7/27/2022

THE TIME VALUE OF MONEY

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By the end of this topic, students should be able
to:
• To discuss the role of time value of money
• Understand the concept of future and present
value
• Understand some practical applications of
Present Value and Future Value

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Money has a time value. A shilling today is more valuable than a
shilling a year from today. Why is this so? There are several
reasons:
1. Individuals, in general prefer current consumption to future
consumption.
2. Capital can be employed productively to generate positive
returns. An investment of one shilling today would grow to (1+k)
a year from now (where k is the rate of return earned on the
investment).
3. In an inflationary period a shilling today represents a greater real
purchasing power than a shilling a year from now.
4. The world is uncertain. There is always a certain risk that
something unexpected may occur and the firm becomes
bankrupt or subject to some other misfortune.
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With simple interest, you don’t earn interest on interest.
• Year 1: 10% of $100 = $10 + $100 = $110
• Year 2: 10% of $100 = $10 + $110 = $120
• Year 3: 10% of $100 = $10 + $120 = $130
• Year 4: 10% of $100 = $10 + $130 = $140
• Year 5: 10% of $100 = $10 + $140 = $150

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With compound interest, a depositor earns interest on
interest earned!
• Yr 1: 10% of $100.00= $10.00 + $100.00 = $110.00
• Yr 2: 10% of $110.00= $11.00 + $110.00 = $121.00
• Yr 3: 10% of $121.00 = $12.1+ $121.00 = $133.10
• Yr 4: 10% of $133.10= $13.31 + $133..10= $146.41
• Yr 5: 10% of $146.41= $14.61 + $146.41 = $161.02

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FUTURE VALUES AND
PRESENT VALUES

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This section will discuss methods of dealing with time
value of money. Several areas will be considered:

1. Future value of a single amount

2. Future value of an annuity
3. Present value of a single amount
4. Present value of a mixed (irregular) stream of cash
flows
5. Present value of an annuity.
6. Present value of a perpetuity
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• Suppose you deposit Shs 1,000 today with a financial
institution, which pays 10% interest compounded
annually for a period of 3 years, what will you have at the
end of 3 years?
Formula:
• FVn = PV (1+k)n
• Where FVn = future value n years hence
• PV = Cash today (present value)
• k = interest rate per year
• n = number of years for which compounding is
done.
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• The factor (1+k)n is referred to as the
compounding factor or the future value
interest factor (FVIFk,n).
• It is very tedious to compute this figure with
calculators but published tables are available
showing the value of (1+k)n for various
combinations of k and n.
• SEE Tables for Future Value Interest factors,
FVIFk,n for various combinations of k and n.

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Cash flow diagram for single payment factors given P
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Cash flow diagram for single payment factors given F
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Example
If you deposit Shs 1,000 today in a bank which
pays 10% interest compounded annually, how
much will the deposit grow to after (i) 8 years
and (ii)12 years?
i. Using formula
ii. Using tables

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SOLUTION
(i) The future value 8 years hence will be:
Using formula
FVn = 1000(1 + k) n
FV8 = 1000(1 + 10%) 8
= Shs 1,000(1.10)8
= Shs 1,000(2.144)
= Shs 2,144
Using future value tables
FV8 = Shs 1,000 X FVIF10%, 8yrs
= Shs 1,000(2.1436)
= Shs 2,144
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SOLUTION
(ii) The future value 12 years hence will be:
FV12 = 1,000(1+ 10%)12
= 1000(1.10)12
= Shs 1,000(3.138)
= Shs 3,138
Using future value tables
FV12 = Shs 1,000 X FVIF10%, 12yrs
= Shs 1,000(3.1384)
= Shs 3,138
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EXERCISE
• Shabella places Shs 800,000 in a savings
account paying 6% interest compounded
annually. she wants to know how much
money will be in the account at the end
of five years.
• Use formula
• Use tables

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EXAMPLE:
The Hima Cement Factory will require an investment of $200
million to construct. Delays beyond the anticipated
implementation year of 2012 will require additional money to
construct the factory. Assuming that the cost of money is 10%
per year, compound interest, determine the following for the
board of directors of the Lafarge Company that plans to
develop the plant.
a) The equivalent investment needed if the plant is built in
2015
b) The equivalent investment needed had the plant been
constructed in 2008.

