Financial Management chapter -3: Time Value of Money

Chapter Three
Time Value of Money

Chapter objectives
At the end of this unit, students will be able to:
 explain the meaning of time value of money
 understand future value and present value
 calculate the future and present values
Introduction
The time value of money is a very important concept in financial management. It has many
applications in financial decisions like loan settlements, investing in bonds and stocks of other
entities, acquisition of plant and equipment. Therefore, understanding the time value of money
concept is essential for a financial manager to achieve the wealth maximization goal of a firm.
3.1 The concept of time value of money
If an individual behaves rationally, he or she would not value the opportunity to receive specific
amount now equally with the opportunity to have the same amount at some future date. Most
individuals value the opportunity to receive money now higher than waiting for one or more
periods to receive the same amount. Time preference for money is an individual’s preference
for possession of a given amount of money now, rather than the same amount at some future
time. Three reasons may be attributed to the individual’s time preference for money.
 Risk: we live under uncertainty, as an individual is not certain about future cash receipts;
he or she prefers receiving cash now.
 Preference for consumption: most people have subjective preference for present
consumption over future consumption of goods and service either because of the urgency
of their present wants or because of the risk of not being in a position to enjoy future
consumption that may be caused by illness or death, or because of inflation. As money is

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Financial Management chapter -3: Time Value of Money

the means by which individuals acquire most goods and services, they may prefer to have
money now.
 Investment opportunities: further, most individual’s present cash to future cash because
of the available investment opportunities to which they can put present cash to earn
additional cash.
3.2 Interest
Interest is the price paid for the use of a sum of money over a period of time. It is a fee paid for
the use of another’s money, just rent is paid for the use of another’s house.
A savings institution (Banks) pays interest to depositors on the money in the savings account
since the institutions have use of those funds while they are on deposit. On the other hand, a
borrower pays interest to a lending agent (bank or individual) for use of the agent’s fund over
the term of the loan.

Interest is usually computed as percentage of the principal over a given period of time. This is
called interest rate. Interest rate specifies the rate at which interest accumulates per year
throughout the term of the loan. The original sum of money that is lent or invested/ borrowed is
called the principal.

 In general, interest is the difference between money now and the same money in the
future is called interest.
Interests are of two types: simple interest and compound interest. In the first part of this unit
we shall explore these two concepts.
3.2.1 Simple Interest
If interest is paid on the initial amount of money invested or borrowed only and not on
subsequently accrued interest, it is called simple interest. The sum of the original amount
(principal) and the total interest is the future amount or maturity value or in short amount.
Simple interest generally used only on short-term loans or investments –often of duration less
than one year. Simple interest is given by the following formula.

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Financial Management chapter -3: Time Value of Money

I = prt Where: I = Simple interest

P = principal amount

r = Annual simple interest rat

t = time in years, for which the interest is paid

Example 1
Ato Kassahun wanted to buy TV which costs Br. 10, 000. He was short of cash and went to
Commercial Bank of Ethiopia (CBE) and borrowed the required sum of money for 9 months at
an annual interest rate of 6%. Find the total simple interest and the maturity value of the loan.

Solution:
p = Br. 10,000 A=P+I
t** = 9 months = 9/12 = ¾ (0.75) year = P (1 + rt)

r = 6% per year = 0.06 = 10, 000 (1 + 0.06 x ¾)

I=? A=? = 10, 000 x 1.045

Interest (I) = Prt = Br. 10, 450

= 10, 000 x 0.06 x ¾

= Br. 450

The total amount which will have to be repaid to CBE at the end of the 9 th month is Br.
10, 450 (the original borrowed amount plus Br. 450 Interest).

** Note: It is essential that the time period t and r be consistent with each other. That is if r is
expressed as a percentage per year, t also should be expressed in number of years
(number of months divided by 12 if time is given as a number of months). If time is given
No .ofdays
as a number of days, then t = 360 days . this approach is known as ordinary interest

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Financial Management chapter -3: Time Value of Money

year method which uses a 360 day years, whereas if we use 365 days years the approach
is called exact time method.

