Chapter 3

Time Value of Money

Concept of Time Value of Money and other Relevant Values
In the literature of Finance and Mathematics, time value of money concept has been recognized.
The concept signifies that money has time value. That is, the value of money varies in terms of
time. According to this concept, a dollar received today is worth more than a dollar expected to
be received in the future. This is because of the fact that the sooner a dollar is received, the
quicker it can be invested to earn a positive return. Therefore, it is true that one dollar in the
future is less valuable than one dollar of today. The relationship between one dollar in the future
and one dollar of today is known as the time value of money. This present value concept of time
value of money should be clearly understood by the investors as well as financial managers in
order to examine its impact on the value of an asset.

Future value or terminal value and present value are associated with present value of money. The
following paragraphs deal with these values.

FUTURE VALUE OR TERMINAL VALUE

Future value is the value of a cash flow or a series of cash flows at some time of a present amount
of money. That is, future value refers to the amount to which a cash flow or a series of cash flows
will grow over a given period of time. Therefore, the future value is dependent on three things : i)
present value; (ii) period and (iii) rate of interest. Thus, the future value at the end of one year
equals the present value multiplied by one plus interest rate. As for example, if present value
equals to Tk. 100, period is 1 year and rate of interest is 10 percent; then future value will be Tk.
110.

PRESENT VALUE
Present value is the value today of a future cash flow or series of cash flows. That is, present
value is a future amount discounted to the present by some required rate. The present value is
dependent on three things: (i) future value, (ii) period and rate of interest. As for example, if
future value is Tk.115, period is one year and rate of interest is 15 percent; then present value will
be Tk. 100 only.

Since, cash flow is involved in both the future value and present value; it needs clarification.
Cash flow embraces both cash outflow and cash inflow. Cash outflow is a payment or
disbursement of cash for expenses, investments and so on. On the other hand, cash inflow is a
receipt of cash from an investment, an employer, a banker or from any other sources.

Tools and Techniques of Time Value of Money

Tools used in Time Value of Money
One of the most important tools in time value of money analysis is the cash flow time line. It is a
graphical representation used to show the timing of cash flows. Such line is used helping us
visualizing when the cash flows associated with a particular situation. Constructing a cash flow
time line will help us to solve problems related to the time value of money. This is because of the
fact that it illustrates what happens in a particular situation, making it easier to set up the problem
for solution. To illustrate the time line concept, let us consider the following diagram.

0 1 2 3 4
TIME :

1
The above diagram shows that time 0 is today, time-1 one period from today or the end of the
period-1; time-2 is two periods from today or the end of period-2 and so on. Thus the values on
the top of the tick marks represent end of period values. Often the periods are years, but other
time intervals like semi-annuals, quarters, months or even days are also used.

Cash flows are placed directly below the tick marks and interest rates are shown directly above
the cash flows time line. Unknown cash flows which need to be found out in the analysis are
indicated by question mark. As for example, consider the following time line.
0 1 2 3 4
5
TIME : 15%

Cash flows : -1000 ?

In the above diagram, the interest rates for each of the five periods is 15%; a single amount or
lump sum cash flows are made at time-0; and the time-5 value is an unknown inflow. Because,
the initial Tk. 1000 is a cash outflow or an investment, so it has a minus sign. But, the period-5
amount is a cash inflow; so it does not have a minus sign. Note that no cash flows occur at times-
1, 2, 3 and 4. Also note that we do not show Taka signs on time lines; this reduces clutter.

The cash flow time line is an essential tool for better understanding time value of money
concepts. The financial experts use cash flow time line to analyze the complex problems.

Techniques of Time Value of Money

The following two techniques are generally used in time value money : (i) compounding and (ii)
discounting. The following paragraphs deal with each of the techniques.

Compounding Technique
A Taka in hand today is worth more than a Taka to be received in the future. This is because of
the fact that if you had it now, you could invest it, earn interest and end up with more than one
Taka. The process of going from today’s values which are termed as present values (PV), to
future values (FV) is called compounding. That is, the process of determining the value of a cash
flow sometime in the future, by applying compound interest rate is known as compounding. By
compound interest we mean interest earned on interest.

Compound Interest vs. Simple Interest

Compound interest refers to the interest earned on both the initial principal and the interest
reinvested from prior periods, while simple interest refers to the interest earned only on the
original principal amount invested. Let us clear these with examples. Suppose your principal
amount is Tk. 1000 and the rate of interest is 10% and the period is 3 years. In the example,
compound interest comes to Tk. 331 (100+110+121); whereas, simple interest comes to Tk. 300
(100+100+100) only at the end of 3 years.