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SOLUTION:
The figure below is a cash flow diagram showing
the expected investment of $200 million in
2012, which we will identify as time t = 0.
The required investments 3 years in the future
and 4 years in the past are indicated by F3 = ?
and P-4 = ?, respectively.

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a) To find the equivalent investment required in
3 years, apply the F/P factor. You could as
well use $1 million units and the tabulated
value for 10% interest. i.e.
F3 = P(1 + k)n = 200(1.1)3 = $266.2 million
= P X FVIF10%, 3yrs = $200 x 1.331 = $266.2
million

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• An annuity is a series of periodic cash flows
(payments or receipts) of equal (uniform)
amounts.
• The premium payments of life insurance
policy, for example are an annuity.
• When these occur at the end of each period,
the annuity is called a regular or ordinary
annuity.
• When these occur at the beginning of each
period, it is an annuity due.
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• Suppose you deposit Shs 1,000,000
annually in a bank for 5 years and your
deposits earn compound interest rate of
10% p.a.
• What will be the value of this series of
deposits (an annuity) at the end of 5
years?

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• Annuities are of two types
1. Ordinary or regular annuity ( cash flows occur
at the end of the period)
2. Annuity due (cash flows occur at the
beginning of the period)
Note : annuities due are adjusted with (1+k)
since they have an extra period than a regular
annuity.

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Example
Four equal annual payments of Shs 2,000,000
are made into a deposit account that pays 8%
interest per year. What is the future value of this
annuity at the end of 4 years if it is an ordinary
annuity?
i. Use formula
ii. Use tables

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CLASS ACTIVITY
• Okite George makes equal annual payments of
Shs 2,500,000 on behalf of his son into a
deposit account that pays 10% interest per
year. How much will the son have in the
account at the end of 8 years? If the deposits
are made:
i. Every 1st January of each year
ii. Every 31st of December of each year

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• Interest is sometimes earned more than once a year. In this
case interest is compounded for periods shorter than a
year. When interest is compounded semi-annually, for
example, there are two compounding periods within a year.

EXAMPLE
Find the future value of Shs 1,000,000 compounded at 6% p.a
after three years. If compounding is done:
i. Annually
ii. Semi-annually
iii. quarterly

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o Suppose someone promises to give you
Shs 10,000,000 three years from now.
What is the present value of this amount
if the interest rate is 10 per cent?
o The present value can be calculated by
discounting Shs 10,000,000 to the
present point of time using the future
value formula.
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Formula
The process of discounting, used for calculating the present
value, is simply the inverse of compounding. The present
value formula can be readily obtained by manipulating
the compounding formula:
FVn = PV(1+k)n
Dividing both sides of the equation by (1+k)n, we get:
PV = FVn[1/(1+k)n]
The factor [1/(1+k)n] is called the discounting factor or the
present value interest factor(PVIFk,n).
The tables for present value interest factors, gives PVIFk,n for
several combinations of k and n.
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Example

Find the present value of Shs 10,000,000 receivable 6

years from now if the rate of discount is 10% p.a.
i. Using formula
ii. Using tables

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• In financial analysis we often come across uneven
cash flow streams. For example, the cash flow stream
associated with a capital investment project is
typically uneven. Likewise, the dividend stream
associated with an equity share is usually uneven and
perhaps growing.

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• Where, PV = present value of a cash flow
stream
• At = cash flow occurring at the end
of year t
• k = discount rate
• n = duration of the cash flow
stream

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Isooba John, a shareholder, has been offered an opportunity to
receive the following mixed stream of cash flows in dividends
over the next 4 years. (assume end of year cash flows)

Year cash flow

1 Shs 300
2 400
3 280
4 320

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• How much would he be willing to take if he
opted to get his money as one payment today
at a discount rate of 6%?

