CHAPTER THREE

THE TIME VALUE OF MONEY

Introduction
To make it a valuable as possible to stack holders; an enterprise must choose the best
combination of decisions on investment, financing and dividends. In any economy in which
individuals, firm and government have the time preference, the time value of money is an
important concept. The decision to purchase new plant and equipment or to introduce a new
product in the market requires using capital allocating or capital budgeting techniques.
Essentially, we must determine whether future benefits are mathematical tools of the time value
of money as the first step towards making capital allocating decisions.

3.1. The Concept of Time Value of Money

The value of money depends on time. The value of a given amount of money at one point in time
is not the same as the value of the same face amount at another time. Thus, the value of money is
dependent on the point of time it occurs at payment or receipt. It is the expression of the fact that,
if the rate of interest is positive, the money in hand now is worth more than money to be received
at a date in the future. It refers to the value derived from the use of money over time as a result of
investment and reinvestment. It is the concept that an amount in hand today is worth more than
the same amount that will be received in future year. This is because; the amount could be
deposited in an interest-bearing bank account (or otherwise invested) from now to time "t" and
yield interest. Similarly, it means that, cash paid out later is worth less than a similar sum paid at
an earlier date.
3.2. Simple Interest Versus Compound Interest
Interest is the growth in a principal amount representing the fee charged for the use of money for
specified time period.
3.2.1. Simple Interest: is the return on a principal amount for one period time. It is based on the
assumption that interest itself does not earn a return, but this kind of situation occurs rarely in the
business world.
Simple interest I= principal x rate x time

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3.2.2. Compound Interest: is the return on a principal amount for two or more time periods,
assuming that the interest for each time is added to the principal amount at the end of each period
and earns interest in all subsequent periods.
Exercise3.1
Suppose that Br. 200,000 is invested at 20% simple interest per annum. The following table
shows the state of the investment, year by year.

Year Principal Interest Earned Amount Cumulative Amount

1 200,000 40,000 (20% of 200,000) 240,000
2 200,000 40,000 (20% of 200,000) 280,000
3 200,000 40,000 (20% of 200,000) 320,000

Assuming the above case, the compounded amount would be as indicated on the following table.

Year Principal Interest Earned Amount Cumulative Amount

1 200,000 40,000 (20% of 200,000) 240,000
2 240,000 48,000 (20% of 240,000) 288,000
3 288,000 57,600 (20% of 288,000) 345,600

3.3. Future Values Versus Present Values

When correctly applied, both techniques will result in the same decisions but they view the
decision from opposite angles. Future value techniques are used to find the future values of the
amount (s) involved at some future time, usually at the end of the life of the project whereas,
present value techniques are used to find the today's equivalent (present values) of amounts
expected at some time in the future. Present values are measured at the start of the project's life
(time zero). Future value computation techniques use compounding to find the future value of each
cash flow at the end of the investment's life and then sums them to find the investment's future
value, on the other hand, the present value techniques uses discounting to find the present value of
each cash flow at time zero and then sums them to find the present value of the investments.

3.3.1. Future Value of Single Amount

The accumulated amount of a single amount invested, at compound interest may be computed
period by period by a serious of multiplications.

Exercise3.2

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Suppose your father gives you 10,000 on your eighteenth birthday. You deposited this amount in a
bank at 8 per cent compounded quarterly for one year. How much future sum would you receive
after one year?
Solution
If n is used to represent the number of periods that interest is to be compounded, i is used to
represent the interest per period, and p is the principal amount invested, the series of
multiplications to compute the amount is:
a = P (1+i) n
a= birr 10,000 (1 + 0.02)4
a= 10,824.32

3.3.2. Present Value of Single Amount

It is a method of assessing the worth of an investment by investing the compounding process to
give the present value of future cash flows. This process is "discounting".
The present value of "P" of the amount "A" due at the end of "n" conversion periods at the rate
"i"per conversion period. The value of "P" is obtained as follows:
P= A or P= A (1+i) -n
(1+i) n

Exercise3.3
AtoAsfaw has been given the opportunity to receive birr 10,000 four years from now. If he can
earn 6 % on his investment, what is the amount that would make him indifferent if he is to
receive the amount as of today?
Solution
P= A = 10,000 = 10,000 = 7,921
(1+i) n (1+0.06)4 1.26428

This means that, if Asfaw deposited birr 7,921 in to the bank at interest rate of 6 per cent, he will
get birr 10,000 at the end of 4 years.

Exercise 3.4: Determining the Interest Rate

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If birr 1,000 is deposited at compound interest on January 1 year 1, and the amount on deposit on
December 31, year 10, is birr 1,806.11, what is the semiannual interest rate accruing on the
deposit?

Solution
The amount of 1 for 20 periods at the unstated rate of interest is birr 1.80611 (birr 1,806.11÷birr
1,000 = birr 1.80611). Referring the future value table, 1.80611 is the amount of 1 for 20 periods
at 3 %.
Therefore, the semiannual interest rate is 3%.

