FINANCIAL MANAGEMENT

CHAPTER THREE
TIME VALUE OF MONEY
Chapter Outlines
3.1 Introduction
3.2 Definition of Terminologies in the Time Value of Money
3.3 Cash Flow Diagrams/Time Lines
3.4 Interest
3.5 Present and Future Value of a Single Sum
3.5.1 Present value of a single amount
3.5.2 Future value of a single amount
3.5.3 Number of Periods
3.5.4 Rate of Return (Interest Rate)
3.6 Present and Future value of Annuity Payments
3.6.1 Present value of annuities
3.6.1.1 Present value of an ordinary annuity
3.6.1.2 Present value of an annuity due
3.6.2 Future value of annuity
3.6.2.1 Future value of an ordinary annuity
3.6.2.2 Future value of an annuity due
3.6.3 Calculating payments (Annuity)
3.6.4 Calculating for interest rate
3.6.5 Calculating for the number of payments
3.6.6 Present value of perpetuity
3.6.7 Uneven cash flow streams
3.7 Loan Amortization
3.8 Using Spreadsheet for Time Value of Money Calculation
3.9 Solved Problems
3.10 Chapter Review
3.11 Chapter Review Questions
Chapter Learning Objectives
After successful completion of this chapter the students should able to:
 Explain the reasons for the time preference.
 Define different terminologies used in time value of money.
 Plot the cash flow diagrams.
 Calculate effective annual rate.
 Discuss on interest
 Evaluate & understand what present and future value of a single sum.
 Evaluate & understand what present and future value of annuity payments.
 Solve time value of money using calculator, computer-spreadsheet and manual system.

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3.1 Introduction
In Chapter 1 we saw that the primary objective of financial management is to maximize the value
of a firm’s stock. We also saw that stock values depend on the timing of the cash flows investors
expect from an investment – a dollar expected sooner is worth more than a dollar expected
further. Therefore, it is essential for financial managers to understand the time value of money
and its impact on stock prices. In this chapter we will explain exactly how the timing of cash
flows affects asset values and rates of return. The principles of time value analysis have many
applications, including retirement planning, loan payment schedules, and decisions to invest (or
not) in new equipment. In fact, of all the concepts used in finance, none is more important than
the time value of money (TVM), also called discounted cash flow (DCF) analysis.
Suppose, for instance, you were offered the choice of receiving Br 1,000 today or Br 1,000 one
year from now, like most people your preference would probably be for the Br 1,000 now. You
probably didn’t even have to think about your answer; your response, like that of most people,
was probably instinctive. However let us now explore more formally the reasons why most of us
have this time preference.
A. Risk- there is no risk associated with the Br 1,000 if it is to be received today, Br 1,000 to be
received one year from now is much uncertain - a bird in the hand as the proverb goes.
B. Preference to current consumption – there is what economists call personal consumption
preference, most people prefer to spend or consume now rather than at some less certain time
in the future.
C. Availability of investment opportunities – perhaps the most relevant for our purposes, is
that there always exists alternative investment opportunities: you can decide to forgo present
consumption, accept some risk and invest the Br 1,000 with the aim of increasing its value
(and your wealth) in a year’s time. Thus the sum of Br 1,000 to be received one year from
today (ignoring inflation), is worth less than the same Br 1,000 received today. If you had the
Br 1,000 today you would have the opportunity to invest it, perhaps in an interest-bearing
deposit account paying a rate of interest of say 10 per cent per year, so that in one year’s time
your initial Br 1,000 would be worth Br 1,100. If 10 per cent is the best rate of return you can
get in the market for investments of this type, then you would in fact be indifferent between
receiving the Br 1,000 today or receiving Br 1,100 a year from now.
D. Inflation - you may have wondered about the role inflation plays in the time value of money.
It is certainly the case that in times of inflation the value of money is eroded. Expressed in
terms of its purchasing power, the same nominal amount of money will purchase less goods
and services over time. This is another reason for rational individuals prefer money today
rather than sometime in the future.
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. The time value of money shows
mathematically how the timing of cash flows, combined with the opportunity costs of capital,
affects asset values. A thorough understanding of these concepts gives a financial manager,
powerful tool to maximize wealth.
The time value of money serves as the foundation for all other notions in finance. It impacts
business finance, consumer finance and government finance.

