CHAPTER 3

The Time Value of Money

 Learning Objectives
• Understand the concept of the time
value of money.
• Be able to determine the time
value of money:
Future Value.
Present Value.
Present Value of an Annuity.
Future Value of an Annuity.
 The Time Value of Money
Would you prefer to
have 1 million dollar now or
1 million dollar 10 years
from now? This preference rests
on the Time value of money.

Of course, we would all prefer the

money now! This illustrates that
there is an inherent monetary
value attached to time.
What Does Time Value of Money Mean?
• The concept is that money available today is
worth more than the same amount of money in
the future
• The money received today is worth more than a
money received tomorrow, why?
• This is because that
– a money received today can be invested to
earn interest
– Due to money's potential to grow in value
over time.
– Because of this potential, money that's
available in the present is considered more
valuable than the same amount in the future
 Time Value of Money is dependent not only on the
time interval being considered but also the rate of
discount used in calculating current or future
values.
Example: You need to sell your car and you receive
offers from three different buyers.
– The first offer gives 4,000 Birr to be paid now
– The second offer gives 4,100 Birr to be paid one
year from now
– The third offer gives 4,600 Birr to be paid after
five years.
• Assume that the second and third offers have
no credit risk.
– The risk free interest rate is 5%.
• Which offer would you accept?
 Interest
• A rate which is charged or paid for the use of
money. An interest rate is often expressed as
an annual percentage of the principal.
• a nominal interest rate, is one where the effects
of inflation have not been accounted for.
• Real interest rates are interest rates where inflation
has been accounted for
Simple Interest and Compound Interest

Simple interest is Rate of interest is the

money paid only on percent charged or
the principal. earned.

I = P 
r 
t
Time that the money
is borrowed or
Principal is the amount invested (in years).
of money borrowed or
invested.
 Compound interest
Compound interest is interest paid not only on
the principal, but also on the interest that has
already been earned. The formula for compound
interest is below.

A  p1  r 
t

“A” is the final dollar value, “P” is the principal,

“r” is the rate of interest, and “t” is the number
of compounding periods per year.
 Uses of Time Value of Money
• Time Value of Money, or TVM, is a concept
that is used in all aspects of finance
including:
– Bond valuation
– Stock valuation
– Accept/reject decisions for project
management
– Financial analysis of firms
– And many others!
 Types of TVM Calculations
• There are many types of TVM calculations
• The basic types that will be covered are:
– Future value of a lump sum
– Present value of a lump sum
– Present and future value of cash flow
stream
– Present and future value of annuities
 Example
• How much money will you have in 5
years if you invest $100 today at a
10% rate of return?
• Draw a timeline

i = 10%
$100 ?

0 1 2 3 4 5

• Write out the formula using symbols:

FVt. = CF0 * (1+r)t
THE Future value of Money
 Future Value
• Future value is the value of an asset at
a specific date in the future.
• It measures the nominal future sum of
money that a given sum of money is
"worth" at a specified time in the future
assuming a certain interest rate, or more
generally, rate of return.
• Actually, the future value does not include
corrections for inflation or other factors
that affect the true value of money in the
future.
 Future Value Equation
• FV,n = PV(1 + i)n
FV = the future value of the
investment at the end of n
year
i = the annual interest rate
PV = the present value, in today’s
dollars, of a sum of
money
• This equation is used to determine
the value of an investment at some
point in the future.
Future Value of a Lump Sum
• Future value determines the amount
that a sum of money invested today
will grow to in a given period of time
• You can think of future value as the
opposite of present value
• The process of finding a future value
is called “compounding”
 Time Line
 An important tool used in time value analysis;
it is a graphical representation used to show
the timing of cash flows
 Future Value (FV); The amount to which a
cash flow or series of cash flows will grow
over a given period of time when
compounded at a given interest rate
 Present Value (PV): The value today of a
future cash flow or series of cash flows
 Compounding: The arithmetic process of
determining the final value of a cash flow or
series of cash flows when compound interest
is applied
 Example
• Example1: What would the future value
of $100 be
after five years at 10 percent compound
interest? At 10 percent simple
interest?
Draw a timeline i = 10%
$100 ?

