CH 3
CH 3
CH 3
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Financial Management, ch-3: Time Value of Money
3.2. Interest
Interest is the price paid for the use of a sum of money over a period of time. It is a fee paid for
the use of another’s money, just rent is paid for the use of another’s house.
A savings institution (Banks) pays interest to depositors on the money in the savings account
since the institutions have use of those funds while they are on deposit. On the other hand, a
borrower pays interest to a lending agent (bank or individual) for use of the agent’s fund over the
term of the loan.
Interest is usually computed as percentage of the principal over a given period of time. This is
called interest rate. Interest rate specifies the rate at which interest accumulates per year
throughout the term of the loan. The original sum of money that is lent or invested/ borrowed is
called the principal.
In general, the difference between money now and the same money in the future is called
interest.
Interests are of two types: simple interest and compound interest. In the first part of this unit
we shall explore these two concepts.
3.2.1. Simple Interest
If interest is paid on the initial amount of money invested or borrowed only and not on
subsequently accrued interest, it is called simple interest. The sum of the original amount
(principal) and the total interest is the future amount or maturity value or in short amount.
Simple interest generally used only on short-term loans or investments –often of duration less
than one year. Simple interest is given by the following formula.
Where: I = Simple interest
I = Prt P = Principal amount
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Financial Management, ch-3: Time Value of Money
Example 1
Ato Kassahun wanted to buy TV which costs Br. 10,000. He was short of cash and went to
Commercial Bank of Ethiopia (CBE) and borrowed the required sum of money for 9 months at
an annual interest rate of 6%. Find the total simple interest and the maturity value of the loan.
Solution:
p = Br. 10,000 A=P+I
t** = 9 months = 9/12 = ¾ (0.75) year = P (1 + rt)
= Br. 450
The total amount which will have to be repaid to CBE at the end of the 9 th month is Br.
10, 450 (the original borrowed amount plus Br. 450 Interest).
** Note: It is essential that the time period t and r be consistent with each other. That is if r is
expressed as a percentage per year, t also should be expressed in number of years
(number of months divided by 12 if time is given as a number of months). If time is given
No .ofdays
as a number of days, then t = 360 days . this approach is known as ordinary interest
year method which uses a 360 day years, whereas if we use 365 days years the approach
is called exact time method.
Example 2
How long will it take if Br. 10, 000 is invested at 5% simple interest to double in value?
Solution
Given: p = Br.10, 000 A=P+I
r = 5% = 0.05 I = prt
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Financial Management, ch-3: Time Value of Money
A = Br.20, 000 (2 x 10, 000) 20000 = 10000 + 10000(0.05) t
t=? 10000 = 500t
t = 20 Years Or
10,000
= 10,000 (0.05) = 20Years = 20, 000 – 10, 000 = 10,000
Therefore, it will take 20 years for the principal (Br. 10, 000) to double itself in value if it is
invested at 10% annual interest rate.
Example 3
How much money you have to deposit in an account today at 3% simple interest rate if you are
to receive Br. 5, 000 as an amount in 10 years?
Solution
A = Br. 5, 000
A
t = 10 Years
P=
1 + rt
r = 3% = 0.03
5 ,000
= 1 + (0 .03 x 10)
= Br. 3, 846.15
In order to have Br. 5, 000 at the end of the 10 th year, you have to deposit Br. 3846.15 in an
account that pays 3% per year.
Example 4.
At what interest rates will Br. 5, 000 yield Br. 2, 000 in 8 years’ time.
Solution:
P = Br. 5, 000 r = I/pt
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Financial Management, ch-3: Time Value of Money
2, 000
I = Br. 2, 000 = 5, 000 x 8
t = 8 years = 0.05 = 5%
r=?
Example 5
I=?
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Financial Management, ch-3: Time Value of Money
by dividing the annual nominal rate (r) by the number of compounding periods per year (m): =
r/m. Example if r = 12%, i is calculated as follows:
Conversion period (m) Rate per compound period (i)
1. Annually (once a year) -------------------------------- i = r/1 = 0.12/1 = 0.12
2. Semiannually (every 6 months) --------------------- i = r/2 = 0.12/2 = 0.06
3. Quarterly (every 3 months) -------------------------- i = r/4 = 0.12/4 = 0.03
4. Monthly ------------------------------------------------- i = r/12 = 0.12/12 = 0.01
Example 1
Assume that Br. 10,000 is deposited in an account that pays interest of 12% per year,
compounded quarterly. What are the compound amount and compound interest at the end of one
year?
Solution
P = Br. 10, 000
r = 12%
t = 1 year
m = No. of conversion periods = 4 times per quarter. This means interest will be computed at the
end of each three-month period and added in to the principal.
