CHAPTER THREE

THE TIME VALUE OF MONEY

3.1 Why money has a time value?
One of the basic problems faced by the financial manager is how to determine the value today of
cash flows expected in the future. For example, the jackpot in a PowerBall™ lottery drawing was
$110 million. Does this mean the winning ticket was worth $110 million? The answer is no
because the jackpot was actually going to pay out over a 20-year period at a rate of $5.5 million
per year. How much was the ticket worth then? The answer depends on the time value of money,
the subject of this chapter.
In the most general sense, the phrase time value of money refers to the fact that a dollar in hand
today is worth more than a dollar promised at some time in the future. On a practical level, one
reason for this is that you could earn interest while you waited; so a dollar today would grow to
more than a dollar later. The trade-off between money now and money later thus depends on,
among other things, the rate you can earn by investing. Our goal in this chapteris to explicitly
evaluate this trade-off between dollars today and dollars at some future time.
The cost of money or price of money is interest rate. Due to the interest rate the value of a sum of
money is different at different time which is called time value of money. A birr in hand today is
worth more than a birr to be received in the future since if you have it now, you can invest it and
earn the interest.

3.2 Future Value of a single amount

Future value (FV) refers to the amount of money an investment will grow to over some period of
time at some given interest rate. Put another way, future value is the cash value of an investment
at some time in the future. We start out by considering the simplest case: a single-period
investment.

Investing for a single period

Suppose you invest $100 in a savings account that pays 10 percent interest per year. How much
will you have in one year? You will have $110. This $110 is equal to your original principal of
$100 plus $10 in interest that you earn. We say that $110 is the future value of $100 invested for
one year at 10 percent, and we simply mean that $100 today is worth $110 in one year, given
that 10 percent is the interest rate.
In general, if you invest for one period at an interest rate of r, your investment will grow to (1+
r) per dollar invested. In our example, r is 10 percent, so your investment grows to 1+0.10 = 1.1
dollars per dollar invested. You invested $100 in this case, so you ended up with $100×1.10 =
$110.

Investing for more than one period

Going back to our $100 investment, what will you have after two years, assuming the interest
rate doesn’t change? If you leave the entire $110 in the bank, you will earn $110×0.10 = $11 in

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interest during the second year, so you will have a total of $110 + 11 = $121. This $121 is the
future value of $100 in two years at 10 percent. Another way of looking at it is that one year
from now you are effectively investing $110 at 10 percent for a year. This is a single-period
problem, so you’ll end up with $1.10 for every dollar invested, or $110 × 1.1 = $121 total.
This $121 has four parts. The first part is the $100 original principal. The second part is the $10
in interest you earned in the first year, and the third part is another $10 you earn in the second
year, for a total of $120. The last $1 you end up with (the fourth part) is interest you earn in the
second year on the interest paid in the first year: $10 × 0.10 = $1.
This process of leaving your money and any accumulated interest in an investment for more than
one period, thereby reinvesting the interest, is called compounding. Compounding the interest
means earning interest on interest, so we call the result compound interest. With simple
interest, the interest is not reinvested, so interest is earned each period only on the original
principal.
We now take a closer look at how we calculated the $121 future value. We multiplied $110 by
1.1 to get $121. The $110, however, was $100 also multiplied by 1.1. In other words:
$121 = $110 × 1.1
= ($100 × 1.1) × 1.1
= $100 × (1.1 × 1.1)
= $100 × 1.1 2
= $100 × 1.21
At the risk of overstating the obvious, let’s ask: How much would our $100 grow to after three
years? Once again, in two years, we’ll be investing $121 for one period at 10 percent. We’ll end
up with $1.10 for every dollar we invest, or $121 × 1.1 = $133.10 total. This $133.10 is thus:
$133.10 = $121 × 1.1
= ($110 × 1.1) × 1.1
= ($100 × 1.1) × 1.1 × 1.1
= $100 × (1.1 × 1.1 × 1.1)
= $100 × 1.1 3
= $100 × 1.331
You’re probably noticing a pattern to these calculations, so we can now go ahead andstate the
general result. As our examples suggest, the future value of $1 invested for tperiods at a rate of
rper period is this:
Future value = $1 × (1 +r)t
The expression (1+r) tis sometimes called the future value interest factor (or just futurevalue
factor) for $1 invested at r percent for t periods and can be abbreviated as FVIF (r, t).
In our example, what would your $100 be worth after five years? We can first computethe
relevantfuture value factor as follows:
(1 +r) t= (1 +0.10)5=1.15= 1.6105
Your $100 will thus grow to:
$100 × 1.6105 = $161.05

