Chapter Three

FUNDAMENTAL CONCEPTS IN FINANCIAL MANAGEMENT

3. Time value of Money
3.1. Why money has a time value?
If an individual behaves rationally, he would not value the opportunity to receive
a specific amount of money now equally with the opportunity to have the same amount at some
future date. Most individuals value the opportunity to receive money now higher than waiting for
one or more years to receive the same amount. Three reasons for this are
 Risk
 Preference for consumption
 Investment opportunities
Risk:- we live under risk or uncertainty. As an individual is not certain about future cash receipts,
he prefers receiving cash now.
Preference for consumption: most people have subjective preference for present consumption
over future consumption of goods and services either because of the urgency of their present
wants or because of the risk of not being in a position to enjoy future consumption that may be
caused by illness or death, or because of inflation.
Investment Opportunities: - Most individuals prefer cash to day to future cash because of the
available investment opportunities to which they can put present cash to earn additional cash.
The recognition of the time value of money and risk is extremely vital in financial decision -
making. The welfare of owner's would be maximized when net worth or net present value is
created form making a financial decision. What is net present value? It is a time value concept.

Future Values

Interest: When A borrows money from B, then A has to pay certain amount to B for the use of
the money. The amount paid by A is called Interest.
Principal:- The amount borrowed by A from B is called principal.
Amount :( Total Amount):- the sum of the interest and principal is usually called the amount.

3.2. Future Value of a single amount

When interest is payable on the principal only, it is called simple interest.
E.g. Simple interest on birr 100 at 5% per annum will be birr 5 each year. i.e. at the end of one
year, total amount will be birr 105, at the end of second year, it will be birr 110 and so on.
 When money is put out at simple interest, the interest is payable for each year, but is not
added to the principal.
Let P be the principal and n, the number of years for which the principal is lent, r, the rate
of interest per annum.

Fn= P+ Pnr P (1 +nr)

Example 1. Find the future value if birr 20, 000 is borrowed at 6 percent simple interest for 3
months.
Here, 3 months is 3/12 = 1/4 of a year, so n = 1/4
Hence, Fv = p+pnr
 =20,000 + 20,000 (3/12x 6%)
= 20,000+300 = birr 20,300
Example 2 Mamush has placed birr 500 in an employees’ savings account that pays 8% simple
interest. How long will it be, in months, until the investment amount to birr 530?
Fv= P (1+nr)
530 =500(1+nx8%)
530= 500(1+0.08n)
n=0.75 Years
N= 0.75x12 months
= 9 month
Example 3 At what annual rate of simple interest will an investment of birr 1000 for 2 years
grow to the amount of birr 1100?
F= p (1+nr)
1100= 1000 (1+2r)
r=5%
3.3. Present value of a single amount

Example 1 How much will Mimi have to invest now in the 8% simple interest savings account
in order to have birr 600 a year from now ?
P= F
(1+nr)
= 600
(1+ 1x8%) = birr 555.56
Example 2 Find the present value of birr 1000 at 9% simple interest due 8 months from now.
P= F
(1+nr)
= 1000
(1+ 8/12 x 9%) = birr 943.40

3.4. Future value of annuity

If the money is lent at compound interest, the interest is added each year to the principal and for
the following year the interest is calculated on their sum.
Let p be the principle and n, the number of years for which the principal is lent at i, percent per

Fn =P (1+i) n

annum compound interest.

Example 1 If you deposited birr 10,000 in NIB bank which was paying a 6% rate of interest
compounded annually on a ten year time deposit, how much would the deposit grow at the end
of ten years?
Fv = P (1+) n
= 10000(1.06)10
= 10000(1.7908)

=Birr 17,908.48
Example 2
 If Sara deposited birr 10,000 in Awash Bank which was paying a 6 percent rate of
interest compounded semi- annually, on a ten year time deposit, How much would the deposit
grow at the end of ten years?
I=6%/2= 3%, since it is compounded semiannually,
n= 10x2 =20
Fv= p (1ti) n
= 10,000 (1.03)20
= 10,000(1.8061)
=birr 18,061.11
Exercise
If Fekadu deposited birr 8,000 in Dashen Bank which was paying a 4% rate of interest
compounded quarterly on an 8 year time deposit ,how much the deposit grow at the end of 8
years?
Fn =10,999.53
Example 3
A sum of money may double itself in n years, compounded at 12 percent interest
annually. Find n ?
Fv= p(l+i)n
2P= P(l+i)n
2=(l+0.12)n
2=(1.12)n
log 2 = log 1.12n