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3.2 Definition of Terminologies in the Time Value of Money

A key concept of TVM is that a single 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. Translating a value to the present is referred to as discounting. Translating a
value to the future is referred to as compounding or accumulating. In order to determine the
time values of money, the factors/components required are: interest rate, number of periods,
payments, Present value, and future value. Each of these factors is very briefly defined below.
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.
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.
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 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 is an amount today that is equivalent to a future payment or series of payments,
which 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 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.
You can calculate the fifth value if you are given any four of: Interest Rate, number of periods,
Payments, present value, and future value.
3.3 Cash Flow Diagrams/Time Lines
A cash flow diagram is a picture of a financial problem that shows all cash inflows and outflows
plotted along a horizontal time line. It can help you to visualize a financial problem and to
determine if it can be solved using TVM methods. The first step in a time value analysis is to set
up a time line to help you visualize what’s happening in the particular problem. To illustrate,
consider the following diagram, where PV represents $100 that is in a bank account today and
FV is the value that will be in the account at some future time (3 years from now in this
example):
Periods 0 1 2 3

Cash PV=$100 FV=?

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The intervals form 0 to 1, 1 to 2, and 2 to 3 are time periods such as years or months. Time 0 is
today, and it is the beginning of period 1; Time 1 is one period from today, and it is both the end
of period 1 and the beginning of period 2; and so on. In our example the periods are years, but
they could also be quarters or months or even days. Note again that each tick mark corresponds
to both the end of one period and the beginning of the next one. Thus, if the periods are years,
the tick mark at Time 2 represents both the end of year 2 and the beginning of year 3.
Cash flows are shown directly below the tick marks, and the relevant interest rate is shown just
above the time line. Unknown cash flows, which you are trying to find, are indicated by question
marks. Here the interest rate is 5%; a single cash outflow, Br 100, is invested at Time 0; and the
time-3 value is unknown and must be found.
In this example, cash flows occur only at Times 0 and 3, with no flows at Times 1 or 2. We will,
of course, deal with situations where multiple cash flows occur.
Note also that in our example the interest rate is constant for all 3 years. The interest rate is
generally held constant, but if it varies then in the diagram we show different rates for the
different period.
The time line is a horizontal line divided into equal periods such as days, months, or years. Each
cash flow, such as a payment or receipt, is plotted along this line at the beginning or end of the
period in which it occurs. Funds that you pay out such as savings deposits or lease payments are
negative cash flows that are represented by arrows which extend downward from the time line
with their bases at the appropriate positions along the line. Funds that you receive such as
proceeds from a mortgage or withdrawals from a saving account are positive cash flows
represented by arrows extending upward from the line.
Example3.1: you are 40 years old and have accumulated $ 50,000 in your savings account. You
can add $100 at the end of each month to your account which pays an annual interest rate of 6%
compounded monthly. Will you be able to retire in 20 years? ?

Interest Rate= 6%

0 1 2 3 238 239 240

After 20 Years
-100 -100 -100 -100 -100 -100

50,000
The time line is divided into 240 monthly periods (20 years times 12 payments per year) since
the payments are made monthly and the interest is also compounded monthly. The $ 50,000 that
you have now (present value) is a negative cash outflow since you will treat it as though you
were just now depositing it into the account. It is represented with a downward pointing arrow
with its base at the beginning of the first period. The 240 monthly $100 deposits are also
negative outflows represented with downward pointing arrows placed at the end of each period.
Finally you will withdraw some unknown amount (the future value) after 20 years. Represent
this positive inflow with an upward pointing arrow with its base at the very end of the last
period.
This diagram was drawn from your point of view. From the bank’s point of view, the present
value and the series of deposits are positive cash inflows, and the final withdrawal of the future
value will be a negative outflow.

