Lecture2 TimeValueofMoney

The Time Value of Money (TVM)
 The Time Value of Money is a key concept in

investment decision
 The other concepts are cashflow estimation and
risk-return tradeoff
 TVM concept allows one to compare
cashflows at two different points of time
 What evidence do we have of the existence
of time value of money?
 Interest on deposits
 Inflation and purchasing power
November 1, 2023 Lecture2_Time Value of Money 1

 Compounding and discounting are at the
heart of the TVM concept
 The key issue: a shilling in the future is
NOT as valuable as a shilling today

 Compounding and discounting take
cashflows accruing at different times to a
common time point
 Compounding takes cashflow to a future date/time
(or brings cashflow from the past to the present)
 Discounting brings future cashflow to the present
time (or takes today’s cashflow to a previous
date/time)

Compounding and Discounting: Basic
Considerations
 Future or Present Value
 Nature of cash flows
 lump sum or annuities?
 Timing conventions
 At the beginning or at the end of the period?
 Simple vs. Compounding interest
 How frequent is the compounding?
 Additivity of cash flows

 Lump sum and compounding interest rate,
 The future value (FVn) of a lump sum (PVo) after
n periods with interest rate (i%) per period is
given as:
FVn = PVo(1+i)n
 Notice that PVo is a lump sum as at present and
FVn is a lump sum n periods in the future
 (1+i)n is the future value interest factor,
 In FVn = PVo(1+i)n, (1+i)n is the future
value interest factor, FVIF,i,n
 FVIF,i,n represents the future value of one
shilling after n periods with interest rate i.
 There are financial tables for these values

 The rule of 72
 Given an interest rate of i% per period
compounding once, it takes about 72/i periods
for an amount (PVo) to double
 For example with 8% annual interest rate it will take
about 9 years (72/8) for an amount to double

 PVo is the present value of the lump
sum FVn to be received after n periods
with interest rate i
 We can rewrite the relationship as:
PVo = FVn /(1+i)n
 The value 1/(1+i)n is known as the
present value interest factor
 It represents the present value of one shilling to
be received n periods from now with interest rate
i.
 For a lump sum, future value increases with
both n and i while present value decreases
with both n and i.
 This is true as long as the values of n and i are
greater than zero
 We assume interest rate that is going to
remain constant over the given period.
 It is still possible to compute present or future
value with changing interest rates

 Multiple Cash Flow
 Unequal amounts each period
 Equal amount each period
 For unequal amounts each period the
approach will be to compound or discount each
amount (considering the applicable period and
interest rate)

Multiple Cash Flow: Unequal amounts
Example: You have approached a loan shark for a loan to
enable meet your studying costs. Your proposal is to
repay the amount using some money that you expect
to earn from your part-time businesses. This will be
shs. 1.2m after one year, shs. 1m after two years and
shs. 2m after 4 years. The loan shark tells you that the
interest rate on this type of arrangement is 20 percent
per annum. How much should you expect to receive
from the loan shark now?

 For equal amounts each period we use the
concept of annuity
 An annuity is a series of periodic payments or
receipts of equal amount
 Annuity due – the amount comes at the beginning
of the period
 Ordinary annuity – the amount comes at the and of
the period (This is the one that is commonly used)

 An annuity - is a fixed payment (amount),
made at fixed intervals, at the end of the
period (ordinary annuity) or at the
beginning of the period (annuity due)
 The concept of annuity is commonly used in
life insurance and retirement benefits.
 Annuity is also known simply as payment and
denoted as PMT in some calculators and computer
programs
 The concept of annuity simplifies the tedious
process of compounding or discounting each
amount separately
 The future value of an annuity is given as:
FVao = a (FVIFai,n,)
 The present value of an annuity is given as:
PVao = a (PVIFai,n,)
 Where
 a is the periodic amount (the annuity)

PVIFai,n and FVIFai,n are interest factors
 PVIFai,n and FVIFai,n represent, respectively,
the present and future values of an annuity
of one shilling for n periods with interest
rate i.
n
1  (1  i )
PVIFan ,i 
i
 PVIFai,n the present value of an
annuity of one shilling for n periods
with interest rate i.
 For annuity due
PVIFad,i,n = PVIFai,n(1+i)
(1  i )  1 n
FVIFan ,i 
i
 FVIFai,n the future value of an annuity
of one shilling for n periods with
interest rate i.
 For annuity due
FVIFad,i,n = FVIFai,n(1+i)
 Suppose you decide to deposit Shs 1million
each month in an account carrying 1%
interest rate per month. How much are you
going to have in the account at the end of 4
months if:
 The deposit is made at the beginning of the month?
 The deposit is made at the end of the month?

 NOTES on annuity:
 The present value interest factor of an annuity
is not the reciprocal of the future value interest
factor of annuity!
 Future value of annuity increase with both n
and i
 Present value of annuity increase with n but,
for given n, it decreases with i
 as long as the values of n and i are greater than
zero

 Suppose you received a 10-years, Shs.
70million mortgage from a bank. The bank is
charging you a 6% interest rate per annum for
this mortgage. How large your periodic
payment need to be for you to clear the
mortgage in the 10 years:
 (a) If you make one payment at the end of each
year and interest compounds annually?
 (b) If you make one payment at the end of each
month and interest compounds monthly?

 Quoting Interest rates
 Interest rates and rates of return are normally
quoted on per annum basis
 In some cases interest rates are quoted for
periods other than a year
 Interest rate per month
 Converting other period rates to annual rates
 The annual Percentage Rate (APR) = ip x p
 The Equivalent Annual Return (EAR) = (1+ip)p-1
 Where

ip= per period rate and p = number of periods per year
 Multiple Compounding
 Annual rate i compounds p times a year
 Per period rate is estimated as ip=i/p
 Number of periods changes to n*p
 Continuous compounding
 FVn = PVo x ei*n

• You are planning to retire 15 years from now. You
have estimated that you will have 25 years to live
after your retirement. Your objective is to set up an
individual retirement fund that will provide shs.
800,000 each month to meet your living costs after
retirement. Your investigation has shown that it is
possible to set up the fund by depositing a fixed
amount from your salary in a special retirement
account that earn 4.8% p.a. You have also estimated
that this interest rate will remain constant for the first
15 years and then increase to 6% p.a. thereafter.
How large does your monthly deposit needs to be for
you to achieve your objective assuming interest
compounds monthly?
A bank offers three different accounts which are similar in
all respects – including the level of riskness – except in
the interest rates and the way interest compounds.
CLASSICS Account carries 7.9 percent interest that
compounds annually
ROYAL Account carries 7.8 percent interest that compounds
semi-annually, and
PRINCESS Account carries 7.5 percent interest that
compounds monthly.
 Which account you will recommend to a friend? Why?
 Will your answer change if the friend has a 20-year
investment horizon? Why?

Lecture2 TimeValueofMoney

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The Time Value of Money (TVM)

 The Time Value of Money is a key concept in

November 1, 2023 Lecture2_Time Value of Money 1

NOT as valuable as a shilling today

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