Corporate Finance 1a

Time Value for Money Module 2

Lesson Objectives
• By the end of this lecture, you should be able to :
• 1. Discuss the time value of money and compute future value and present values using simple and
compound interest, and PVs and FVs of annuities
• 2. Explain the impact of inflation on time value for money and interest rates

Lets take out our Calculators

 TIME VALUE FOR MONEY
• The concept is used in the evaluation of investment projects, the calculation of a company's cost of
capital and the valuation of a company's shares.
• The concept of the time-value of money is based on the observation that people prefer to receive money
now rather than in the future, or to make payments in the future rather than now. In other words, a dollar
received today is worth more than a dollar to be received tomorrow. There is a very simple reason for
this. The reason is that a dollar received today can be invested to earn interest.
• Interest is the cost of delaying the payment of money and the reward for delaying the receipt of money.
• Thus, when you borrow money, you must pay interest on the money borrowed and when you lend or
invest money, you will earn interest on the money lent or invested. The concept of interest applies to both
business decisions and decisions made by individuals. Interest can, however, be calculated as simple
interest or compound interest. Interest is calculated as a fraction of the amount borrowed or lent, which is
known as the principal. The difference between simple interest and compound interest lies in the manner
in which the fraction is applied to the principal.

2
PRESENT VALUE WITH SIMPLE INTEREST (DISCOUNTING)
• The process of bringing future, expected, values to the present is called discounting. We can discount an expected
future value using either simple or compound interest. Let’s start with simple interest which is Interest earned only on the
original investment; no interest is earned on interest.
• Simple interest is I = P X R X T R = I /PT T = I /PT
• FUTURE VALUE is the amount to which an investment will grow after earning interest. Future value (FV) using simple
interest is equal to: FV= PV (1+ rt). Rearranging this equation, we get:
• Present Value (PV) = FV/(1 +rt)
• Where r is the interest rate and t is the time I is interest amount P is the Principal

• √ Suppose Steve and Edward wanted to find the present value of $5 000.00 expected to be received in 7 years
from now and the interest rate on deposit is 8% per year, with simple interest. The present value of this amount
would be: = $3 205
• This means that an amount of $5000.00 received in 7 years from now is equivalent to an amount of $3 205 received
today if the interest rate is 8% per year.

3
PRESENT VALUE WITH COMPOUND INTEREST

• The process of going from today’s values [present value] to future values is called compounding.
Compound interest is different from simple interest in that the interest is compounded, that is,
interest is earned on interest that has been earned before. Compound growth means that value
increases each period by the factor (1 + growth rate). The value after t periods will equal the initial
value times (1 + growth rate)t. When money is invested at compound interest, the growth rate is the
interest rate.

• ANNUAL FV = PV(1 + i) t………. PV = [FV / (1 + i)t ]

• SEMIANNUAL FV = PV(1 + i /2)2t …….. PV = [ FV / (1 + i / 2)2t
• MONTHLY FV = PV(1 + i / 12)12t ………. PV = [FV / (1 +i / 12)12t

• From the above table, we can generalize and say that the future value of an amount of $1 earning interest
at i% per year which is compounded n times per year for a number of years t would be:
• 𝑭𝑽 = 𝑷𝑽(𝟏 + 𝒊 /n) 𝒏t
• Where: n = the number of times that the interest is compounded (paid) during the year eg yearly, semi
annually or quarterly i = the interest rate per year. t =number of years.

4
 USE OF PRESENT VALUE TABLES
PRESENT VALUE OF $1 to be receivable or payable at the end of n periods

Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909

2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826

3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751

4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683

5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564

7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513

8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467

When we use a calculator we deduced that PV = 1/ (1+r) t if r is 10% and t is 5 years then the PV = 1/ (1+0.1) 5
= 0.6209
Using the PV table PVIF 10%, 5 years is where 10% and 5 years intersect, thus the shaded part … 0.621
It is important that you understand both methods since the tables has limited range of number of years and period.

