Financial Management I (ACFN 3041)

Chapter Three
Time Value of Money
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 The Concept of
Time Value of Money /TVM/

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TVM
◼ In the case of longer-term projects (investments), the
time at which profits start accruing can have a bearing
on the worth of future earnings because of the TVM.

◼ TVM is an important financial concept that states

❑ Money loses its value over time which makes it more desirable to
have it now rather than later

◼ In other words, it means, money earned now is worth

more than money earned at some time in the future,
◼ Reasons!
❑ Additional return could have been obtained if the money had
been invested in the intervening period:
❑ Purchasing power is reduced, due to Inflation
TVM
◼ Furthermore, profits made much later in the future are
more vulnerable to changes in circumstances than near-
term earnings; for this reason, less value should be
attached to them.

◼ In the case of long-term investments (projects), it has

become normal practice to consider the TVM by applying
a discount rate to future cash flows.

◼ The discount rate used is based on the required or

desired rate of return, and may also include the expected
rate of inflation over the life of the project.
Future Value Vs Present Value
◼ Financial values and decisions can be assessed by
using either future value or present value techniques.
Although these techniques will result in the same
decisions, they view the decision differently.
◼ Future value techniques typically measure cash flows at
the end of a project’s life.
◼ Present value techniques measure cash flows at the
start of a project’s life (time zero).
◼ Future value is cash you will receive at a given future
date, and present value is just like cash in hand today.

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 Compounding discounting
◼ The future value technique uses compounding to find the future
value of each cash flow at the end of the investment’s life and
then sums these values to find the investment’s future value.
◼ Alternatively, the present value technique uses discounting to
find the present value of each cash flow at time zero and then
sums these values to find the investment’s value today

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Future Value of a Single Amount
FV1 = PV(1 + i)
and
FV2 = FV1(1 + i)

◼ Substituting PV(1 + i) in the first equation for FV1

in the second equation:
FV2 = PV(1 + i)(1 + i) = PV(1 + i)2

◼ For (n) Periods:

FVn = PV(1 + i)n

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Future Value of a Single Amount
◼ Example:
◼ Suppose you invest $100 at 5% interest, compounded
annually.
❑ What is the value at the end of year 1
❑ What is the value at the end of year 2
◼ At the end of one year, your investment would be worth:
$100 + .05($100) = $105
or
$100 (1 + .05) = $105
◼ During the second year, you would earn interest on $105.
At the end of two years, your investment would be worth:
$105 (1 + .05) = $110.25
 Future Value of a Single Amount
◼
 Future Value of a Single Amount
◼
 Future Value of a Single Amount
◼
Interest Rates, Time, and Future Value

Future Value of $100

2500
16%
2000
0%
1500
6%
10% 1000
16% 10%
500 6%
0%
0
0 4 8 12 16 20
Number of Periods
Nonannual Periods
mn
 i
FVn = PV 1 + 
 m
1
PV = FVn mn
 i 
1 +
m 
m = number of times compounding occurs per year
i = annual stated rate of interest

◼ Example: Suppose you invest $1000 at an annual

rate of 8% with interest compounded a) annually, b)
semi-annually, c) quarterly, and d) daily. How much
would you have at the end of 4 years?
 Nonannual Example Continued
◼ Annually
❑ FV4 = $1000(1 + .08/1)(1)(4) = $1000(1.08)4 = $1360

◼ Semi-Annually
❑ FV4 = $1000(1 + .08/2)(2)(4) = $1000(1.04)8 = $1369

◼ Quarterly
❑ FV4 = $1000(1 + .08/4)(4)(4) = $1000(1.02)16 = $1373

◼ Daily
❑ FV4 = $1000(1 + .08/365)(365)(4)

= $1000(1.000219)1460 = $1377
 Present Value of a Single Amount
◼ Calculating present value (discounting) is simply the
inverse of calculating future value (compounding):