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• Suppose you expect to receive Shs 200
annually for 4 years, each receipt occurring at
the end of the year. What is the present value
of this stream of benefits if the discount rate is
6%. The present value of this annuity is simply
the sum of the present values of all the
inflows of this annuity.
• Tables for present value interest factors, gives
the value of PVIFAk,n for several combinations
of k and n.
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Class activity
• What is the present value of an amount of
Shs10,000,000 to be received at the end of 10
years from today discounted at 10% per
annum?
• What is the present value of 10 equal deposits
of Shs 1,000,000 each per year over a 10 year
period discounted at 10% per annum? If it is
an ordinary annuity and if it is an annuity due.

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Perpetuity is an annuity of infinite duration.
PV of a perpetuity = constant periodic flow
k
Where k is the discount rate
For example, how much would I have to deposit today
in order to withdraw Shs10,000,000 each year
forever if I can earn 8% on my deposit?
Solution
• PV = Shs10,000,000/0.08
• = Shs 12,500,000.
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• Sometimes cash flows may have to be discounted
more frequently than once a year – semi annually,
quarterly, monthly or daily. As in the case of intra-
year compounding, the shorter discounting period
implies that
• (i) the number of periods in the analysis increases
and
• (ii) the discount rate applicable per period decreases.

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EXAMPLE
• Consider a cash flow of Shs10,000,000 to be
received at the end of four years. The discount
rate is 12 per cent (k=12%) and discounting is
done quarterly (m=4). Determine the present
value of this cash flow:

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SOLUTION
PV =$ 10,000x PVIFk/m,mxn
= 10,000,000 x PVIF3%, 16
= 10,000,000 x 0.623
= 6,230,000

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• FVAn = A x (FVIFAk,n)

• PCF = Amount deposited or received annually

at the end of each year (Periodic cashflow).

• PCF = FVAn
FVIFAk,n

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EXAMPLE
• Suppose you want to buy a house 5 years from
now and you estimate that the down payment
needed will be Shs30,000,000. How much
would you need to deposit at the end of each
year for the next 5 years to accumulate
Shs30,000,000 if you can earn 6% on your
deposits?

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SOLUTION
• PCF = 30,000,000/5.637 = 5,321,979.78

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• At times, it may be desirable to determine the
number of time periods needed to generate a
given amount of cash flow from an initial
amount.
EXAMPLE
Ann Bates wishes to determine the number of
years it will take for her initial $1,000 deposit,
earning 8% annual interest, to grow to equal
$2,500.
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Clue
• Simply stated, at an 8% annual rate
of interest, how many years, n, will it
take for Ann’s $1,000 (PVn) to grow
to $2,500 (FVn)?

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SOLUTION
• Either (point of view of present value)
• PVIF8%,n = PV/FV = ($1,000/$2,500) = 0.400

• PVIF8%,n = Approximately 12years

Or (point of view of future value)

• FVIF8%,n = FV/PV = ($2,500/$1,000) = 2.5

• FVIF8%,n = Approximately 12years

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THE FORMULAE
Single amounts
• FV = PV x FVIFk,n
• PV = FV x PVIFk,n

Annuity
• FVA = PCF x FVIFAk,n
• PVA = PCF x PVIFAk,n

P is periodic cash flow (uniform cash flow)

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• The term loan amortization refers to the
computation of equal periodic loan payments. The
loan amortization process involves finding the future
payments over the term of the loan whose PV at the
loan interest rate equals the amount of initial
principal borrowed.
Example
• Loan Amortization Schedule, ($6,000 Principal, 10%
Interest, 4-Year Repayment Period)

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• PVAn = PCF x (PVIFAk,n)
• PCF = Amount deposited or received annually
at the end of each year.

• PCF = PVAn
PVIFAk,n
= 6,000
3.170
= 1892.74 will be the annual end year payments

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SCHEDULE

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THE FORMULAE
Single amounts
• FV = PV x FVIFk,n
• PV = FV x PVIFk,n

Annuity
• FVA = PCF x FVIFAk,n
• PVA = PCF x PVIFAk,n

PCF is periodic cash flow (uniform cash flow)

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