Time Value of Money

Abel M Agoba, PhD.

 Changes in Interest Rates
• If the interest rates changes during the period
of an investment, the compounding formula
must be amended as follows;

Eg. Kojo invests Ghc1000 at 5% for 2 years and 7%

for the remaining years. How much will he earn at
the en of 5 years?

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 Present Value
• Present value of a future cash flow (inflow or outflow) is the amount of current
cash that is of equivalent value to the decision-maker.

• It is the value in the present of a sum of money, in contrast to some future value
it will have when it has been invested at compound interest.

• We can find the present values of:

– A single payment
– Uneven periodic sum
– Annuity

• Discounting is the process of determining present value of a series of future cash

flows.

• The interest rate used for discounting cash flows is also called the discount rate.

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 (1) Present Value of a Single Cash Flow
• The following general formula can be employed to calculate
the present value of a lump sum to be received after some
future periods:
Fn
P   F 
n  (1  i ) n


(1  i ) n

PV  Fn  PVFn ,i

• The term in parentheses is the discount factor or present

value factor (PVF), and it is always less than 1.0 for positive i,
indicating that a future amount has a smaller present value.

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 Example
• Suppose
  that an investor wants to find out the
present value of GH¢50,000 to be received after
15 years. Her interest rate is 9 per cent.

• First, we will find out the present value factor,

which is 0.275. Multiplying 0.275 by GH¢50,000,
we obtain GH¢ 13,726.9 as the present value:

• 26.9
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(2) Present Value of an Uneven Periodic Sum

• Investments made by of a firm do not frequently yield

constant periodic cash flows (annuity).
• In most instances the firm receives a stream of uneven cash
flows.
• Thus the present value factors for an annuity cannot be used.
• The procedure is to calculate the present value of each cash
flow and aggregate all present values.

𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝟑 𝑪𝑭𝒏

𝑷𝑽 = + + +⋯
ሺ𝟏 + 𝒊ሻ ሺ𝟏 + 𝒊ሻ ሺ𝟏 + 𝒊ሻ
𝟏 𝟐 𝟑 ሺ𝟏 + 𝒊ሻ𝒏

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Present Value of an Uneven Periodic Sum

• Your company invested in a project which is

expected to generate GH¢50,000 in year 1, GH
¢70,000 in year 2 and GH¢85,000 in year 3. If
the cost of capital for the company is 15%,
what will be the value of the future cash flows
today?

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 (3) Present Value of an Annuity
• The computation of the present value of an annuity can be
written in the following general forms:
• For Ordinary Annuity (payments at period end):

• For Annuity Due (payments at beginning of period):

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 Present Value of an Annuity
Find the present value of the following ordinary
annuities
a. GHȼ400 per year for 10 years at 10%
b. GHȼ200 per year for 5 years at 5%
c. GHȼ400 per year for 5 years at 2%

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 Present Value of an Annuity
Kwaku Manu has inherited GHȼ25,000 and wishes to purchase an
annuity that will provide him with a steady income over the next
12 years.

He has heard that the local savings and loans association is

currently paying 6 percent compound interest on an annual basis.

If he were to deposit his funds, what year-end equal-cedi amount

(to the nearest cedi) would he be able to withdraw annually such
that he would have a zero balance after his last withdrawal 12
years from now?

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 CAPITAL RECOVERY AND LOAN
AMORTISATION
• Capital recovery is a term that has several related meanings in the world of business.

• It is, primarily, the earning back of the initial funds put into an investment.

• Capital recovery is when funds initially paid at the beginning of an investment are
earned back.

• Suppose you take out a loan. The process in which your debt will be paid off in equal
installments consisting of proportionate amounts of principal and interest is called
capital recovery. This is termed loan amortization.

• The capital recovery factor is an effective cost analysis tool, and is used by many
start-up businesses and investors looking to determine the success of their
investments.

