FINANCIAL

MANAGEMENT
CHAPTER 5
TIME VALUE OF MONEY
Chapter 5
TIME VALUE OF MONEY (TVM)
Learning Objectives:
1. Understand the concept of TVM and its importance in finance.
2. Understand the computational tools and the basic patterns of cash flows.
3. Understand the concepts of future value and present value, their calculation for a single amount (or lump-
sum), their relationship, and their use in making business decisions.
4. Understand the differences between simple interest and compound interest.
5. Be able to apply the appropriate formula to calculate interest rates, growth rates and an unknown number of
years.
TIME VALUE OF MONEY (TVM)
• TVM refers to the concept that money today is worth more than money in future or R1 received today is
worth more than R1 received after one year. Reasons for this include:
 Today’s money can be invested to earn interest.
 Today’s money can be spent before inflation reduces its buying power.
 Today’s money has no uncertainty regarding its receipt in future (No risk).
 For example, a project requires an initial investment (cash outflow) of R10 000 and will generate R15 000
total cash inflows (CFs) over 5 years: R5 000 end of year 1; R4 000 end of year 2; R3 000 end of year 3; R2
000 end of year 4 and R1 000 end of year 5. Is this a smart investment? You cannot tell.
• To make the right investment decision, cash flows occurring at different times must first be adjusted to reflect
their values at a single point in time before they can be compared.
• Two methods of adjusting CFs occurring at different times before they can be compared are:
 Future value technique: Uses compounding to find FV of each cash flow.
 Present value technique: Uses discounting to find PV of each cash flow.
Timeline showing compounding to find future value and discounting to find present value
Timelines visualize cash flows and aid problem solving in Finance
• Time-value-of-money analysis (especially the PV technique) is extensively used in investment decision
making – (e.g., basic valuations, advanced valuations, and capital budgeting).
• Computational tools: Finding FVs and PVs can be done using:
 Formulas and a scientific calculator (e.g., a Casio fx 991ES PLUS) – You DO NOT need a financial
calculator for this course. THIS IS A MUST KNOW.
 Tables showing future and present value interest factors. Limited use.
 Electronic spreadsheets. Popular in practice. Not examined.
 Pre-programmed financial calculators. Recommended for Aspiring CAs.
• Conceptual understanding of the calculations is important.
BASIC PATTERNS OF CASH FLOWS:
• Both cash outflows and inflows can be described by their patterns as follows:
 Single amount: A lump-sum received or paid today or at a future date – this is the focus of Chapter 5.
 Annuity: A stream (series) of equally spaced and level cash flows.
 E.G. rental payments, vehicle or home loan repayments. This is covered in Chapter 6.
 Mixed stream: A stream of unequal periodic cash flows or a stream of cash flows that is not an annuity
– (Refer to the previous Slide).
FUTURE VALUE & COMPOUNDING: LUMP SUM
SOME DEFINITIONS:
• The principal: Is the amount (original investment) on which interest is paid.
• Simple interest: Is the amount of interest paid on the original investment or principal amount only. The
assumption is that: Interest paid is withdrawn from the account (i.e., it is not re-invested).
• Compound interest: Consists of both simple interest and interest-on-interest paid in a prior period. The
assumption is that: Interest paid is not withdrawn but is re-invested.
FUTURE VALUE FORMULA/EQUATION (For A LUMP-SUM):

• Where:
 FV = Future value of investment at the end of period n.
 PV = Present value, original investment, or principal amount.
 i = The interest rate per period, often a year, but can also be half-yearly, quarterly, monthly, weekly or
daily.
 n = The number of years.
 (1 + i)n = The future value interest factor (FVIF). Given in tables.
 FV is equal to the original investment (or PV) plus total interest.
 Be able to calculate any one of the 4 variables (FV, PV, i, and n), given the other 3. This is what Chapter 5
is ALL about.
LECTURE EXAMPLE 1:
• R100 000 is deposited in a bank savings account earning interest at 10% per year. Calculate: the FV, total
interest, total simple interest, and total interest-on-interest if the amount is invested for (a) 5 years; (b) 20
years or (c) 50 years.
a) Future Value After 5 Years:
• FV = 100 000 x (1 + 0.1)5
• FV = 100 000 x (1.1)5
• FV = 100 000 x 1.61051 (or read-off FV table if given) (See Table on Slide 9)
• FV = R161 051
• Total interest earned = (FV – PV): R161 051 – R100 000 = R61 051
• Total simple interest = R100 000 x 0.1 x 5 years = R50 000
• Total interest-on-interest = (Total interest – Total simple interest): = R61
051 – R50 000 = R11 051.