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3.4 Interest
Interest is the cost of borrowing money. An interest rate is the cost stated as a percent of the
amount borrowed per period of time, usually one year. Interest is the compensation for the
opportunity cost or funds, compensation for inflation and the uncertainty of repayment of the
amount borrowed; that is it, represents both the price of time and the price of risk. The price of
time is compensation for the opportunity cost of funds and the price of risk is compensation for
bearing risk. The prevailing market rate is composed of:
1. The Real Rate of Interest that compensates lenders for postponing their own spending
during the term of the loan.
2. An inflation premium to offset the possibility that inflation may erode the value of the
money during the term of the loan. A unit of money (Birr, dollar, euro, etc) will purchase
progressively fewer goods and services during a period of inflation, so the lender must
increase the interest rate to compensate for that loss.
3. Various Risk Premiums to compensate the lender for risky loans such as those that are
unsecured made to borrowers with questionable credit ratings, or illiquid loans that the
lend may not be able to readily resell. The first two components of the interest rate listed
above, the real rate of interest and an inflation premium, collectively are referred to as
the nominal risk-free rate. Nominal risk-free rate can be approximated by the rate of
treasury bills since they are generally considered to have a very small risk. The sum of
the three components stated is known as nominal interest rate.
Simple Interest
Interest is compound interest if interest is paid on both the principal and any accumulated
interest. Most financial transactions involve compound interest, though there are a few consumer
transactions that use simple interest (that is, interest paid only on the principal or amount
borrowed). Simple interest is calculated on the original principal only. Accumulated interest
from prior periods is not used in calculations for the following periods; simple interest is
normally used for a single period of less than a year, such as 30 or 60 days. Mathematically
simple interest is calculated using:
Simple Interest = P*k*n
Where: p = principal (original amount borrowed or loaned)
k = interest rate for one period
n = number of periods
Maturity value/ Future value = Principal + Interest = P+P*k*n=P (1+ (k*n))
Example 3.2: You borrow Br 10,000 for 3 years at 5% simple annual interest.
Interest = p*k*n = 10,000 * .05 * 3 = 1,500
Example 3.3: You borrow Br 10,000 for 60 days at 5% simple interest per year (assume a 365
day in a year).
Interest = p * k * n = 10,000 * .05 * (60/365) = 82.19
Compound Interest
Compound interest is calculated each period on the original principal and all interest
accumulated during past periods. Although the interest may be stated as a yearly rate, the
compounding periods can be yearly, semi-annually, quarterly, or even continuously.
You can think of compound interest as a series of back-to-back simple interest contracts. The
interest earned in each period is added to the principal of the previous period to become the
principal for the next period.

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Example 3.4: You borrow Br 10,000 for three years at 5% annual interest compounded
annually:
Interest year 1 = p * k * n = 10,000 * .05 * 1 = 500
Interest year 2 = (p2 = p1 + k1) * k * n = (10,000 + 500) * .05 * 1 = 525
Interest year 3 = (p3 = p2 + k2) * k * n = (10,500 + 525) * .05 * 1 = 551.25
Total interest earned over the three years = 500 + 525 + 551.25 = 1,576.25. Compare this to
1,500 earned over the same number of years using simple interest. The difference Br 76.25 (Br
1,576.25-1,500) is the interest on interest.
The power of compounding can have an astonishing effect on the accumulation of wealth. Given
the principal/present value (PV), the maturity value can be calculated for non annual
compounding, semiannual, quarterly, monthly, and daily and etc. compounding frequency, using
the formula:
FV = PV (1 + k/m) mn where: - m – Number of compounding per year
n – Number of years
In the extreme case, interest can be compounded continuously. Continuous compounding
involves compounding over the smallest time period imaginable (over microsecond). In this case,
m (number of compounding period) would approach infinity, and through the use of calculus, the
equation would become:
FV = PV x e k x n where: e ≈ 2.71828
Example 3.5: Determine the results, the future values, of making a one-time deposit of Br
10,000 for 10 years using 6% interest compounded;
a. Annually c. Monthly
b. Semiannually d. Continuously
Solutions:
1x10
a. FV = 10,000 X = 17,908.48
2x10
b. FV = 10,000 X = 18,061.11
12x10
c. FV = 10,000 X = 18,193.97
kxn
d. FV = PV x e = 10,000 X (2.71828)0.06x10 = 18,221.18
The future value of the present sum of money is the largest in case of continuous compounding
and the smallest in case of simple interest. You can solve a variety of compounding problems
including leases, loans, mortgages, and annuities by using the present value, future value, present
value of an annuity, and future value of an annuity formula.
Effective Annual Rate (Effective Yield)
The effective rate is the actual rate that you earn on an investment or pay on a loan after the
effects of compounding frequency are considered. To make a fair comparison between two
interest rates when different compounding periods are used, you should first convert both
nominal (stated) rates to their equivalent effective rates. So the effects of compounding can be
clearly seen. Nominal rate is the rate quoted or stated by banks, brokers and other institutions.
The effective rate of an investment will always be higher than the nominal or stated interest rate
when interest is compounded more than once per year. As the number of compounding period’s
increases, the difference between the nominal and effective rates will also increase.
To convert a nominal rate to an equivalent effective rate:
Effective Annual Rate = )m - 1
Where: k = Nominal or stated interest rate

