Time Value of Money Time Value of Money is an important concept in financial management.

It is one of the important tools used in project appraisals to compare various investment alternatives, and solve problems involved in loans, mortgages, leases, savings, and annuities. A key concept behind Time Value of Money is that a single sum of money or a series of equal, evenly spaced payments or receipts promised in the future, can be converted to an equivalent value today. Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date. The former is called Present Value of Cash Flows and the later is called Future Value of Cash Flows.

Session 4: Time Value of Money

Learning Objective Explain to the learner on the concept of time value of money. Important Terms

Time line Discounting Compounding Principal amount Simple interest Annuity Amortized loan

Time Value of Money To make itself a valuable as possible to stock holders; an enterprise must choose the best combination of decisions on investment, financing and dividends. In any economy in which individuals, firm and governments have the time preference, the time value of money is an important concept. Stockholders will pay more for an investment that promises returns over years 1 to 5 than they will pay for an investment that promises identical returns for 6 years through 10. The decision to purchase new plant and equipment or to introduce a new product in the market requires using capital allocating or capital budgeting techniques. Essentially we must determine whether future benefits are sufficiently large to justify current outlays. It is important that we develop the mathematical tools of the time value of money as the first step towards making capital allocating decisions.

Principal amount (P) This is the amount of money that is initially being considered. It might be an amount to be invested or loaned or it may refer to the initial value or cost of plant or machinery. Thus if the company was considering a bank loan of say K500,000, this would be referred to as the principal amount borrowed. Accrued amount (A) This term is applied generally to a principal amount after some time has elapsed for which interest has been calculated and added. Simple and Compound Interest When an amount of money is invested over a number of years, the interest earned can be dealt with in two ways. SIMPLE INTEREST This is where any interest earned is NOT added back to the principal amount invested. For example, suppose that K200,000 is invested at 20% simple interest per annum. The following table shows the state of the investment, year by year: Year 1 2 3 etc. COMPOUND INTEREST The notion of compound interest is central to understanding the mathematics of finance. The term itself merely implies that interest paid on loan or an investment is added to the principle. As a result, interest is earned on interest. Compounding is the arithmetic process of determining the final value of a cash flow or series of cash flow or series of cash flows when compound interest is applied. Principal Interest earned amount 200,000 200,000 200,000 40,000 (20% of 200,000) 40,000 (20% of 200,000) 40,000 (20% of 200,000) Cumulative amount 240,000 280,000 320,000

Year 1 2 3 etc.

Principal Interest earned amount 200,000 240,000 288,000 40,000 (20% of 200,000) 48,000 (20% of 240,000) 57,600(20% of 288,000)

Cumulative amount 240,000 280,000 345,600

The difference between the two methods can easily be seen by comparing the above two tables. Notice that the amount on which simple interest is calculated is always the same.

Time Line An important tool used in time value of money analysis and graphically shows the timing of cash flows. In the above example for the simple interest, the time line can be produced as:

Discounting The process of determining the present value of future cash flows. It is an important concept, which is used in project appraisals. The opportunity cost rate is the rate available on the next best alternative with same equal risk as the current investment.

Suppose money can be invested at 10%. The K200, 000 could be invested and be worth K220,000 in one years time. Put another way, the value K200,000 in one years time is exactly the same as K200,000 now.( if the investment rate is 10%). Similar K200,000 now has the value as K200,000(1.1)2 = K242,000 in two years time. To state the above ideas more precisely, if the current investment rate is 10%, then:

Appendix 1 gives tables showing the present values of the discount

factor (these are two rows marked D) for a wide range of values of i and n. these are known as discounting tables. Suppose we wanted to find the present value of K15,000 in 6 years time, subject to a discount rate of 19%. The discount factor (from the table, with D = 19% and N = 6) is 0.3521. Therefore the present value = K15,000 (0.3521) = K5281.5. Annuity Annuity is a sequence of fixed equal payments (or receipts) made over uniform time intervals. Some common examples of annuities include: weekly wages, monthly salaries, insurance premiums, hire purchase payments. Annuities are used in all areas of business and commerce. Loans are normally repaid with an annuity, investment funds are set up to meet fixed future commitments (for example, asset replacement) by the payment of an annuity. Annuities may be paid: 1. At the end of payment intervals( called an ordinary annuity) 2. At the beginning of payment intervals (called annuity due). The terms of an annuity may: 1. Begin and end on fixed dates ( a Certain annuity) 2. Depend on some event that cannot be fixed ( a Contingent annuity) A perpetuity annuity is one that carries on indefinitely. The most common form of annuities are certain and ordinary. That is the annuity is paid at the end of the payment interval and will begin and end on fixed dates. Personal loans and most domestic hire purchase are paid off in a similar manner but normally without the initial deposit. Annuities that are being invested however are often due, that is paid of in advance of the intervals The present value (PV) of an annuity could be found as for any cash flow by discounting each return individually, but there is a more economical method. Consider the case of an annuity of K10,000 that