5
FUTURE VALUE WITH COMPOUND INTEREST

• Using a Calculator

Suppose you deposited $100 in an investment that pays a guaranteed return of 6% pa., how much will
you have at the end of year 1, year 2 and year 3?
This question is requires us to calculate the future value of $100.00 compounded annually for three
years. The future value of $1 compounded annually for n years at a rate of 6%
Value 1 year = initial investment × (1 + r) = $100 × (1.06) = $106
Value 2nd year = Initial investment x (1 + r) 2 = $100 x (1.06)2 = $112.36
Value 3rd Year = Initial investment x (1 + r)3 = $100 x (1.06)3 = $119.10
Using a Formula 𝑭𝑽 = 𝑷𝑽(𝟏 + r)t
Where r is the interest rate
T is the time
When interest is compounded semi annually i= 6%/2 = 3% or 0.03
Quarterly i = 6% /4 = 1.5% 0r 0.015

6
PRACTICE QUESTIONS
1. Panashe deposited $10 000 into an investment that promises a return of 22.24% per year. How much would he have in investment at the end
of 5 years if the interest rate is compounded :
• (a) Semi-annually (twice per year), (b) Quarterly (four times per year)?
• (a) Future value with semi-annual compounding:
• FV = 10 000.00(1 + 0.2224 /2) 5x2
• = 10 000(1.1112)10 =$28 702.67

• (b) FV with quarterly compounding:

• FV = 10 000.00(1 + 0.2224 /4) 5x4
• = 10 000 (1.0556)20
• = $29 511.25

• Practice Question.. Find the future value of $40 000 which Nyasha deposited for 6 years into an account that earns 12.62% per year
compounded:
• 1. Yearly. 2. Semi-annually. 3. Quarterly. 4. Monthly. 5. Daily.

7
DISCOUNTING
• The concept of discounting is applied to the financial instrument which does not have a specific interest rate or maturity by investors to receive
the face value on maturity, for example treasury bills, commercial papers and trade bills.
• These instruments are issued at a discount
• Which means the investor pay the discount value and receive the face value on maturity.
• The difference between the discounted value and the face value is the profit of the investor.
• D is Discount N is Face Value or Nominal Value P is Discount Value/Amount Paid
• d is the Discount Rate and T is Time

• Therefore D = NdT
• P=N–D
• P = N – NdT or P = N (1 –dT)

• Example.. Simbarashe and Patson signed a promissory note to pay $100 000 in 3 months. They decided to discount the notes with the bank at
a discount rate of 22%. How much will they receive from the bank?
• Answer = $94 500.

8
ANNUITY
• Is the series of payments made at fixed intervals for a specified period or number of years. Or Equally spaced level stream of cash flows.
PMT is the amount of any recurring payment (called an annuity).
• Ordinary annuity means an annuity which is related to the period preceding its date, simply a payment at the end of each period. Annuity due
is the annuity related to the period following its date. ... Thus the payment is made at the beginning of each period.
• Perpetuity is when the annuity is to be received forever.
• An Annuity table may be used, the PVIFA,10%, 5 years is where 10%and 5 years meet using the Annuity Tables

• Future Value of an Ordinary Annuity(FVIFA) USING Formulas. See next slide

9
Example. A trust fund is set up to pay for the university education of a 3-year old Grade Zero boy. With
the arrangement, a sum of $45,000 will be paid to the student at the end of every quarter for 4 years
starting when he turns 18 years old. The fund earns 27.5% interest per annum compounded quarterly.
Calculate the sum that must be deposited now to launch the trust fund.
Present Value of Deferred Annuity= R[] = 45,000[]
= 45,000[]
= 45000[
= 45000*0.1763255012 = $7,934.65

10
PERPETUITIES
• The rate of interest on a perpetuity is equal to the promised annual payment C divided by the present value. For example, if a perpetuity pays
$10 per year and you can buy it for $100, you will earn 10 percent interest each year on your investment. In
• general, Interest rate on a perpetuity = cash payment/present value
• We can rearrange this relationship to derive the present value of a perpetuity, given the
• interest rate r and the cash payment C: PV of perpetuity =C (cash payment) /r interest rate
• Suppose some worthy person wishes to endow a chair in finance at your university. If the rate of interest is 10 percent and the aim is to provide
$100,000 a year forever, the amount that must be set aside today is
• The present value of a stream of future cash flows is the amount you would have to invest today to generate that stream.
• ANNUITY is Equally spaced level stream of cash flows whilst a PERPETUITY is a Stream of level cash payments that never ends.
• Present value of perpetuity = ( C )$100,000/(r)0.1 = $1,000,000