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The growth of your $100 each year is illustrated in Table 3.1. As shown, the interest earnedin
each year is equal to the beginning amount multiplied by the interest rate of 10 percent.
Table 3.1 Future Value of $100at 10 percent
Year Beginning Beginning Compound Total Interest Ending
Amount Amount Interest Earned Amount
1 $100.00 $10 $0.00 $10.00 $110.00
2 110.00 10 1.00 11.00 121.00
3 121.00 10 2.10 12.10 133.10
4 133.10 10 3.31 13.31 146.41
5 146.41 10 4.64 14.64 161.05
Total $50 Total Total $61.05
simple $11.05 interest
interest compound
interest

In Table 3.1, notice the total interest you earn is $61.05. Over the five-year span of this
investment, the simple interest is $100 × 0.10 = $10 per year, so you accumulate $50 this way.
The other $11.05 is from compounding.
Notice how the simple interest is constant each year, but the amount of compound interest you
earn gets bigger every year. The amount of the compound interest keeps increasing because more
and more interest builds up and there is thus more to compound.
Future values depend critically on the assumed interest rate, particularly for long-lived
investments. Notice the future value of $1 after 10 years is about $6.20 at a 20 percent rate, but it
is only about $2.60 at 10 percent. In this case, doubling the interest rate more than doubles the
future value.

To solve future value problems, we need to come up with the relevant future value factors. There
are several different ways of doing this. In our example, we could have multiplied 1.1 by itself
five times. This would work just fine, but it would get to be very tedious for, say, a 30-year
investment.
Fortunately, there are several easier ways to get future value factors.
Alternatively, you can use a table that contains future value factors for some common interest
rates and time periods. Table 3.2 contains some of these factors. Table A.1 in the appendix at the
end of the book contains a much larger set. To use the table, find the column that corresponds to
10 percent. Then look down the rows until you come to five periods. You should find the factor
that we calculated, 1.6105.
Tables such as 3.2 are not as common as they once were because they predate inexpensive
calculators and are available only for a relatively small number of rates. Interest rates are often
quoted to three or four decimal places, so the tables needed to deal with these accurately would
be quite large. As a result, the real world has moved away from using them. These tables still
serve a useful purpose. To make sure you are doing the calculations correctly, pick a factor from

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the table and then calculate it yourself to see that you get the same answer. There are plenty of
numbers to choose from.
Table 3.2 Future Value Interest Factors
Number of Periods Interest Rate
5% 10% 15% 20%
1 1.0500 1.1000 1.1500 1.2000
2 1.1025 1.2100 1.3225 1.4400
3 1.1576 1.3310 1.5209 1.7280
4 1.2155 1.4641 1.7490 2.0736
5 1.2763 1.6105 2.0114 2.4883

The effect of compounding is not great over short time periods, but it really starts to add up as
the horizon grows. To take an extreme case, suppose one of your more prudent ancestors had
invested $5 for you at a 6 percent interest rate 200 years ago. How much would you have today?
The future value factor is a substantial 1.06 200 = 115,125.90 (you won’t find this one in a table),
so you would have $5 × 115,125.90 = $575,629.52 today. Notice that the simple interest is just
$5 × 0.06 = $0.30 per year. After 200 years, this amounts to $60. The rest is from reinvesting.
Such is the power of compound interest!

