BM Chap IV Edited

CHAPTER IV
MATHEMATICS OF FINANCE
(THE TIME VALUE OF MONEY)
AcFn 2131 Ch4 By Yoseph T Friday, June 7, 2024 1

Learning Objectives.
▪ After completing this chapter students will be able to:
➢ Understand the concept of time value money.
➢ Understand how to calculate the future values of a single, annuities and

uneven cash flows
➢ know how to calculate the present values of a single, annuities and uneven
cash flows.
➢ Identify the special cases in annuity.
➢ Identity the more frequent compounding interest rates.
AcFn 2131 Ch4 By Yoseph Tadesse Friday, June 7, 2024 2

4.0. Introduction to Time Value of Money
o Which one do you prefer, a birr amount just today or the same birr amount
one year from today? Why?
o If your preference is just today, your reason must be at least for the expected
return from investing the received birr amount in interest bearing options.
o If your expectation is this concept, it is nothing but the concept of the time
value of money.
o Understanding the time value of money concept is essential for a financial

manager to achieve the wealth maximization goal of a firm.
o The goal of a firm is wealth maximization recognizes the difference in the

value of equal cash flows received at different time periods.

4.0. Introduction to Time Value of Money
o So the concept of the time value of money is that money received now is
generally better than the same amount of money received some time later,
this is because there is an opportunity to invest the money we have now and
earn a return on it.
o The trade-off between money now and money later thus depends on, among
other things, the rate you can earn by investing.
o In this chapter we look closer the time value of money and the ways of
computations these values, first understanding the concepts of exponential
and logarithmic functions both of are basics mathematics for finance as
discussed below.

4.1.Overview of Exponential and Logarithmic Functions
▪ Chapter 1 through 3 we have seen the algebraic equations equalities or

inequalities that are contains one or more first degree unknown variables
which are collectively expressed as linear equations and their applications in
real business world.
▪ i.e. x + 5 = 15; 3y > 24 and x - y ≤ 12
▪ Solving an equation means finding the value of the unknown quantity that
will make the equation an equality with no unknowns with the help of the
following properties of algebra;
▪ Property 1: the same number may be added to, or subtracted from both
sides of an equation i.e. x + 5 = 15;; x=10; 5 is subtracted from both sides.
▪ Property 2: each side of an equation can be multiplied or divided* by the

same number i.e. y/3=24;= y=72; 3 is multiply from both sides.
▪ Note that in an algebraic term such as 4x or (a+b)x, the number or symbol

multiplying a variable or an unknown quantity is called the coefficient of that
term.
▪ Thus, in the term 4x, the number 4 is the coefficient of that term, and in
(a+b)x, the coefficient is (a+b).
▪ Likewise, the coefficient of y in equation y/3 = 24 is 1/3, and the coefficient

of y in in equation y =72 is 1since 1y=y .
▪ In other words, every algebraic term has a coefficient, and if it is not shown,
it is understood to be 1 since, in general, 1x = x.
▪ Other algebraic equations may contain exponents and logarithms and For
these equations have their own laws of applicability as discussed next.

• 4.1.1 Exponents
• In the mathematical expression an, a is the base, n is the exponent or power,

and an is said to be a number in exponential form.
• The exponent indicates the number of times the base appears in a string of
multiplication operations as illustrated by the following example.
▪ Laws of Exponents
▪ For any number a and for a positive integer n, the exponential number is
defined as a ⋅ a ⋅ a ⋅ …⋅ a and n = number of a′s.
▪ Example 4.1. Express the following numbers in exponential form and

identify the base and exponents. 7 × 7 × 7 × 8 × 8
▪ Solution. 73 × 82; 7 and 8 are the bases and 3 and 2 are the exponents and
read as 7 cubed times 8 squared.
• 4.1.1 Exponents
▪ The laws of exponents is applied in business, science, technology, and

engineering.
▪ We will consider a few examples to illustrate their application in business

particularly in computation of future and present value of annuities.

• 4.1.2 .The Common and Natural Logarithmics

▪ The common logarithm or base 10 logarithm of a number, denoted as ,
is the power (exponent) to which the base 10 must be raised to produce that
number.
▪ Thus, if a number is denoted as M and , then for example,
log10100 = 2; 102 =100
▪ Another type of logarithm is the natural or base e logarithm where e =
271828... and it is denoted as ln or loge.
▪ It is the exponent to which the base e must be raised to produce that
number.
▪ Thus, if a number is denoted as N and logeN = lnN = y then for
example, ln2 = loge2 =0.693 sincee0.693=2.

▪ The natural logarithm is mostly used in science and engineering, although it

appears also in the computation of some financial functions.
▪ The logarithm (common or natural) of a positive number that is less than 1 is

negative.
▪ The logarithm of a negative number is an imaginary number and, as

mentioned before, we will not concerned with these numbers.
▪ For brevity, we will use log to represent the common (base 10) logarithm,
and ln to represent the natural (base e) logarithm.


▪ The common (base 10) logarithm and the natural (base e) logarithm, where
e is an irrational (endless) number whose value is ....., are the most widely
used.
▪ Both occur in many formulas of probability, statistics, and financial formulas.
▪ For instance, the formula shown below computes the number of periods
required to accumulate a specified future value by making equal payments at
the end of each period into an interest−bearing account.
▪ We will see later in detail the uses of Logarithmic in business world.

▪ Example 4.2
▪ Compute the number of months required to accumulate $100,000 by making

a monthly payment of $500 into a savings account paying 6% annual interest
compounded monthly.
▪ Soln. The monthly interest rate is 6%/12 or 0.5%, Future Value = $100,000
and Payment = $500
Then, =138.9757≈139
▪ This represents the number of the months that a payment of $500 is required
to be deposited at the end of each month.
▪ This time is equivalent to 11 years and 7 months.

4.2. Why Money has a Time of Value?
▪ As we have discuss at the introductory of this chapter, money can be thought of as

having a time value.
▪ In other words, an amount of money received today is worth more than the same
dollar amount would be if it were received a year from now.
▪ The primary reason that a dollar today is worth more than a dollar to be received
sometime in the future is that the current dollar can be invested to earn a rate of
return. (This holds true even if risk and inflation are not considerations.)
▪ Suppose that you had $100 and decided to put it into a savings account for a year, by
doing this, you would temporarily give up, or forgo, spending the $100 however you
wished, or you might forgo the return that the $100 might earn from some alternative
investment, such as U.S. Treasury bonds or you might forgo paying an additional $100
on your mortgage.

