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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 Principal Interest earned amount Cumulative amount


1 200,000 40,000 (20% of 200,000) 240,000
2 200,000 40,000 (20% of 200,000) 280,000
3 200,000 40,000 (20% of 200,000) 320,000

… 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.
Year Principal Interest earned amount Cumulative amount
1 200,000 40,000 (20% of 200,000) 240,000
2 240,000 48,000 (20% of 240,000) 280,000
3 288,000 57,600(20% of 288,000) 345,600

… etc.

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 Discount factor Present value


Year 1 10,000 0.9091 9,091
Year 2 10,000 0.8264 8,264
Year 3 10,000 0.7513 7,513
Year 4 10,000 0.6830 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, Semi-
annually 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 Martín 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 −
r·PV = 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. PV is the value at time=0
2. FV is the value at time=n
3. i is the rate at which the amount will be compounded each period
4. 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 is a charge for borrowing money, usually stated as a
Interest percentage of the amount borrowed over a specific period of
time. Simple interest is computed only on the original amount
• Simple borrowed. It is the return on that principal for one time period.
In contrast, compound interest is calculated each period on the
• Compound original amount borrowed plus all unpaid interest accumulated
to date. Compound interest is always assumed in TVM
problems.

Periods are evenly-spaced intervals of time. They are


Number of Periods 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 are a series of equal, evenly-spaced cash flows. In


Payments TVM applications, payments must represent all outflows
(negative amount) or all inflows (positive amount).

Present Value is an amount today that is equivalent to a future


Present Value payment, or series of payments, that has been discounted by an
appropriate interest rate. The future amount can be a single sum
• Single Amount 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
• Annuity time value, the present value of a promised future amount is
worth less the longer you have to wait to receive it.

Future Value is the amount of money that an investment with a


Future Value fixed, compounded interest rate will grow to by some future
date. The investment can be a single sum deposited at the
• Single Amount beginning of the first period, a series of equally-spaced payments
(an annuity), or both. Since money has time value, we naturally
• Annuity 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.