runs for four years at 10% interest. Assume that the first payment will be made after one year. Using the discount factor table the PV is: Cash flow Year 1 Year 2 Year 3 Year 4 10,000 10,000 10,000 10,000 Discount factor 0.9091 0.8264 0.7513 0.6830 Present value 9,091 8,264 7,513 6,830 31,698 Sinking Fund A sinking fund can be defined as an annuity invested in an order to meet a known commitment at some future date. Sinking funds are usually used for the following purposes: 1. Repayment of debts. 2. To provide funds to purchase a new asset when the existing asset is fully depreciated. Example of debt repayment using a sinking fund: Here a debt is incurred over a fixed period of time, subject to a given interest rate. A sinking fund must be set up to mature to the outstanding amount of the debt. For example, if K250,000 is borrowed over three years at the rate of 12% compounded, the value of the outstanding debt at the end of third year will be K250,000(1.12)3 = K351,232. If money can be invested at 9.5%, we need to find the value of the annuity, A, which must be paid into the fund in order that it matures to K351,123. Assuming that payments into the funds are in arrears, we need:

That is the annual payment into the sinking fund is K106,627.8 (which will produce, 9.5%, K251,232 at the end of 3 years). Perpetuities A special case of an annuity is where a contract runs indefinitely and there is no end to the payments. This is called a perpetuity. Steam of equal payments expected to continue forever.

Semi annual and other compounding periods semi-annual compounding is the arithmetical process of determining the final value of determining the final value of cash flows when interest is added twice a year. A Mortised Loan Loan repaid in equal payments over its life. Installment prepayments are prevalent in mortgage loans, auto loan and consumer loans and in certain business loans. The distinguishing feature is that the loan is repaid in equal periodic payments that embody both interest and principal. These payments can be made monthly, quarterly, Semiannually or annually. The debt is said to be amortized if this method is used. Examples: A company negotiates a loan of K200,000 over 15 years at 10.5% per annum. Calculate the annual payment necessary to amortize the debt.

Interest Rates 1. Nominal rates The rate which is quoted or stated on loan or investment. 2. Effective annual rate The rate, which would produce the same ending (future), values if annual compounding had been used. 3. Periodic rate The rate charged by a lender or paid by a borrower each period. It can be rate per year, per six-month period, per quarter, per month or per day.

The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. For example, 100 dollars of today's money invested for one year and earning 5 percent interest will be worth 105 dollars after one year. Therefore, 100 dollars paid now or 105 dollars paid exactly one year from now both have the same value to the recipient who assumes 5 percent interest; using time value of money terminology, 100 dollars invested for one year at 5 percent interest has a future value of 105 dollars.[1] This notion dates at least to Martn de Azpilcueta (1491-1586) of the School of Salamanca. The method also allows the valuation of a likely stream of income in the future, in such a way that the annual incomes are discounted and then added together, thus providing a lump-sum "present value" of the entire income stream. All of the standard calculations for time value of money derive from the most basic algebraic expression for the present value of a future sum, "discounted" to the present by an amount equal to the time value of money. For example, a sum of FV to be received in one year is discounted (at the rate of interest r) to give a sum of PV at present: PV = FV rPV = FV/(1+r). Some standard calculations based on the time value of money are: Present Value The current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations[2]. Present Value of an Annuity An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period for an annuity due[3]. Present Value of a Perpetuity is an infinite and constant stream of identical cash flows[4]. Future Value is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today[5]. Future Value of an Annuity (FVA) is the future value of a stream of payments (annuity), assuming the payments are invested at a given rate of interest.

Calculations
There are several basic equations that represent the equalities listed above. The solutions may be found using (in most cases) the formulas, a financial calculator or a spreadsheet.