▪ Similarly, a bank that loans money to a firm forgoes the opportunity to earn a return on
some alternative investment.
▪ So that there is an return earned for the forgone opportunities that could be earn on
some alternative investment opportunities called interest.
▪ Interest is the cost of using money over a specified time period, or the return earned
on the amount paid to someone who has forgone current consumption or alternative
investment opportunities or simply return earned on rented money over time.
▪ The amount of money borrowed or invested or rented is known as the principal and the
length of time during which the borrower can use the principal is called term of a loan.
▪ The percentage on the principal that the borrower pays the lender per time period as
compensation for forgoing other investment or consumption opportunities is known
as “rate of interest”.
▪ Therefore, the first basic point in the concept of the time value of money is to
understand the concept of interest.
▪ There are two basic types of interest: Simple interest and Compound .
▪ Simple interest can be understood in two different ways.
▪ One is that simple interest is an interest computed for just a period, if interest is
computed for one period only, the interest is always simple interest.
▪ Another way is that it is an interest computed for two or more periods only from the
principal (original) value.

▪ The accumulated amount (A), is the sum of the principal and interest after t years, is
given by A = P + I =P + Prt =P(1+rt) and is a linear function of t.
▪ In business applications, we are normally interested only in the case where t is

positive and the line that lies in Quadrant I as shown on fig1 below.

▪ Example 4.3. An amount of $2000 is invested in a 10-year trust fund that pays 6%
annual simple interest.
▪ (a) What is the total amount of the trust fund at the end of 10 years?
▪ (b) What is the interest earned in that period of time?
▪ Soln (a) A = P(1 + rt )
= 2000[1 + (0.06)(10)]
= $3200
▪ (b) I = Prt
= 2000(0.06)(10)]
= $1200

▪ Compound interest, on the other hand, is an interest computed for a minimum of two
periods whereby the previous interests produce another interest for subsequent or
next periods.
▪ It is interest earned on both the initial principal and the interest reinvested from prior
periods and yields the amount of money accumulated when an initial amount of
money is invested in a fixed term account and hence it is called interest on interest.
▪ To find a formula for the accumulated amount, lets consider $1000 is deposited in a
bank for a term of 3 years, earning interest at the rate of 8% per year (called the
nominal, or stated, rate) compounded annually.
▪ Then, using Equation (1b) the accumulated amount at the end of year 1 is
▪ A1 = P(1+rt) = 1000[1 + (0.08(1)] = 1000(1.08) = $1080

▪ To find the accumulated amount A2 at the end of the year2, we use (1b) once again,
this time with P = A1. (the principal and interest now earn interest over the second
year.)
A2 = P(1 + rt) =A1(1+ rt)
= 1000[1 + 0.08(1)][1 + 0.08(1)]
= 1000[1 + 0.08]2 = 1000(1.08) 2=1166.40
▪ Finally, the accumulated amount A3 at the end of the third year is found using (1b)
with P = A2, giving
A3 = P(1 + rt ) =A2(1 + rt )
= 1000[1 + 0.08(1)]2 [1 + 0.08(1)]
= 1000[1 + 0.08] 3 = 1000(1.08) 3 ≈ 1259.71

▪ If you reexamine the calculations, you will see that the accumulated amounts at the
end of each year have the following form:
▪ These observations suggest the following general result: If P dollars is invested over a
term of t years, earning interest at the rate of r per year compounded annually, then the
accumulated amount is;
▪ Formula (2) was derived under the assumption that interest was compounded
annually. In practice, however, interest is usually compounded more than once a year
and the interval of time between successive interest calculations is called the
conversion period usually represent by m.
▪ If interest at a nominal rate of r per year is compounded m times a year on a principal

of P dollars, then the simple interest rate per conversion period is;
• But there are n = mt periods in t years (number of conversion periods times the term)
and the accumulated amount at the end of t years is given by;

▪ Example 4.4.
▪ Find the accumulated amount after 3 years if $1000 is invested at 8% per year
compounded (a) annually, (b) semiannually, (c) quarterly, (d) monthly, and (e) daily.
▪ Soln (a) A =1000(1+0.08)3 = $1259.71
(b) A =1000(1+0.08/2)3(2) =1265.32
(c) A =1000(1+0.08/4)3(4) =1268.24
(d) A =1000(1+0.08/12)3(12) =1270.24
(e) A =1000(1+0.08/365)3(365) =1271.22
▪ These results are can be summarized in Table 1 below.

▪ Example 4.4.Cont.
▪ One question that arises naturally in the study of compound interest is, what happens
to the accumulated amount over a fixed period of time if the interest is computed
more and more frequently?
▪ Intuition suggests that the more often interest is compounded, the larger the
accumulated amount will be, this is confirmed by the results of Example 3.4, above
where we found that the accumulated amounts did in fact increase when we
increased the number of conversion periods per year.
▪ This leads us to another question: Does the accumulated amount keep growing, or
does it approach a fixed number when the interest is computed more and more
frequently over a fixed period of time?
▪ To answer this question, lets look again at the compound interest formula 4:
▪ Recall that m is the number of conversion periods per year and so to find an answer to
our question, we should let m get larger and larger in formula (4) above, let u = mr so
that m = ru, then (4) becomes

▪ Now lets see what happens to the expression as u gets larger and larger.
▪ From Table 2, below you can see that as u increases, seems to
approach the number 2.71828 which is the irrational number denoted by e.
▪ Using this result, we can see that, as m gets larger and larger, A approaches P(e)rt, in
this situation, we say that interest is compounded continuously which leads the
formula 5 presented below.

▪ Example 4.5. Find the accumulated amount after 3 years if $1000 is invested at 8%
per year compounded (a) daily (assume a 365-day year) and (b) continuously.
▪ Soln (a) A =1000(1+0.08/365)3)(365) ≈ $1271.22
(b) A =1000e(0.08)(3) ≈ $1271.25

▪ Observe that the accumulated amounts corresponding to interest compounded daily
and interest compounded continuously differ by very little.
▪ The continuous compound interest formula is a very important tool in theoretical work
in financial analysis.

▪ Examples 4.3 – 4.8 are tell us how to compute the simple interest amount and
compound interest amount given the interest rate.
▪ However sometime there is a need to compute the interest rate(r) needed to get the
required return on a given investment.
▪ For such cases we need determine the appropriate interest rate, for simple interest
which is the percentage on the principal that the borrower pays the lender per time
period as shown in example 3.5 below.
▪ Example 4.6
▪ Find the interest rate, if the simple interest earned on the principal amount of $10,000
for the consecutive 3 years is $ 2400
▪ Soln: $800/$10,000=0.08= 8%

▪ As you can understand from Examples 3.5 above, the computation simple interest rate
is direct forward which is the percentage on annual interest earned divide by the
principal(invested) amount.
▪ However, this will not do for compound interest rate, because compound interest
amount is Interest earned on both the initial principal and the interest reinvested from
prior periods.
▪ So that to compute the interest rate earned on compound interest we need to

breakdown /discount the accumulated amount into the present value and solving for
the interest rate(r) as shown below.