Now, the question arises how the FVs are determined. There are two approaches to determine
FVs: one is Equation approach and the other is Tabular approach.

2
In case of annual (single) compounding :

Under Equation Approach : Where, FVn = Future value at period n

PV = Present value
FVn = PV (1+i)n I = Rate of interest
n = Time period

Under Tabular Approach:

FVn = (1 + i) n = PV(FV IF i,n)
Where, FVn = Future value at period n
PV = Present value
IF = Interest factor to be found out from
Future Value Table
I = Rate of interest
n = Time period

Terms of Interest and Future Values

Interest may be paid annually, semiannually, quarterly, monthly, even daily and even
continuously or infinitely and such mode of payment of interest is known as terms of interest.
Interest may be paid annually, semiannually, quarterly, monthly, even daily and even
continuously or infinitely and such mode of payment of interest is known as terms of interest.
Such terms of interest have impact on the FVs. In the above Equation and Tabular Approaches of
calculating FVs, we have assumed that interest is paid annually. Now, let us consider the
relationship between FVs and interest rates for different periods of compounding. FVs and terms
of interest have direct relationship, implying that the number of times interest paid in a year (m)
is increased, the FV also increases. For different terms of interest, the formula for finding out FVs
under both the Equation and Tabular Approaches need to be adjusted as follows :

a) In case of Multiple Compounding

Under Equation Approach Under Tabular Approach

i i i
FVn = Pv (1 + ------)mn FVn = (1 + ------)mn PV (FVIF -------, mn)
m m m

b) In case of continuous or infinite compounding

Under Tabular Approach
FVn = PV (ei x n)
Where, e is the value equal to 2.7183

Future Value Interest Factor for i and n (FVIF i, n)

FVIFi,n refers to the future value of Tk. 1 left on deposit for n periods at a rate of i percent per
period that is, the multiple by which an initial investment grows because of the interest earned. In
order to find out IF from Future Value Table, time period (n) and rate of interest (i) should be
considered simultaneously. In the Table, the vertical column represent n; whereas, the horizontal
columns represent rates of interest.

3
Problems and solutions
Problem – 1
Find out the future values (FV) in the following situations :
a) At the end of 3 years, how much is an initial deposit of Taka 1,000 worth, assuming a annually
compounded interest rate of (i) 10% and (ii) 100%.
b) At the end of 10 years, how much is an initial investment of Taka 1,000 worth, assuming an
interest rate of 10% compounded : (i) annually; (ii) semiannually; (iii) quarterly, (iv)monthly and
(v) continuously ?

Solution :
a) In this problem, given PV = Tk. 1,000; n = 3years and i = 10% percent; 100%; required finding
out FV.
Under Equation Approach Under Tabular Approach
FVn = PV(1+i)n FVn = PV (FVIFi,n)
Where, FVn = Future value at n period; 1,000(FVIF10%,3)
PV = Present value 1,000 x 1.3310
i = Interest rate and Tk. 1,331.
n = Time period
= 1,000(1 + .10)3 FVn = PV(FVIFi,n)
= 1,000(1.10)3 = 1,000(FVIF100%,3)
= 1,000 x 1.331 = 1,000 x 8.000
= Tk. 1,331 = Tk. 8.000.

Again, 1,000(1 + 1)3

= 1,000 x 8
= 8,000.

b) In this problem, given PV = Tk. 1,000; n = 10 years and i = 10%; what is FV.
Solution :

Under Equation Approach Under Tabular Approach

In case of annual interest :
i ) FVn = PV (1 + i ) n i ) FVn = PV ( FVIFi, n)
= 1000(1 + 0.10) 10 = 1,000( FVIF10%,10)
= 1,000 × 2.594 = 1,000 × 2.594
= Tk .2,594 = Tk .2,594

In case of semiannual interest :

i mn ii ) FVn = PV ( FVIF i mn)
ii ) FVn = PV (1 + )
m m

10 = PV ( FVIF 5%,20)
= 1000(1 + ) 2×10
2 = PV (2.6533)
= 1000(1 + 0.05) 20 = Tk .2653
= 1000 × 2.6533
= Tk .2,653

4
 In case of quarterly interest :
.10 4.10 iii ) FVn = PV ( FVIF i , mn)
iii ) FVn = PV (1 + )
4 m

= 1000(1 + .025) 40 = 1000( FVIF.25% ,40)

= 1000(2.6851) = 1000 x 2.6851
= TK .2,685 = TK .2,685
In case of monthly interest :