FVn = PV (1 + i ) n Compoundin g
FVn  1 
PV = = FVn  n
Discountin g
(1 + i ) n
 (1 + i ) 
 1 
where :  n
is the PV of $1 interest factor
 (1 + i ) 
 Present Value of a Single Amount
◼ Example:
◼ How much would you be willing to pay today for the right
to receive $10,000 five years from now, given you wish
to earn 6% on your investment:

 1 
PV = $10,000  5
 (1.06) 
= $10,000(.7 47)
= $7,470
Interest Rates, Time, and Present Value
(PV of $100 to be received in 16 years)

Present Value of $100

120

100
0%
80 0%
6%
60
6% 10%
40 16%
10
20 %
16%
0
0 4 8 12 16
End of Time Period
ANNUITY

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Annuities
◼ An annuity is a stream of equal periodic cash flows,
over a specified time period. These cash flows are
usually annual but can occur at other intervals, such as
quarterly or monthly.
◼ The cash flows in an annuity can be inflows or outflows
◼ Types of Annuities
◼ There are two basic types of annuities.
❑ Ordinary annuity
❑ Annuity due
◼ For an ordinary annuity, the cash flow occurs at the end
of each period.
◼ For an annuity due, the cash flow occurs at the beginning
of each period.
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Future Value of an Annuity
◼ Ordinary Annuity
◼ Example:
◼ Suppose you invest $100 at the end of each
year for the next 3 years and earn 8% per year
on your investments. How much would you be
worth at the end of the 3rd year?
 T1 T2 T3
$100 $100 $100

Compounds for 0 years:

$100(1.08)0 = $100.00

Compounds for 1 year:

$100(1.08)1 = $108.00

Compounds for 2 years:

$100(1.08)2 = $116.64
______

Future Value of the Annuity $324.64

 FV3 = $100(1.08)2 + $100(1.08)1 +$100(1.08)0
= $100[(1.08)2 + (1.08)1 + (1.08)0]
= $100[Future value of an annuity of $1
factor for i = 8% and n = 3.]
(See table)
= $100 (3.246)
= $324.60

FV of an annuity of $1 factor in general terms:

(1 + i) n − 1
(useful when using a non - financial calculator )
i
Future Value of an Annuity
◼ Example
◼ If you invest $1,000 at the end of each year for the next
12 years and earn 14% per year, how much would you
have at the end of 12 years?
◼ Use the formula:

(1 + i) n − 1
FV = Periodic PYT * [ ]
i

FV12 = $1000(27.2 71) given i = 14% and n = 12

= $27,271
Present Value of an Annuity
◼ Example 2
◼ Suppose you can invest in a project that will
return $100 at the end of each year for the next
3 years. How much should you be willing to
invest today, given you wish to earn an 8%
annual rate of return on your investment?
 T0 T1 T2 T3
$100 $100 $100

Discounted back 1 year:

$100[1/(1.08)1] = $92.59
Discounted back 2 years:
$100[1/(1.08)2] = $85.73
Discounted back 3 years:
$100[1/(1.08)3] = $79.38
PV of the Annuity = $257.70
PV = $100[1 /(1.08)1 ] + $100[1 /(1.08) 2 ] + $100[1 /(1.08)3 ]
= $100[1 /(1.08)1 + 1 /(1.08) 2 + 1 /(1.08)3 ]
= $100[Prese nt value of an annuity of $1 factor for i = 8% and n = 3]
(See Table)
= $100(2.577)
= $257.70

PV of an annuity of $1 factor in general terms :

1
1−
(1 + i ) n
(useful with non - financial calculator s)
i
 Present Value of an Ordinary Annuity
◼ Example:
◼ Suppose you won a national lottery in the amount of
$10,000,000 to be paid in 20 equal annual payments
commencing at the end of next year. What is the present
value (ignoring taxes) of this annuity if the discount rate
is 9%?
1
◼ Formula: 1−
(1 + i )
n
PV = Periodic PYT * [ ]
i