▪ Suppose, you are considering a one-year investment, if you put up $1,250, you will get
back $1,350. What rate is this investment paying?
▪ First, in this single-period case, the answer is fairly obvious. You are getting a total of
$100 in addition to your $1,250 and the implicit rate on this investment is thus
$100/1,250 = 8 percent.
▪ More formally, from the basic future value/ accumulated amount equation, the
present value/the principal the amount you must put up today is $1,250 and what this
value grows to is $1,350 and the time involved is one period, so we have:
▪ In this simple case, of course, there was no need to go through this calculation, but, as
we describe next, it gets a little harder when there is more than one period.
▪ To illustrate what happens with multiple periods, let’s say that we are offered an
investment that costs us $100 and will double our money in eight years.
▪ To compare this to other investments, we would like to know what discount rate is
implicit in these numbers.
▪ This discount rate is called the rate of return, or sometimes just return, on the
investment.
▪ In this case, we have a present value of $100, a future value of $200 (double our
money), and an eight-year life.
▪ To calculate the return, we can write the basic present value equation as:
▪ It could also be written as:

▪ Now to solve for r, we need consider the following three ways we could do it:
1. Use a financial calculator.
2. Solve the equation for 1 + r by taking the eighth root of both sides, this is because the
same thing as raising both sides to the power of 1⁄8 or .125, which is actually easy to
do with the “yx” key on a calculator, just enter 2, then press “yx,” enter .125, and press
the “=” key, which would be the eighth root should be about 1.09, which implies that r
is 9 percent.
3. Use a future value table, the future value factor after eight years is equal to 2 and if
you look across the row corresponding to eight periods in Table A.1, provided below
you will see that a future value factor of 2 corresponds to the 9 percent column, again
implying that the return here is 9 percent.

32
33
▪ Actually, in this particular example, there is a useful “back of the envelope” means of
solving for r-the Rule of 72.
▪ For reasonable rates of return, the time it takes to double your money is given
approximately by 72/r%. In our example, this means that 72/r% = 8 years, implying that
r is 9 percent (72/8years), as we calculated.
▪ This rule is fairly accurate for discount rates in the 5 percent to 20 percent range.
▪ Given this, a rule of thumb, let’s see how one investment stacked up, suppose in 1976,
British Rail purchased the Renoir portrait La Promenade for $1 million as an
investment for its pension fund (the goal was to diversify the fund’s holdings more
broadly). In 1989, it sold the portrait for nearly $15 million. Relative to the rule of
thumb, how did British Rail do? Did they make money, or did they get railroaded?

▪ We will assume that British Rail bought the painting on January 1, 1976, and sold it at
the end of 1989, for a total of 14 years.
▪ The present value is $1 million, and the future value is $15 million and now we need to
solve for the unknown rate, r, as follows:
▪ Solving for r, we get that British Rail earned about 21.34 percent per year, or almost
three times the 7.2 percent rule of thumb, which is not bad.
▪ Example 4.7: You would like to retire with$1,000,000 in 50 years as a millionaire . If

you have $10,000 today, what rate of return do you need to earn to achieve your goal?
▪ Soln. $10,000= $1,000,000/(1+r )50

(1 + r )50 =100; r = 9.65 percent
▪ Therefore, the future value factor is thus 100 and the implicit rate is 9.65%.
▪ More on Finding the Number of Periods
▪ An other important issues related the time value of money is length of time required
that the money will be tied up or rent.
▪ The length of time required that money will be tied up or rented and a credit customer
has to pay the account in full is called the credit period.
▪ Suppose we are interested in purchasing an asset that costs $50,000 and we currently
have $25,000.
▪ If we can earn 12 percent on this $25,000, how long until we have the $50,000?
▪ For answering this question it needs solving for the number of periods, that you
should know how to get an approximate answer to this particular problem.
▪ From the Rule of 72, this will take about 72/12 = 6 years at 12 percent we need to
double our money.
▪ To come up with the exact answer, we can again manipulate the basic present value
equation, that the present value is $25,000, and the future value is $50,000, with a 12
percent discount rate, the basic equation takes one of the following forms:
▪ We thus have a future value factor of 2 for a 12 percent rate and we now need to solve
for t.
▪ If you look down the column in Table A.1 presented above that corresponds to 12
percent, you will see that a future value factor of 1.9738 occurs at six periods.
▪ It will thus take about six years, as we calculated.
▪ To get the exact answer, we have to explicitly solve for t (or use a financial calculator)
and the answer is 6.1163 years, so our approximation was quite close in this case.

▪ Example 4.8
▪ You’ve been saving up to buy the Godot Company. The total cost will be $10 million.
You currently have about $2.3 million. If you can earn 5 percent on your money, how
long will you have to wait? At 16 percent, how long must you wait?
▪ Solution: At 5%, you’ll have to wait about 30 years long last as computed from the
basic present value equation shown below;
▪ At 16 percent, things are a little better and verify for yourself that it will take about 10
years.

▪ Example 4.9
▪ You’ve been offered an investment that will pay you 9 percent per year. If you invest
$15,000, how long until you have $30,000? How long until you have $45,000?
▪ Solution: At 9%, you’ll have to wait about 8.04 years long last as computed from the
basic present value equation shown below;
▪ If we solve for t, we get that t = 8.04 years. Using the Rule of 72, we get 72/9 = 8 years,
so, once again, our answer looks good.
▪ To get $45,000, verify for yourself that you will have to wait 12.75 years.

4.3.Future Values of Cash Flows
▪ To understand future value, we need to understand compounding first.

▪ Compounding is a mathematical process of determining the value of a cash
flow(s)at the final period.
▪ It is the process of going from today’s values, or present values (PVs), to
future values (FVs) of an asset.
▪ The cash flow(s) could be a single cash flow, an annuity cash flows or
uneven cash flows.
▪ FV is the amount to which a cash flow(s) will grow over a given period of
time when compounded at a given interest rate.
▪ It is a direct result of the compounding process.