.10 12 x10 iv) FVn = PV ( FVIF i , mn)

iv) FVn = PV (1 + )
12 m

= 1000(1 + .00833)120 = 1,000 (2.7059)

= 1000(2.7059) = TK .2,706
= TK .2706

In case of Continuous Compounding Interest:

v) FVn = PV (ei x n)
= (2.7183).10 x 10
= Tk. 2,718.30

[Note : In cases of FVIF value has not been provided in the Future Value Table. So, in these
 i 
cases FVIF has been calculated by using the alternative formula viz. FVIF = 1 + mn]
 m

Problem - 2
Assume that it is now January 1, 2000. On January 1, 2001, you will deposit Tk. 1000 into a
Savings Account of Janata Bank that pays 12 percent interest per annum.
Required :
(a) If the bank compounds interest annually how much will you have in your account on January-
1,
2006 ?
(b) What would your January-1, 2005 balance be if the bank used quarterly compound ?
(c) Suppose you deposited Tk. 1000 in payments of Tk. 200 each on January 1, 2001, 2002, 2003,
2004 and 2005. How much would you have in account on January-1, 2005, based on 10
percent
annual compounding ?

Solution :
Under Equation Approach Under Tabular Approach
(a) FVn = PV (1 + i)n FVn = PV (FVIFi, n)
= 1000 (1 + 0.12)5 = 1000 (FVIF12%, 5)
= 1000 x 1.7623 = 1000 x 1.76723
= Tk. 1762 = Tk. 1762

(b) Under Equation Approach Under Tabular Approach

5
 FVn =
i
PV (1 + ) mn PVn = PV ( FVIF i , mn )
m m

= 1000 (1 +
.12 4.4
) = PV ( FVIF 3% ,16 )
4 = 1000 ×1.6047
= 1000 (1.03 )16
= Tk .1605
= 1000 ×1.60477
= Tk .1605

(c) You may solve this problem by finding the future value of an annuity of Tk. 200 for 4 years at
10 percent:
FVn = PMT (FVIFAi,n)
Tk. 200(FVIFA10%,5)
Tk. 200 (6.1051)
Tk. 1,221.

Discounting Technique
Discounting refers to the process of determining the present value of a cash flow or a series of
cash flows. It is the reverse of compounding. That is, the process of finding present values from
future values is called discounting. If you know the FVs, you can discount the PVs. At the time of
discounting you would follow these steps.

CASH FLOW TIME LINE

0 5% 1 2 3 4 5

PV = -100 127.63

In the above figure it is seen that Tk. 100 would grow to Tk. 127.63 in 5 years at a 5 percent
interest rates. Therefore, Tk. 100 is the PV of Tk. 127.63 due in 5 years in the future when the
opportunity cost rate is 5 percent.

DETERMINING PVs THROUGH DISCOUNTING

Like determination of FVs, PVs can also be determined by Equation Approach and Tabular
Approach.

Under Equation Approach Under Tabular Approach

FVn PV (Single payment) =

i ) PV = (In case single interest
(1 + i ) n  1 
FVn  n 
= FVn( PVIFi , n)
payment)  (1 + i) 
FVn
ii ) PV = PV (Multiple payment) =
i  
(1 + ) mn  
m 1
FVn  = FVn ( PVIF i , mn )
(In case multiple interest payment in a year like i mn  m
 (1 + ) 
semiannually, quarterly, monthly and daily.)  m 

6
 FVn
iii) PV = = FVn(e i×n ) (In case
eixn
continuous or infinite compounding)

Where e is the value equal to 2.7183.

PRESENT VALUE INTEREST FACTOR (PVIF)

Present value interest factor for i and n (PVIFi,n) refers to the present value of Tk. 1 due n
periods in the future discounted at i percent per period. In order to find out IF from Present Value
Table, time period (n) and rate of interest (i) should be considered simultaneously. In the Table,
the vertical column represents n; whereas, the horizontal column represent rates of interest.

PROBLMES AND SOLUTIONS

Problem - 3
Determine the Present Values (PVs) in the following cases :
a) Taka 1,000 at the end of 5 years is worth how much today, assuming a discount rate of : (i) 10
percent and (ii) 100 percent;
b) What is the aggregate PVs of the following receipts, assuming a discount rate of 15 percent :
i) Taka 1,000 at the end of 1 year;
ii) Taka 1,500 at the end of 2 years;
iii) Taka 1,800 at the end of 3 years;
iv) Taka 2,200 at the end of 4 years and
v) Taka 2,500 at the end of 5 years ?

