CHAPTER 4

TIME VALUE OF MONEY

AND ITS APPLICATION
 Time Value of Money
 Time value of money is the concept that the value
of a dollar to be received in future is less than the
value of a dollar on hand today. The reason is the
Inflation is the rise in general level of prices.
 Yusuf bought a one-year guaranteed investment
certificate (GIC) for $5000 from a bank on May 15
last year. The bank was paying 10 percent on one-
year guaranteed investment certificates at the time.
 One year later, Yusuf cashed in his certificate for
$5500. We may think of the interest payment that
he got from the bank as compensation for giving up
the use of money.
 When Yusuf bought the GIC for $5000, he gave up the
opportunity to use the money in some other way during
the following year. On the other hand, the bank got use
of the money for the year.
 In effect, Yusuf lent $5000 to the bank for a year. The
$500 interest was payment by the bank to Yusuf for the
loan.
 The bank wanted the loan so that it could use the money
for the year. (It may have lent the money to someone
else at a higher interest rate).
 Each dollar on May 15 last year was worth the right to
collect 5500/5000 1.1 dollars a year later. This 1.1 may
be written as 1 and 0.1, where 0.1 is the interest rate.
 INTEREST
• Interest is the charge against the use of money by
the borrower.
• Simple Interest.
• Compound Interest.
Formula of simple interest SI = P0(i)(n)
SI: Simple Interest
P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
• Suppose $1,000 were invested on January 1, 2010
at 10% simple interest rate for 5 years. Calculate
the total simple interest on the amount.

• SI= P*(i*n) = 1000*(0.1*5)= 500

• Assume that you deposit $1,000 in an account

earning 7% simple interest for 2 years. What is the
accumulated interest at the end of the 2nd year?
• SI = P0(i)(n)
=$1,000(.07)(2) = $140
• If you were to lend $100 for three years at 10
percent per year simple interest, how much
interest would you get at the end of the three
years?
• The total amount of interest earned on the
$100 over the three years would be $30.
• This can be calculated by using Is P(I*N):
• Is P(I*N) = 100(0.10)(3) = $30
 Compound Interest
• Compound interest is charged on the principal
plus any interest accrued till the point of time
at which interest is being calculated.
• Formula of compound interest.
= P(1+I)^N
$1,000 (1.07)^1 = $1,070
 If you were to lend $100 for three years at 10 percent per year
compound interest, how much interest would you get at the end
of the three years?
 If you lend $100 for three years at 10 percent compound interest
per year, you will earn $10 in interest in the first year. That $10
will be lent, along with the original $100, for the second year.
Thus, in the second year, the interest earned will be $11
 $110(0.10). The $11 is lent for the third year. This makes the loan
for the third year
 $121, and $12.10 $121(0.10) in interest will be earned in the
third year. At the end of
 the three years, the amount you are owed will be $133.10. The
interest received is then
CI = P(1 + i)^N – P
CI = 133.1 – 100
CI = $33.10.
 Future value
• Future value (FV) is the value of a current
asset at a specified date in the future based
on an assumed rate of growth over time.
FV= PV*(1+i)^n
• Where C0 is the cash flow at period 0
• I is interest rate
• N is number of period.
• PV is present value
 FV of an initial $100 after
3 years (I = 10%)

0 1 2 3

10%

100 FV = ?

Finding FVs (moving to the right on a time line)

is called compounding.
 Example
 Farah want to know how large his
deposit of $10,000 today will become
at a compound annual interest rate of
10% for 5 years.
Aisha wants to know how large her
deposit of $10,000 today will become
at a compound annual interest rate of
12% for 10 years.?
 Present value
The concept of present value is frequently
used in capital budgeting techniques and its
understanding, therefore, very important for
the people involved in capital budgeting
decisions. Examples of capital budgeting
techniques that take into account the present
value of money are ‘net present value
method.
 Example
• Suppose you are depositing an amount today in an
account that earns 5% interest, compounded annually. If
your goal is to have $5,000 in the account at the end of six
years, how much must you deposit in the account today?

• Solution
• The following information is given:
• future value = $5,000
• interest rate = 5%
• number of periods = 6
PV = FV/(1+i)^n
• present value = future value / (1 + interest rate)number of periods
 Example
• Let's assume we are to receive $100 at the end
of two years. How do we calculate the present
value of the amount, assuming the interest rate is
8% per year compounded annually?
• We need to calculate the present value (the value
at time period 0) of receiving a single amount of
$1,000 in 20 years. The interest rate for
discounting the future amount is estimated at
10% per year compounded annually.
• What is the present value of receiving a single
amount of $5,000 at the end of three years, if the
time value of money is 8% per year, compounded
quarterly?
• Notice that the timeline shows n = 12, because there are 12
quarters in the three-year period. Because the time periods
are three months long, the rate for discounting is i = 2%
(the quarterly rate that results from the annual rate of 8%
divided by the four quarters in each year)

The answer tells us that receiving $5,000 three years from today is
the equivalent of receiving $3,942.45 today, if the time value of
money has an annual rate of 8% that is compounded quarterly. ?
• What is the present value of receiving a single
amount of $10,000 at the end of five years, if the
time value of money is 6% per year,
compounded semiannually?