0 1 2 3 4 5

2. Write out the formula using symbols:

FV,n = PV(1 + i)n
 Example
3. Substitute the numbers into the formula:

FV = $100 * (1+0.1)5

4. Solve for the future value:

FV = $161.05

FV of simple interest = P+ I = $150

• Example 2: Suppose you currently have $2,000
and plan to purchase a 3-year certificate of
deposit (CD) that pays 4% interest compounded
annually. How much will you have when the CD
matures? Answer $2,249.73
• Present value

• Example 3: Suppose a U.S. government bond

promises to pay $2,249.73 three years from now.
If the going interest rate on three-year
government bonds is 4%, how much is the bond
worth today? How would your answer change if
the bond matured in 5 years rather than 3? ANS:
$2,000; $1,849.11
• Example 4: suppose we know that a
given bond has a cost of $100 and
that it will return $150 after 10 years,
calculate the interest rate
• ANS: 4.14%
• Example 5: How long would it take
$1,000 to double if it was invested in
a bank that paid 6% per year? How
long would it take if the rate was
10%? (11.9 years; 7.27 years)
Future Value of a Cash Flow
Stream
• The future value of a cash flow stream is
equal to the sum of the future values
of the individual cash flows.
• The FV of a cash flow stream can also be
found by taking the PV of that same
stream and finding the FV of that lump
sum using the appropriate rate of return
for the appropriate number of periods.
• The following equation can be used
to find the Future Value of a Cash
Flow Stream at the end of year t.

• where
– FVt = the Future Value of the Cash Flow Stream
at the end of year t,
– CFt = the cash flow which occurs at the end of
year t,
– r = the discount rate,
– t = the year, which ranges from zero to n, and
– n = the last year in which a cash flow occurs
• For example, consider an investment
which promises to pay $100 one year
from now, $300 two years from now,
500 three years from now and $1000
four years from now. How much will
be the future value of the cash flow
streams at the end of year 4, given
that the interest rate is 10%?
1. Draw a timeline:

$100 $300 $500 $1000

0 1 2 3 4
?
i = 10% ?
?
?
2. Write out the formula using symbols
n

FV = S [CFt * (1+r)n-t]
t=0

OR
FV = [CF1*(1+r)n-1]+[CF2*(1+r)n-2]+
[CF3*(1+r)n3] + [CF4*(1+r)n-4]

3. Substitute the appropriate numbers:

FV = [$100*(1+.1)4-1]+[$300*(1+.1)4-2]+
[$500*(1+.1)4-3] +[$1000*(1+.1)4-4]
4. Solve for the Future Value:
FV = $133.10 + $363.00 +
$550.00 + $1000
FV = $2046.10

5. Check using the calculator:

– Make sure to use the appropriate interest
rate, time period and present value for
each of the four cash flows. To illustrate,
for the first cash flow, you should enter
PV=100, n=3, i=10, PMT=0, FV=?. Note
that you will have to do four separate
calculations.
Exercise
• Find the Future Value at the end of
year 4 of the following cash flow
stream given that the interest rate is
10%.
•
• Solution:
•
 Annuities
• An annuity is a cash flow stream in which
the cash flows are all equal and occur
at regular intervals.
• To considered as annuity the following
conditions must be present
– The periodic payment must be equal in amount
– The time period between payments should be
constant
– The interest rate per year remains constant
– The interest is compounded at the end of each
time period
 Types of Annuities
• There are different types of annuities,
among these are
1. An ordinary annuity is one where the
payments are made at the end of each
period
2. An annuity due is one where the
payments are made at the beginning of
each period
3. A deferred annuity is one where the
payments do not commence until period
of times have elapsed
4. A perpetuity is an annuity in which the
payments continue indefinitely
 Ordinary Annuity
• Ordinary Annuity
– The amount of an ordinary annuity
(annuity in arrears) consists of the sum
of the equal periodic payments and
compounded interest on the payments
immediately after the final payments.
– The future value (or accumulated
value) of an annuity is the amount
due at the end of the term
  1  r   1
n
FVordianryAnnuity  CF  
 r 
• Where
– CF = Cash flow per period
– r = interest rate
– n = number of payments
• Example: What amount will accumulate if we deposit
$5,000 at the end of each year for the next 5 years?
Assume an interest of 6% compounded annually
PV = 5,000
i = .06
n=5

Year 1 2 3 4 5
Begin 0 5,000.00 10,300.00 15,918.00 21,873.08
Interest 0 300 618 955.08 1,312.38
Deposit 5,000.00 5,000.00 5,000.00 5,000.00 5,000.00
End 5,000.00 10,300.00 15,918.00 21,873.08 28,185.46
  1  r n  1
FVordianryAnnuity  CF  
 r 
 1  0.06 5  1 
FVoa  5000  
 0 . 06 
 1.06 5  1 
FVoa  5000  
 0. 06 
1.3382255776  1 
FVoa  5000  
 0.06
 0.3382255776 
FVoa  5000  
 0.06
FVoa  50005.63709296
FVoa  28185.4648
 Annuity Due
• A form of annuity where periodic
receipts or payments are made at the
beginning of the period and one period
of the annuity term remains after the
last payment.
• The Future Value of an Annuity Due is identical
to an ordinary annuity except that each payment
occurs at the beginning of a period rather than
at the end.
• Since each payment occurs one period earlier, we
can calculate the future value of an ordinary
annuity and then multiply the result by (1 + i).

