
2nd quarter-------10,200 x 0.08 x ¼ 204 10,404
3rd quarter--------10,404 x 0.08 x ¼ 208.08
10,612.08
4th quarter-----10,612.08 x 0.08 x ¼ 212.24
10,824.32
Interest--------------------------------------824.32
3.3 Future and Present Values
• Future value involves a current amount that is
increased in the future as a result of compound
interest accumulation.
• Present value, in contrast, involves a future amount
that is decreased to the present as a result of
compound interest discounting.
• Discounting, in effect, extracts the interest from a
future value thereby returning to the principal
amount.
• Present value and future value apply to interest
calculations on both single payment amounts and
periodic equal payment amounts (annuities)
3.3.1. Future value of a single sum
Future value involves a current amount that is increased in
the future as a result of compound interest
accumulation (to end-point dollar (birr) values.
Formula
FV=PV(1+i)n
Where, FV, future value of a single investment, PV Present
value, at interest rate per period, i, for n periods.
Example. a future value of $10,000 invested for one year
at 8% compounded quarterly.
FA = PV (1 + i)n
FA = Br. 10,000 (1.02)4
Or FA = Br. 10,000 (1.02) (1.02) (1.02) (1.02)
FA = Br. 10,824.32 FA I U 5
9
3.3.2. Present value of a single sum
Present value, in contrast, involves a future amount that is
decreased to the present as a result of compound interest
discounting. (to dollar (birr) values at the starting point of an
investment) (PV is today value of money from some point in the
future).
Formula PV= FV /(1+i)n
Where; PV = present value FV = future amount i = interest rate
per period n = number of compounding period
E.g. : If we want an amount of Br. 30,000 after 12 years by making a
single deposit in a saving account which will pay 16% interest
compounded quarterly, what should the amount of initial deposit
be?
So: The present value is Br. 30,000 discounted at 4% for 48 periods.
Using PV Table, the present value is
Br. 30,000 x 0.152195 = Br. 4565.84 . Or using the formula:-
PV=FV/(1+i)n=30000/(1+0.04)48=30000/6.570528=Br.
FA I U 5 4565.84 10
Annuity
An annuity is a series of uniform payments or receipts
occurring at uniform intervals over a specified investment
time frame, with all amounts earning compound interest at
the same rate.
Payments of any type are considered as annuities if all of
the following conditions are present:
i. The periodic payments are equal in amount
ii. The time between payments is constant such as a year,
half a year, a quarter of a year, a month etc.
iii. The interest rate per period remains constant.
iv. The interest is compounded at the end of every time.
11
FA I U 5
…Con’t
• Annuities are classified according to the
time the payment is made.
• Accordingly, we have two basic types of annuities.
1) Ordinary annuity: is a series of equal
periodic payment is made at the end of each
interval or period.
In this case, the last payment does not earn interest.
2)Annuity due: is a type of annuity for which a
payment is made at the beginning of each interval or
period.
Present Value of an annuity
The present value of an annuity is the value of a series of equal future
receipts/payments (rents) made at regular time intervals and
discounted at the same compound interest rate on each date rents
are due.
1) Present value of an ordinary annuity
An ordinary consists of a series of equal payment made at the end of
each period. The present value of an ordinary annuity may be
computed using the following formula.
FVAn= PMT(1+i)0 + PMT(1+i)1 + PMT(1+i)2+----+ PMT (1+i)n-1
In this equation the first term (i.e. PMT (1+i)0) is the compounded
value of the payment at the end of last year, or year n of the
annuity payments; while the last term in the equation (i.e. PMT
(1+i)n-1) is the compounded amount of the payment made at the
end of year one (n-1).
FA I U 5 13
Present Value of an ordinary annuity
$100 100 100 100 100
$ 421.24
Today 1 2 3 4 5
Cf
PV = 100 + 100 + 100 ……….