4.3.1.Future Value of A single Cash Flow
▪ 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:
▪ FV(A) = PV(1 + i)n
▪ Where: FVn(A) - Future value at the end of n periods
PV - Present Value, or the principal amount
i - Interest rate per period
n=mt Number of periods

▪ Or FVn = PV (FVIFr,n)
▪ Where: (FVIFr, n) = The future value interest factor for r and n.
▪ The future value interest factor for i and n is defined as (1 + i)n and it is the
future value of 1Br for n periods at a rate of i percent per period.
4.3.1 Future Value of A single Cash Flow
▪ Example 4.10 Hana deposited Br. 1,800 in her savings account in CBE for 7
years with annual interest of 6% . How much will she have at the end of 7th
year?
▪ To solve this problem, let’s identify the given items:
PV = Br, 1,800; r= 6%; n = 7 .
FVn = PV(1+r )n = Br. 1,800(1.06)7 = Br. 2,706.48
▪ The (FVIFi,n) can be found by using a scientific calculator or interest tables.
▪ From the future value of table shown below looking down the first column to
period 7, and then looking across that row to the 6% column, we obtain that
FVIF6%,7 =1.5036.
▪ Then, the value of Br.1,800 after 7 years is found as follows:
▪ FVn = PV (FVIFi,n)= Br. 1,800 (FVIF6%,7)
= Br.1,800 (1.5036) = Br. 2,706.48
Example 4.11
▪ You hope to buy your dream car four years from now. Today, that car costs
$82,500. You expect the price to increase by an average of 4.8 percent per
year over the next four years. How much will your dream car cost by the time
you are ready to buy it?
▪ Soln Future value = $82,500  (1 + .048)4 = $99,517.41

Example 4.12
▪ Yonas deposited Br.10,000 in a fund that will earn 8% interest compounded
quarterly for the first four years and 10% for interest compounded semi-
annually for the next six year. How much will he have the fund at the end of
ten years?
▪ Soln MV= P (1+r/4)4n
= Br.10,000(1+0.08/4)4(4)
= Br.13,727.85 for the first 4 years
MV= P(1+r/2)2n
=Br.13727.85 (1+0.1/2)2(6)
= Br.24,653.26 for the next 6 years.
▪ ⸫ Yonas will have Br.24,653.26 in the fund at the end of 10 years.

▪ Example 4.13.
▪ You invested $1,650 in an account that pays 5 percent simple interest. How
much more could you have earned over a 20-year period if the interest had
compounded annually?
Solution
▪ Simple interest = $1,650 + ($1,650  .05  20) = $3,300
▪ Annual compounding = $1,650  (1.05)20 = $4,377.94
▪ Difference = $4,377.94 - $3,300 = $1,077.94

4.3.2.The Future Value of Annuity Cash Flows
▪ An annuity is a sequence of equal payments/receipts made at fixed/regular

intervals for a specified number of periods.
▪ The time period in which these payments are made is called the term of the
annuity.
▪ Depending on whether the term is given by a fixed time interval, a time

interval that begins at a definite date but extends indefinitely, or one that is
not fixed in advance, an annuity is called an annuity certain, a perpetuity, or
a contingent annuity, respectively.
▪ Examples of annuities are regular deposits to a savings account, monthly

home mortgage payments, and monthly insurance payments.

▪ Annuities are also classified by payment dates in to 3 basic categories:
▪ An annuity in which the payments are made at the end of each payment
period is called an ordinary annuity, whereas
▪ An annuity in which the payments are made at the beginning of each period
is called an annuity due and
▪ An annuity for which the amount is computed two or more period after the
final payment/ cash flow is made is known as deferred annuity.
▪ Furthermore, an annuity in which the payment period coincides with the

interest conversion period is called a simple annuity, whereas
▪ An annuity in which the payment period differs from the interest conversion
period is called a complex annuity.
.
▪ For a series of cash flows to be an annuity the following four conditions

should be meets.
1) The cash flows must be equal.
2) The interval between any two cash flows must be fixed/regular.
3) The interest rate applied for each period must be constant.
4) Interest should be compounded during each period.
▪ If any one of these conditions is missing, the cash flows cannot be an
annuity.
▪ We derive formulas for future value of an annuity (what you end up with) and
the present value of an annuity (the lump sum that, when invested now, will
yield the same future value as that of the annuity) used to answer questions
involving the amortization of certain types of installment loans and sinking
funds that are set up to be used for a specific purpose at a future date.
I. Future Value of Ordinary Annuity(FVOA):- the future value of an ordinary

annuity is the amount computed at the period when exactly the final (nth)
cash flow is made.
▪ Graphically, FVOA can be represented as follows:
▪ The general annuity FV factor is computed based on the future value factor
for single payment /cash flow as shown below;
▪ Annuity FV factor = (Future value factor - 1)
i
= [(1+ i)n -1]
i
▪ The sum of the accumulated amounts is the amount of the annuity is
symbolized by S.
I. Future Value of Ordinary Annuity(FVOA)
• To find a general formula for the accumulated amount S of an annuity,

suppose a sum of $R is paid into an account at the end of each period for n
periods account earns interest at the rate of i per period.
FVOA(S)
▪ Where: FVOA(S) = Future value of an ordinary annuity
R = Periodic payments
i = Interest rate per period
n = Number of periods
Or FVOA = R (FVIFAr,n)
(1+i) n -1
Where: (FVIFAr,n) is the FV interest factor for an annuity= i
I. Future Value of Ordinary Annuity(FVOA)
▪ Where: FVOA(S) = Future value of an ordinary annuity

R = Periodic payments
i = Interest rate per period
n = Number of periods
Or FVOA = R (FVIFAr,n)
Where: (FVIFAr,n) is the FV interest factor for an annuity= (1+i) n -1
i
Example 4.14
▪ Alex plans on saving $3,000 on the last day of each year and expects to
earn an annual rate of 10.25 percent. How much will he have in his account
at the end of 45 years?
Soln FVOA(S)= R (1+r) -1
n
=$3,000 (1+0.1025) 45 -1
=$2,333,572
r 0.1025
▪ Example 4.15
▪ W/ro Helen deposited at the end of each year Br.5,000 at annual interest
rate of 8% compounded quarterly for the consecutives five years. How much
will she have in her account at the end of 5th year?
Sol FVOA=R (1+r) -1 =Br5,000 (1+0.08/4) -1 =Br121,486.50
n 4*5
r 0.08/4

▪ Example 4.16: Find the accumulated amount of $100 is paid into an

account a rate of 8% at the end of each quarter over a period of 3 years.
▪ Soln

▪Example 4.17:
▪You need to accumulate Br. 25,000 to acquire a equipment after5 years from
now. To do so, you plan to make equal monthly deposits for 5years which
pays12% interest compounded monthly. How much should you deposit every
month to reach your goal, if you make the first payment a month from today?
▪Soln Given: FVOA= Br.25,000; r=12% ; n =5; R = ?
FVOA = R (FVIFAr, n)
Br.25,000 = R (FVIFA, 1%, 60)
Br. 25,000 = R (81.670)
R= Br. 25,000/81.670
= Br. 306.11