Example 2
How long will it take if Br. 10, 000 is invested at 10% simple interest to double in value?
Solution
Given: p = Br.10, 000 I = prt Divide both sides of
r = 10% = 0.10
the equation by pr and
A = Br.20, 000 (2 x 10, 000) t = I*/pr
10,000
t=? = 10,000 (0.10)
= 10 Years
I* = Amount (A) – principal (p)

= 20, 000 – 10, 000

= 10,000

Therefore it will take 20 years for the principal (Br. 10, 000) to double itself in value if it is
invested at 10% annual interest rate.
Example 3
How much money you have to deposit in an account today at 3% simple interest rate if you are
to receive Br. 5, 000 as an amount in 10 years?
Solution
A = Br. 5, 000
A
t = 10 Years
P = 1 + rt
r = 3% = 0.03
5 ,000
= 1 + ( 0.03 x 10)

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Financial Management chapter -3: Time Value of Money

= Br. 3, 846.15

In order to have Br. 5, 000 at the end of the 10 th year, you have to deposit Br. 3846.15 in an
account that pays 3% per year.
Example 4.
At what interest rates will Br. 5, 000 yield Br. 2, 000 in 8 years time.
Solution:
P = Br. 5, 000 r = I/pt
2, 000
I = Br. 2, 000 = 5, 000 x 8
t = 8 years = 0.05 = 5%
r=?
Example 5

Find the Interest on Br. 5, 000 at 10% for 45 days.

Solution:
P = Br. 5, 000 I = Prt

t = 45 days = 45/360 years = 5, 000 x 0.1 x 45/360

r = 10% = 62.50 Br.

I=?

4.2.2 Compound Interest

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Financial Management chapter -3: Time Value of Money

If the interest, which is due, is added to the principal at the end of each interest period (such as a
month, quarter, and year), then this interest as well as the principal will earn interest during the
next period. In such a case, the interest is said to be compounded.
 The result of compounding interest is that starting with the second compounding period,
the account earns interest on interest in addition to earning interest on principal during the
next payment period.
 Interest paid on interest reinvested is called compound interest.
 The sum of the original principal and all the interest earned is the compound amount.
 The difference between the compound amount and the original principal is the compound
interest.
The compound interest method is generally used in long-term borrowing unlike that of the
simple interest used only for short-term borrowings.
The time interval between successive conversions of principal into interest is called the interest
period, or conversion period, or Compounding period, and may be any convenient length of
time.
The interest rate is usually quoted as an annual rate and must be converted to appropriate rate
per conversion period for computational purposes. Hence, the rate per compound period (i) is
found by dividing the annual nominal rate (r) by the number of compounding periods per year
(m):i = r/m
Example if r = 12%, i is calculated as follows:
Conversion period (m) Rate per compound period (i)
1. Annually (once a year) -------------------------------- i = r/1 = 0.12/1 = 0.12

2. Semi annually (every 6 months) --------------------- i = r/2 = 0.12/2 = 0.06

3. Quarterly (every 3 months) -------------------------- i = r/4 = 0.12/4 = 0.03

4. Monthly ------------------------------------------------- i = r/12 = 0.12/12 = 0.01

Example 1

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Financial Management chapter -3: Time Value of Money

Assume that Br. 10, 000 is deposited in an account that pays interest of 12% per year,
compounded quarterly. What are the compound amount and compound interest at the end of
one year?
Solution
P = Br. 10, 000
r = 12%
t = 1 year
m = No. of conversion periods = 4 times per quarter. This means interest will be computed at
the end of each three month period and added in to the principal.