FVad  FVoa 1  i 
Where:
FVad = Future Value of an Annuity Due
FVoa = Future Value of an Ordinary
Annuity
i = Interest Rate Per Period
• Example: What amount will accumulate if we
deposit $5,000 at the beginning of each year for
the next 5 years? Assume an interest of 6%
compounded annually.
• PV = 5,000, i = .06, n = 5
Year 1 2 3 4 5
Begin 0 5,300.00 10,918.00 16,873.08 23,185.46
Interest 0 300 618 955.08 1,312.38
Deposit 5,000.00 5,000.00 5,000.00 5,000.00 5,000.00
End 5,000.00 10,300.00 15,918.00 21,873.08 28,185.46

• FVoa = 28,185.46 (1.06) = 29,876.59

Begin 5,000.00 10,300.00 15,918.00 21,873.08 28,185.46
Deposit 5,000.00 5,000.00 5,000.00 5,000.00 5,000.00
Interest 300 618 955.08 1,312.38 1,691.13
End 5,300.00 10,918.00 16,873.08 23,185.46 29,876.59
  1  0.06 5  1 
FVad  5000  
 0.06 
1.06 
 1.06 5  1  1.06 
FVad  5000  
 0 . 06 
1.3382255776  1  1.06 
FVad  5000  
 0.06

 0.3382255776  1.06 
FVad  5000  
 0.06

FVoa  50005.63709296 1.06 

FVad  28,185.46481.06 
FVad  29,876.59
• Example: What amount will accumulate
if we deposit $1,000 at the beginning of
each year for the next 5 years? Assume
an interest of 5% compounded annually.
• PV = 1,000
i = .05
n=5
• Or

= $1000*5.53*1.05
= $5,801.91
Future value of Deferred Annuity

• When the amount of an annuity

remains on deposit for a number of
periods beyond the final payment,
the arrangement is known as a
deferred annuity.
– When the amount of an ordinary
annuity continues to earn interest
for an additional one period we have an
annuity due situation
– When the amount of an ordinary annuity
continues to earn interest for more than
one additional periods, we have a
deferred annuity situation.
Formula to calculate future value of deferred annuity

 1  i n  m   1  i m 
FV  P   1  p   1
 i   i 

• Where
– FV = Future Value
– P = regular Payments
– n = the Number of compounding
periods
– m = The number of deferred periods
• Example: What amount will accumulate
if we deposit $5,000 at the beginning of
each year for the next 5 years and wait to
get the amount for additional 2 years.
Assume an interest of 6% compounded
annually.
PV = 5,000
i = .06
n=5
m=2
  1  i n  m  1  1  i m  1
FV  P    p 
 i   i 
 1  0.065 2  1   1  0.062  1
FV  5,000    5,000  
 0.06   0 . 06 
 1.06 7  1   1.06 2  1 
FVda  5000   5000
 


 0.06   0.06 
 1.503630  1   1.1236  1 
FVda  5000   5000 
 0 .06   0 .06 
 0.503630   0.1236 
FVda  5000   5000 
 0 .06   0 . 06 
FVda  50008.3938  50002.06 
FVda  41969  10300
FVda  31,669
 Application
• To know how much to save/deposit/paid
annually A  FV r
1  r n  1
• To find out the interest rate i  n FV
• To know how long should wait to get the
accumulated money FV
n
log(1  r )  log r
A
 The Present
Value of Money
What does mean present value of money?