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n = Number of compounding periods per year
Effective Annual Rate (EAR) for continuous compounding is calculated using the following
formula:
Effective Rate = e k -1 Where: e ≈ 2.71828
Example 3.6: Find out the effective annual rate of interest, if the nominal rate of interest is 12%
and is compounded:
a. Annually d. Monthly
b. Semiannual e. Continuously
c. Quarterly
Solutions:
a. (1+0.12/1)1 – 1 = 0.12 = 12%
b. (1+0.12/2)2 – 1 = 0.1236=12.36%
c. (1+0.12/4)4 – 1 = 0.1255=12.55%
d. (1+0.12/12)12 – 1 = 0.1268=12.68%
e. e k – 1 = 2.718280.12 – 1 = 0.1275 = 12.75%
Effective annual rate and nominal rate are equal for annual compounding.
3.5 Present and Future Values of a Single Sum
3.5.1 Present Value of a Single Amount
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. 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. The
difference between the two depends on the number of compounding periods involved and the
interest (discount) rate. The present value can be calculated using financial calculator or
computer (excel) or formula or interest table given at the end of this material. Using formula and
interest table, it is determined as follows:
Formula: PV = FV [1/ (1 + k) n]
Interest table: PV = FV [PVIFk,n]
Where: PV = Present Value
FV = Future Value
k = Interest Rate per period
n = Number of compounding periods
PVIF = Present Value Interest Factor for single sum. It is the present value of Br 1 at
i interest rate for over n periods. You can read the factor from interest table,
Table A, provided at the back of this material.
Example 3.7: You want to buy a house 5 years from now for Br 150,000. Assuming a 6%
interest rate compounded annually, how much should you invest today to yield Br 150,000 in 5
years?
Given: FV = 150,000
k = 0.06
n=5
Formula: PV = 150,000 [1/ (1 + .06)5] = 112,088.73*
Interest table: PV = 150,000 X PVIF0.06, 5 = 150,000 X 0.7473 = 112,095.00*
* The difference between the two is the rounding effect.
The PVIF can be read from Table A at the back of this material on the line n=5 perpendicularly
under k = 6%.

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The amount of interest to be earned on the account during the five year time is Br 37,911.27
(150,000-112,088.73).
Example 3.8: You find another financial institution that offers an interest rate of 6%
compounded semiannually. How much less can you deposit today to yield Br 150,000 in five
years?
Interest is compounded twice per year so you must divide the annual interest rate by two to
obtain a rate per period of 3%. Since there are two compounding periods per year, you must
multiply the number of years by two to obtain the total number of periods.
Given: FV = 150,000
k = .06 /2 = .03
n = 5 * 2 = 10
Formula: PV = 150,000 [1/ (1 + .03)10] = 111,614.09
Interest table: PV=150,000 X PVIFA 0.03,10 = 150,000 X 0.7441 = 111,615.00
The amount of interest to be earned on the account during the five year time is Br 38,385.91
(150,000-111,614.09). The more the discounting frequency, the less the present value of the cash
flow and the higher the interest rate to be earned.
3.5.2 Future Value of a Single Amount
Future value is the amount of money that an investment made today (the present value) will grow
to some future date. 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.
The future value of an investment is mathematically calculated as:
Formula: FV = PV (1+k) n
Interest table: FV = PV [FVIFk,n]
Where: FV = Future value
PV = present value
k = interest rate per period
n = Number of compounding periods
FVIF = Future value interest factor for single sum. It is the future value of Br 1 at k
interest rate for over n periods. For the interest factor use table B provided at the
back of this material.
Example 3.9: you can afford to put Br 10,000 in a savings account today that pays 6% interest
compounded annually. How much will you have 5 years from now if you make no withdrawals?
Given PV = 10,000
k = .06
n=5
Formula: FV = 10,000 (1+.06)5 = 13,382.26
Interest table: FV = 10,000 X FVIF0.06, 5 = 10,000 X 1.3382 = 13,382
The amount of interest to be earned on the account during the five year time is Br 3,382.26
(13,382.26-10,000).
Example 3.10: Another financial institution offers to pay 6% compounded semiannually. How
much will your Br 10,000 grow to in five years at this rate?
Interest is compounded twice per year so you must divide the annual interest rate by two to
obtain a rate per period of 3%. Since there are two compounding periods per year, you must
multiply the number of years by two to obtain the total number of periods.
Given: PV = 10,000