▪Example 4.18:
▪Holiday Tours (HT) has an employment contract with its newly hired CEO.
The contract requires a lump sum payment of $10.4 million be paid to the
CEO upon the successful completion of her first three years of service. HT
wants to set aside an equal amount of money at the end of each year to
cover this anticipated cash outflow and will earn 5.65 percent on the funds.
How much must HT set aside each year for this purpose?
▪Soln Given: FVOA= Br.10,400,000; r=5.65% ; n =3; R = ?
FVOA = R (FVIFAr, n)
Br.10,400,000 = R (FVIFA, 5.65%, 3)
Br. 10,400,000 = R (3.1726924)

R = $$3,277,973
▪Example 4.19:
▪ ABC Company wants to accumulate Br.600,000 on Dec31 year 5 to retire
along term notes payable and the company intended to make five equal
annual deposits in a fund that will earn interest at 6% compounded annually.
(a)How much should the Company deposit every year to achieve its goal, if
the first deposit was made on Dec31 year1? (b) prepare a fund accumulation
schedule to verify that Br.600,000 will be available on Dec 31, year 5,
▪ Spln (a) Br.600,000 = R (FVIFA, 6%, 5)
R = Br.600,000/5.63709
=Br106,437.84

▪Example 4.19 Cont.
▪ (b) ABC Company fund accumulation schedule

II. Future Value of Annuity Due(FVAD)

▪ Annuity due (AD) is an annuity for which the cash flows occur at the
beginning of the period.
▪ Suppose an annuity due has five payments of $400 each, and the relevant
rate is 10 percent, the time line looks like as follows:
▪ And the value of FVAD is computed by using the formula;
▪ FVAD = R (1+r) -1 (1+r)

n
r
Or FVAD = R (FVIFAr,n)(1+r)
(1+r) n -1
Where: its FV interest factor = r (1+r)

▪ Example 4.20
▪ Hiwot is going to save $10,500 in her saving account on the first of each
month, starting today, to buy new Automobile six years from now . If she
can earn a monthly interest rate of 0.90 percent, how much will she have in
her saving account six years from now?
▪ Soln FVAD = R (1+r) -1 (1+r)

n
= $10,500 (1+0.009/12) 6*12 -1 (1+0.009/12)

0.009/12
=$10,500(73.95099)(1.00075)
= $10,500(74.006449)
= $777,067.72

▪ Example 4.21
▪ ABC Corporation needs Br.200,000 for March31, year 5. This amount is to
be accumulated by making 16 equal deposits in a fund at the beginning of
each quarterly starting March31 year 31 and ending Dec31 year 4. The fund
will earn interest at 8% compounded quarterly. How much the periodic
payment should the ABC must made?
= R (1+r) -1 (1+r)
n
▪ Soln FVAD
r
Br.200,000 = R (1+0.08/4) 4*4 -1 (1+0.08/4)

0.08/4
Br.200,000 = R (19.01207)
R = Br.10,519.63

III. Future Value of Deferred Annuity (FVDA)
▪ The FVDA is computed exactly two or more periods after the final payment
is made. Graphically, this can be depicted as:
▪ The following diagram illustrates the relationship of an ordinary annuity of 16

payment (rent, deposit---), an annuity due of 16 payment(rent, deposit--) and
an ordinary annuity of 16 rent deferred for 7 periods.

▪ And the value of FVAD is computed by using the formula;
▪ FVAD = R (1+r) n -1
(1+r) x Or FVAD = R (FVIFAr,n)(1+r) x
r
Where: its FV interest factor = (1+r) n -1

(1+r) x and
r
x is the number of periods after the final payment; and x  2

▪ Example 4.22
▪ Henok has a saving account which he had been depositing Br. 3,000 every
year on Jan1, starting in 2000. His account earns 10% interest compounded
annually. The last deposit Henok made was on Jan1, 2009. How much
money will he have on Dec31, 2013?
Soln The future value is computed on Dec 31, 2013 (or Jan1, 2014).
FVDA = R (FVIFAr, n) (1+r) x
FVDA = Br. 3,000 (FVIFDA 10%, 10) (1.10)5
= Br. 3,000 (15.937) (1.6105)
= Br. 76, 999.62

▪ Example 4.23
▪ Referring to Example 4.21 above, compute periodic deposit that ABC
Corporation must make deferred for 7 periods.
FVDA = R (1+r) -1 (1+r) x

n
▪ Soln
r
Br.200,000 = R (1+0.08/4) 4x4 -1 (1+0.08/4)7
0.08/4
Br.200,000 = R (18.639285) (1.148685)
Br.200,000 = R (21.410863)
R = Br.200,000
(21.410863)
R= Br.9,341.13

4.3.3.The Future Value of Uneven Cash Flows
▪ Uneven cash flow stream is a series of cash flows in which the amount cash
flows varies from one period to another period.
▪ The future value of an uneven cash flow stream is computed by summing up

the future value of each cash flow.
▪ Suppose you deposit $100 today in an account paying 8 percent and

another $100 one year from today. How much will you have in two years?
▪This particular problem is easy, at the end of the first year, you will have $108
plus the second $100 you deposit, for a total of $208 and at the end of this
second year, it worth:$224.64 ($208x1.08).
▪ The following fig shows the time line that illustrates the process of calculating
the future value of these two $100 deposits.

▪ In the first part of the fig, we show the first cash flow occurs today, which we
label as Time 0 we put $100 at Time 0 on the time line and the second $100
cash flow occurs one year from today, so we write it down at the point
labeled as Time1.
▪ In the second part of the fig, we calculate the future values one period at a
time to come up with the final $224.64 as shown below.

▪ When we calculated the future value of the two $100 deposits, we simply
calculated the balance as of the beginning of each year and then rolled that
amount forward to the next year.
▪ We could have done it another, quicker way that the first $100 is on deposit
for two years at 8 percent, so its future value is: $100(1.08)2 =$116.64
▪ The second $100 is on deposit for one year at 8 percent, and its future value
is:$100(1.08 )= $108
▪ The total future value, as we previously calculated, is equal to the sum of

these two future values:$116.64 + $108 =$224.64

▪ On the base of this example, there are two ways to calculate FVs for
multiple cash flows:
(1) Compound the accumulated balance forward one year at a time or
(2) Calculate the future value of each cash flow first then add them up.
▪ Both give the same answer, so you can do it either way.
▪ Example4.24
▪ Compute future values of $1,000, 3,000, 4000, 1200, and $900 deposited at
the end of the next five years with interest rate of 10% compounded
annually using the two methods mentioned above.