• It is a process of discounting the

future value of money to obtain its
value at zero time period (at
present)
• Present values tell you the amount
you must invest today to accumulate
a certain amount at some future
time
• To determine present values, we need to know:
– The amount of money to be received in the future
– The interest rate to be earned on the deposit
– The number of years the money will be invested

Discounting and Compounding

Compounding converts present cash flows into
future cash flows.
 The process of finding the equivalent value
today of a future cash flow is known as
discounting.
 Calculating the Present Value
• Using the Present Value Table
– Present value interest factor (PVIF):
a factor multiplied by a future value to
determine the present value of that
amount (PV = FV(PVIFA)
– Notice that PVIF is lower as the number
of years increases and as the interest rate
increases
• It can also be calculated using a
financial calculator PV = [FV/(1+r)n]
 Cash Flow Types and
Discounting Mechanics
• There are five types of cash flows -
– single cash flows (Lump sum cash
flows),
– Cash flows stream
– annuities,
– growing annuities and
– perpetuities
 I. Single Cash Flows
• A single cash flow is a single cash
flow in a specified future time period.
• Cash Flow: CFt
_______________________|
Time Period: n
• The present value of this cash flow
is-  CFn 
PV   
n 
PV of Single Cash Flow =  1  r  
 Example: Present Value of a
single cash flow:

• You would like to accumulate Birr

50,000 in five years by making a single
investment today. You believe you can
achieve a return from your investment
of 8% annually.
• What is the amount that you need to
invest today to achieve your goal?
 50,000
PV  5
 34029.16 Or
(1.08)
We can use table

PV = 50,000(PVIF)5,8%
=50,000 x 0.681

= 34,050
II. Valuing a Stream of Cash
Flows
• Valuing a lump sum (single) amount is easy to
evaluate because there is one cash flow.
• What do we need to do if there are multiple cash
flow?
– Equal Cash Flows: Annuity or Perpetuity
– Unequal/Uneven Cash Flows
FV1 FV2 FVN
PV     
1  i  1  i 
1 2
1  i N

n
FVn
PV  
t 1 1  i 
n
 Valuing a Stream of Cash Flows

? 1000 2000 3000

0 1 2 3
• Uneven cash flows exist when there are
different cash flow streams each year
• Treat each cash flow as a Single Sum
problem and add the PV amounts together.
 • What is the present value of the preceding
cash flow stream using a 12% discount rate?
n
FVn  100
PV  
n 3
200 300 
t 1 1  r n

= PV  
t  0  1  0.12 
1
  3
1  0.12 1  0.12 
2

PV   893  1594  2135

PV  4,622

Yr 1 $1,000 / (1.12)1 = $ 893

Yr 2 $2,000 / (1.12)2 = 1,594
Yr 3 $3,000 / (1.12)3 = 2,135
$4,622
 III. Annuities
• The present value of an annuity is the
value now of a series of equal
amounts to be received (or paid out)
for some specified number of periods in
the future.
• It is computed by discounting each of
the equal periodic amounts.
• An annuity is a series of nominally equal
payments equally spaced in time
• The timeline shows an example of a 5-
year, $100 annuity
100 100 100 100 100

0 1 2 3 4 5
Present Value of an Annuity
• The present value of an annuity
can be calculated by discounting
cash flow (back to the present),
and adding up the present values.
N


Pmt Pmt 1 Pmt 2 Pmt
PVA  t
     N

1  i 1  i 1  i 1  i
t 1 2 N
t 1
Present Value of an Annuity
(cont.)
• Alternatively, there is a short cut that can be
used in the calculation [A = Annuity; r =
Discount Rate; n = Number of years]
• The closed-form of the PVA equation is:

 1 
1  (1  i ) n 
PV  A 
 i 
 
Present Value of an Annuity
(cont.)
• Using the example, and assuming a
discount rate of 10% per year, we find
that the present value is:
PVA 
100
1.10 1

100
1.10 2

100
1.10 3

100
1.10 4

100
1.10 5
 379.08

62.0
68.3
9
75.1
0
82.6
3
90.9
4
1
379.08 100 100 100 100 100

0 1 2 3 4 5
 • We can use this equation to find the present
value of our annuity example as follows:
 1 
1 
 (1  0.1)5 
PV  100  
 0.1 
 1  
1  (1.1)5 
PV  100  
 0.1 
 

PV  100 
0.3791
PV  1003.791
 0.1 
PV  379.1
NB: This equation works for all regular (ordinary)
annuities, regardless of the number of payments
 Present value of Annuities Due
• The annuities that we begin their
payments at the end of period 1 are
referred as regular annuities (ordinary
annuities)
• An annuity due is the same as a regular
annuity, except that its cash flows occur
at the beginning of the period rather
than at the end