PV = $500,000(9 .129) given i = 9% and n = 20

= $4,564,500
 Annuity Due
◼ A series of consecutive payments or receipts of equal
amount at the beginning of each period for a specified
number of periods.
◼ To analyze an annuity due using the tabular approach,
simply multiply the outcome for an ordinary annuity for the
same number of periods by (1 + i).
◼ Note: Throughout the course, assume cash flows occur at
the end of each period, unless explicitly stated otherwise.
◼ FV and PV of an Annuity Due:
FV n = FV of an ordinary annuity (1 + i)
PV = PV of an ordinary annuity (1 + i)
Annuity Due
◼

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Exercises
1. BACK Co plans to deposit Br. 500 at the end of each of the next four years in a
bank account that pays 12% interest compounded annually. How much will be the
balance of the account at the end of year-4? What will be the balance at the end of
year-4 if the deposit is made at the beginning of each year?

◼ Answer:
❑ If deposit is made at the end of each year for four years, the future value is Br. 2,389.66

❑ If deposit is made at the beginning of each year for four years, the future value is Br. 2,676.42
◼ On January 1, 2014 BACK Co purchased equipment by signing a note promising to
pay Br. 80,000 at the end of each of the next five years starting 2014. What is the
cost of the equipment today if the market interest rate is 10% compounded
annually? What is the cost of the equipment today if payment is to be made at the
beginning of each year?
◼ Answer:
❑ If deposit is made at the end of each year for five years, the future value is Br. 488,408

❑ If deposit is made at the beginning of each year for five years, the future value is Br. 537,248.80

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Special Case Annuities
◼

PP
PV =
i
Exercise
◼ An investment offers a perpetual cash flow of Br. 500 every year.
The return you require on such an investment is 8%. What is the
value of this investment if interest is compounded:
❑ a) annually?

❑ b) quarterly?

❑ c) What if the yearly cash flow grows at 3% annually?

◼ Answer:
❑ A) Annually = Br. 500/0.08 = Br. 6250

❑ B) Quarterly = Br 500/(0.08/4) = Br. 25,000

❑ C) Annually with a growth rate = Br. 500/(8% - 5%) = Br. 10,000

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Special Case Annuities
◼ Deferred Annuities
◼ Fixed-period annuities, also known as term deferred
annuities, are a type of annuity that is paid out over a
certain period of time.
◼ For example, it might pay out over the course of 10 or 20
years. If you unexpectedly pass away during the payment
term, you can have payments continue to a beneficiary.

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Uneven Cash Flow
◼ Example 1:
◼ Assume there are two projects that are having two different unequal
cash flows as shown below. If the required rate of return is 7% for
investment A and 8% for investment B, compute the present value .

Year Investment A Investment B

1 Br. 10,000 Br. 20,000
2 11,000 25,000
3 13,000 10,000
4 16,000 5,000
5 30,000 0
Effective annual rate and the nominal rate
◼ The nominal interest rate does not take into account the
compounding period.
◼ The effective interest rate does take the compounding period
into account and thus is a more accurate measure of interest
charges.
◼ A statement that the "interest rate is 10%" means that interest
is 10% per year, compounded annually. In this case, the
nominal annual interest rate is 10%, and the effective annual
interest rate is also 10%. However, if compounding is more
frequent than once per year, then the effective interest rate
will be greater than 10%. The more often compounding
occurs, the higher the effective interest rate.

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Effective annual rate and the nominal rate

◼ The relationship between nominal annual and effective

annual interest rates is:
◼ ia = [ 1 + (r / m) ] m - 1
❑ where "ia" is the effective annual interest rate,
"r" is the nominal annual interest rate, and
"m" is the number of compounding periods per year.
◼ Example:
◼ A credit card company charges 21% interest per year,
compounded monthly. What effective annual interest
rate does the company charge?

◼ Answer: 0.23143 or 23.143%

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 End of Chapter Three

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