(1+i) –n (1+i) 1 (1+i) 2 (1+i) 3
PvA=R 1 - 1 Where P v A =PV the amount of ordinary annuity
1+i) -n R=the amount of each Periodic rent
I
C = 100 N=5 I = 6%
Pv = 100 1 - 1
1+.06) 5
0.06
Pv = 100 * 4.21236
= $ 421.24 FA I U 5 14
Present Value of an ordinary annuity
0 $100 100 100
$ 262.43
Today 1 2 3
Cf
PV = 100 + 100 + 100 ……….
(1+i) –n (1+i) 1 (1+i) 2 (1+i) 3
PvA=R 1 - 1
1+i) -n
I
C = 100 N = 3 I = 7%
Pv = 100 1 - 1
1+.07) 3
0.07
Pv = 100 * 2.6243157
= $ 262.43 FA I U 5 15
Present value of an ordinary annuity
Ex: ERA company has outstanding a Br. 500,000 non interest bearing debt,
payable Br. 100,000 a year for five years starting on December 31, year 1.
A. what is the present value of this debt on January 1, year 1, for financial
accounting, if 8% compounded annually is considered a fair rate of
interest?
B. Prepare loan amortization schedule
Solu: A) 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 at Br. 399,271
(Br. 100,000 x 3.99271) in the accounting records on January 1, year 1.
P v A = R [ 1- (1/(1+i)-n /i] [1-.68058]=0.3194168/0.08 *100000=399,271
100000 [ 1 - 1 ] = 100000 [0.3194168] = 100000 * 3.99271
(1+0.08)5 (0.08) = 399,271
0.08
B) Dec. 31, year 1 [ 1 ] = 0.68058*100000=68058
(1+0.08)5
Dec. 31, year 2 [ 1 ] = 0.73503*100000=73503
(1+0.08)4 FA I U 5
16
The repayment program (loan amortization table) for this debt is summarized below
ERA Company
Repayment program for Debt of Br. 399,271 at 8% interest
Date Interest Repayment Net Debt
Expense at at end of reduction in balance
8% a year year debt
Jan. 1, y1 Br. 399,271
Dec. 31, y 1 31,942 100,000 68,058 331, 213
Dec. 31, y 2 26,497 100,000 73,503 257,710
Dec. 31, y 3 20,617 100,000 79,383 178,327
Dec. 31, y 4 14,266 100,000 83,734 92,593
Dec. 31, y5 7,407 100,000 92,593 -0-
FA I U 5 17
Future Value of an Ordinary annuity
Future Value S of an Ordinary annuity used to accumulate funds is giving by
S = R ( 1+i) n - 1 Where R = is the payment at the end of each period
i i = the interest rate per period
N = the number of periods
Example Suppose that at the end of each year, for the next 10 years, $500 is
deposited in a savings account paying 7% interest compounded annually. This
example of an ordinary annuity.
(a) How much is in the account at the end of the 10 years ? (i.e. The future value)
Solution:- S = 500 ( 1+.07) 10 - 1 S (Fv) = $ 6908.22
.07
(b) How much money would have to deposited one lump sum today ( at the same
compounded interest rate) in order to produce exactly the same balance at the
end of 10 years? ( this called the present value of annuity).
Solution:- A= future value P= Principal present value
A = P (1+i) n 6908.22 = P (1.07) 10 P = 6908.22 / (1.07) 10 = $ 3511.79
FA I U 5 18
Future Value of an Ordinary annuity
Payments = $ 1000
Interest Rate = 5 %
Number of periods = 5 Years
0 1 2 3 4 5
$ 1000 $ 1000 $ 1000 $ 1000 $ 1000
= $ 1000 * (1.05) 0 = $ 1000.00
= $ 1000 * (1.05) 1 = $ 1050.00
= $ 1000 * (1.05) 2 = $ 1102.50
= $ 1000 * (1.05) 3 = $ 1157.63
= $ 1000 * (1.05) 4 = $ 1215.51
Future Value of an Ordinary annuity $5525.64
FA I U 5 19