3.3 Present value of a single amount

When we discuss future value, we are thinking of questions like: What will my $2,000
investment grow to if it earns a 6.5 percent return every year for the next six years? The answer
to this question is what we call the future value of $2,000 invested at 6.5 percent for six years
(verify that the answer is about $2,918).
Another type of question that comes up even more often in financial management is obviously
related to future value. Suppose you need to have $10,000 in 10 years, and you can earn 6.5
percent on your money. How much do you have to invest today to reach your goal? You can
verify that the answer is $5,327.26. How do we know this?

The single-period case

How much do we have to invest today at 10 percent to get $1 in one year? In other words, we
know the future value here is $1, but what is the present value (PV)?The answer isn’t too hard
to figure out. Whatever we invest today will be 1.1 times bigger at the end of the year. Because
we need $1 at the end of the year:
Present value × 1.1 = $1
Or solving for the present value:
Present value = $1/1.1 = $0.909
In this case, the present value is the answer to the following question: What amount, invested
today, will grow to $1 in one year if the interest rate is 10 percent? Present value is thus just the
reverse of future value. Instead of compounding the money forward into the future, we discount
it back to the present.
From our examples, the present value of $1 to be received in one period is generally given as
follows:
PV = $1 × [1/ (1+ r)] = $1/ (1/ r)

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We next examine how to get the present value of an amount to be paid in two or more
periodsinto the future.
Present values for multiple periods
Suppose you need to have $1,000 in two years. If you can earn 7 percent, how much do youhave
to invest to make sure you have the $1,000 when you need it? In other words, what isthe present
value of $1,000 in two years if the relevant rate is 7 percent?
Based on your knowledge of future values, you know the amount invested must grow to$1,000
over the two years. In other words, it must be the case that:
$1,000 = PV × 1.07 × 1.07
= PV × 1.07 2
= PV × 1.1449
Given this, we can solve for the present value:
Present value = $1,000/1.1449 = $873.44
Therefore, $873.44 is the amount you must invest to achieve your goal.

As you have probably recognized by now, calculating present values is quite similar to
calculating future values, and the general result looks much the same. The present value of $1 to
be received t periods into the future at a discount rate of r is:
PV = $1 × [1/ (1+ r)t] = $1/ (1+ r)t
The quantity in brackets, 1/ (1 + r)t, goes by several different names. Because it’s used to
discount a future cash flow, it is often called a discount factor. With this name, it is not
surprising that the rate used in the calculation is often called the discount rate. We will tend to
call it this in talking about present values. The quantity in brackets is also called the present
value interest factor (or just present value factor) for $1 at r percent for t periods and is
sometimes abbreviated as PVIF (r, t). Finally, calculating the present value of a future cash flow
to determine its worth today is commonly called discounted cash flow (DCF) valuation.

To illustrate, suppose you need $1,000 in three years. You can earn 15 percent on yourmoney.
How much do you have to invest today? To find out, we have to determine thepresent value of
$1,000 in three years at 15 percent. We do this by discounting $1,000 back three periods at 15
percent. With these numbers, the discount factor is:
1/ (1+0.15)3= 1/1.5209 =0.6575
The amount you must invest is thus:
$1,000 × .6575 = $657.50
We say that $657.50 is the present or discounted value of $1,000 to be received in threeyears at
15 percent.
There are tables for present value factors just as there are tables for future value factors,and you
use them in the same way (if you use them at all). Table 3.3 contains a small set.
Table 3.3 present value interest factors
Number of Periods 5% 10% 15% 20%
1 .9524 .9091 .8696 .8333
2 .9070 .8264 .7561 .6944
3 .8638 .7513 .6575 .5787
4 .8227 .6830 .5718 .4823
5 .7835 .6209 .4972 .4019

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In Table 3.3, the discount factor we just calculated (.6575) can be found by lookingdown the
column labeled “15%” until you come to the third row.