b) Future Value After 20 Years:
• FV = 100 000 x (1.1)20
• FV = 100 000 x 6.7275 (or read-off Table) (See Table on Slide 9)
• FV = R672 750
• Total interest earned: 672 750 – 100 000 = R572 750
• Total simple interest: R200 000 (100 00 x 10% x 20)
• Total interest-on-interest: 572 750 – 200 000 = R 372 750
NOTE: How compound interest grows or the power of compounding.
c) Future Value After 50 Years:
• FV = 100 000 x (1 + 0.1)50
• FV = 100 000 x (1.1)50
• FV = 100 000 x 117.3908529
• FV = R11 739 085.29
• Total interest earned: 11 739 085.29 – 100 000 = R11 639 085.29
• Total simple interest: 100 000 x 0.1 x 50 = R500 000
• Total interest-on-interest: 11 639 085 – 500 000 = R11 139 085.29
POINTS TO NOTE:
• How compound interest grows or the power of compounding.
• Because of compounding, the growth of the investment over time is exponential, rather than linear – hence the sooner
you start investing (e.g. for retirement) the better.
• When compounding, the higher the interest rate, the higher future value and vice versa.
This Table shows the Future Value Interest Factors (FVIF) for a Lump-sum, which is 1.611 at 10% for 5 years and 6.727 at
10% for 20 years as calculated using the FV formula. FVIF and PVIF tables for a lump-sum (or R1) are provided on Vula,
under Resources.
COMPOUNDING MORE FREQUENTLY THAN ONCE A YEAR
• The more frequently the interest payments are compounded (i.e., paid and re-invested), the larger the future value of R1 for
a given period.
• The formula is:

• Where:
 m = The number of compounding periods in a year. [How many compounding periods per year are there if interest is
paid and reinvested: Yearly, Half yearly? Quarterly? Monthly? Weekly? Daily?]
 Answer = [Yearly, m=1]; [Half-yearly, m=2]; [Quarterly, m=4]; [Monthly, m=12]; [Weekly, m=52]; [Daily,
m=365.]
 Note that banks quote an interest rate (i) as a nominal annual rate called the Annual Percentage Rate (APR) or the
quoted annual percentage rate.
• To calculate the periodic interest rate, divide the nominal interest rate or the APR by the number of compounding periods
per year (i/m).
• To calculate the total number of periods, multiply the number of years by the number of compounding periods per year
(nm) or (nxm).
LECTURE EXAMPLE 2
Assume that you borrow a sum of money at an interest rate of 8% per annum for 5 years. What is the periodic rate and total
number of periods if compounding per year is done annually, semi-annually, quarterly, monthly or daily.
COMPOUNDING MORE FREQUENTLY THAN ONCE A YEAR
SOLUTION TO LECTURE EXAMPLE 2:]

• Where a FVIF table is used, the periodic interest rate and the total number of periods are then used to read-off the FVIF.
E.G. 4% for 10 half-yearly periods = 1.4802 using the FVIF table in Vula.
LECTURE EXAMPLE 3:
You invest R100 000 in a bank savings account that pays interest at 10% per year compounded semi-annually for 5 years.
How much money would you have at the end of 5 years? What is the total interest-on-interest after 5 years?
ANSWER:
• FV = PV x (1 + i/m)nm
• FV = 100 000 x (1 + 0.1/2)5×2
• FV = 100 000 x (1.05)10
• FV = 100 000 x 1.628894627 (or read-off FVIF Table: 5% for 10 periods)
• FV = R162 889.46
• Total interest = R62 889.46 (162 889.46 – 100 000)
• Total simple interest = R50 000 (100 000 x 10% x 5 years)
• Total interest-on-interest = R12 889.46 (62 889.46 – 50 000)
PRESENT VALUE & DISCOUNTING: LUMP SUM
PRESENT VALUE (PV) MEASURES WHAT ONE OR MORE CASH FLOWS RECEIVED IN FUTURE ARE
WORTH TODAY (AT TIME t=0):
• The process of calculating the PV is called discounting and the interest rate “i” is known as the discount rate.
• The PV is often called the discounted value of future cash payments.
THE PV FORMULA FOR A LUMP-SUM IS:
• or
 is preferred because it gives you the present value interest factor (PVIF) provided in tables. The PVIF is the reverse
of the FVIF.
• PV calculations show how much money you need today in order to achieve your financial goals in the future. Examples
are: providing for retirement or an education fund for your children.