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k = .06/2 = .03
n = 5 * 2 = 10
Formula: FV = 10,000 (1 + 0.03)10 = 13,439.16
Interest table: FV= 10,000 X FVIF0.03, 10 = 10,000 X 1.3439 = 13,439
The amount of interest to be earned on the account during the five year time is Br 3,439.16 (13,439.16-10,000). The more the compounding
frequency, the more the futures value of the cash flow and the higher the interest rate to be earned is.
3.5.3 Number of Periods
The variable n in Time Value of Money formulas represents the number of periods. It is
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.
The interest rate and number of periods must both be adjusted to reflect the number of
compounding periods per year before using them in TVM formulas. For example, if you borrow
Br 1,000 for 2 years at 12% interest compounded quarterly, you must divide the interest rate by 4
to obtain rate of interest per period (k = 3%). You must multiply the number of years by 4 to
obtain the total number of periods (n=8).
You can determine the number of periods required for an initial investment to grow to a specified
amount by rearranging the formula for the future value:
FV = PV (1+k) n
(1+k) n= FV/PV
n=log [(FV / PV)] / log (1 + k)
Where: PV = Present Value, the amount you invested
FV = Future Value, the amount your investment will grow to
k = interest per period
Example 3.11: You put Br 10,000 into a savings account at a 9% annual interest rate
compounded annually. How long will it take to double your investment?
FV = PV (1+k) n
20,000 = 10,000 (1.09) n
(1.09) n = 2
n = Log [20,000 / 10,000] / log (1.09)
= log (2) / log (1.09) = 8 years
We have a future value interest factor (FVIF) of 2 for a 9% rate. We now need to solve for n. if
you look down the column in Table B that corresponds to 9%, you will see that a future value
factor of 1.9926 occurs at n=8 (eight periods). It will thus take about eight years, as we
calculated.
3.5.4 Rate of Return/Interest Rate
When we know the present value, future value and number of periods, we can calculate the rate
of return or the interest rate with formula or financial calculator/ excel.
FV = PV (1+k) n
(1+k) n = FV / PV
k = (FV / PV) (1/n) -1
K √
Example 3.12: suppose you can buy a security at a price of Br. 78.35 and it will pay you Br 100
after 5 years. Find the interest rate you would earn if you bought the security.
K = (100/ 78.35) (1/5) – 1 = 5%
We have a future value interest factor (FVIF) of 1.2763 (100/78.35) for over 5 years period. We now need to solve for i. if you
look horizontally the row in Table B that corresponds to n=5, you will see that a future value factor of 1.2763 occurs exactly
under 5%. Thus interest rate is 5%, as we calculated.

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3.6 Present and Future Values of Annuity Payments

An annuity is a series of equal payments or receipts that occur at evenly spaced intervals.
Leases, mortgage, rental payments and monthly receipts from a retirement account are examples.
Payments (PMT) in Time value of money formulas are a series of equal, evenly spaced cash
flows of an annuity.
Payments (PMT) must:
 be the same amount each period
 occur at evenly spaced intervals
 occur exactly at the beginning or end of each period
 be all inflows or all outflows (payments or receipts)
 represent the payment during one compounding (or discount) period
3.6.1 Present Value of Annuities
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.
3.6.1.1 Present Value of an Ordinary Annuity
The present value of an Ordinary annuity (PVoa) is the value of a stream of expected or
promised future payments that have been discounted to a single equivalent value today. It is
extremely useful for comparing two separate cash flows that differ in some way. PVoa can also
be thought of as the amount you must invest today at a specific interest rate so that when you
withdraw an equal amount each period, the original principal and all accumulated interest will be
completely exhausted at the end of the annuity.
The present value of an Ordinary annuity could be solved by calculating the present value of
each payment in the series using the present value formula for single amount and then summing
the results. A more direct formula is:

Formula:
Interest table: PVoa = PMT X [PVIFAk,n]
Where: PVoa = Present Value of an ordinary annuity
PMT = amount of each payment
k = discount rate per period
n = number of periods
PVIFA = present value interest factor for annuity. It is the present value of annuity of
Br 1 at the end of each period for over n periods at k interest rate. For the
interest factor use Table C provided at the back of this material.
Example 3.13: What amount must you invest today at 6% compounded annually so that you can
withdraw Br 5,000 at the end of each year for the next 5 years?
Given: PMT = 5,000
k = .06
n=5