3.4. Annuities
An annuity is a bunch of structured payments or equal payments made regularly, like every
month or every week.
Many measurement situations involve periodic deposits, receipts, withdrawals, or payments
(called rents), with interest at a stated rate compounded at the time that each rent is paid or
received. These situations are considered annuities if all the following conditions met:
1. The periodic rents are equal in amount.
2. The time period between rents is constant, such as a year a quarter of a year, or a month.
3. The interest rate per time period remains constant.
4. The interest is compounded at the end of each time period.
When rents are paid or received at the end of each period and the total amount on deposit is
determined at the final rent is made, the annuity is an ordinary annuity (or annuity in arrears).
The other type of annuity is an annuity due in which payments or receipts occur at the beginning
of each period.
3.4.1. Future Value of Ordinary Annuity
The future value of an ordinary annuity is the aggregate sum of the future value of each
individual payment on the final rent is made.
If we assume an investor who wants to know how much is the value of just birr 1 deposit to be
made at the end of each of the coming five years at 10 % compounded annually, the first
payment earns an interest for four years ( n-1) years because, it is made at the end of the first

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year. So, it is late to earn anything in the first year. The second payment earns interest for 3 (n-2)
years. And the last payment does not earn any thing because it is made just at the end of the last
year. Thus, for ordinary annuity of n payments, there is n-1 compounding periods.
The Future value of Ordinary Annuity is calculated by the following formula:
FVOA= R [(1+i) n -1]
i
Where:
FVOA = is the future value of ordinary annuity
R = Periodic payments
i = Interest rate
n = Periods for which rent is made
Exercise3.5:
Ato Abebe wishs to determine the sum of money he will have in his saving account at the end of
6 years by depositing birr 1,000 at the end of each year for the next 6 years at an annual interest
rate of 8 per cent .
Required: 1. Determine the amount
2. Prepare fund accumulation table
Solution
1. FVoA= R [(1+i) n -1]
i
= 1000 [(1+ 0.08)6-1] = 7,336
0.08
2. Fund accumulation table
Date Annual Deposit Interest earned Increase in fund Fund balance
December 31 balance
Year 1 1,000 - 1,000.00 1,000.00
Year 2 1,000 80.00 1,080.00 2,080.00
Year 3 1,000 166.40 1,166.40 3,246.40
Year 4 1,000 259.70 1,259.70 4,506.10
Year 5 1,000 360.50 1,360.50 5,866.60
Year 6 1,000 469.33 1,469.30 7,336.00

3.4.2. Future Value of Annuity Due

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The future value of annuity due is the total amount on deposit one period after the final rent is
made. It assumes periodic rents occur at the beginning of the period. The future value of annuity
due can be given by either of the following formulas:
1. FVAD= R [(1+i) n-1 ](1+i) or
i
2. FVAD= R [(1+i) n+1 - 1] - R
i
Where: FVAD- Future Value of Annuity Due
R= Periodic payments
i=Interest rate
n=Periods for which rent is made

Exercise3.6:Abera deposits birr 5,000 on January 1 of each year for the coming eight years in to
an account paying 9 % compounded annually. How much will be in his account by the end of the
year 8?
Solution
FVAD= 5,000 [(1.09)8-1] * (1.09)
0.09
= 5,000 (11.0285) *(1.09) = 60,105.00 or

FVAD = 5,000 [(1.09)8+1 -1] - 5,000

0.09
= 5,000 [13.021] –5,000  65,105- 5,000 = 60,105.00

3.4.3. Present Value of Ordinary Annuity

The present value of ordinary annuity is the discounted value of a series of future rents on the date
one period before the first rent is made.
It can be calculated by using the following formula:
PVOA = R [1- (1+i)-n]
i
Where: PVOA = Present Value of Ordinary Annuity
R= Periodic Payments
i = Interest Rate
n= Periods for which Rent is Made

Exercise3.7

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ABC Corporation purchased Machinery on January 1 2001 and agreed to pay for the purchase
payment of birr 5,000 each including principal and interest on December 31 of each of the next
five year beginning December 31, 2001. The agreed interest rate is 6 per cent compounded
annually.
Required: 1. Compute the price of the machinery excluding interest charge
2. Prepare liability table for the purchase showing periodic interest charges
Solution
PVOA= R [1- (1+i)-n]
i
= 5,000 [1-(1.06)-5] = 21,061.82
0.06
Therefore, the price of the machinery is birr 21,061.82

2. Debt Payment Program

Interest Payment at Net Reduction in Debt

Date 6 %/Year End of the year Debt Balance
Jan 1,01 - - - 21,061.82
Dec 31,01 1,263.71 5,000 3,736.29 17,325.53
Dec 31,02 1,039.53 5,000 3,960.47 13,365.06
Dec 31,03 801.90 5,000 4,198.10 9,166.96
Dec 31,04 550.02 5,000 4,449.98 4,716.98
Dec 31,05 283.02 5,000 4,716.98 0

3.4.4. Present Value of Annuity Due

The present value of annuity due is the discounted value of a series of future rents on the date the
first rent is received or paid. It can be calculated by using either of the following formulas:
PVAD= R [1- (1+i)-n] (1+i) or
i
PVAD= R [1- (1+i) – (n-1)] +R
i
Where: PVAD= Present Value of annuity Due
R= Periodic payments

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i = Interest rate
n= Periods for which rent is made

Exercise3.8
XYZ Company acquired office equipment on January 1, 1999 and agreed to pay for the purchase
with three installments of birr 5,000 each including principal and interest, every year beginning
January 1, 1999. The interest rate was 12 per cent compounded annually.

Required: 1. Compute the acquisition cost of the equipment excluding interest charges.
2. Prepare a liability table showing periodic interest charges and payment
1. PVAD= R [1- (1+i)-n] (1+i)
i
= 5,000 [(1- (1.12)-3] (1.12)
0.12 = 13,450.26

2. Liability Table

Lear Beginning Debt Payment at Balance Accruing Interest Ending Dent

Balance Beginning Interest Balance
1999 13,450.26 5,000 8,450.26 1,014.03 9,464.29
2000 9,464.29 5,000 4,464.29 535.71 5,000
2001 5,000 5,000 0 0 0