The formulas are programmed into most financial calculators and several spreadsheet functions (such as PV, FV, RATE, NPER, and PMT)[6]. For any of the equations below, the formula may also be rearranged to determine one of the other unknowns. In the case of the standard annuity formula, however, there is no closed-form algebraic solution for the interest rate (although financial calculators and spreadsheet programs can readily determine solutions through rapid trial and error algorithms). These equations are frequently combined for particular uses. For example, bonds can be readily priced using these equations. A typical coupon bond is composed of two types of payments: a stream of coupon payments similar to an annuity, and a lump-sum return of capital at the end of the bond's maturity - that is, a future payment. The two formulas can be combined to determine the present value of the bond. An important note is that the interest rate i is the interest rate for the relevant period. For an annuity that makes one payment per year, i will be the annual interest rate. For an income or payment stream with a different payment schedule, the interest rate must be converted into the relevant periodic interest rate. For example, a monthly rate for a mortgage with monthly payments requires that the interest rate be divided by 12 (see the example below). See compound interest for details on converting between different periodic interest rates. The rate of return in the calculations can be either the variable solved for, or a predefined variable that measures a discount rate, interest, inflation, rate of return, cost of equity, cost of debt or any number of other analogous concepts. The choice of the appropriate rate is critical to the exercise, and the use of an incorrect discount rate will make the results meaningless. For calculations involving annuities, you must decide whether the payments are made at the end of each period (known as an ordinary annuity), or at the beginning of each period (known as an annuity due). If you are using a financial calculator or a spreadsheet, you can usually set it for either calculation. The following formulas are for an ordinary annuity. If you want the answer for the Present Value of an annuity due simply multiply the PV of an ordinary annuity by (1 + i).

[edit] Formula
[edit] Present value of a future sum
The present value formula is the core formula for the time value of money; each of the other formulae is derived from this formula. For example, the annuity formula is the sum of a series of present value calculations. The present value (PV) formula has four variables, each of which can be solved for:

1. 2. 3. 4.

PV is the value at time=0 FV is the value at time=n i is the rate at which the amount will be compounded each period n is the number of periods (not necessarily an integer)

The cumulative present value of future cash flows can be calculated by summing the contributions of FVt, the value of cash flow at time=t

Time Value of Money

Introduction
Time Value of Money (TVM) is an important concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities. TVM is based on the concept that a dollar that you have today is worth more than the promise or expectation that you will receive a dollar in the future. Money that you hold today is worth more because you can invest it and earn interest. After all, you should receive some compensation for foregoing spending. For instance, you can invest your dollar for one year at a 6% annual interest rate and accumulate $1.06 at the end of the year. You can say that the future value of the dollar is $1.06 given a 6% interest rate and a one-year period. It follows that the present value of the $1.06 you expect to receive in one year is only $1. A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today. Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date. You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods, Payments, Present Value, and Future Value. Each of these factors is very briefly defined in the right-hand column below. The left column has references to more detailed explanations, formulas, and examples.

Interest

Simple Compound

Interest is a charge for borrowing money, usually stated as a percentage of the amount borrowed over a specific period of time. Simple interest is computed only on the original amount borrowed. It is the return on that principal for one time period. In contrast, compound interest is calculated each period on the original amount borrowed plus all unpaid interest accumulated to date. Compound interest is always assumed in TVM problems.

Number of Periods

Periods are evenly-spaced intervals of time. They are intentionally not stated in years since each interval must correspond to a compounding period for a single amount or a payment period for an annuity.

Payments

Payments are a series of equal, evenly-spaced cash flows. In TVM applications, payments must represent all outflows (negative amount) or all inflows (positive amount).

Present Value

Single Amount Annuity

Present Value is an amount today that is equivalent to a future payment, or series of payments, that has been discounted by an appropriate interest rate. The future amount can be a single sum that will be received at the end of the last period, as a series of equally-spaced payments (an annuity), or both. Since money has time value, the present value of a promised future amount is worth less the longer you have to wait to receive it.

Future Value

Single Amount Annuity

Future Value is the amount of money that an investment with a fixed, compounded interest rate will grow to by some future date. The investment can be a single sum deposited at the beginning of the first period, a series of equally-spaced payments (an annuity), or both. Since money has time value, we naturally expect the future value to be greater than the present value. The difference between the two depends on the number of compounding periods involved and the going interest rate.