Solution
a) (i) In case of 10 percent discounting rate :
Under Equation Approach Under Tabular Approach
FVn PV = FVn (PVIFi,n)
PV = = 1,000 (PVIF10%,5)
(1 + i ) n
= 1,000(.6209)
= TK. 620.9
1000
=
(1 + .10) 5
1000
=
1.6105
= TK 620.93
(ii) In case of 100 percent discounting rate :
Under Equation Approach Under Tabular Approach
FVn PV = FVn (PVI Fi,n)
PV = = 1,000 (PVI F 100%,5)
(1 + i ) n
= 1,000(.031259)
= TK. 31.25

7
 1000
=
(1 + 1) 5
1000
=
325
= TK 31.25

b) Under Equation Approach Under Tabular Approach

FVn 1000 i) PV = FVn (PVI Fi,n)
i) PV = = = TK . 869.57 = 1,000 (PVI F15%,1)
(1 + i ) n
(1 + .15)1
= 1,000(.8696)
= TK. 869.60
ii) PV = FVn (PVI F15%,2)
FVn 1500 1500 = 1,500 (.7561)
ii) PV = = = = TK . 1134.22
(1 + i) 2
(1 + .15) 2
1.3225 = TK. 1134.15
iii) PV = FVn (PVI F15%,3)
= 1,800 (.6575)
FVn 1800 1800
iii) PV = = = = TK . 1183.51 = TK. 1183.50
(1 + i ) 3
(1 + .15) 3
1.5209 iv) PV = FVn (PVI F15%,4)
= 2,200 (.5718)
FVn 2200 2200 = TK. 1257.96
iv) PV = = = = TK . 1257.86 v) PV = FVn (PVI F15%,5)
(1 + i) 4
(1 + .15) 4
1.7490 = 2,500 (.4972.
= TK. 1243.00
FVn 2500 2500
v) PV = = = = TK . 1242.92
(1 + i ) 5
(1 + .15) 5
2.0114

Hence, aggregate PV s = Tk. 869.57 + Tk. 1,134.22 + 1,183.51 + Tk. 1,257.86 + 1,242.92
= Tk. 5,688.08

Hence, aggregate PV s = Tk. 869.60 + Tk. 1,134.15 + 1,183.50 + Tk. 1,257.96 + Tk. 1,243.00
= Tk. 5,688.21

Problem - 4
Find the present values of the following amount due :
a) Taka 6,600 due in 10 years at a 6 percent discount rate, calculating annually;
b) Taka 9,000 due in 8 years at a 12 percent discount rate, calculated semiannually;
c) Taka12,000 due in 6 years at a 18 percent discount rate, calculated quarterly and
d) Taka 15,000 due in 3 years at a 12 percent discount rate, calculated monthly.
e) Taka 18,000 due in 5 years at a 15 percent discount rate, calculated continuously.

Solution:
FVn 6,600 6,600 a) PV = FVn (PVI Fi,n)
a) PV = = = = TK. 3,685.50 = 6,600 (PVI F6%,10)
(1 + i) n (1 + .06)10 1.7908 = 6,600(.5584)
= TK. 3685.44
b) PV = FVn (PVI Fi/m,mn)
= 9,000 (PVI F12%/2,2.8)
= 9,000 (PVIF 6%, 16)

8
 FVn 9000 9000 = TK. 3542.40
PV = = = = TK. 3542.82 c) PV = FVn (PVI Fi/m,mn)
b) i mn .12 2.8 2.54035
(1 + ) (1 + ) = 12,000 (PVIF 4.5%, 24)
m 2 =12,000 (.3477)
= TK. 4172.40
FVn 12000 12000
PV = = = = TK. 4172.46 d) PV = FVn (PVI Fi/m,mn)
c) i mn .18 4.6 2.8760
(1 + ) (1 + ) = 15,000 (PVIF 1%, 36)
m 4 = 15,000 (.6989)
= TK. 10483.50

d)
FVn 15000 15000 FVn
PV = = = = TK. 10483.65 e) PV =
i mn .12 12.3 1.4308
(1 + ) (1 + ) ei x n
m 12 18,000
= ------------
2.7183.12 x 5
18,000
e) Not Applicable = ------------
1.8221
= Tk. 9,878.71

[Note – In the present Value Table, PVIF for 4.5% and 24 periods and 1% for 36 periods are not
shown. Hence, in cases two cases PVIF has been found out by using the alternative formula
1
PVIF =
which goes as under : i ]
(1 + )mn
m
Solving Time and Interest Rates
In the determination of present values and future values, time factor and interest or discount
factor have been worth-mentioning. As for example, in determining future value, present value,
time factor and interest factor must exist. On the other hand, in determining present value future
value, time factor and interest factor must exist. It is evident that in each of these cases, the values
of any three are given. The value of the fourth one can be found out. In such a context the
necessity of determining the value of either interest (i) or period (n) has arisen.

