CHAPTER FOUR

TIME VALUE OF MONEY

After completing this chapter, you will be able to:

 Compute the future value of a single amount and series of amounts
 Compute the present value of a single and series of amounts
 Compute the present value of perpetuity
 Prepare loan amortization table

Introduction

“A Birr today is worth more than a Birr tomorrow”

 One of the basic problems faced by financial manager is how to determine the value today of cash
flows expected in the future.
 The phrase time value of money refers to the fact that a Birr in hand today is worth more than a Birr
promised at some time in the future. One reason for this is that one could earn interest while s/he
waited. So a Birr today would grow to more than a Birr later.
 Among other things, the trade-off between money today and money later depends on the rate you can
earn by investing.

COMPOUNDING AND FUTURE VALUE

 Compounding refers to the process of accumulating interest on investment over time to earn more
interest.
 Future value (FV) refers to the amount of money an investment will grow to over some period of
time at some given interest rate. In other words, future value is the cash value of an investment at
some time in the future. The today’s value is referred to as principal. The amount by which the
money will grow is referred to as interest.
 Interest is the money paid or earned for the use of money.
 Interest may be:
1. Interest on interest
 Is interest earned on the reinvestment of previous interest earned

2. Compound (Total) interest

 Is interest on both the initial principal & interest reinvested from prior periods

3. Simple interest
 Interest earned only on the original principal amount invested

Example: Suppose you identified a two-year investment that pays 10% per year. If you invest Br.
1000 today,
a. How much will you have at the end of the two years?
End of year 1 Amount = 1000 x 1.10 = 1100
End of Year 2 amount = 1100 x 1.10 = 1210

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 b. How much is compound interest?
Compound interest = 1210 – 1000 = 210

c. How much interest is earned on interest?

= Year 1 interest x 10%
= 100 x 10% = 10
d. How much is simple interest?
= Compound interest – interest on interest
= 210 – 10 = 200

 Future value computation may include:

 Future value of a single amount
 Future value of Annuities
 Future value of series of unequal amount

Future value of a single amount

FV = Po (1+i) n
Where,
FV = Future value
Po = Principal
i =Periodic interest rate
n = Number of periods

Future Value of Annuities

 Annuity refers to a series of equal payments or receipts occurring over a specified number of periods
 Annuity may be ordinary annuity or annuity due
 Ordinary annuity exists when payments or receipts occur at the end of each period
 Annuity due exists when payments or receipts occur at the beginning of each period

FVA = A
( (1+i)n −1
i )
Where,
FVA = Future Value of an annuity
A = Annuity
i = Periodic interest rate
n = Number of periods

Future Value of Series of Unequal Amounts

 Future value is equal to the sum of the future value of each amount

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PRESENT VALUE AND DISCOUNTING

 Discounting refers to the process of determining today’s (current) value of future cash flows.
 Present value refers to today’s (current) value of future cash flows discounted at the appropriate
discount rate.
 Present value computation includes:
 Present value of a single amount
 Present value of series of equal amounts (annuities)
 Present value of series of unequal amounts
 Present value of perpetuity

Present value of a single amount

PV = FV
( 1
( 1+i )
n )
Where,
PV = Present value
FV = Future value
i = Interest rate
N = Number of periods
Present value of Annuities

[ ]
1
1−
( 1+i )n
PVA = A
i
Where,
PVA = Present value of Annuity
A = Annuity
i = Interest rate
N = Number of periods

Present value of Series of Unequal Amounts

 Present value is equal to the sum of the present value of each future value.

Present Value of Perpetuity

 Perpetuity refers to an ordinary annuity whose payments or receipts continue forever

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 A
PVA∞ = i