3.4 Future value of an annuity

An annuity is a sequence of equal, periodic payments. The payments may be made weekly,
monthly, quarterly, semi-annually, annually or for any fixed period of time. The time between
successive payments is called the payment period for an annuity. Each payment is called
periodic payment or periodic rent, and it is denoted by R. The time from the beginning of the
first payment period to the end of the last period is called the term of an annuity. If payments
are made at the end of each time interval, then the annuity is called an ordinary annuity. If
payments are made at the beginning of the payment period, it is called an annuity due.
The amount (future value) of an ordinary annuity is the sum of all payments plus all interests
earned.
A=
Example: Newly married couples are both working and decide to have Birr 10,000 at the end of a
year for a down payment on a home. The account earns 12% compound annually. How large a
down payment will they have saved in three years?
Solution
R = Birr 10,000
n = 3 years.
i= 12%
Compound interest = A - R(n)
A =?
= 33,744 - 30,000
= 3,744 Birr

Example: A person deposits Birr 500 at the end of a year for 10 years in to an account that pays
6% compounded annually.
Solution:
R = Birr 500
n = 10years = 500×13.1807
i = 6% = Birr 6,590.40
A10 =?

3.5 Present value of an ordinary annuity

The present value of an ordinary annuity is the amount of money today, which is equivalent to
the sum of a series of equal payment in the future. It is the sum of the present values of the
periodic payments of an annuity, each discounted to the beginning of an annuity. The present
value represents the amount that must be invested now to purchase the payment due in the future.

Example 19: What is the PV of an annuity if the size of each payment is Birr 200 payable at the
end of each year for 10years and the interest rate is 8% compounded annually?
Using the above formula; the PV of the former example is computed as:

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R = Birr 200
i = 8% = 200 (6.7100814)
n = 10yr = Birr 1,342.016
P =?
Example :20 How much should you deposit in an account paying 6% compounded annually in
order to be able to withdraw Birr 1000 every year for the next 12 years?
Solution.
R = Birr 1000
n= 12years = 1000(8.38385)
i = 6% = Birr 8383.85
PV =?

3.6 Special Case Annuities

3.6.1 Perpetuities
We’ve seen that a series of level cash flows can be valued by treating those cash flows as an
annuity. An important special case of an annuity arises when the level stream of cash flows
continues forever. Such an asset is called a perpetuity because the cash flows are perpetual.
Because a perpetuity has an infinite number of cash flows, we obviously can’t compute its value
by discounting each one. Fortunately, valuing a perpetuity turns out to be the easiest possible
case. The present value of a perpetuity is simply:
PV for a perpetuity =Earned interest
Interest rate
For example, an investment offers a perpetual cash flow of $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:
Perpetuity PV =C/r = $500/.08 = $6,250
Perpetuity commonly have payments that grow over time.Suppose, for example, that weare
looking at a lottery payout over a 20-year period. The first payment, made one yearfrom now,
will be $200,000. Every year thereafter, the payment will grow by 5 percent. What’s the present
value if theappropriate discount rate is 11 percent?
Growing perpetuity present value = C × [ 1/r-g] = C/r-g
PV =$ 200,000 ×1/ 0.11-0 .05
= $ 200,000 × 16.6667 = $ 3,333,333.33
3.6.2 Deferred Annuity
Future value of deferred annuity (FVDA) When the amount of an ordinary annuity remains on
deposit for a number of periods beyond the final rent, the arrangement is known as a deferred
annuity. When the amount of an ordinary continues to earn interest for one additional period, we
have an Annuity Due situation.

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Plugging in the numbers from our lottery example under perpetuities.

3.7 Uneven Cash Flow Streams

The definition of an annuity includes the words constant payment in other words; annuities
involve payments that are the same in every period. Although many financialdecisions do involve
constant payments, other important decisions involve uneven, or non-constant, cash flows. For
example, common stocks typically pay an increasing stream of dividends over time, and fixed
asset investments such as new equipment normally do not generate constant cash flows.
Consequently, it is necessary to extend ourtime value discussion to include uneven cash flow
streams.Throughout the book, we will follow convention and reserve the term payment (PMT)
for annuity situations where the cash flows are equal amounts, and we will usethe term cash flow
(CF) to denote uneven cash flows.
Present Value of an Uneven Cash Flow Stream
The PV of an uneven cash flow stream is found as the sum of the PVs of the individual cash
flows of the stream. For example, suppose we must find the PV of the followingcash flow
stream, discounted at 6 percent:

The PV will be found by applying this general present value equation:

We could find the PV of each individual cash flow using the numerical and then sum these
values to find the present value ofthe stream. Here is what the process would look like:

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Future Value of an Uneven Cash Flow Stream
The future value of an uneven cash flow stream (sometimes called the terminal value)is found
by compounding each payment to the end of the stream and then summingthe future values:

The future value of our illustrative uneven cash flow stream is $2,124.92:

3.8 More frequent compounding

@ Compounding for less than a year
Interest is often compounded more frequently than once a year. Savings institutionscompound
interest semiannually, quarterly, monthly, weekly, daily, or evencontinuously.
Semiannual compounding of interest involves two compounding periods withinthe year.
Instead of the stated interest rate being paid once a year, one-half of thestated interest rate is paid
twice a year.
Quarterly compounding of interest involves four compounding periods withinthe year. One-
fourth of the stated interest rate is paid four times a year.
The formula for annual compounding can be rewritten for usewhen compounding takes place
more frequently. If m equals the number of timesper year interest is compounded, the formula for
annual compounding can berewritten as

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Example: Fred Moreno has found an institution that will pay him 8% interest. If he leaves his
$100 in this account for 5 years,
Future Value
FV =
1. For semiannual compounding:
FV =100 ×12.0061 = 1,200.61
2. For quarterly compounding:
FV = 100 × 24.297369 = 2429.7369
3. For monthly compounding?
Present value

1. For semiannual compounding:

PV = 100 × 8.1109 = 811.09
2. For quarterly compounding:
PV = 100 ×16.35145 = 1,635.145
3. For monthly compounding?
@ Effective annual rate
Effective or equivalent annual rate (EAR): This is the annual rate that produces the same
result as if we had compounded at a given periodic rate m times per year. The EAR, also called
EFF% (for effective percentage), is found as follows:

In the EAR equation, iNom/m is the periodic rate, and m is the number of periods per year. For
example, suppose you could borrow using either a credit card that charges 1 percent per month
or a bank loan with a 12 percent quoted nominal interest rate that is compounded quarterly.
Which should you choose?
To answer this question, the cost rate of each alternative must be expressed as an EAR:

Thus, the credit card loan is slightly costlier than the bank loan. This result should have been
intuitive to you—both loans have the same 12 percent nominal rate, yet you would have to make
monthly payments on the credit card versus quarterly payments under the bank loan.The EAR

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rate is not used in calculations. However, it should be used to compare the effective cost or rate
of return on loans or investments when payment periods differ, as in the credit card versus bank
loan example.
@ Nominal rate
This is the rate that is quoted by banks, brokers, and other financial institutions. So, if you talk
with a banker, broker, mortgage lender, auto finance company, or student loan officer about
rates, the nominal rate is the one he or she will normally quote you. However, to be meaningful,
the quoted nominal rate must also include the number of compounding periods per year. For
example, abank might offer 6 percent, compounded quarterly, on CDs, or a mutual fund might
offer 5 percent, compounded monthly, on its money market account.
The nominal rate on loans to consumers is also called the Annual PercentageRate (APR). For
example, if a credit card issuer quotes an annual rate of 18 percent, this is the APR.
Nominal annual rate =iNom = (Periodic rate) (m). Here iNom is the nominal annual rate and m is
the number of compounding periodsper year.
To illustrate, consider a finance company loan at 3 percent per quarter:
Nominal annual rate = iNom = (Periodic rate) (m) = (3%) (4) = 12%,or
Periodic rate = iNom/m = 12%/4 = 3% per quarter.
If there is only one payment per year, or if interest is added only once a year, then m = 1, and the
periodic rate is equal to the nominal rate.
To illustrate use of the periodic rate, suppose you invest $100 in an account that pays a nominal
rate of 12 percent, compounded quarterly. How much would you have after two years?
For compounding more frequently than annually, we use the following modification

FV = $l00 (1 + 0.03)8
= $126.68.

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