Formula: PVoa =
Interest Table: PVoa = 5,000 X [PVIFA0.06, 5] = 5,000 (4.2214) = 21,062
The total interest on this plan is Br 3,938 (5,000 X 5-21,062).
3.6.1.2 Present value of an Annuity Due (PVad)
The present value of an annuity due is identical to an ordinary annuity except that each payment
occurs at the beginning of a period rather than at the end. Since each payment occurs one period

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earlier, we can calculate the present value of an ordinary annuity and then multiply the result by
(1 + k).
PVad = PVoa (l+i) or PVad = PMT [(PVIFAk, n-1) + 1]
Where
PVad = present value of an annuity due
PVoa = present value of an Ordinary annuity
K = discount rate per period
Example 3.14: Continuing with example 3.13 what amount must you invest today a 6% interest
rate compounded annually so that you can withdraw Br 5,000 at the beginning of each year for
the next 5 years?
PVoa = 21,061.82 (1.06) = 22,325.53
The present value of annuity due is larger than that of ordinary annuity, if the amount of
payment, interest rate and number of payments are the same, because each payment is discounted
back for one less period.
3.6.2 Future Value of Annuity
3.6.2.1 Future Value of an Ordinary Annuity
The Future value of an ordinary annuity (FVoa) is the value that a stream of expected or
promised future payments will grow to after a given number of periods at a specific compounded
interest. The future value of an ordinary annuity could be solved by calculating the future value
of each individual payment in the series using single amount future value formula and then
summing the results. A more direct formula is:
Formula:
Interest table: FVoa = PMT [FVIFAi,n]
Where: FVoa = Future Value of an Ordinary annuity
PMT = amount of each payment
k = interest rate per period
n = number of periods
FVIFA = Future Value Interest Factor for annuity. It is the future value of annuity of
Br 1 at the end of each period for over n periods at k interest rate. For the
interest factor use Table D provided at the back of this material.
Example 3.15: What amount will accumulate if we deposit Br 5,000 at the end of each year for
the next 5 years/ Assume an interest of 6% compounded annually. Given : PV = 5,000
k = .06
n=5
Formula: FVoa =
Interest Table: FVoa = 5,000 X [FVIFA0.06, 5] = 5,000 (5, 6371) = 28,185.50
3.6.2.2 Future value of an Annuity Due (FVad)
The future value of an annuity due is identical to an ordinary annuity except that each payment
occurs at the beginning of a period rather than at the end. Since each payment occurs one period
earlier, we can calculate the present value of an ordinary annuity and then multiply the result by
(1+k).
FVad = FVoa (1+k) or FVad = PMT [(FVIFAi, n+1)-1]
Where: FVad = future value of an annuity due
FVoa = future value of an ordinary annuity

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K = interest rate per period
Example 3.16: Continuing with example 3.15 what amount will accumulate if we deposit Br
5,000 at the beginning of each year for the next 5 years? Assume an interest of 6% compounded
annually.
FVoa = 28,185.46 (1.06) = 29,876.59
The future value of the annuity due is larger than that of ordinary annuity, if the amount of
payment, interest rate and number of payments are the same, because each payment is
compounded for an extra period.
3.6.3 Calculating Payment (Annuity)
Calculate Payments when present value is known
The present value is an amount that you have now, such as the price of property that you have
just purchased or the value of equipment that you have leased. When you know the present
value, interest rate, and number of periods of an ordinary annuity, you can solve for the payment
with this formula.

Example 3.17: You can get a Br 100,000 home mortgage at 12% annual interest rate for 20
years. Payments are due at the end of each month and interest is compounded monthly. How
much will your payments be?
Given: PVoa = 100,000, the loan amount
K = 0.01 interest per month (0.12 / 12)
n = 240 periods (12 payments per year for 20 years)

Total interest to be paid over the loan period is Br 164,216.60 (1,101.09 X 240 – 100,000)
Calculate payment when future value is known
The future value is an amount that you wish to have after a number of periods have passed. For
example, you may need to accumulate Br 20,000 in ten years to pay for college tuition. When
you know the future value, interest rate, and number of periods of an ordinary annuity, you can
solve for the payment with this formula:

Example 3.18: In 10 years, you will need Br 100,000 to pay for college tuition. Your savings
account pays 6% interest compounded monthly. How much should you save each month to reach
your goal?
Given: FVoa = 100,000, the future savings goal
k = 0.005 interest per month (.06/12)
n = 120 periods (12 payments per year for 10 years)

Total interest to be paid over the loan period of Br 26,774.80 (100,000 – 610.21 X 120)
3.6.4 Calculating for Interest Rate

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Some financial contracts and certain types of corporate investment can be described as yielding a
future sum in return for making specific number of annuity payments. The rate of return is an
important determinant in accepting or rejecting such opportunities, but rarely stated explicitly.
The implied rate can be obtained by treating the future sums as the compounding amount of the
annuity payments and solving for the interest rate by using financial calculator, spreadsheet
(excel), interest table plus interpolation or by trial and error.
Example 3.19: Three equal yearly payments of Br. 3,000 are offered in return for Br. 9,800 to be
received upon making the last annuity payment. What is the implied rate of return?
FV = PMT x FVIFA k,n
9,800 = 3000 x FVIfA k, 3
FVIfA k, 3 = 9800/3000 = 3.2667
Then look up the three payment row (n=3) in FVIFA table for the value closest to 3.2667. The
8% table value is 3.2464 and the 9% table value is 3.2781. Since the computed value of 3.2667
lies between these two table values. The implied rate of return is greater than 8% and less than
9%. Using linear interpolation and Microsoft Excel the implied interest rate approximately is
8.64%. Use Table D in the provided at the back of this material.
3.6.5 Calculating for the Number of Payments
Given the interest rate, the size of the desired final amount of present amount, and the value of
each annuity payment, the number of payments require to attain the future sum of regular
(annuity) deposits can be determined using financial calculator, spreadsheet (excel), interest table
or by trial and error.
Example 3.20: How many annual deposits of Br. 1,000 each must be made into an account
paying 6% compounded per year in order to accumulated Br. 5,500?
FV = PMT x FVIFA k,n
5,500 = 1,000 x FVIFA 6%, n
FVIFA k, 3 = 5,500/1,000 = 5.5
Then look at the 6% column in FVIFA table and read down until a table value equals or exceeds
the computed 5.5. The computed value falls between 4.3746 and 5.6371. Thus the correct answer
is 5.6371 and corresponds to a value of five payments. Given the payments are made only once a
year, four payments will yield only Br. 4,374.60; hence a fifth payment is necessary.
3.6.6 Present Value of Perpetuity
Perpetuity is an annuity with an infinite life i.e. an annuity that never stops providing its holder
with given constant cash at the end of each period. As the life of an annuity becomes infinitely
longer, the annuity discounting factor approaches an upper limit. It may be shown the limit is
1/k. The PV of a perpetuity (a perpetual annuity) formula is as follows:

Example 3.21: What is the present value perpetuity of Br. 100 per year if the appropriate
discount rate is 7%?

3.6.7 Uneven Cash Flow Streams

The definition of an annuity includes the words constant payment in other words; annuities
involve payments that are the same in every period. Although many financial decisions do
involve constant payments, other import decisions involve uneven or non-constant cash flows.
The practical example is the cash flows of projects which flow the product life cycle.
Consequently, it is necessary to extend our time value discussion to include uneven cash flow

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streams. The PV of an uneven cash flow stream is found as the sum of the PVs of the individual
cash flows of the stream. The future value of an uneven cash flow stream (sometimes called the
terminal value) is found by compounding each payment to the end of the stream and then
summing the future values.
Example 3.22: Suppose we must find the PV of the following cash flow stream, discounted at 6percent:
0 6% 1 2 3 4 5 6 7

100 200 200 200 200 0 1,000

94.34
178.00
167.92
158.42
149.45
0.00
665.06
1,413.19
PV = 100 X 0.9434 + 200 X 0.8900 + 200 X 0.8396 + 200 X 0.7921 + 200 X 0.7473 +
0X0.7050 + 1,000 X 0.6651 = 1,413.24
All we did was to apply single sum present value formula of PVIF, show the individual PVs in
the left column of the diagram, and then sum these individual PVs to find the PV of the entire
stream. The present value of a cash flow stream can always be found by summing the present
values of the individual cash flows as shown above.
However, cash flow regularities within the stream may allow the use of shortcuts. For example,
notice that the cash flows in periods 2 through 5 represent an annuity. We can use that fact to
solve the problem in a slightly different manner:
0 6% 1 2 3 4 5 6 7