In cases of Future Value (FV) and Present Value (PV)

Suppose, you can buy a security at a price of Tk. 78.35 that will pay you Tk. 100 after 5years. In
this case, PV, FV, and n are given; we are to find out i, the interest rate you will earn on your
investment.
Value of i is found out by applying the following formula :
FVn = PV (1 + i)n = PV (FVIFi, n)
Hence, Tk. 100 = Tk. 78.35 (1 + i)5 = (FVIFi, n)
100
or, (1 +i)5 = ---------- = 1.2763 = FVIFi, 5
78.35
or, (1 = i) = (1.2763)1/5 = 1.05
or, i = 1.05-1 = 0.05 = 5%

9
Solving for Period (n)
In cases of PV, FV and Annuities (ordinary and due), the period n can be found out if other
elements of Time Value of Money viz.; PV, FV, Annuities and rate of interest/ discount (i) are
given. The following paragraphs deal with the determination of period n.

Solving for period n in cases of FVs and PVs

Suppose you know that the investment in security will provide a return of 10% per year, that it
will cost Taka 204.90 and that you will receive Tk. 300 at maturity. But, you do not know when
the security matures. In this case you know PV, FV and i; but you are to know n, the number of
periods. The solution is as under :
We know that FVn = PV (1 + i)n = PV (FVIFi, n)
or, 300 = 204.90 (FVIF10%, n)
300
or, FVIF10%, n = ----------- = 1.4641
204.90
Now, let us look across the 10% column in Future Value Table until we find FVIF = 1.4641. This
value is in Row 4, which indicates that it takes 4 years for Taka 204.90 to grow to Taka 300 at
10% interest rate.

Case Study :
A father is planning a savings program to put his daughter through university. His daughter is
now 18 years old. He plans to enroll at the university in 5 years. Currently, the cost per year for
everything – food, clothing, tuition fees, books, conveyance and so forth is Tk. 15,000, but a 5
percent inflation rate in these costs is forecasted. The daughter recently received Tk. 7,500 from
her grand father’s estate; this money which is invested in a mutual fund paying 8 percent interest
compounded annually, will be used to help meet the cost of the daughter’s education. The rest of
the costs will be met by money the father will deposit in the savings account. He will 6 equal
deposits to the account in each year from now until his daughter starts university. These deposits
will begin today and will also earn 8 percent interest.
a) What will be the present value of the cost of 5 years of education at the time the daughter
becomes 24?
b) What will be the value of Tk. 7,500 that the daughter received from her grand father when she
Starts university at the age 24?
c) If the father is planning to make the first 6 deposits today, how large must each deposit be for
him to be able to put his daughter through university?

Annuity: Time Value of Money

Concept of Annuity
An annuity is a series of equal payments known as installments at fixed intervals for specified
number of periods. As foe instances Tk. 100 paid as an installment at the end of the each of the
next five years is a five year annuity. The installment payments are symbolized as PMT and they
can occur at either the beginning or the end of each year. If the installment payments occur at the
end of each period, as they typically do in business transactions, the annuity is known as
ordinary/ deferred annuity. If installment payments are made at the beginning of each period, the
annuity is called an annuity due. Since ordinary annuities are more common in Finance, when the
annuities are used in this book, you should assume that the installment payments occur at the end
of each period values otherwise mentioned. Such annuities are closely related with PV and FV
which are examined in the following sub-sections.

10
Future Value of an Ordinary Annuity
Future value of an ordinary annuity depends on three things namely : (i) amount of PMT; (ii) rate
of interest and (iii) period. The more the amount of PMT, rate of interest and the period, the
higher will be the amount of FV of an annuity. Let us take an example. If you deposit Taka 100 at
the end of each of three years in a Savings A/C that pays 5% interest per year; how much will you
have at the end of 3 years ? To answer this question, we must find out FV of an ordinary annuity
(FVAn). Hence, FVAn represents the FV of an ordinary annuity over periods. Each payment is
compounded out to the end of period n and he sum of the compounded payments is the FVAn.
There are two approaches of determining FVAn viz. (i) Equation Approach and (ii) Tabular
Approach.

i) Under Equation Approach ii) Under Tabular Approach

(1 + i ) n − 1
n1
FVAn = PMT [ ]
FVAn = PMT ∑ (1 + i ) t i
t =0
= PMT ( FVIFAi, n)

Explanation of FVIFAi,n :
The summation term in the brackets in the formula under Tabular Approach is called the Future
Value Annuity Interest Factor for an annuity of n payments compounded at 1 percent of interest.
In order to find out this interest factor, both n and I should be considered simultaneously in the
Future Value Annuity Table.