log2= n log 1.12

n= log2
log 1.12
n= 0.301029
0.049218
= 6 years
Exercise
At 8% compounded annually, how many years will it take far birr 2,000 to grow to birr 3,000
F= p(l+i)n
3000=2000(1.08) n
3000 =1.08 n
2000
1.5 =1.08n
log 1.5 = log 1.08n
log 1.5=n log 1.08
n= log1.5
log1.08
n=0.17609  n=5.27
0.03342
Example 4, IF Ato Gebru Tsehayneh deposited birr 11,000 in commercial Bank of Ethiopia at i,
rate of interest compounded annually, on a 5 years time deposit, the deposit would be birr
14,720.48. Find the interest rate?
Fv = p (l+i) n
14720.48= 11,000(l+i)5
 14720.48 = (l+i) 5
11,000
1.338225 =(l+i)5
(1.338225)1/5= (l+i)
=1.05999= l+i
i=1.05999-1
i=6%

Exercise
Find the rate of interest that, compounded annually, will result in tripling a sum of money in 10
years.
Solution i=11.61%

3.5. Present value of annuity

F= P (l+i) n
Dividing both sides of the future value formula by (l+i) n leads to
F = P
(l+i) n
By The definition of negative exponent,
P=F (l+i)-n
Example 1 Suppose that an investor wants to find out the present value of birr 20,000 to be
received after 5 years. Her interest rate is 12% compounded annually. Find the present value?
P= F (l+i) -n
= 20,000(1.12)-5
20,000(0.5674)
Birr 11,348.54
Example 2 How much must be deposited now in an account paying 8% compounded monthly
in order to have just enough in the account 5 years from now to make a birr 10,000 down
payment on a home?
P= F (l+i)-n i=8/12= 0.00666
=10,000(1+8/12%)-60 n= 5x12= 60
=10,000(0.671210)
= 6,712.10
Exercise 6
What sum of money deposited now at 8% compounded quarterly will provide just enough
money to pay a birr 1,000 debit due 7 years from now?
Solution =birr 574.37

3.6. More frequent compounding

3.6.1. Compounding for less than a year
3.6.2. Effective annual rate and the nominal rate
 Effective Rate
Because of lack of comparability, it is hard to judge whether interest quoted at 8 percent
compounded semiannually results in more or less interest than would be the case if the rate was
7.9 percent compounded monthly. To make the comparison possible, we change both to their
equivalent annual rates, there equivalents are called effective rate.

Example: Birr 1 at 8 % compounded quarterly for one year would amount to

F= P(l+i) n
=1(1+8/4%) 4
= 1(1.02)4
=1.08243
Which is the same as, the amount of birr 1 at a rate of 0.08243, or 8.243% for one year.
F= 1(1.08243)1
= 1.08243
Similarly, Birr at 7.9% compounded monthly for one year would amount to
F= P(l+i)n
=1(1+7.9%) 12
12
=1.08192

Which is equivalent to the amount of birr 1 at a rate of 8.192 percent for one year.

Effective rate of i compounded m times a year

re= (l+i)m – l, where i = J
m
Where, J= nominal (annual rate)
m= compounded times a year
re= effective rate
Example 1 find the effective rate of 24% compounded monthly.
i = 24% = 2%
12
m= 12 months in a year.
re= (1+ 0.02)12-1
= 1.26824-1
= 0.26824
= 26.824%
Example 2 Find the effective rate of 15 percent compounded annually, semiannually, quarterly
and weekly.
Annually: 15%, re =15%
Semiannually: re =15.563%
Quarterly: re = 15.865%
Weekly: re = 16.158%

3.7. Special Case Annuities

Annuity Payments
An Annuity is a series of fixed payment (or receipt) in which each payment is made at the end /
beginning of the period. Annuity can be:
i) Ordinary Annuity
ii) Annuity Due

i) Ordinary Annuities: Future Value

An ordinary Annuity is a series of equal periodic payments in which each payment is made at the
end of the period.   Periods

0 1 2 3 n

Fv=R [(1+i) n-1] Where n=Number of periods

i i=Interest rate per period
p=Payment per period
Fv= future value of the annuity