LECTURE EXAMPLE 4
• You need a sum of R100 000 at the end of 5 years as deposit for a flat. How much do you need to invest today, if the bank
savings account pays interest of 10% per year (a) compounded quarterly; and (b) half-yearly.
LECTURE EXAMPLE 4 - SOLUTION
a) Compounded quarterly:
• PV = 100 000 x [1/(1+0.1/4]
• PV = 100 000 x [1/(1.025]
• PV = 100 000 x 0.6102709 (or use PVIF Table on Vula: 2.5% for 20 periods)
• PV = R61 027.09
b) Compounded half-yearly:
• PV = 100 000/(1+0.1/2
• PV = 100 000/(1.05
• PV = 100 000/1.628894627
• PV = R61 391.33
POINTS TO NOTE:
• The further in the future the money will be received, the less it is worth today – TVM concept. Also, as “n” gets larger, the
PVIF gets smaller – see the preferred PV Formula.
• The higher the discount rate, the lower the present value of the money. As “i” gets larger, the PVIF gets smaller (see the
preferred PV Formula).
LUMP – SUM: SOLVING FOR THE INTEREST RATE
• There are a number of situations that require you to determine the: (a) interest rate (discount rate) for a given cash flow;
(b) rate of return on an investment; or (c) interest rate on a loan. This is achieved by solving for (i) in the FV formula.
LECTURE EXAMPLE 5
• You have an opportunity to invest R10 000 today with a promise to receive R31 058 at the end of 10 years., Calculate the
interest rate earned assuming compounding takes place (a) monthly; and (b) half-yearly.
a) Monthly compounding:
• FV = PV x (1 + i/m
• 31 058 = 10 000 x (1 + i/12
• (1 + i/12 = (31 058/10 000) – How do you solve this?
• 1 + i/12 = (3.1058
• i/12 = (3.1058 -1
• i/12 = 0.009488662
• i = 0.1139 or 11.39%
b) Half-yearly compounding:
• (1 + i/2= (31 058/10 000)
• i/2 = 0.0583
• i = 11.66%
LUMP – SUM: SOLVING FOR THE NO. OF YEARS.
• Investors sometimes need to know how many years it will take for their investment to double or triple or to grow to a
given amount. Logarithms are used to solve the number of years “n” (not periods).
LECTURE EXAMPLE 6
• You deposit R100 000 today in a bank savings account that pays interest at 12% p.a. How many years will it take to grow
the amount to R1 million, if compounding is done (a) monthly; and (b) half-yearly.
a) Monthly compounding:
• FV = PV x (1 + i/m
• 1 000 000 = 100 000 x (1 + 0.12/12
• (1.01 = (1 000 000/100 000) = 10
• 12n log(1.01) = log(10)
• 12n = log(10)/log(1.01) = 231.4078926 (Total monthly periods)
• n = 19.28 years (231.4078926/12)
b) Half-yearly compounding:
• 1 000 000 = 100 000 x (1 + 0.12/2
• 2n log(1.06) = log(10)
• n = [log(10)/log(1.06)]/2 = 39.51653064/2 = 19.76 years
CALCULATING COMPOUND GROWTH RATES
• The concept of compounding extends beyond money.
• Compound growth occurs when the initial value of a number increases/decreases each period by the factor (1 + growth
rate).
 Examples include: Population growth, earnings growth, dividend growth, sales growth.
 The formula is: , Where:
• “g” is the growth rate per period, and “n” is the number of periods - A period is a year, but may also be a
quarter, month, or week).
• For tests/exams, a period = 1 year for compound growth questions.
LECTURE EXAMPLE 7
• A firm increased its sales from R20m in 2011 to R35m in 2014. (a) Calculate the average annual growth rate in sales. (b)
What would the sales be in 2020 if the historical growth rate is maintained? “n” is how many years?
LECTURE EXAMPLE 7 – SUGGESTED SOLUTION:
a) Average annual growth rate:
• “n” is equal to three years. How? From 2011 to 2012 is 1 year, 2012 to 2013 another year, and from 2013 to 2014
another year. Growth occurs over a period (e.g. from Dec 2011 to Dec 2012). Remember that “m” is equal to 1
(since compounding is annually).
• 35 = 20 x (1 + g
• (1 + g = (35/20)
• (1 + g) = (35/20
• g = (35/20-1
• g = 20.51%
a) Estimated sales in 2020:
• FV = 35 x (1 + 0.2051
• FV = 35 X 3.06294
• FV/Sales in 2020 = R107.2 million