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 CAPITAL RECOVERY AND LOAN
AMORTISATION
• Given an annuity present value factor as:

• The capital recovery factor is the inverse of the annuity present value
factor. i.e

• Then we can find the periodic amounts (A) one should pay in order to
amortise their loan by either dividing the loan amount (PV) by the APVF:

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CAPITAL RECOVERY AND LOAN
AMORTISATION

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CAPITAL RECOVERY AND LOAN
AMORTISATION

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Capital Recovery and Loan Amortisation

A loan that is to be repaid in equal amounts on a

monthly, quarterly, or annual basis is called an
amortized loan. Each payment will consist of two
parts—part interest and part repayment of
principal. This breakdown is shown in the
amortization schedule

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 Example
• You have applied to your bankers for a loan of GH¢30,000
to complete your dream house for deductions to be made
over 3 years equal annual instalments.

• Your bankers, however, maintained that your 40% annual

salary which amounts to GH¢12,000 cannot meet both
the principal and interest payment.

• It is the bank’s policy to maintain a debt service ratio of

40%. Interest rate charged by the bank is 18% per annum.

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 Example
• Required:
a. Calculate the size of the loan you qualify for.
b. Prepare amortization table to show how the
loan will be liquidated

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 Solution
• Value of the loan:
Annual Payment = GH¢12,000

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 Solution

Amortization Schedule
Year Bal b/ f Interest Instalment Principal payment Bal c/ f
1 26091.27 4696.4 12000.0 7303.6 18787.70
2 18787.7 3381.8 12000.0 8618.2 10169.48
3 10169.5 1830.5 12000.0 10169.5 -0.01

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 Example
• Mr Zidi borrowed GH¢20,000 to renovate his
house. He will pay it back in equal annual
payments, which begins today and 4
additional payments. Interest rate on the loan
is 8% per annum.
a. Calculate the annual loan payments
b. Show the amortization table

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 Solution
• Finding annual payment

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 Solution

Amortization Schedule
Year Bal b/ f Interest Instalment Principal payment Bal c/ f
0 20000.00 0.0 4638.11 4638.1 15361.89
1 15361.9 1229.0 4638.11 3409.2 11952.73
2 11952.7 956.2 4638.11 3681.9 8270.84
3 8270.8397 661.7 4638.11 3976.4 4294.40
4 4294.3969 343.6 4638.11 4294.6 -0.16

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 Example 2
a. Set up an amortization schedule for a GHȼ 25,000 loan to be
repaid in equal installments at the end of each of the next 5 years.
The interest rate is 10%.
b. How large must each annual payment be if the loan is for GHȼ
50,000? Assume that the interest rate remains at 10% and that the
loan is still paid off over 5 years.
c. How large must each payment be if the loan is for GHȼ 50,000,
the interest rate is 10%, and the loan is paid off in equal
installments at the end of each of the next 10 years? This loan is for
the same amount as the loan in part b, but the payments are spread
out over twice as many periods. Why are these payments not half as
large as the payments on the loan in part b?
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 Solution 2
We find annual payment GHȼ 6,594.94

Year Bal b/f Repayment Interest Principal payment Bal c/f

1 25,000 6,594.94 2500 4,094.94 20,905.06

2 20905.1 6,594.94 2090.51 4,504.43 16,400.63

3 16400.6 6,594.94 1640.06 4,954.88 11,445.75

4 11445.7 6,594.94 1144.57 5,450.37 5,995.38

5 5995.38 6,594.94 599.538 5,995.40 -0.02

    32,974.70 7974.68 25,000.02  

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 Solution 2
b. Here the loan size is doubled, so the payments
also double in size to GHȼ 13,189.87.
c. The annual payment on a GHȼ 50,000, 10-year
loan at 10 percent interest would be GHȼ 8,137.27.
Because the payments are spread out over a longer
time period, more interest must be paid on the loan,
which raises the amount of each payment. The total
interest paid on the 10-year loan is GHȼ 31,372.70
versus interest of GHȼ 15,949.37 on the 5-year loan.
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 Example 3
Assume that your father is now 50 years old, that he plans to
retire in 10 years, and that he expects to live for 25 years after
he retires—that is, until age 85. He wants his first retirement
payment to have the same purchasing power at the time he
retires as GHȼ 40,000 has today. He wants all of his subsequent
retirement payments to be equal to his first retirement
payment. (Do not let the retirement payments grow with
inflation: Your father realizes that the real value of his
retirement income will decline year by year after he retires.) His
retirement income will begin the day he retires, 10 years from
today, and he will then receive 24 additional annual payments.