PROBLEM AND SOLUTION

Problem - 1
Find out the Future Values of the following ordinary annuities :
(i) Taka 4,000 per year for 10 years at 12 percent;
(ii) Taka 2,000 per year for 5 years at 10 percent;
(iii) Taka 1,000 per year for 6 years at 0 percent.

Solution
(i) FVAn = PMT (FVIFAi,n) (ii) FVAn = PMT (FVIFAi,n)
= 4,000 (FVIFA12%, 10) = 2,000 (FVIFA10%, 5)
= 4,000 (17.549) = 2,000 (6.1051)
= Tk. 70,196 = Tk. 1,2210.20
(iii) FVAn = PMT (FVIFAi,n)
= 1,000 (FVIFA0%, 6)
= 1,000 (6)
= Tk. 6,000.

Future Value of an Annuity Due

Like future value of an ordinary annuity, future value of an annuity due also depends on the :
(i) amount of payments; (ii) rate of interest and (iii) number of periods. The more the amount of
PMT, rate of interest and the number of periods; the higher will be future value of annuity due.
Had there been Tk. 100 payments in the previous example being made at the beginning of each
year, the annuity would have been known as an annuity due.

Future value of an annuity due FVA (DUE) can also be found out in two approaches viz. : (i)
Equation Approach and (ii) Tabular Approach.

11
Under Equation Approach

 (1 + i ) n − 1 
FVA( DUE ) = PMT   × (1 + i )
 i  

Under Tabular Approach

FVA( DUE ) = PMT [{ FVIFA } × (1 + i)]
i ,n

Future value interest factor annuity (DUE) for n periods at I interest percent can be found from
the Future Value Annuity Table, considering n periods and I interest rates.

PROBLEM AND SOLUTION

Problem – 2
Find out the future value of the following annuities due -
(a) Tk. 3,000 per year for 8 years at 8%;
(b) Tk. 5,000 per year for 10 years at 12% and
(c) Tk. 2,000 per year for 7 years at 0%.

Solution
(a) FVA (DUE) = PMT [(FVIFAi, n) (1 + i)] (b) FVA (DUE) = PMT [(FVIFAi, n) (1 +
i)]
= 3,000 [(FVIFA8%, 8) (1 + .08)] = 5,000 [(FVIFA 12%, 10) (1 + .
12)]
= 3,000 [(10.637) (1.08)] = 5,000 [(17.549) (1.12)]
= Tk. 34,463.88 = Tk. 98,274.40

(c) FVA (DUE) = PMT [(FVIFAi, n) (1 + i)]

= 2,000 [(FVIFA0%, 7)]
= 2,000 (7) (1)
= Tk. 14,000

Present Value of an Ordinary Annuity

Present value of an ordinary annuity refers to the value today of a future ordinary annuity.
Suppose you are offered the following alternatives : (i) a three year annuity with payments of Tk.
100 at the end of each of the 3 years and (ii) a lump-sum payment today. Now, the question is :
How large must the lump-sum payment today be to make it equivalent to the annuity ? To answer
this question, we must find out the present value of an ordinary annuity (PVAn). Each of the
payment is to be discounted and the sum of the discounted payments is the PVAn.

There are two approaches of finding out PVAn viz.: (i) Equation Approach and (ii) Tabular
Approach.

Under Equation Approach Under Tabular Approach

n 1 
PVAn = PMT ∑ t 
 t =1 (1 + i )  PVAn = PMT (PVIFAi,n)

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PVIFA refers to the summation term in the bracket in this Equation is called the Present Value
Interest Factor Annuity. It is the present value interest factor for an annuity of n periods,
discounted at I interest percent. In order to find out this interest factor, Present Value Annuity
Table should be consulted considering n periods and discounted I interest factor. The present
value of an annuity depends on : (i) amount od PMT; (ii) n periods and (iii) rate of discount i. The
more the amount of PMT, n periods and rate of discount, the higher will be the amount of annuity
and vice-versa.

PROBLEM AND SOLUTION

Problem - 3
Find out the present values of the following ordinary annuities :
a) Taka 2,500 for 10 years at 12 percent;
b) Taka 4,500 for 12 years at 10 percent and
c) Taka 6,000 for 8 years at 0 percent.

