Chapter 3: Time Value of Money

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 Learning Objectives

1. Meaning of Time Value

2. Distinguish between simple and compound interest.
3. Solve future and present value of problems.
4. Solve future value of ordinary and annuity due problems.
5. Solve present value of ordinary and annuity due problems.

04/30/2024 lectured by: Yonas M. 2

1. Introduction
• How to determine the value today of cash
flows expected in the future?
• 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.

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Time lines: it is a graphical representation used to
show the timing of cash flows in the time value of
money analysis.

0 1 2 ….……… n
i%

CF0 CF1 CF2 ………………. CFn

• Show the timing of Cash flows (CFs), both cash inflows

and outflows.
• Tick marks occur at the end of periods, so Time 0 is
today; Time 1 is the end of the first period (year, month,
etc.) or the beginning of the second period, and so on.
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2. Future Value and Compounding
• A Birr in hand today is worth more than a Birr to be received in
the future because, if you had it now, you could invest it, earn
interest, and end up with more than one Birr in the future.
• Future Value (FV): refers to the amount of money an
investment will grow to over some period of time at some
given interest rate.
• Compounding: The process of accumulating interest on an
investment over time to earn more interest.
 It is the process of going from today’s values, or present values (PVs), to
future values (FVs)
• compound interest: Interest earned on both the initial
principal and the interest reinvested from prior periods.
• simple interest: Interest earned only on the original principal
amount invested.
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Cont’d
• Annual compounding: is the arithmetic process of determining
the final value of a cash flow or series of cash flows when
interest is added once a year.
• Semiannual compounding: is the arithmetic process of
determining the final value of a cash flow or series of cash flows
when interest is added twice a year.
• whenever payments occur more frequently than once a year, or
when interest is stated to be compounded more than once a
year, then you must convert:
a. The stated rate to a ‘periodic rate’:
Periodic rate= stated rate/number of payments per year

b. Number of years to ‘number of periods’:

Number of periods = Number of years * Periods per year 6
Cont’d
• The formula to determine future value:

Where, FVn = Future value or ending amount

PV = Present value, or beginning value
i = Interest rate
n = number of periods
• Example:
Suppose you deposit Br. 100 in a bank that pays 5 percent
interest each year. How much would you have at the end of
the fifth year?

= Br. 127.63
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3. Present Value and Discounting
• How much do you have to invest today to reach your future
goal?
• Present value (PV): The current value of future cash flows
discounted at the appropriate discount rate (i).
• Discounting: The process of finding the present value of a
cash flow or a series of cash flows; discounting is the reverse
of compounding.

 Thus, the formula to determine the present value is:

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Cont’d
• In general, the present value of a cash flow due ‘n’ years in
the future is the amount which, if it were on hand today,
would grow to equal the future amount.
• Thus, from the FV example, the PV can be calculated as:
PV = Br 127.63 = Br. 100
(1+ 0.05)5
• Example:
Assume that you would like to buy a new automobile for Br
600,000 after 3 years. If you can earn 9 percent, how much do
you have to invest today to buy the car in three years?
Solution: FV= Br 600,000, n= 3 years, and i=9%

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4. Future Value of Multiple Cash Flows (Annuity)
• Annuity: is a series of payments of an equal amount
at fixed intervals for a specified number of periods.
• Ordinary (Deferred) Annuity: is an annuity whose
payments occur at the end of each period.
• Annuity Due: is an annuity whose payments occur at
the beginning of each period.

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i. Ordinary Annuity
Future Value of an Ordinary Annuity

R = periodic rent
FVF-OA = future value factor of an ordinary annuity
i = rate of interest per period
n= number of compounding periods
Example: If you deposit Br100 at the end of each year for three years
in a savings account that pays 5 percent interest per year, how
much will you have at the end of three years?

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ii. Annuity Due
• It is series of equal payments made at the beginning of each
period.
• Under annuity due, the payments occur earlier, so more
interest can be earned.

• Example:
If you deposit Br100 at the beginning of each year for three
years in a savings account that pays 5 percent interest per
year, how much will you have at the end of three years?

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Time line for Ordinary annuity and annuity due

 Ordinary Annuity:

 Annuity Due:

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5. Present Value of an Annuity
 Which one you choose from these two alternatives:
a. A three-year annuity payments of Br 100, or
b. A lump sum payment today of Br. 280.
 Your choice will depend on the PV of annuity payments as
compared to the lump sum payment Br 280. The PV of the
annuity in turn depend on the annuity type and available
discount rate.
PV of Ordinary Annuities:
• If the payments come at the end of each year, then the PV of
an ordinary annuity can be calculated as:

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Cont’d
Example:
Suppose you are to receive a Br 100 at the end of each year
for three years, and interest (discount) rate is 5%. What is the
PV of this annuity?
Solution: PMT = Br 100, n = three years, and i= 5%.

PVOA%,n = R * 1 – (1+i)-n

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PV of Annuity Due:
• To find the PV of annuity due, the formula is:

• PVOA%,n = R * 1 – (1+i)-n (1xi) or

• i

Example:
If you receive the annuity Br 100 annuity at the beginning of
each year for three years, and interest rate is 5%. Determine
the PV of this annuity?
Solution: this is annuity due, PMT= Br 100, n= 3 years, and i=5%

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6. Perpetuities

• Is a stream of equal payments continue forever.

• The present value of perpetuity is determined as:

Example:
The present value of a Br 100 perpetuity payments with 5%
interest rate would be:
PV (perpetuity) = Br 100/0.05 = Br 2,000

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7. Uneven Cash Flow Streams
• It is a series of cash flows in which the amount varies from
one period to the next.
• Present Value of Uneven Cash Flows:
• It is found as the sum of the PVs of the individual cash flows of
the stream.

Where, CF = is the amount of cash flows at each period

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Cont’d
• Future Value of Uneven Cash Flows:
• It is also called terminal value.
• The formula to compute FV of uneven cash flows is:

Example: Consider the following stream of cash flows that

comes at the end of each year, and interest rate is 6%.
Year 1 2 3 4 5 6 7

CFs 1,000 2,000 2,000 2,000 2,000 0 1,000

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Cont’d
• PV of uneven cash flows:

• FV of uneven cash flows:

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Thank You!!!

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