Example. Supposes Martha deposits birr 1000 at the end of each year for 3 years at 6 % rate of
interest. How much would this annuity accumulate at the end of the third year?
Fu= R[(1+i)n-1]
i
=1000[(1.06)3-1]
0.06
=1000(3.1836)
Fv =birr 3183.60
Example 2: If birr 100 is Deposited in an account at the end of every quarter for the next 5 years,
how much will be in the account at the time of the final deposit if interest is 8 % compounded
quarterly?
i=8%=2%
4
n=5x4=20
Fv=100[(1.02)20-1
0.02
=100[24.2974
= 2429.74
Exercise: When Derartu was born, her parents decided to deposit birr 500 every 6 months at the
end for 15 years in an account earning 6% compounded semiannually. How much will be in
account after the last deposit is made?
F=R[1+i)n-1] i=6%/2=3%
i n=15X2=30
=500[(1.03)30-1]
0.03
=birr 23787.71
Ordinary Annuities: Sinking fund
A sinking fund is fund in to which periodic payments are made in order to accumulate a
specified amount at point in the future.
F= R [l+i) n-1]
i
R= F
[(1+i)n-1]
i
R=F[ i ]
(1+i)n-1

Example: How much should be deposited in a sinking fund at the end of each quarter for 5 years
to accumulate birr 10,000 if the fund earns 8 % compounded quarterly?
N=5x4=20
i= 8%/2=2%
R=F[ i ]
(1+i)n-1
R=10,000 [ 0.02 ]
(1.02)20-1
=10,000(0.0411567) = birr 411.57

Ordinary Annuities: Present Value

Present value annuity calculations arise when we wish to determine what lump sum must be
deposited in an account now if this sum and the intersect it earns are to provide equal payments
for a stated number of periods, with the last payment making the account balance zero.

P=R[1-(1+i)-n]
i

Example 1
What sum deposited now in an account earning 8% interest compounded quarterly will provide
quarterly payments of birr 1000 for 10 years, the first payments to be made 3 months from now?
n=10x4=40
i=8%=2%
4
p=R[1-(1+i)-n]
i
=1000[1-(1.02)-40]
0.02
=1000(27.35548)
=birr 27355.48
Example 2.a) The directors of a company have voted to establish a fund that will pay a retiring
accountant, birr 1000 per month for the next 10 years , the first payment to be made a month
from now. How much should be placed in the fund if it earns interest at 12% compounded
monthly?
b) How much interest will the fund earn during its existence?
a) p=R[1-(1+i)-n] n=10x12=120
i i=12%/12=0.01
=1000[1-(1+0.01)-120
0.01
=69,700.52
b) We have 120 payment X birr 1000=birr 120,000
Interest earned= 120,000-69700.52
=50299.48
Example. Ato Ayalkebet borrowed birr 5,000 to buy a television. He will amortize the 1000 by
monthly payments of birr R each over a period of 3 years. The payment is made at the end of
each month.
a) Find the monthly payment if interest is 12% compounded monthly.
b) Find the total amount Ato Ayalkebet will pay.

a) P=R[1-(1+i)-n] I=12%=1%
i 12
5,000=R[1-01)-36 n=3x12=36
0.01
5,000=R[30.107505]
R=5,000
30.107505
R= 166.07

b) Ato Ayailkebet pays birr 166.07 a month for 36 months. The total paid will be
= 36x166.07 =5978.52 of which interest is 5978.52-5000=978.52
Exercise: A birr 70,000 car is to be purchased by paying birr 10,000 in cash and mortgage for 30
years at 12% compounded monthly. The payment is made at the end of each month.
a) Find the monthly payment on the mortgage
b) What will be the total amount of interest paid?
a) P=R[ 1-(1+i)-n] i=12%/12=1%
i n=30x12=360
360
60,000=R[1-1.01)- ]
0.01
R=617.17
b) The total amount paid in 360 months will he
360x617.17=222,181.20
Interest paid will be 222,181.20-60,000
=162,181.20
ii. Annuity due: future value
Annuity due is a series of equal periodic payments in which each payment is made at the
beginning of the period.

_____________ Periods
Fv=R[(1+i)n-1] (1+i)
0 1 2……..n
i
Example, suppose Daniel deposits birr 1000 at the beginning of each year for 3 years at 6% rate
of interest How much would this annuity accumulate after the third year payment is made?
Fv=R[1+i)n-1](1+i)
i
=1000[(1.06)3-1](1.06)
0.06
=birr 3374.62
Example 2. If birr 100 is deposited in an account at the beginning of every quarter for the next 5
years, how much will be in the account at the time of the final deposit if interest is 8%
compounded quarterly?
Solution
Fv=R[(1+i)n-1] (1+i) n=5x4=20
i i=8%/4=2%
=100[(1.02)20-1(1.02)
0.02
=birr 2478.33
Annuity Due: present value
P=R[1-(1+i)-n](1+i)
i
Example. What sum deposited now in an account earing 8% interest compounded quarterly will
provide quarterly payments of birr 1000 for 10 years, the first payment to be made now?
n=10x4=40
i=8%/4=2%