i = r/m 12%/4 = 3%
The compound amount formulas
1. Compound amount after one period = p (1 + i)1
2. Compound amount after two periods = p (1 + i)2
3. Compound amount after three periods = p (1 + i)3
4. Compound amount after nth periods = p (1 + i)n
A = P (1 + i) n
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Financial Management, ch-3: Time Value of Money
t = total number of years
m = number of compounding/ conversion periods per year
r = annual nominal rate of interest
Example 2 Find the compound amount and compound interest after 10 years if Br. 15, 000 were
invested at 8% interest;
a) If compounded annually
Compounding annually means that there is one interest payment period per year. Thus
t = 10 years
m=1
n = mt = 1 x 10 = 10
i = r/m = 8 %/1 = 8% = 0.08
The compound amount will be:
A = 15, 000 (1.08)10
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Financial Management, ch-3: Time Value of Money
= 15, 000 (2.158925)
= Br. 32, 383.875
Compound Interest = compound amount (A) – Principal (P)
= 32, 383.875 – 15, 000
= Br. 17, 383.875
b) If compounded semiannually
Compounding semiannually means that there are two interest payment periods per year. Thus,
the number of payment periods in 10 years n = 2 x 10 = 20 and the interest rate per conversion
period will be i = r/m = 8%/2 = 4%. The compound amount then will be:
A = P (1 + i)n
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Financial Management, ch-3: Time Value of Money
i = r/m = 8%/12 = 0.667% = 0.00667
Under these conditions:
A = 15, 000 (1. 00667)120
= 15, 000 (2.220522)
= Br. 33, 307.84
Interest = Br. 18, 307.84 (33,307.84 – 15,000)
3.2 Future value (compounding)
To understand future value, we need to understand compounding first. Compounding is a
mathematical process of determining the value of a cash flow or cash flows at the final period.
The cash flow(s) could be a single cash flow, an annuity or uneven cash flows. 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 is always a direct result of the compounding
process.
3.2.1 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: Hana deposited Br. 1,800 in her savings account now. Her account earns 6 percent
compounded annually. How much will she have after 7 years?
To solve this problem, let’s identify the given items: PV = Br, 1,800; i = 6%; n = 7
FVn = PV (1 + i)n
= Br. 2,706.53
Exercise
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Financial Management, ch-3: Time Value of Money
Suppose you want to deposit Br. 100 in Dashen bank at 10% interest. What would be amount
after 3 years?
Solution
FVn = PV (1 + i)n
= Br. 100 (1.1)3
= Br. 133.1
[ ]
n
(1+i) − 1
FVAn = PMT i
Where:
FVAn = Future value of an ordinary annuity
PMT = Periodic payments
i = Interest rate per period
n = Number of periods
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Financial Management, ch-3: Time Value of Money
Example1: You need to accumulate Br. 25,000 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?
[ ]
n
(1+i) − 1
FVAn = PMT i
[ ]
60
(1+0.01) − 1
Br. 25,000 = PMT 0. 01
Br. 25,000 = PMT [81.670]
PMT = Br. 25,000/81.670
PMT = Br. 306.11
Example 2. Mr X. Deposits Br. 100 in a special savings account at the end of each month. If the
account pays 12%, compounded monthly, how much money, will Mr. X have
accumulated just after 15th deposit?
Solution:
A= PMT
[
( 1 + i )n − 1
i ] A = PMT
[
(1 + i)n − 1
1 ]
[ ]
R = Br. 100
(1.01)15 − 1
n = 15
= 100 0.01
r = 12% = 100 (16.096896)
m = 12
Br. 1609.69
i = r/m = 12%/12 = 1%
A=?
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Financial Management, ch-3: Time Value of Money
ii) 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.
The future value of an annuity due is computed at point n where PMT n + 1 is made and it is
computed by:
= PMT i [
(1+i)n − 1
(1 + i)
]
Example: Assume that pervious example except that the first payment is made today instead of a
month from today. How much should your monthly deposit be to accumulate Br.
25,000 after 60 months?
Example 2 Mr X. Deposits Br. 100 in a special savings account at the beginning of each month.
If the account pays 12%, compounded monthly, how much money, will Mr. X have
accumulated just after 15th deposit?
Solution:
A= PMT
[
( 1 + i )n − 1
[ ]
15
(1.01) − 1
n = 15
= 100 0.01 (1+0.01)
r = 12%
= 100 (16.096896) (1+0.01)
m = 12
i = r/m = 12%/12 = 1% Br. 1625.75
A=? ~ 12 ~
Financial Management, ch-3: Time Value of Money
( )
n
FVn 1
= FVn
PV = ( 1+i )
n 1+i
Where: PV = Present Value
n = Number of periods
Example: Zelalem PLC owes Br. 50,000 to Always Co. at the end of 5 years. Always Co. could
earn 12% on its money. How much should Always Co. accept from Zelalem PLC as of today?
( ) ( )
n
1 1
PV = FVn 50000 5
1+i 1 + 0.12
= Br. 50,000 (0.5674) = Br. 28,370
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Financial Management, ch-3: Time Value of Money
PVOA
= PMT [
1− ( 1 + i )−n
i ]
Where: PVOA = The present value of an ordinary annuity
Example: Ato Mengesha retired as general manager of Tirusew Foods Company. But he is
currently involved in a consulting contract for Br. 35,000 per year for the next 10 years. What is
the present value of Mengesha’s consulting contract if his opportunity cost is 10%?
[ ]
−10
1− ( 1 + 0.1 )
= 35000
PVA10 0.1
= Br. 35,000 (6.1446) = Br. 215,061.
This means if the required rate of return is 10%, receiving Br. 35,000 per year for the next 10
years is equal to receiving Br. 215,061 today.
ii) Present value of an Annuity Due – is the present value computed where exactly the first
payment is to be made and it is determined by:
The present value of an annuity due is computed at point 1 while the present value of an ordinary
annuity is computed at point 0.
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Financial Management, ch-3: Time Value of Money
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