Solution
a) PVAn = PMT (PVIFAi,n) b) PVAn = PMT (PVIFAi,n)
= Tk. 2,500 (PVIFA12%, 10) = Tk. 4,500 (PVIFA10%, 12)
= Tk. 2,500 (5.6502) = Tk. 4,500 (6.8137)
= Tk. 14,125.50 = Tk. 30,661.65
c) PVAn = PMT (PVIFAi,n)
= Tk. PMT (PVIFA0%, 8)
= Tk. 6,000 (8)
= Tk. 48,000

Present Value of an Annuity Due

In the previous example cited in 3.3.3, had the three Tk. 100 payments been made at the
beginning of each of the three years; the annuity would have been an annuity due. Like the
present value of an ordinary annuity; present value of an annuity due can be found out on the
basis of the amount of payment, n periods and present discount rate. He more the amount of
PMT, n periods and i percent of discount; the higher will be the annuity due and vice-versa.

Present value of an annuity due can also be measured by two approaches viz. : (i) Equation
Approach and (ii) Tabular Approach.

(i) Equation Approach

(ii) Tabular Approach
 1  
1 − (1 + i ) n   PVAn (DUE) = PMT [(PVIFAi, n) (1 + i)]
PVAn( DUE ) = PMT   × (1 + i ) 
 i  
 
  
The present interest factor for an
annuity due – PVIFAn (DUE)I, n is equal to PVIFAi, n X (1 + i). Such interest factor would be
found out from the Present Value Annuity Table, considering n periods and I rate of discount.

PROBLEM AND SOLUTION

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Problem - 4
Find the present value of the following annuities; if the PMT occur at the beginning of the year
i.e. annuities due :
a) Taka 7,500 for 9 years at 14 percent;
b) Taka 10,000 for 5 years at 9 percent and
c) Taka 6,600 for 7 years at 0 percent.

Solution
PVA (DUE) = PMT (PVIFAi, n) x (1 +i)
= Tk. 7,500 (PVIFA14%, 9) x (1 + 0.14)
= Tk. 7,500 (4.9464) x (1.14)
= Tk. 42291.72

b) PVA (DUE) = PMT (PVIFAi, n) x (1 +i)

= Tk. 10,000 (PVIFA9%, 5) x (1 + 0.09)
= Tk. 10,000 (3.8897) x (1.09)
= Tk. 42,397.73

c) PVA (DUE) = PMT (PVIFAi, n) x (1 +i)

= Tk. 6,600 (PVIFA0%, 7) x (1 + 0)
= Tk. 6,600(7) x (1)
= Tk. 46,200

Determination of Payments (PMT)

In this sub-section, we shall examine how payments (PMT) are determined in cases of both types
of annuities viz. ordinary annuity and annuity due; where the values of annuities, rate of interest i
and period n are given.

a) Determination of PMT in case of Ordinary annuity

Suppose you have borrowed Taka 18,000 from a bank with 12% interest for a period of 15 years.
What is the annual interest payment if the payments are to be made at the end of each year ?
This is a case of ordinary annuity. So, PVAn = PMT (PVIFAi, n)
18,000 = PMT (PVIFA12%, 15)
18,000 = PMT (6.8109)
18,000
= PMT
6.8109
PMT = Taka 2642.82

b) Determination of PMT in case of Annuity Due

Suppose you have borrowed house building loan of Taka 10 lacs from HBFC with 10% interest
for a period of 20 years. What is the annual interest payment if the payments are to be made at the
beginning of each year ?
This is a case of annuity due. So, PVAn (DUE) = PMT (PVIFAi, n) (1 + i)
10,00,000 = PMT (PVIFA10%, 20) (1 + 0.10)
10,00,000 = 1.10 PMT (8.5136)
10,00,000 10,00,000
PMT = = = Tk. 1,06,780.57
1.10 x 8.5136 9.365

Solving Time and Interest Rates

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In the determination of annuities, time factor and interest or discount factor have been worth-
mentioning. While determining annuities, either ordinary or due; payment, time factor and
interest factor must exist. It is evident that in each of these cases, the values of any three are
given. The value of the fourth one can be found out. In such a context the necessity of
determining the value of either interest (i) or period (n) has arisen.

In case of Annuities (Ordinary and Due)

In the previous problems the FVs and PVs of ordinary annuity due as well as annuity have been
found out where PMT, i and n are given. But, here we are interested to determine i where FVs or
PVs, PMT and n are given. For the purpose of determining i, the same formula given under
Tabulation Approach while calculating FVs and PVs in cases of ordinary annuity and annuity due
need to be followed. The following problem deals with the calculation of i.