5-period Annuity Due 100 100 100 100 100

5-period Regular Annuity 100 100 100 100 100

0 1 2 3 4 5
Present Value of an Annuity Due
• The formula for the present value of an annuity
due, sometimes referred to as an immediate
annuity, is used to calculate a series of
periodic payments, or cash flows, that start
immediately
• We can find the present value of an annuity due
in the same way as we did for a regular annuity,
with one exception

 1 
1 
 (1  i ) n 1 
PV  CF    CF
 i 
 
Present Value of an Annuity Due

• Therefore, the present value of our

example annuity due is:
 1 
1  1  0.151 
PVAD  100    100  416.98
 0.1 
 
NB: PV of annuity due is higher than the PV of
the regular annuity
 Deferred Annuities
• A deferred annuity is the same as
any other annuity, except that its
payments do not begin until
some later period
• The timeline shows a five-period
payment deferred annuity
100 100 100 100 100

0 1 2 3 4 5 6 7
 PV of a Deferred Annuity

• We can find the present value of a

deferred annuity in the same way as any
other annuity, with an extra step required
PV deferred annuity formula
1  1  1   1  
 1  i n  m    1  i m  
PVDA  CF   
 i   i 
   
 
OR
  1 
1   1  i n  
PVDA  CF    1 
 i  m
  1  i  
 
 
 PV of a Deferred Annuity
(cont.)
• To find the PV of a deferred annuity, we
can first calculate the ordinary PVA
equation, and then discount that result
back to period 0
• Here we are using a 10% discount rate

PV2 = 379.08
PV0 = 313.29
0 0 100 100 100 100 100

0 1 2 3 4 5 6 7
PV of a Deferred Annuity (cont.)
  1 
1  
 1  0.15 

  1 
PVDA  100

2 
 0.1  1  0.1 
 
 
1  0.6209   1 
PVDA  100   2
 0.1   1.1 
 0.3791  1 
PVDA  100 
 0.1   1.21
PVDA  1003.7910.8264

PVAD  379.10.8264 
PVAD  313.29
Or we can calculate with two steps
  1 
1    
1  0.1 5

PV2  100  
Step 1:  0.1 
 
 
1  0.6209 
PV2  100 
 0.1
 0.3791
PV2  100
 0.1 
PV2  379.1
379.1 379.1
PV0   2   313.29
Step 2:  1.1  1.21
 Uneven Cash Flows
• Very often an investment offers a
stream of cash flows which are not
either a lump sum or an annuity
 Uneven Cash Flows: An
Example (1)
• Assume that an investment offers
the following cash flows. The
required return is 7%, what is the
maximum price that you would pay
to day for this investment?
100 200 300

0 1 2 3 4 5
100 200 300
PV     513.04
1.07  1.07  1.07 
1 2 3
Uneven Cash Flows:Example (2)
• Suppose that you need to deposit the
following amounts in an account
paying 5% per year. What should be
the balance of the account at the end
of the third year?
300 500 700

0 1 2 3 4 5
3001.05 5001.05
2 1
FV   700  1,555.75
 Present value of a Growing
Annuity
• A cash flow that grows at a constant
rate for a specified period of time is a
growing annuity
• A time line of a growing annuity is as
follows
A1  g  A1  g  ..... A1  g 
2 n

0 1 2 ...... n
• The present value of a growing annuity can be
calculated using the following formula
 1  g   n

1  1  r n 
PVga  A1  g  
 rg 
 
• The above formula can be used when
– The growing rate is less than the discount rate
(g<r) or
– The growing rate is more than the discount rate
(g>r)
– However, it doesn’t work when the growing
rate is equal to the discount rate (g=r)
 Example:
• Suppose you have the right to harvest a
tea plantation for the next 20 years
over which you will get 100,000 tons of
tea per year. The current price per ton
of tea is Birr 500, but it is expected to
increase at a rate of 8% per year. The
discount rate is 15% per year.
• Then, how much is the present value of
the tea that you can harvest?
 Solution:

 1  0.08  20

1  1  0.1520 
PVga  Birr 500 X 100,0001  0.08 
 0.15  0.08 
 
PVga  Birr 551,736,683
IV. Present value of perpetuity annuity
• A perpetuity is an annuity of with an infinite duration.
• Hence the present value of perpetuity may be
expressed as follows
PV∞ = CF x PVIFA
• Where PV∞ = present value of a perpetuity
• CF = constant annual cash flows
• PVIFA = present value interest factor for
perpetuity (an annuity of infinite
duration)
– The value of PVIFA is  1 1
PVIFA   
t 1 1  r 
t
r
END OF THE CHAPTER

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