TIME VALUE OF MONEY

• A birr that you have today is

worth more than the promise or
expectation that you will receive
a birr in the future.
• A single sum of money or a series of
equal, evenly-spaced payments or
receipts promised in the future can be
converted to an equivalent value today.
• Conversely, you can determine the value
to which a single sum or a series of future
payments will grow to at some future
date.
 Interest

• Interest is the cost of borrowing

money.
• An interest rate is the cost stated as
a percent of the amount borrowed
per period of time, usually one year.
 The prevailing market rate is composed
of:
• The Real Rate of Interest compensates
lenders for postponing their own
spending during the term of the loan.
• An Inflation Premium to offset the
possibility that inflation may erode the
value of the money during the term of
the loan.
• Various Risk Premiums to compensate
the lender for risky loans such as those
that are:
Unsecured
made to borrowers with questionable
credit ratings, or
illiquid loans that the lender may not be
able to readily resell.
Simple interest is computed only on
the original amount borrowed.

Simple Interest = p x i xn
where:
p = principal (original amount borrowed or
loaned)
i = interest rate for one period
n = number of periods
Example 1: You borrow $10,000 for 3 years at
5% simple annual interest.

Interest = p x i x n = 10,000 x 0.05 x 3

= 1,500

Example 2: You borrow $10,000 for 60 days at

5% simple interest per year (assume a 365
day year).

Interest = p xi x n = 10,000 x 0.05 x (60/365) =

82.1917
Compound interest is calculated each
period on the original amount borrowed
plus all unpaid interest accumulated to
date.
• The interest earned in each period is
added to the principal of the previous
period to become the principal for the
next period.
Example
You borrow $10,000 for three years at 5% annual
interest compounded annually:

interest year 1 = p x i x n = 10,000 x 0.05 x 1 = 500

interest year 2 = (p2 = p1 + i1) x i x n = (10,000 + 500)
x 0.05 x 1 = 525
interest year 3 = (p3 = p2 + i2) x i x n = (10,500 +
525) x 0.05 x 1 = 551.25

• Total interest earned over the three years =

500 + 525 + 551.25 = 1,576.25.
 Interest Rate in Calculations

• Time Value of Money calculations

always use compound interest.
• You must adjust the interest rate and
the number of periods to be
consistent with compounding
periods.
For example a 6% interest rate compounded
semiannually for five years should be
entered 3% (6 / 2) for 10 (5 x 2) periods
 Future Value Of A Single Amount

• The amount of money that an

investment made today will grow to
by some future date.
Example 1: You can afford to put $10,000
in a savings account today that pays 6%
interest compounded annually. How
much will you have 5 years from now if
you make no withdrawals?

pv = 10,000
i = 0.06
n= 5
FV = 10,000 (1 + .06)5 =10,000(1.06) 5

FV=10,000(FVIF 6%, 5)
=10,000 (1.3382)
= 13,382
Example 2: Another financial institution
offers to pay 6% compounded
semiannually. How much will your
$10,000 grow to in five years at this rate?

PV = 10,000
i = .06 / 2 = 0.03
n = 5 x 2 = 10
FV = PV (1 + i) n

FV = 10,000 (1 + .03)10
= 10,000(1.03)10

FV =10,000(FVIF 3%, 10)

=10,000(1.3439)
= 13,439
 Rate of Return

Example
A company is offered a contract that has
the following terms: an immediate cash
outlay of Br 15,000 followed by a cash
inflow of Br 17,900 three years from
now. What is the company’s rate of
return on this contract?
FV = PV (1 + i)n

17,900 = 15,000(1+i)3

(1+i) 3 =1.193

FVIF i %, 3 = 1.193

The closest value on the future value of

$1(FVIF) table is 1.191 and this
 Number of Periods
Example
A deposit of Br 1,000 is made in an
interest-bearing account that pays 10%
compounded yearly. The investor’s goal
is Br 1,500. How many years must the
principal earn compound interest before
the desired amount is realized.
 FV = PV (1 + i)n
1,500 = 1,000(1+0.1)n
(1+0.1)n =1.5
FVIF 10%, n = 1.5

n i
4 1.4641
5 1.6105
n=5
 Present Value Of A Single Amount

• An amount today that is equivalent

to a future payment that has been
discounted by an appropriate
interest rate.
Where:
PV = Present Value
FV = Future Value
i = Interest Rate Per Period
n = Number of Compounding Periods
Example 1

You want to buy a house 5 years from

now for Br 150,000. Assuming a 6%
interest rate compounded annually,
how much should you invest today to
yield Br150,000 in 5 years?