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 Example 3
Inflation is expected to be 5% per year from today
forward. He currently has GHȼ 100,000 saved up; and
he expects to earn a return on his savings of 8% per
year with annual compounding. To the nearest dollar,
how much must he save during each of the next 10
years (with equal deposits being made at the end of
each year, beginning a year from today) to meet his
retirement goal? (Note: Neither the amount he saves
nor the amount he withdraws upon retirement is a
growing annuity.)
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 Solution 3
1. Wants payments of GHȼ40,000 per year in today's
cedis for first payment only. Real income will
decline. Inflation will be 5 percent. Therefore, to
find the inflated fixed payments using lump sum
future value formula = GHȼ65,155.79
2. He now has GHȼ100,000 in an account which pays
8 percent, annual compounding. We need to find
the FV of the GHȼ100,000 after 10 years still using
lump sum formula = GHȼ215,892.50.

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 Solution 3
3. He wants to withdraw, or have payments of, GHȼ65,155.79
per year for 25 years, with the first payment made at the
beginning of the first retirement year. So, we have a 25-year
annuity due with PMT = 65,155.79, at an interest rate of 8
percent. (The interest rate is 8 percent annually, so no
adjustment is required.) we use PV annuity due to find
amount on hand; PV = GHȼ751,165.35. This amount must be
on hand to make the 25 payments.
4. Since the original GHȼ100,000, which grows to
GHȼ215,892.50, will be available, we must save enough to
accumulate GHȼ751,165.35 - GHȼ215,892.50 = GHȼ535,272.85
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 Solution 3
5. The GHȼ535,272.85 is the FV of a 10-year
ordinary annuity. The payments will be deposited in
the bank and earn 8 percent interest. Therefore,
using future value annuity formula we find annual
deposits as; GHȼ36,949.61

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 Review Question
A father is planning a savings program to put his daughter
through university. His daughter is now 13 year old. She plans
to enroll at the university in 5 years, and it should take her 4
years to complete her education. Currently, the cost per year
(for everything – her food, clothing, tuition, books,
transportation, and so forth) is GH¢ 12,000 per year.
This cost is expected to remain constant throughout the four-
year university education. The daughter recently received GH
¢ 7,500 from her grandfathers, estate; this money will be
invested at a rate of 8% to help meet the costs of the
daughter’s education.
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 Review Question
The rest of the costs will be met by money the
father will deposit in a savings account which also
earns 8 percent compound interest per year. He will
make 5 equal deposits into the account, one
deposit per annum starting one year from now until
his daughter starts university. These deposits will
begin one year from now. (Assume that school fees
are paid at the beginning of the year)

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 Review Question
• What will be the present value of the cost of 4 years of
education at the time the daughter turns 18?

• What will be value of the GH¢ 7,500 that the daughter

received from her grandfather’s estate when she starts
college at 18?
• If the father is planning to make the first of 5 deposits
one year from now, how large must each deposit be for
him to able to put his daughter through college?

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 Review Question
• Your company will generate GH¢ 55,000 in annual
revenue each year for the next eight years from a new
information database. The computer system needed to
set up the database costs GH¢ 250,000. If you can
borrow the money to buy the computer system at 7.5
percent annual interest, can you afford the new system?
• First National Bank charges 7.5 percent compounded
quarterly on its business loans. First United Bank charges
7.5 percent compounded semi-annually. As a potential
borrower, which bank would you go to for a new loan?

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 Review Question
• An investment offers GH¢ 2,250 per year for 15 years,
with the first payment occurring one year from now. If
the required return is 10 percent, what is the value of
the investment? What would the value be if the
payments occurred for 40 years? For 75 years? Forever?
• You want to have GH¢ 50,000 in your savings account
five years from now, and you’re prepared to make equal
annual deposits into the account at the end of each
year. If the account pays 9.5 percent interest, what
amount must you deposit each year?

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