Soln Ex4.24 since each cash is deposited at the end of each year, the
current balance is zero, and the interest is computed at the end of each year
so that the last deposit (5th year) has no interest as shown the time line.
▪ We first draw a time line, which novice nothing happens until the first $1,000
deposited at end of the first year.
(1).Future value by compounding forward one period at a time is computed as

shown below;

▪ The above calculations involved if we compound the deposit one period at a

time. As illustrated, the future value is $12,517.10
▪ 2).Calculate the future value of each cash flow first then add them up.
▪ In the following calculations we got the same answer using the second
technique as shown below;

▪ Example 4.25
▪ Lucas will receive $6,800, $8,700, and $12,500 each year starting at the end
of year one. What is the future value of these cash flows at the end of year
five if the interest rate is 7 percent?
Soln FVn= $6,800× (1.07)4 + $8,700× (1.07)3 +$12,500× (1.07)2
= $33,883
Example 4.26
▪ You plan on saving $5,200 this year, nothing next year, and $7,500 the
following year. You will deposit these amounts into your investment account
at the end of each year. What will your investment account be worth at the
end of year three if you can earn 8.5 percent on your funds?
Soln FVn= $5.200×(1.085)2 + $0+$7,500= $13,621.57

4.4.The Present Value of Cash Flows
▪ The compound, or future, value calculations answer the question: What will
be the future value of money invested today, compounded at some rate of
interest, r?
▪ The financial decision maker, however, is often faced with another type of
problem: given the future value, FVn, what is its equivalent value today?
That is, what is its present value, PVo?
▪ The solution requires present value calculations, is the value today’s cash
flow(s) or the amount money today PV0, that is equivalent to some
promised future money amount, FVn.
▪ Present value is the exact reversal of future value the current cash flow
which compounded at a given interest rate over a specified period so as to
obtain future value and the process of decomposing the future value in to the
present value is called discounting.
4.4.1.The Present Value of A single Cash Flows
▪ As with future values, we can determine the present value of a single cash
flow, an annuity cash flows or uneven cash flows.
▪ It is derived from the future value and their inverse relationship by rewriting
the equations as shown below;
▪ FVn = Pvo(1+ r)n
▪ PV0 = FVn 1 .
(1+r) n
▪ Where 1/(1+r) n is the reciprocal of the compound value factor (1+ i) n

▪ Because determining the present value of,1/(1+r)n, can be a tedious process,
the following present value interest factors formula are commonly used to
simplify such computations; Pv = FV(PVIFr, n).
▪ This discounting process can also be illustrated graphically as shown below .
the higher the discount rate, the lower the Pv which is reciprocal of Fvs.


Example 4.27 Your father invested a lump sum 26 years ago at 4.25 percent
interest. Today, he gave you the proceeds of that investment which totaled
$51,480.79. How much did your father originally invest?
Soln PV0=FVn1/(1+r) n=$51,480.79  [1/(1 + .0425)26] = $17,444.86
Example 4.28
▪ You would like to retire with$1,000,000 in 50 years as a millionaire . If you

have $10,000 today, what rate of return do you need to earn to achieve your
goal?
▪ Soln. $10,000= $1,000,000/(1+r )50

(1 + r )50 =100; r = 9.65 percent
▪ Therefore, the future value factor is thus 100 and the implicit rate is 9.65%.

4.4.2.The Present Value of Ordinary Annuity(PVOA) Cash Flows
▪ Present value of an Ordinary Annuity is the sum of the present value of a

series of equal periodic payments made at the end of each period.
 1 
1 −
   1 − (1 + r ) − n 
PVOA = R  (1 + r ) n
r or PVOA = R (PVIFOA r, n)
 R  
 r   r 
 
 
▪ Where: PVOA is the present value of an ordinary annuity and

▪ R is periodic payment.
▪ The term in parentheses on the first line is sometimes called the present
value interest factor for annuities and abbreviated PVIFA(r, n).
▪ is the present value factor .

Example 4.29
▪ For example, to find the present value of an ordinary $1,000 annuity
received at the end of each year for five years discounted at a 6 percent
rate, the sum of the individual present values would be determined as
follows:
PV0A = R(PVIFr,n1) +R(PVIFr,n2) R(PVIFr,n3) +R(PVIFr,n4) R(PVIFr,n5)

=$1,000(6%,1)+$1,000(6%,2)+$1,000(6%,3)+$1,000(6%,4)+$1,000(6%,5)
=$1,000(0.943 + 0.890 + 0.840 + 0.792 + 0.747)

=$4,212
▪ This can e expressed graphically as depicted as follows;

79

Example 4.30
▪ Your grandmother is gifting you $100 at the end of each month for four years
while you attend college to earn your bachelor's degree. At a 5.5 percent
discount rate, how much these payments worth to you on the day you enter
college?
▪ Soln

Example 4.31
▪ Your employer contributes $75 a week to your retirement plan. Assume that
you work for your employer for another 20 years and that the applicable
discount rate is 7.5 percent. Given these assumptions, what is this employee
benefit worth to you today?
▪ Soln

4.4.3.The Present Value of Annuity Due(PVAD) Cash Flows
▪ Annuity due(common in rental or lease contracts) calculations are also

important when dealing with the present value of an annuity problem. In
these cases, the annuity PV interest factors must be modified and PVAD
with the help of the following formula;
 1 
1 −
  ( 1 + r) or
PV AD
A ==RR  (1 + r )n
 PVAD = R (PVIFOA r, n)(1+r)
 r 
 
 
▪ Example 4.32
▪ Referring to the case of a 5-year annuity of $1,000 each year, discounted at

6 percent in Example 4.28 above, What is the present value of this annuity
if each payment is received at the beginning of each year?

▪ Soln Ex4.32 As it is illustrated on fig 5.9 below, the first payment received
at the beginning of year 1 (end of year 0) is already in its present value
form and therefore requires no discounting.
▪ PMT2 is discounted for one period, PMT3 is discounted for two periods,
PMT4 is discounted for three periods, and PMT5 is discounted for four
periods.
▪ The correct annuity due interest factor is obtained from Pv Annuity Table
by multiplying the PVOA interest factor for 5years and 6% (4.212) by 1 plus
the interest rate (1+0.06).
▪ This yields a PVIFA for an annuity due of 4.465, and the present value of
this annuity due (PVAD) is $1,000(4.465) =$4,465


Example 4. 33
▪ The Design Team just decided to save $1,500 a month for the next 5 years
as a safety net for recessionary periods. The money will be set aside in a
separate savings account which pays 4.5 percent interest compounded
monthly. The first deposit will be made today. What would today's deposit
amount have to be if the firm opted for one lump sum deposit today that
would yield the same amount of savings as the monthly deposits after 5
years?
▪ Soln

Example 4.34
▪ You are scheduled to receive annual payments of $4,800 for each of the
next 7 years. What is the difference in the present value you receive these
payments at the beginning of each year rather than at the end of each year
if 8 percent interest rate is charged on this payment?
▪ Soln

4.4.4.The Present Value of Deferred Annuity (PVDA) Cash Flows
▪ The Present Value of Deferred Annuity (PVDA) is computed two or more

periods before the first payment is made.
 1 
−

A ==RR 
PV DA
1
(1 + r )n 

( 1 + r)-x or PMT (PVIFAr, n) (1+ r)-x
 r 
 
 
▪ Where x is the number of periods between the date when the first payment
is made and the date the present value is computed.