PROBLEM AND SOLUTION

Problem - 5
Find out the interest rate (i) in the following cases :
a) You borrow Taka 9,000 and promise to make equal payments of Taka 2,684.80 at the end of
each year for 5 years;
b) You borrow Taka 13,250 and promise to make equal payments of Taka 2,640.07 at the
beginning of each year for 10 years.
Solution
This problem relates to ordinary annuity; since payments are made at the end of the year. So, the
formula for ordinary annuity will be followed which is given as :
PVAn = PMT (PVIFAi, n)
or, 9,000 = 2,684.80 (PVIFAi, 5)

9,000
Hence, PVIFA = ------------- = 3.3522
2684.80
In Present Value Annuity Table, let us look across the period (n) 5 row until we find PVIFA =
3.3522. This value lies in the 15% columns; so the interest rate at which a five year 2,684.80
annuity has a PV of Taka9,000 is 15 percent.

b) This problem relates to annuity due; since payments are made at the beginning of the year. So,
the formula for annuity due will be applied which is as under :
PVAn (DUE) = PMT [(PVIFAi, n) (1 + i)
or, 13,250 = 2,640.07 [(PVIFAi, 10) (1 + i)]
13,250
Hence, PVIFAi, 10 = ------------ = 5.0188 (1 +i)
2,640.07
In the Present Value Annuity Table, let us look across the period (n) 10 row until we find PVIFA
= 5.0188. This value lies in 15% column; so the interest rate at which a ten-year 2,640.07 annuity
has a PV of Taka 13,250 is 15 – 0.15 percent i.e. 14.85%.

b) Solving for period n in cases of Annuities, Ordinary and Due

In case of either ordinary annuity or annuity, period n can be found out if values of ordinary
annuity or annuity due, pmt and i are given. The following examples will clear the matter.

EXAMPLES

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a) Suppose you borrow Taka 15,000 and promise to make equal installment payments of Taka
2,604.62 at the end each of the requisite years at 10 percent.. In this case, you know the value of
ordinary annuity, PMT and i; you are to determine period n. The solution goes as follows :
PVAn = PMT (PVIFAi, n)
or, 15,000 = 2,604.62 (PVIFA10%, n)
15,000
PVIFA10%, n = ------------ = 5.759
2,604.62
In Present Value Annuity Table, let us look across the 10% column until we find PVIFA = 5.759.
This value lies in Row 9, which indicates that it takes 9 years for Taka 2,604.62 to grow to Taka
15,000 at 10% interest rate.
b) Suppose you borrow Taka10,000 and promise to make equal installment payments of Taka
2,054.06 at the beginning of each of the requisite years of 10 percent. In this case, you know the
value of annuity due, PMT and i; you are to find out period n. The solution goes as under :
PVAn (DUE) = PMT (PVIFAi, n) (1 + i)
or, 10,000 = 2,054.06 (PVIFA10%, n) (1 + 0.12)
10,000
or, PVIFAn10%, n = ------------- (1 + 0.10)
2,054.06
= 4.8684 (1 + 0.10) = 5.3552
In the Present Value Annuity Table, let us look across the 10% column until we find PVIFA =
5.3552. This value lies around Row 7, which indicates that it takes around 7 years for Taka
2,054.06 to grow to Taka 10,000 at 10% interest rate.

Review problems
Problem - 1
Find the present value of Taka 5,000 due in the future in case of annuity due and ordinary annuity
under the following conditions :
a) 15 percent interest rate, compounded annually, discounted back 10 years;
b) 15 percent interest rate, semiannually compounding, discounted back 10 years;
c) 15 percent interest rate, quarterly compounding, discounted back 10 years;
d) 15 percent interest rate, monthly compounding discounted back 5 years;
e) 15 percent interest rate, daily compounding discounted back 6 years;
f) 15 percent interest rate, continuously compounding discounted back 7 years.
Problem - 2
To help you reaching your Tk. 10,000 goal, your mother offers to give you Tk. 4,000 on January
1, 2001. You will get a part time job and make 6 additional payments of equal amount each of 6
months thereafter. If all these money is deposited in bank that pays 12 percent, compounded
semiannually, how large must be each of the 6 payments ?

Problem - 3
Find the future value of Taka 15,000 in case of annuity due and ordinary annuity under the
following conditions :
a) 12 percent interest rate, compounded annually, discounted back 10 years;
b) 12 percent interest rate, continuously compounding discounted back 7 years.) 12 percent
interest rate, semiannually compounding, discounted back 10 years;
c) 12 percent interest rate, quarterly compounding, discounted back 10 years;
d) 12 percent interest rate, monthly compounding discounted back 5 years;
..

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