CHAPTER 3

TIME VALUE OF MONEY

 There is a time value of money: a dollar today is not of same
worth as a dollar tomorrow or next year. Another complication
is that any amount of money promised in the future is uncertain,
some riskier than others.
 The time value of money is a very important concept in
financial management. It has many implications in financial
decisions like loan settlements, investing in bonds and stocks of
other entities, acquisition of plant and equipment.
 The time value of money represents the fact that 1Birr today is
more valuable than 1 Birr in the future, say one year from now.
 Reasons for Time Value of Money

(i) Consumption Preference: Individuals prefer current consumption

to future consumptions. So people would have to be offered more in the
future to give up current consumption.
(ii) Inflation: Inflation is a general increase in prices that erodes the
purchasing power of money. Hence, the value of money decreases with
time when there is inflation.
(iii) Uncertainty (Risk): As compared to today’s money future cash
flows have risks (default risk). Hence, delaying cash collection means
assuming greater risks. Individuals want to be rewarded for this
additional risk assumed in relation to uncertainty of future cash flows.
(iv) Investment Opportunities: Cash received today could be invested
and fetch additional income.
 The Future Value of Money

• To understand future value, we need to recall

the idea of compounding. Compounding is a
mathematical process of determining the
value of a cash flow or cash flows at the final
period.
• 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 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: Alem deposited Br. 1,800 in her
savings account in September 2008. Her account
earns 6 percent compounded annually. How
much will she have in September 2015?
Given
PV = Br, 1,800;
i = 6%;
n = 7 (September 2008 – September 2015).
 FVn = PV (1 + i)n
= Br. 1,800 (1.06)7
= Br. 2,706.53
The (FVIF i, n) can be found by using a scientific calculator or using
interest tables given at the end of financial management books. From such
tables, by looking down the first column to period 7, and then looking
across that row to the 6% column, we see that FVIF 6%, 7 = 1.5036.
Then, the value of Br. 1,800 after 7 years is found as follows:
FVn = PV (FVIF i, n)
FV7 = Br. 1,800 (FVIF6%, 7)
= Br. 1,800 (1.5036)
= Br. 2,706.48
 Present Value of Money
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.
The process of computing the present value is
called discounting.
 n
FVn  1 
PV =  FVn  
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
Or
PV = FVn (PVIF i, n)
Where:
(PVIF i, n) = The present value interest factor for i and n = 1/ (1 + i)n
Example: Waliya Company owes Br. 50,000 to Adugna
Co. at the end of 5 years. Adugna Co. could earn 12%
on its money. How much should Adugna Co. accept
from Waliya Company as of today?
Given:
FV5 = Br. 50,000; n = 5 years; i = 12%; PV =?
PV = FV5 (PVIF12%, 5)
= Br. 50,000 (0.5674)
= Br. 28,370
 Future Value of an Annuity

• An annuity is a series of equal periodic rents (receipts,

payments, withdrawals, or 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;-
 the cash flows must be equal.
 the interval between any two cash flows must be fixed.
 the interest rate applied for each period must be constant.
 interest should be compounded in same manner during
each period.
Annuities are classified into three types:
i) Ordinary Annuity,
ii)Annuity Due, and
iii)Deferred Annuity
1. 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.
  (1  i ) 1
n

FVA n = PMT  

 i 

Where:
FVA n = Future value of an ordinary annuity
PMT = Periodic payment
i = Interest rate per period
n = Number of periods
Or
FVA n = PMT (FVIFA i, n)
Where:
(FVIFA i, n) = the future value interest factor for an annuity
Example 1: JT Company has planned to acquire machinery after five years. To that end, the company
deposits Birr 3,000.00 at the end of each year at a deposit rate of 12%. How much is the terminal (future
value) of the deposits at the end of the fifth year?
Given: FVA n =? i = 12% n = 5; PMT = 3,000
FVA n = PMT (FVIFA i, n)
FVA 5 = 3,000 (FVIFA, 12 %, 5)
FVA 5= 3,000 (6.35284736)
FVA 5 = Birr 19,058.54
Example 2: You need to accumulate Br. 250,000 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: FVA n = Br. 250,000; i = 12%  12 = 1%; n = 5 x 12 = 60 months; PMT =?
FVA n = PMT (FVIFA i, n)
Br. 250,000 = PMT (FVIFA, %, 60)
Br. 250,000 = PMT (81.670)
PMT = Br. 250,000/81.670
PMT = Birr 3,061
2. 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.
FVA n (Annuity due) = PMT (FVIFA i, n) (1 + i)
Or
= PMT (1 + i)
Example:
Assume example 1 for ordinary annuity except that the
payments are made at the beginning instead of end of
each year. How much is the terminal (future value) of
the deposits at the end of the fifth year?
FVA n (Annuity due) = PMT (FVIFA i, n) (1 + i)
FVA 5 = 3,000 (FVIFA 12%, 5) (1 + 12%)
FVA 5 = 3,000 (6.35284736) (1.12)
FVA 5 = Birr 21, 345.57
3. Deferred Annuities
A Delayed Annuity One of the tricks in
working with annuities or perpetuities is
getting the timing exactly right. This is
particularly true when an annuity or
perpetuity begins at a date many periods in
the future.