▪ Frequently, in finance, one encounters problems where an annuity begins

more than one year in the future.
▪ Example 4.35
▪ Suppose that you wish to begin your daughter provide for the college
-x
education five years from now, and you wish to have $15,000 available for
her at the beginning of each year in college. How much must be invested
today at a 12% annual rate of return in order to provide the 4-year, $15,000
annuity for your daughter?
▪ This problem can be illustrated in the timeline given in Fig 5.11below.


▪ Four payments of $15,000 each are required at the end of years 5, 6, 7,

and 8. Of course, this problem could be solved by finding the sum of the
present values of each of the payments as follows:

▪ Example 4.36
▪ ACCA has developed a copyrighted accounting software program and
agreed to sell the copyright to Steel Company for 6 annual payments of
$5,000 each. The payments are to begin 5 years from today. If the annual
interest rate is 8%, what is the present value of the six payments?
Soln
▪ Given. R =$5,000; r= 8%; n =6; x = 4; PVDA6 = ?

▪ PVDA6 = $ 5,000 (PVIFA8%, 6) (1.08)-4
= $ 5,000 (4.6229) (0.7350)
= $16,989.16
4.4.4.The Present Value of Uneven Cash Flows
▪ As with future values, there are two ways to calculate the present value of
uneven cash flows: either discount back one period at a time, or calculate
the present values individually and add them up.
▪ Example 4.37
▪ Suppose you need $1,000 in one year and $2,000 more in two years. If you
can earn 9 percent on your money, how much do you have to put up today
to exactly cover these amounts in the future?
▪ SolnThe PV of $2,000 in two years at 9% is:$2,000/1.092= $1,683.36
▪ The PV of $1,000 in one year is: $1,000/1.09 =$917.43
▪ Therefore, the total present value is:$1,683.36+ 917.43=$2,600.79

Example 4.38 (1) Pv calculated by discounting back one period at a time

▪ Suppose we had an investment that was going to pay at the end of each
year of the next five years;$200, $400, $600 $800, and $1000 respectively.
If we earn 12% on similar investments, what is the most we should pay for
this one?
$200×1/1.121 =$178.57
$2,000.36 is the most we should be willing
$400×1/1.122 =$318.88
to pay because we can duplicate this
$600×1/1.123 =$427.07
investment’s cash flows, if we can earn
$800×1/1.124 =$508.41
12% on our money.
$900×1/1.125 = $510.68
⸫Total present value $2,000.36


▪ Example 4.39
▪ Your parents have made you two offers. The first offer includes annual gifts
of $10,000, $11,000, and $12,000 at the end of each of the next three
years, respectively. The other offer is the payment of one lump sum amount
today. You are trying to decide which offer to accept given the fact that your
discount rate is 8 percent. What is the minimum amount that you will accept
today if you are to select the lump sum offer?
▪ Soln

4.4.5.The Present Value of Perpetuities Cash Flows
▪ We’ve seen that a series of level cash flows can be valued by treating those
cash flows as an annuity.
▪ An important special case of an annuity arises when the level stream of cash
flows continues forever, such an asset is called perpetuity because the cash
flows are perpetual.
▪ Perpetuity is an annuity in which the cash flows continue forever.
▪ Preferred stock dividend is an important example of a perpetuity.
▪ Perpetuities are also called consols, particularly in Canada and the United
Kingdom.
▪ Because a perpetuity has an infinite number of cash flows, we obviously
can’t compute its value by discounting each one.
▪ See Example 4.40 below for an important issue of a perpetuity.

▪ The present value of a perpetuity is computed by using the following.
▪ PV for a perpetuity = C/r
▪ Where C is annual Cash flow.
r is Interest rate, rate of return, or discount rate per period.
▪ Example 4.40
▪ You would like to establish a trust fund that will provide $120,000 a year
forever for your heirs. How much money must you deposit today to fund this
gift for your heirs, if the expected rate of return on the fund is 5.75% ?
▪ Soln PV= C/r $120,000/0.0575 = $2,086,957
▪ AcFn 2131 Ch4 By Yoseph Tadesse Friday, June 7, 2024 97

▪ Example 4.41
▪ Fellini Co. wants to sell preferred stock at $100 per share. A very similar
issue of preferred stock already outstanding has a price of $40 per share
and offers a dividend of $1 every quarter. What dividend will Fellini have to
offer if the preferred stock is going to sell?
▪ Soln. The issue that is already out has a present value of $40 and a cash
flow of $1 every quarter forever, this is a perpetuity:
▪ Present value =$40 = $1×(1/r)
r = 2.5%
▪ To be competitive, the Fellini issue will have to offer2.5% per quarter; so, if
the present value is to be $100, the dividend must be such that:
▪ Present val ue =$100= C×(1/.025)= C =$2.50 per quarter.

4.5. More Frequent Compounding Rate
• All illustrations/examples above showed that the interest actually earned on

an investment depends on the frequency with which the interest is
compounded.
• Thus, the stated, or nominal, rate of 8% per year does not reflect the actual
rate at which interest is earned.
• This suggests that we need to find a common basis for comparing interest
rates and one such way of comparing interest rates is provided by the use of
the effective rate.
• The effective rate also called the effective annual yield is the simple interest
rate that would produce the same accumulated amount in 1 year as the
nominal rate compounded m times a year. Effective rate is interest rate
expressed as if it were compounded once per year you actually pay/gain.

▪ To derive a relationship between the nominal interest rate, r per year

compounded m times, and its corresponding effective rate, R per year, lets
assume an initial investment of P dollars.
▪ Then, the accumulated amount after 1 year at a simple interest rate of R per
year is A = P(1 + R)
▪ Also, the accumulated amount after 1 year at an interest rate of r per year
compounded m times a year is
▪ Equating the two expressions we obtain the following Effective Rate of

Interest Formula by divide both sides by P or, upon solving for R.

