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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.

Learning Objective

Important Terms

• Time line

• Discounting

• Compounding

• Principal amount

• Simple interest

• Annuity

• Amortized loan

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.

This term is applied generally to a principal amount after some time

has elapsed for which interest has been calculated and added.

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.

interest per annum. The following table shows the state of the

investment, year by year:

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

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.

comparing the above two tables. Notice that the amount on which

simple interest is calculated is always the same.

Time Line

shows the timing of cash flows. In the above example for the simple

interest, the time line can be produced as:

Discounting

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.

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:

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%.

0.3521.

Annuity

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.

2. At the beginning of payment intervals (called annuity due).

2. Depend on some event that cannot be fixed ( a Contingent

annuity)

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:

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

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.

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

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

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:

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).

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

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.

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 TVM applications, payments must represent all outflows

(negative amount) or all inflows (positive amount).

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 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.

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