P=R[1-(1+i)-n](1+i)
i
=1000[1-(1.02)-40](1.02)
0.02
=27,902.59
Example 2:
On September 1,2002 Zerfie borrowed birr 5,000 to buy a house. She will amortize the loan by
monthly payment of birr R starting from September 1,2001each over a period of 3 years. Find
the monthly payment if interest is 12% compounded monthly?
i=12%=1% n=3X12=36
12
P=R[1-(1+i)-n](1+i)
i
5000=R[1-(1.06)-36](1.01)
0.01
5000=R[30.40858]
R=164.43
3.8. Uneven Cash Flow Streams

ABC company has been offered an opportunity to receive the following mixed stream of cash
flows over the next five years.
Year Cash flows
1 Birr 400
 2 800
3 500
4 400
5 300
If the firm earn 9 Percent on its investment,
A) what is the future value for this opportunity
B) what is the present value for this opportunity
A) Future value
Year Cash flows
1. Birr 400x(1.09)1=436
2 800x(1.09)2=950.48
3. 500x(1.09)3=647.5
4 400x(1.09)4=564.63
5 300x(1.09)5=461.58
Future value =3062
B) Present value
Year Cash flows
1. Birr 400x(1.09)1=366.80
2 800x(1.09)2=673.60
3. 500x(1.09)3=386.00
4 400x(1.09)4=283.20
5 300x(1.09)5=195.00
Present value =1904.60
Example 2, Assume that you can choose between receiving birr 3000 either as an ordinary
three years, birr 1000 annuity or receiving birr 1500, birr 1000 and birr 500 at the end of
years 1,2 and 3, respectively. Which alternative would you prefer assume the annual interest
rate was 10 percent?
Solution: To compare, you should compute the present value of each alternative and select
the alternative which result in higher amount of present value?
Alternative 1(Present value of ordinary annuity)
PV=R[ 1-(1+i)-n]
i
=1000[1-(1.1)-3 =2487
0.1
Alternative 2( Mixed stream)
Year Cash flow PV
1 1500 1500(1.1)-1=1363.5
2 1000 1000(1.1)-2=826
3 500 500(1.1)-3=375.50
Present value =2565, therefore, the second alternative is
better.
A mixed stream with embedded annuity
Example1 A cash flows in the following years and interest of 12 percent per annum.
Year Cash flow Present value
1 10000
2 10000 10000[1-(1.12)-4 ] =30373
 3 10000 0.12
4 10000
5 15000 15000(1.12)-5 =8511
6 16000 16000(1.12)-6 =8106
7 17000 17000(1.12)-7 =7690
Present value =54680

Example2,
Year Cash flow Present value
1 5000 5000(1.12)-1=4464.29
2 6000 6000(1.12)-2=4783.16
3 8000
4 8000 8000[1-(1.12)-3] (1.12)-2=15317.80
5 8000 0.12
6 9000 9000(1.12)-6=4559.68
Present value 29125

Perpetuities: Perpetuity can be defined as an annuity that has an indefinitely long life. Any
perpetuity can be discounted by dividing the value of one payment by the required rate of return.
An important special case of an annuity arises when the level stream of cash flow continues
forever. Perpetuities are also called Consol.
Perpetuity present value X Rate = Cash flow
Pv x r = C
Therefore, given a cash flow and a rate of return, we can compute the present value very easily.

Pv for a perpetuity = C
r
Example, An investment offers a perpetual cash flow of birr 500 every year. The return you
require on such an investment is 8 percent, what is the value of this investment? The value of
this perpetuity is:
Pv = C/r = 500/0.08=6250

Loan Amortization
Loan amortization refers to the determination of equal periodic loan payments necessary to
provide a lender with a specified interest return and repay the loan principal over a specified
period.
Loan amortization schedule is a schedule of equal payments to repay loan . It shows the
allocation of each loan payment to interest and principal.
Example,
An individual borrow birr 6,000 at 10 percent and agree to make equal annual end of year
payments over four years.
Required: Prepare loan amortization schedule?]
Present value formula should apply to find the periodic loan payment.
Pv=R[1-(1+i)-n]
i
6000=R[1-(1.1)-4]
0.1
R= 6000
3.170
R= 1892.74

Loan Amortization schedule

1.End of year 2. Loan Payments End of Year
payment 3. Interest Principal 4=2- Principal 5=5-4
3
0 - - - 6,000
1 1,892.74 6,000x10% =600 1292.74 4,707.26
2 1,892.74 4,707.26 x10%=470.73 1422.01 3,285.25
3 1,892.74 3,285.25x 10%=328.53 1,564.21 1,721.04
4 1,892.74 1,721.04x10%=172.10 1720.64 0