▪If we let i stand for the quoted rate, then, as the number of times the interest
is compounded gets extremely large, the reff approaches:
reff = e i-1 where i is quoted rate and e=2.71828

▪ To see why it is important to work with these rates, suppose ha if a rate is

quoted as 10 percent compounded semiannually, then what this means is
that the investment actually pays 5 percent every six months.
▪ A natural question then arises: Is 5 percent every six months the same thing
as 10 percent per year?
▪ It’s easy to see that it is not. If you invest $1 at 10% per year, you will have
$1.10 at the end of the year.
▪ If you invest at 5 percent every six months, then you’ll have the future value
of $1 at 5 percent for two periods, $1.1025( $1*1.052 )
▪ This is $.0025 more. this is occurred because of your account was credited
with $1*.05= 5 cents in interest after six months and in the following six
months, you earned 5 percent on that nickel, for an extra 5*.05 = .25 cents.
▪
▪ As a result, 10% annual quoted rate compounded semiannually is actually

equivalent to EAR 10.25% per year.
▪ Put another way, we would be indifferent between 10% quoted annual rate
compounded semiannually and 10.25% EAR compounded annually.
▪ Stated Annual Rate (SAR) also called Quoted Annual Interest Rate is the
interest rate expressed in terms of the interest payment made each period
usually in year without consideration of compounding.
▪ By law, the APR is simply equal to the interest rate per period multiplied by
the number of periods in a year (i×m).
▪ EAR
▪ NB:If the compounding occurs annually, EAR=SAR; otherwise EAR>SAR.

▪ Example 4.42
▪ Find the effective rate of interest corresponding to a nominal rate of 8% per

year compounded (a) annually, (b) semiannually, (c) quarterly, (d) monthly,
and (e) daily.
▪ Soln.(a) reff = (1 + 0.08) - 1 = 0.08
(b) reff = (1 + 0.08/2)2 - 1 = 0.0816
(c) reff = (1 + 0.08/4)4 - 1 ≈ 0.08243
(d) reff = (1 + 0.08/12)12 -1 ≈0.08300
(e) reff = (1 + 0.08/365)365 -1 ≈0.08328
▪ So the required effective rates for (b) to (e) are 8.16%, 8.243%, 8.30% and
8.328% per year respectively.

▪ Example 4.43
▪ A bank is charging1.2 percent per month on car loans.
a) What SAR that must be reported for the year?
Soln APR/ASR=1.2%*12=14.4%
b) What is EAR on that loans?
Soln reff= [1+(.144/12)]12 -1=15.39%
c) What is the highest possible EAR earns if compounded continuously?
Soln reff = e0.144 -1=15.48%

▪ Example 4.44
▪ Suppose banks offers the following compounding interest rates to their

customers:
▪ Bank A: 15 percent compounded daily.
▪ Bank B: 15.5 percent compounded quarterly.
▪ Bank C: 16 percent compounded annually.
Required
1) Which of these is the best if you are thinking of opening a savings account?
2) Which of these is best if they represent loan rates?

▪ Soln Ex 4. Let us begin from Bank C is offering 16 percent per year.

Because there is no compounding during the year, this is the effective
annual rate.
▪ Bank B is actually paying .155/4 = .03875 or 3.875% per quarter.
▪ At this rate, an investment of $1 for four quarters would grow to:
▪ $1*(1.03875)4 = $1.1642 and EAR=16.42%
▪ For a saver, this is much better than the 16% Bank C is offering; for a
borrower, it’s worse.
▪ Bank A is compounding every day which seems a little extreme, in this case,
the daily interest rate is 15/365=.000411=.0411% per day, at this rate, an
investment of $1 for 365 periods would grow to $1(1.000411)365 = $1.1618
and EAR=16.18%. This is not as good as Bank B’s 16.42 percent for a
saver, and not as good as Bank C’s 16 percent for a borrower.
▪ Now, if the effective rate of interest reff is known, the accumulated amount
after t years on an investment of P dollars may be more readily computed by
using the formula;
• The 1968 Truth in Lending Act passed by Congress requires that the
effective rate of interest be disclosed in all contracts involving this effective
interest charges, this is because it enables consumers to compute the actual
charges involved in a transaction and to have a common basis for
comparing the various nominal rates quoted by different financial institutions.
• When Ex 4.4 were known, the accumulated values of Ex 4.5, could have
been readily found as shown in Table 3, below.



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CHAPTER IV

(THE TIME VALUE OF MONEY)

AcFn 2131 Ch4 By Yoseph T Friday, June 7, 2024 1

▪ After completing this chapter students will be able to:

➢ Understand the concept of time value money.

➢ Understand how to calculate the future values of a single, annuities and

➢ Identify the special cases in annuity.

➢ Identity the more frequent compounding interest rates.

AcFn 2131 Ch4 By Yoseph Tadesse Friday, June 7, 2024 2

o Understanding the time value of money concept is essential for a financial

o The goal of a firm is wealth maximization recognizes the difference in the

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▪ Chapter 1 through 3 we have seen the algebraic equations equalities or

▪ i.e. x + 5 = 15; 3y > 24 and x - y ≤ 12

▪ Property 2: each side of an equation can be multiplied or divided* by the

▪ Note that in an algebraic term such as 4x or (a+b)x, the number or symbol

▪ Likewise, the coefficient of y in equation y/3 = 24 is 1/3, and the coefficient

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• In the mathematical expression an, a is the base, n is the exponent or power,

▪ Example 4.1. Express the following numbers in exponential form and

▪ The laws of exponents is applied in business, science, technology, and

▪ We will consider a few examples to illustrate their application in business

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• 4.1.2 .The Common and Natural Logarithmics

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• 4.1.2 .The Common and Natural Logarithmics

▪ The natural logarithm is mostly used in science and engineering, although it

▪ The logarithm (common or natural) of a positive number that is less than 1 is

▪ The logarithm of a negative number is an imaginary number and, as

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• 4.1.2 .The Common and Natural Logarithmics

▪ We will see later in detail the uses of Logarithmic in business world.

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▪ Compute the number of months required to accumulate $100,000 by making

▪ This time is equivalent to 11 years and 7 months.

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▪ As we have discuss at the introductory of this chapter, money can be thought of as

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▪ Simple interest can be understood in two different ways.

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▪ In business applications, we are normally interested only in the case where t is

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▪ (b) What is the interest earned in that period of time?

▪ Soln (a) A = P(1 + rt )

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▪ A1 = P(1+rt) = 1000[1 + (0.08(1)] = 1000(1.08) = $1080

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A2 = P(1 + rt) =A1(1+ rt)

= 1000[1 + 0.08(1)][1 + 0.08(1)]

= 1000[1 + 0.08]2 = 1000(1.08) 2=1166.40

= 1000[1 + 0.08(1)]2 [1 + 0.08(1)]

= 1000[1 + 0.08] 3 = 1000(1.08) 3 ≈ 1259.71

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▪ If interest at a nominal rate of r per year is compounded m times a year on a principal

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▪ Soln (a) A =1000(1+0.08)3 = $1259.71

(b) A =1000(1+0.08/2)3(2) =1265.32

(c) A =1000(1+0.08/4)3(4) =1268.24

(d) A =1000(1+0.08/12)3(12) =1270.24

(e) A =1000(1+0.08/365)3(365) =1271.22

▪ These results are can be summarized in Table 1 below.

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