FV = 150,000
i =0.06
n=5
PV = 150,000 [1 / (1 + .06)5]
= 150,000(PVIF 6%, 5)
= 150,000 (0.7473)
= 112,095
Example 2: You find another financial
institution that offers an interest rate of
6% compounded semiannually. How
much less can you deposit today to yield
$150,000 in five years?

FV = 150,000
i = 0.06 / 2 = .03
n = 5 x 2 = 10
PV = 150,000 [1 / (1 + .03)10]
= 150,000(PVIF 3%, 10)
= (0.7441)
= 111,615
 Effective Rate (Effective Yield)
• The actual rate that you earn on an
investment or pay on a loan after the
effects of compounding frequency are
considered.
• The effective rate of an investment will
always be higher than the nominal or
stated annual interest rate when interest
is compounded more than once per year.
Where:
i = Nominal or stated interest rate
n = Number of compounding periods per
year
Example: What effective rate will a stated annual rate
of 6% yield when compounded semiannually?
 Annuity Payments
• An annuity is a series of equal
payments or receipts that occur at
evenly spaced intervals.

Example
• Leases and rental payments
• The payments or receipts occur at the
end of each period for an ordinary
annuity while they occur at the
beginning of each period for an annuity
due.
 Payments must:
• be the same amount each period
• occur at evenly spaced intervals
• occur exactly at the beginning or end
of each period
• be all inflows or all outflows (payments
or receipts)
• represent the payment during one
compounding (or discount) period
 Future Value of an Ordinary
Annuity(FVoa)
• The value that a stream of expected or
promised future payments will grow to
after a given number of periods at a
specific compounded interest.
Where:
FVoa = Future Value of an Ordinary
Annuity
PMT = Amount of each payment
i = Interest Rate per Period
n = Number of Periods
Example1: 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 = 0.06
n=5
= 5,000(FVIFA 6%, 5)
=5,000(5.6371)
= 28,185.50
Example 2: You are 40 years old and have
accumulated Br50,000 in your savings
account. You can add Br 100 at the end
of each month to your account which
pays an interest rate of 6% per year. How
much will you have in 20 years?
You can treat this as the sum of two
separate calculations:

1. the future value of 240 monthly

payments of $100 Plus
2. the future value of the $50,000 now in
your account.
PMT = $100 per period
Interest per period = i= 6% / 12
= .06 /12 =0.005
n = 20x12 = 240 periods

FVoa = 100 [(1+0.005) 240 -1]

0.005
= 100(462.0409) = 46,204.09
 +
FV = 50,000 (1+i) 240
= 50,000 (1.005)240
= 50,000(3.3102)
= Br 165,510

After 20 years you will have accumulated

Br 211,714.09 (46,204.09 + 165,510).
Example 3 Three equal yearly payments of
Br 3,000 are offered in return for Br 9,800
to be received upon making the last
annuity payment. What is the implied
rate of return?
FVoa = PMT [(1+i) n -1]
i
9,800 = 3,000[(1+i) 3 -1]
i
[(1+i)3 -1]
i = 9,800/3,000 = 3.2667

FVIFA i%, 3 = 3.2667 i = 9%

 8% 9%

n=3 3.2464 3.2667 3.2781

The closer rate is 9%.

Example 4 How many annual deposits of Br
1,000 each must be made into an account
paying 6% compounded per year in order to
accumulate Br 5,500?

FVoa = PMT [(1+i) n -1]

i

5,500 = 1,000 [(1+0.06) n -1]

i
[(1.06) n -1]
0.06
= 5,500/ 1,000 = 5.5
FVIFA 6%, n =5.5

n i
4 4.3746
5.5
5 5.6371 n= 5
Example 5: In 10 years, you will need
$50,000 to pay for college tuition. Your
savings account pays 8% interest
compounded monthly. How much should
you save each month to reach your goal?
FVoa = 50,000, the future savings goal
Interest per month = i = 0.08 / 12) = 0
0.0067
n = 10 x 12 = 120 periods
FVoa = PMT [(1+i) n -1]
I

50,000 = PMT [(1+0.0067) 120 -1]

0.0067
50,000 = PMT (183.3548)

PMT = 50,000 / 183.3548 = 272.70

 Future Value of an Annuity Due (FVad)

• 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.
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 = 0.06, n = 5

FVoa = 5,000 [(1+0.06) 5 -1]

0.06
= 5,000(FVIFA 6%, 5)