Notice that the timeline shows n = 10, because there are 10 six-
month (or semiannual) periods in five-years time. Because the
compounding occurs semiannually, the rate for discounting is i =
3% per six-month period (the annual rate of 6% divided by the two
semiannual periods in each year)
 PV vs FV
• when one increases, the other
increases, assuming that the interest
rate and number of periods remain
constant.
• As the interest rate ( discount rate)
and number of periods increase, FV
increases or PV decreases
 Net Present Value (NPV)

• Net present value (NPV) is the difference between

the present value of cash inflows and the present value of
cash outflows.
• The NPV technique is a discounted cash flow method that
considers time value of money in evaluating capital
investments.
• NPV is the present value of an investment project’s net
cash flows minus the project’s initial cash outflow.
 NPV – Decision Rule

• If the NPV is positive, accept the project

• A positive NPV means that the project is expected to add value
to the firm and will therefore increase the wealth of the owners.
• Since our goal is to increase owner wealth, NPV is a direct
measure of how well this project will meet our goal.
• EXAMPLE:
1. Calculating NPV, if a sum of $400,000 is investing today in an
harvest machine may give a series of below cash inflows in future;
$70,000, $120,000, $140,000, $140,000 and $40,000 respectively,
if the opportunity cost of capital is 8% per annum, should we
accept or reject to purchase this machine.
Methods of Agricultural Projects
 Assignment (1)

• Calculating NPV, if a sum of $380,000 is investing

today in an harvest machine may give a series of
below cash inflows in future; $75,000, $117,000,
$150,000, $128,000 and $68,000 respectively, if the
opportunity cost of capital is 15% per annum, should
we accept or reject to purchase this machine.
 Assignment (2)
• A project requires an initial investment of $225,000
and is expected to generate the following net cash
inflows:
• Year 1: $95,000
• Year 2: $80,000
• Year 3: $60,000
• Year 4: $55,000
• Required: Compute net present value of the project
if the minimum desired rate of return is 12%
 Assignment (3)
Net Present Value – Salaam Industries has a project with the following projected cash

flows:

Initial Cost, Year 0: $240,000

Cash flow year one: $25,000

Cash flow year two: $75,000

Cash flow year three: $150,000

Cash flow year four: $150,000

a. Using a 10% discount rate for this project and the NPV model should this

project be accepted or rejected?

 Assignment (4)
Net Present Value – Horsed Industries has a project with the following projected cash

flows:

Initial Cost, Year 0: $468,000

Cash flow year one: $135,000

Cash flow year two: $240,000

Cash flow year three: $185,000

Cash flow year four: $135,000

a. Using an 8% discount rate for this project and the NPV model should this

project be accepted or rejected?

 Even Cash Inflows
• When cash inflows are even:

NPV = R ×(1 − (1 + i)-n) /I − Initial Investment

• In the above formula,

R is the net cash inflow expected to be received in each
period;
i is the required rate of return per period;
n are the number of periods during which the project is
expected to operate and generate cash inflows.
• Example:
• Calculate the net present value of a project which requires an
initial investment of $243,000 and it is expected to generate a
cash inflow of $50,000 each month for 12 months.
• The target rate of return is 12% per annum.
• Solution
• We have,
Initial Investment = $243,000
Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%
• Net Present Value
= $50,000 × (1 − (1 + 1%)^-12) ÷ 1% − $243,000
= $50,000 × (1 − 1.01^-12) ÷ 0.01 − $243,000
≈ $50,000 × (1 − 0.887449) ÷ 0.01 − $243,000
≈ $50,000 × 0.112551 ÷ 0.01 − $243,000
≈ $50,000 × 11.2551 − $243,000 = 319,753.87
 Uneven Cash Inflows
• NPV= {R1/(1+r)^1 + R2/(1+r)^2 + R3/(1+r)^3}-initial
investment.
• Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period,
and so on.
 Example
• An initial investment of $8,320 thousand on plant
and machinery is expected to generate cash inflows
of $3,411 thousand, $4,070 thousand, $5,824
thousand at the end of first, second, and third year,
($2,065+900) thousand at the end of the fourth
year. At the end of the fourth year, the machinery
will be sold for $900 thousand. Calculate the net
present value of the investment if the discount rate
is 18%.