i = r/m 12%/4 = 3%
The compound amount formulas
1. Compound amount after one period = p (1 + i)1
2. Compound amount after two periods = p (1 + i)2
3. Compound amount after three periods = p (1 + i)3
4. Compound amount after nth periods = p (1 + i)n
The above formula is tedious so using the following formula is important:
A = P (1 + i)n
Where: A = amount (future value) at the end of n periods.
P = Principal (present value)
i = r/m = Rate per compounding period.
n = mt = total number of conversion periods
t = total number of years
m = number of compounding/ conversion periods per year
r = annual nominal rate of interest
Now let us solve the above problem.
A = 10, 000 (1.03)1 = Br. 10, 300……..1st quarter

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Financial Management chapter -3: Time Value of Money

A = [10, 000 (1.03)] (1.03) = 10, 000 (1.03)2 = 10, 609 …….2nd quarter.

A = [10, 000 (1.03)2] (1.03) = 10, 000 (1.03)3 = 10, 927.27 …….3rd quarter.

A = [(10, 000) (1.03)3] (1.03) = 10, 000 (1.03)4 = 11, 255.088 ……..4th quarter.
In general, the compound amount can be found by multiplying the principal by (1 + i) n. So for
the above problem the amount at the end of the year, using the general formula, is equal to:
A = P (1 + i)n n = mt = 4 x 1 = 4

= 10, 000 (1.03)4 i = r/m = 12%/4 = 3%

= Br. 11, 255.088

Compound Interest = Compound amount – original principal

= 11, 225.088 – 10, 000
= Br. 1, 255.088

Example 2 Find the compound amount and compound interest after 10 years if Br. 15, 000 were

invested at 8% interest;
a) If compounded annually
Compounding annually means that there is one interest payment period per year. Thus
t = 10 years
m=1
n = mt = 1 x 10 = 10
i = r/m = 8 %/1 = 8% = 0.08
The compound amount will be:
A = 15, 000 (1.08)10
= 15, 000 (2.158925)
= Br. 32, 383.875
 Compound Interest = compound amount (A) – Principal (P)

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Financial Management chapter -3: Time Value of Money

= 32, 383.875 – 15, 000

= Br. 17, 383.875

b) If compounded semiannually
Compounding semiannually means that there are two interest payment periods per year. Thus,
the number of payment periods in 10 years n = 2 x 10 = 20 and the interest rate per conversion
period will be i = r/m = 8%/2 = 4%. The compound amount then will be:

A = P (1 + i)n
= 15, 000 (1.04)20
= 15, 000 (2.191123
= Br. 32, 866.85
Compound Interest = A – P
= 32, 8666.85 – 15, 000
= Br. 17, 866.85
c) If Compounded quarterly
If compounding takes place quarterly (four times a year), then an 8% annual interest rate, the
interest rate per conversion period will be i = 0.08/4 = 0.02, there will be a total of n = 4 x 10
= 40 conversion periods over the 10 years. The compound amount will be:
A = 15, 000 (1.02)40
= 15, 000 (2.208039)
= Br. 33, 120.60
d) If compound monthly
p = 15, 000
t = 10 years
m = 12 (12 payment periods per year)
n = 12 x 10 = 120 payment periods over the 10 years

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Financial Management chapter -3: Time Value of Money

i = r/m = 8%/12 = 0.667% = 0.00667

Under these conditions:
A = 15, 000 (1. 00667)120
= 15, 000 (2.220522)
= Br. 33, 307.84
Interest = Br. 18, 307.84 (33,307.84 – 15,000)
3.2 Future value (compounding)
To understand future value, we need to understand compounding first. Compounding is a
mathematical process of determining the value of a cash flow or cash flows at the final period.
The cash flow(s) could be a single cash flow, an annuity or uneven cash flows. Future value
(FV) is the amount to which a cash flow or cash flows will grow over a given period of time
when compounded at a given interest rate. Future value is always a direct result of the
compounding process.