100 200 200 200 200 0 1,000

94.34
693.02
653.79
0.00
665.06
1,413.19
PV = 100 X 0.9434 + 200 X 3.4651 X 0.9434 + 0 X 0.7050 + 1,000X0.6651 = 1,413.24
Cash flows during years 2 to 5 represent an ordinary annuity, and we find its PV at year 1 (one
period before the first payment). This PV (Br 693.02) must then be discounted back one more
period to get its year 0 value, Br 653.79.

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The future value of our illustrative uneven cash flow stream is Br 2,124.92:
0 6% 1 2 3 4 5 6 7

100 200 200 200 200 0 1,000

0
224.72
238.20
252.50
267.65
141.85
2,124.92
PV = 100 X 1.4185 + 200 X 1.3382 + 200 X 1.2625 + 200 X 1.1910 + X 1.1236 + 0 X 1.0600 +
1,000 X 1 = 2,124.92
Or
PV = 100 X 1.4185 + 200 X 4.3746 X 1.1236 + 0X1.0600 + 1,000 X 1 = 2,124.92
Exercises
1. Suppose you invest 1,000 in an account that pays 6% interest, compounded annually, how
much will you have in the account at the end of 5 years if you make no withdrawals? After 0
years?
2. How much would you have to deposit now to have Br 15,000 in 8 years in interest is 7%?
3. If a commodity costs Br 500 now and inflation is expected to go up at the rate of 10% per
year, how much will the commodity cost in 5 years?
4. Sutume expects an expenditure of Br 200,000 after a period of 10 years. How much should
she save annually to have the required sum after 10 years, if she invests her savings at a rat of
12%?
5. A computer dealer offers to lease a system to you for Br 500 per month for two years. At the
end of two years, you have the option to buy the system for Br 5,000. You will pay at the end
of each month. He will sell the same system to you for 1200 cash now. If interest rate is 12%,
which is the better offer?
6. You invest Br 1,500 at the end of year one, Br 2,000 at the end of the second year, and Br
5,000 each year from the third year to the tenth. Calculate the present value of the stream if
the discount rate is 10%. What is the future value at the end of the tenth year?
7. Rumana is due to retire 20 years from now. Se wants to invest a lump sum now so as to be
able to withdraw Br 10,000 every year, beginning from the end of the 20th year for 20 years.
How much should she invest now if the deposit earns a return of 12%?

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8. How many years will it take for Br 5,000 invested today at 12% rate of interest to grow to Br
160,000?
9. At the end of 6 years, Ato Thomas will start receiving a pension of Br 1,000 per month and
will keep receiving it for the next 20 years. How much can he borrow now at 10%, so that
both the principal and the interest can be paid off with 25% of the pension amount? Assume
that the interest payable- will be accumulate till the first pension is received.
10. You have borrowed Br. 14,300 at a compound annual interest rate of 15%. You feel that you
will be able to make annual payments of Br. 3,000 per year on your loan. How long will it be
before the loan is entirely paid off?
11. Dembel wishes to borrow Br. 10,000 for three years. A group of individuals agrees to lend
him this amount if the contracts to pay them Br. 16,000 at the end of the three years. What is
the implicit compound annual interest rate implied by this contract (to the nearest whole
percent).
12. Using annual, semiannual, and quarterly compounding periods, for each of the following (1)
calculate the future vale of Br 5,000 is initially deposited, and (2) determine the effective
interest rate
a) At 12 percent annual interest for 5 years
b) At 16 percent annual interest for 6 years
c) At 20 percent annual interest for 10 years
13. Assume that you just inherited at annuity that will pay you Br 10,000 per year for 10 years,
with the first payment being made today. A friend of your mother offers to give you Br
60,000 for the annuity. If you sell it to him, what rate of return will your mother’s friend earn
on the investment?
14. What is the present value of a perpetuity that pays Br 1,000 per year, beginning 1 year from
now, if the appropriate interest rate is 5%? What would the value be if the annuity began its
payments immediately?
15. What is the future value of this cash flow stream: Br 100 at the end of 1 year, Br 150 after 2
years, and Br 300 after 3 years, assuming the appropriate interest rate is 15%?

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