Topic 5

TIME VALUE OF MONEY

(part 1)

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 Learning Objectives
• To elaborate the concept of time value of money and time line.
• To explain the differences between simple interest and
compound interest.
• To elucidate the future value of single amount.
• To explain the effects of frequent compounding towards future
value amount.
• To clarify the differences between effective and nominal
interest rate.
• To explain the present value for an amount in the future
• To illustrate the calculation of future value and present value
for both ordinary annuity and annuity due.
• To calculate the value of uneven cash flows.
• To discuss perpetuity.
• To elaborate the application of time value of money concept in
loan amortization.

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 Time Value of Money: Definition
• The phrase “time value of money” refers to the fact
that it is better to receive money sooner than later.
• A dollar today is worth more than a dollar in the
future.
Today Future

Preferable

• One reason for this is that money that you have in

hand today can be invested to earn interest/return,
producing more money in the future.
• Time value of money is also known as “Time
Preference for Money.”
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 Time line: Definition
•A time line is a horizontal line which can be used to depict
the cash flows of a given investment.
•A time line starts with time period zero and future periods
are marked from left to the right.
Figure 1.1 Time Line

• Time zero (0) represents today. Time 1, time 2, and time 3

represent the 1st period, 2nd period and 3rd period respectively.
• these periods can be days, weeks, months, quarters, or
years. However, generally year is used in the time line.

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 Time line: Definition (cont.)
• The end of the 1st period is also the beginning of the 2nd
period. In the same way, the end of the 2nd period is the
beginning of the 3rd period.
Figure 1.1 Time Line

• Cash flows for the respective periods are shown above the
line.
• Cash flows are assumed to occur at the end of the period
unless otherwise stated.
• The negative value of a cash flow represents cash outflow or
investment. On the other hand, the positive value of a cash
flow represents cash inflow.

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 Principal and Interest: Definition

• The term principal refers to the original amount of

money invested or borrowed.

• In other words, principal is the amount of money on

which interest is earned or paid.

• The term interest refers to the money paid for the

use of another party’s money. Interest is charged on
the principal amount.

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Simple Interest versus Compound Interest
• Simple interest is the interest earned only on the
original principal amount invested.
• In other words, simple interest is charged only on the
original principal for each period of time.
Example: Suppose you invest $100 in a savings account
that pays 10 percent simple interest. How much will be the
amount of interest at the end three (3) years?

Solution: Amount of interest at the end of 1st year

= original principal x rate of interest
= $100 x 0.10 = $10
Amount of interest at the end of 2nd year
= $100 x 0.10 = $10
Amount of interest at the end of 3rd year
= $100 x 0.10 = $10
Total interest earned = $10 + $10 + $10 = $30

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Simple Interest versus Compound Interest
• Compound interest is the interest earned on both the
initial principal and the interest from previous period.
• Compound interest is also known as interest on
interest.
Example: Suppose you invest $100 in a savings account
that pays 10 percent compound interest. How much will be
the amount of interest at the end three (3) years?

Solution: Amount of interest at the end of 1st year

= original principal x rate of interest
= $100 x 0.10 = $10
Amount of interest at the end of 2nd year
= ($100 + $10) x 0.10 = $110 x 0.10 = $11
Amount of interest at the end of 3rd year
= ($110 + $11) x 0.10 = $121 x 0.10 = $12.10
Total interest earned = $10 + $11 + $12.10 = $33.10

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 Basic Patterns of Cash Flow
• The cash flows (either inflow or outflow) of a firm can be
described by its general patterns.
• According to the patterns, the cash flows of a firm can be
classified into three groups:
- Single amount
- Annuity
- Mixed stream

• A single amount of cash flow is a lump- sum amount of

money either held currently or expected to be received at
some future date.

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 Basic Patterns of Cash Flow (cont.)
• An annuity is an equal amount of money received or paid for
each period of time. It is also known as even/ equal cash flow
stream.

• A mixed stream is a stream of unequal periodic cash flows. It is

also known as uneven/ unequal cash flow stream.

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 Future Value: Definition
• Future value is the value at a given future date of
some amount of money invested today and earning
interest at a specified rate.

• The future value of a present amount is found by

applying compound interest over a specified period
of time.

• The process of determining the future value of a

present amount is called compounding.

• The interest rate used to calculate future value is also

known as required rate of return/ discount rate/
cost of capital/ opportunity cost of capital.
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 Future Value of a Single Amount
The following equation can be used to calculate the future value
of a single amount at the end of period n:
FVn = PV x (FVIFr,n)
Where,
FVn = future value at the end of period n
PV = initial principal, or present value
r = annual rate of interest
n = number of periods (typically years). However, it may

be semi-annual, quarters, months, weeks, and days.

FVIFr,n = future value interest factor for a specific interest rate
(r) and time period (n)

N.B: The value of FVIFr,n can be found in mathematical table

(usually in appendix) provided by the standard books on
finance.
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 Future Value of a Single Amount (cont.)
Example
Mr. Farhan deposits $800 in a savings account that pays 6
percent interest compounded annually. He wants to know
how much money will be in the account at the end of five (5)
years.

Solution
The future value of $800, earning 6%, at the end of 5
years can be found as follows:
FVn = PV x (FVIFr,n)
FV5 = $800 x (FVIF6%,5 yrs)
= $800 x (1.3382) [from FVIF table]
= $1,070.58

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 Present Value: Definition
• Present value is the current dollar value of a future
amount.

• In other words, present value is the amount of money that

would have to be invested today at a given interest rate
over a specified period to equal the future amount.

• The process of determining the present value of a future

amount is called discounting. It is the inverse of
compounding.

• The interest rate used to calculate present value is called

discount rate. It is also known as required rate of
return/ cost of capital/ opportunity cost of capital.

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 Present Value of a Single Amount
The following equation can be used to calculate the
present value of a future amount:

PV = FVn x (PVIFr,n)
Where,
FVn = future value at the end of period n
PV = initial principal, or present value
PVIFr,n = present value interest factor for a specific interest
rate (r) and time period (n)

N.B: The value of PVIFr,n can be found in mathematical

table (usually in appendix) provided by the standard
books on finance.

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 Present Value of a Single Amount (cont.)
Example
Pam Valenti wishes to find the present value of $1,700 that
will be received 8 years from now. Pam’s opportunity cost is
8 percent.

Solution
The present value of $1,700 to be received 8 years from now at
8% interest rate can be found as follows:
PV = FVn x (PVIFr,n)
= $1,700 x (PVIF8%,8 yrs)
= $1,700 x (0.5403) [from PVIF table]
= $ 918.50

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 To be continued…………

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