3.2.1 Future Value of a Single Amount

This is the amount to which a specified single cash flow will grow over a given period of time
when compounded at a given interest rate. The formula for computing future value of a single
cash flow is given as:
FVn = PV (1 + i)n
Where:

FVn = Future value at the end of n periods

PV = Present Value, or the principal amount

i = Interest rate per period

n= Number of periods

Example: Hana deposited Br. 1,800 in her savings account now. Her account earns 6 percent
compounded annually. How much will she have after 7 years?

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Financial Management chapter -3: Time Value of Money

To solve this problem, let’s identify the given items: PV = Br, 1,800; i = 6%; n = 7
FVn = PV (1 + i)n

= Br. 1,800 (1.06)7

= Br. 2,706.53

Exercise
Suppose you want to deposit Br. 100 in Dashen bank at 10% interest what would be amount
after 3 years?
Solution
FVn = PV (1 + i)n
= Br. 100 (1.1)3

= Br. 133.1

3.2.2 Future Value of an Annuity

An annuity is a series of equal periodic rents (receipts, payments, withdrawals, and deposits)
made at fixed intervals for a specified number of periods. For a series of cash flows to be an
annuity four conditions should be fulfilled.
I. First, the cash flows must be equal.
II. Second, the interval between any two cash flows must be fixed.
III. Third, the interest rate applied for each period must be constant.
IV. Last but not least, interest should be compounded during each period. If any one of these
conditions is missing, the cash flows cannot be an annuity.
Basically, there are two types of annuities namely ordinary annuity and annuity due:
a. Ordinary annuity,
b. Annuity due, and
i) Future value of an Ordinary Annuity – An ordinary annuity is an annuity for which the cash
flows occur at the end of each period. Therefore, the future value of an ordinary annuity is the
amount computed at the period when exactly the final (nth) cash flow is made.

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Financial Management chapter -3: Time Value of Money

The future value is computed at point n where PMTn is made.

[ ]
n
(1+i) − 1
FVAn = PMT i

Where:
FVAn = Future value of an ordinary annuity
PMT = Periodic payments
i = Interest rate per period
n = Number of periods
Example1: You need to accumulate Br. 25,000 to acquire a car. To do so, you plan to make
equal monthly deposits for 5 years. The first payment is made a month from today, in a bank
account which pays 12 percent interest, compounded monthly. How much should you deposit
every month to reach your goal?

Given: FVAn = Br. 25,000; i = 12%  12 = 1%; n = 5 x 12 = 60 months; PMT = ?

FVAn = PMT (FVOA factor)

[ ]
n
(1+i) − 1
FVAn = PMT i

[ ]
60
(1+0 .01 ) − 1
Br. 25,000 = PMT 0 . 01

 Br. 25,000 = PMT [81.670]
 PMT = Br. 25,000/81.670
 PMT = Br. 306.11
Example 2. Mr X. Deposits Br. 100 in a special savings account at the end of each month. If
the account pays 12%, compounded monthly, how much money, will Mr. X have
accumulated just after 15th deposit?

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Financial Management chapter -3: Time Value of Money

Solution:

A= PMT
R = Br. 100
[
(1 + i )n − 1
i ] A = PMT
[
(1 + i)n − 1
1 ]
n = 15
r = 12%
= 100 0.01[
(1.01)15 − 1
]
= 100 (16.096896)
m = 12
Br. 1609.69
i = r/m = 12%/12 = 1%
A=?

ii) Future value of an Annuity Due. An annuity due is an annuity for which the payments
occur at the beginning of each period. Therefore, the future value of an annuity due is computed
exactly one period after the final payment is made.

The future value of an annuity due is computed at point n where PMTn + 1 is made and it is

computed by: = PMT

[
(1+i)n − 1
i ]
( 1 + i)

Example: Assume that pervious example except that the first payment is made today instead of
a month from today. How much should your monthly deposit be to accumulate Br.
25,000 after 60 months?