= 5,000 (5.6371) = 28,185.50

FVad = 28,185.50 (1.06) = 29,876.63

Present Value of an Ordinary Annuity

PVoa is the value of a stream of

expected or promised future
payments that have been discounted
to a single equivalent value today.
Where:
PVoa = Present Value of an Ordinary
Annuity
PMT = Amount of each payment
i = Discount Rate per Period
n = Number of Periods
Example 1: What amount must you invest
today at 6% compounded annually so
that you can withdraw Br5,000 at the
end of each year for the next 5 years?
PMT = 5,000
i = 0.06
n=5
PVoa = PMT [(1 - (1 / (1 + i)n)) ]
I
PVoa = 5,000 [(1 - (1 / (1 + 0.06)5)) ]
0.06
= 5,000(PVIFA 6%, 5)
= 5,000 (4.2124) = 21,062
Example 2: A computer dealer offers to
lease a system to you for Br 50 per
month for two years. At the end of two
years, you have the option to buy the
system for Br 500. You will pay at the end
of each month. He will sell the same
system to you for Br 1,200 cash. If the
going interest rate is 12%, which is the
better offer?
 You can treat this as the sum of two
separate calculations:

1. the present value of an ordinary

annuity of 24 payments at Br 25 per
monthly period Plus
2. the present value of Br 500 paid as a
single amount in two years.
1.
PMT = 50 per period
i = 0.12 /12 = 0 .01,
n = 24 number of periods

PVoa = 50 [(1 - (1 / (1 .01)24)) ]

0.01
= 50(PVIFA 1%, 24) = 50(21.2434) =
1,062.17
+
2.
FV = 500 Future value (the lease buy out)
i = 0.01 Interest per period
n = 24 Number of periods

PV = FV [1 / (1 + i) n]
= 500 [1 / (1 .01) 24]
= 500(PVIF 1%, 24)
= 500(0.7876)
= 393.80
Example 3: You can get a $150,000 home
mortgage at 7% annual interest rate for
30 years. Payments are due at the end of
each month and interest is compounded
monthly. How much will your payments
be?
PVoa = 150,000, the loan amount
i = 0.07/12 =0.0058
n = 12x30 = 360 periods
Payment = PVoa / [(1- (1 / (1 + i) n )) / i]

Payment = 150,000 / [(1 - (1 /

(1.0058)360)) /0 .0058]
= 150,000/150.9165 = 993.93
Example: You can get a $150,000 home
mortgage at 7% annual interest rate for 30
years. Payments are due at the end of
each month and interest is compounded
monthly. How much will your payments
be?
PVoa = 150,000, the loan amount
i = 0.005833 interest per month (0.07 / 12)
n = 360 periods (12 payments per year for
30 years)

Payment = 150,000 / [(1 - (1 / (1.005833)360)) /

0.005833] = 997.95
 Present Value of an Annuity Due (PVad)

• The Present 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.
Where: PVad = Present Value of an Annuity Due
PVoa = Present Value of an Ordinary Annuity
i = Discount Rate per Period
Example: What amount must you invest today a
6% interest rate compounded annually so that
you can withdraw $5,000 at the beginning of
each year for the next 5 years?

PMT = 5,000
i=0.06
n=5
PVoa = PMT [(1 - (1 / (1 + i)n)) ]
i
PVoa = 5,000 [(1 - (1 / (1 + 0.06)5)) ]
0.06

= 5,000(PVIFA 6%, 5)
= 5,000 (4.2124) = 21,062
PVoa = 21,062 (1.06) = 22,325.72
 Perpetuities
• A special case of an annuity where a
contract runs indefinitely and there is no
end to the payments.
Present value of perpetuity
= Cash Payment/ Interest rate
= PMT/i
Example
What is the present value of perpetuity of
Br.100 per year if the appropriate
discount rate is 7%?

PV of perpetuity = PMT/i
= 100/0.07
=Br. 1,428.57
 Loan Amortization
• Amortization is a method for
repaying a loan in equal installments.
• Part of each payment goes toward
interest due for the period and the
remainder is used to reduce the
principal
Example
Suppose a firm borrows Br. 100,000 and
the loan is to be repaid in 3 equal
payments at the end of each of the next
3 years. The lender is to receive a 6 %
interest rate on the loan balance that is
outstanding at the beginning of each
year.
PVoa =PMT (PVIFA i, n)

100,000 = PMT (PVIFA 6%, 3)

100,000 = PMT (2.6730)

PMT =100,000/2.6730 = Br.37,411