FVAn (Annuity due) = PMT

(1+i)n − 1
i [
(1+i)
]
 Br. 25,000 = PMT
[
(1+0 .01 )60 − 1
0. 01 ]
(1 + 0.01)
 Br. 25,000 = PMT (81.670) (1.01)

 PMT = Br. 25,000/82.487

 PMT = Br. 303.08

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Financial Management chapter -3: Time Value of Money

Example 2 Mr X. Deposits Br. 100 in a special savings account at the beginning of each month.
If the account pays 12%, compounded monthly, how much money, will Mr. X have
accumulated just after 15th deposit?
Solution:

A= PMT
[
(1 + i )n − 1
i
PMT = Br. 100
] A = PMT
[ 1 ]
(1 + i)n − 1
(1+i)

[ ]
15
(1.01) − 1
n = 15
= 100 0.01 (1+0.01)
r = 12%
m = 12 = 100 (16.096896)(1+0.01)
i = r/m = 12%/12 = 1% Br. 1625.75
A=?

3.3 Present value (Discounting)

Present value is the exact reversal of future value. It is the value today of a single cash flow, an
annuity or uneven cash flows. In other words, a present value is the amount of money that
should be invested today at a given interest rate over a specified period so that we can have the
future value. The process of computing the present value is called discounting.

3.3.1 Present Value of a Single Amount

It is the amount that should be invested now at a given interest rate in order to equal the future
value of a single amount.

( )
n
FVn 1
= FVn
PV = ( 1+i )
n 1+i

Where: PV = Present Value

FVn = Future value at the end of n periods

i = Interest rate per period

n = Number of periods

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Financial Management chapter -3: Time Value of Money

Example: Zelalem PLC owes Br. 50,000 to Always Co. at the end of 5 years. Always Co. could
earn 12% on its money. How much should Always Co. accept from Zelalem PLC as of today?

Given: FV5 = Br. 50,000; n = 5 years; i = 12%; PV =?

( ) ( 1 + 10.12 )5
n
PV = FVn 1 50000
1+i
= Br. 50,000 (0.5674) = Br. 28,370

3.3.2 Present Value of an Annuity

i) Present value of an Ordinary Annuity is a single amount of money that should be invested
now at a given interest rate in order to provide for an annuity for a certain number of future
periods.

PVOA = PMT
= PMT
i [
1− ( 1 + i )−n
]
Where:
PVOA = The present value of an ordinary annuity

Example: Ato Mengesha retired as general manager of Tirusew Foods Company. But he is
currently involved in a consulting contract for Br. 35,000 per year for the next 10
years. What is the present value of Mengesha’s consulting contract if his opportunity
costs is 10%?
Given: PMT = Br. 35,000; n = 10 years; i = 10%; PVAn = ?

[ ]
−10
1− ( 1 + 0.1)
= 35000
PVA10 0.1

= Br. 35,000 (6.1446) = Br. 215,061.

This means if the required rate of return is 10%, receiving Br. 35,000 per year for the next 10
years is equal to receiving Br. 215,061 today.

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Financial Management chapter -3: Time Value of Money

ii) Present value of an Annuity Due – is the present value computed where exactly the first
payment is to be made and it is determined by:
The present value of an annuity due is computed at point 1 while the present value of an
ordinary annuity is computed at point 0.

PVAn = (Annuity due) = PMT i [

1 −(1+i)−n
]
(1 + i) = PMT (PVIFAi, n) (1 + i)
Example: Ruth Corporation bought a new machine and agreed to pay for it in equal
installments of Br. 5,000 for 10years. The first payment is made on the date of purchase, and
the prevailing interest rate that applies for the transaction is 8%. Compute the purchase price of
the machinery.
Given: PMT = Br. 5,000; n = 10 years; i = 8%; PVAn (Annuity due) = ?

PVA (Annuity due) = Br. 5,000

[
1 −(1+0 . 08)−10
0. 08 (1+0.08)
]
= Br. 5,000 (6.7101) (1.08) = Br. 36,234.54.
So the cost of the machinery for Ruth is Br. 36,234.54. We have identified the case as an
annuity due rather than ordinary annuity because the first payment is made today, not after one
period.

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