11
LOAN AMORTISATION

• When a firm borrows money, the repayments may be in the form of fixed installments which include both
the interest payment and the repayment of the principal amount borrowed. The interest payment is an
expense which is allowed for tax purposes. Therefore it is important to split the installments into their two
components.
• Example: A firm borrows $ 100 000 which will be paid off by 3 equal installments made at the end of each
of the subsequent three years. The applicable interest rate is 12% per year. The equal annual payments will
combine both interest and repayment of principal so that the loan is completely repaid by the end of the
third year.
• To calculate the annual payment, we find the PVIFA, 12%,3yrs and then divide it into the amount borrowed. The
annual payment is the annuity that will pay off the amount borrowed.
• Thus, the annual payment is : 100 000 / 2.4018 = $ 41 634.90

12
AMORTIZATION SCHEDULE

Year Beginning Annual Payment Interest Repayment Balance

Amount Principal
1 100 000.00 41 634.90 12 000.00 26 634.90 70 365.10
2 70 365.10 41 634.90 8 443.81 33 191.09 37 174.01
3 37 174.01 41 634.90 4 460.88 37 174.01 00
INFLATION AND TIME VALUE FOR MONEY
• In the absence of inflation, the real rate is equal to the nominal [quoted] rate of interest. The cost of capital, that is the RRR, includes an inflation
premium because investors always try to protect themselves against a decline in their purchasing power by including an adjustment for inflation
in the required rate of return. The cost of capital is a nominal rate in that it takes into account the expected rate of inflation. On the other hand,
cash flows are usually real cash flows in that they do not include inflation effects. As inflation increases so does the minimum return required by
an investor. It is, therefore important to adjust the cash flows before we discount them at the nominal rate, which already contains an inflation
premium. Alternatively, we should convert the nominal rate into a real rate before we discount the cash flows.
• To convert a nominal interest rate to a real rate , we use the following formula :
• ( 1 + nominal rate ) = ( 1 + real rate )( 1 + inflation rate )
• Let us say for example, the required [ quoted ] rate of return is 20% under the current and anticipated conditions and the rate of inflation is
currently running at 10% per year, we can solve for R [ the real rate ] as follows :
• ( 1 + 0.20 ) = ( 1 + R ) ( 1 + 0.10 )
• Therefore R = 0.091 or 9.1%.
• This means that a return of 20% will protect the shareholders against the loss of purchasing power and also provide a real return of 9.1%.
• In dealing with inflation, we should always : discount nominal cash flows using a nominal discount rate; and discount real cash flows using a
real discount rate.
• If the information is mixed, that is real cash flows with nominal rates, or nominal cash flows with real rates, we should :change nominal cash
flows to real cash flows, or
• · change real cash flows to nominal cash flows,
• · change nominal rates to real rates, or
• · change real rates to nominal rates,
• so that nominal cash flows are discounted at nominal rates or real cash flows are discounted at real rates.

14
DISCOUNTING REAL CASH FLOWS AT A REAL RATE OF RETURN
• Economists sometimes talk about current or nominal dollars versus constant or real dollars. Current or nominal dollars refer to the
actual number of dollars of the day; constant or real dollars refer to the amount of purchasing power.The following nominal cash flows
must first be converted to real cash flows before being discounted at the real rate of 9.1%.
• Year Nominal CF Real CF
• 0 ( 15 000 ) ( 15 000 )
• 1 9 000 9 000 / ( 1.10 ) = 8 182
• 2 8 000 8 000 / ( 1.10 )2 = 6 612
• 3 7 000 7 000 / ( 1.10 )3 = 5 259

• Lastly the Real Cash flows are then discounted at 9.1%

15
INFLATION AND INTEREST RATES
• Nominal Interest Rate is the Rate at which money invested grows whilst Real Interest Rate is the Rate at which the purchasing power of an
investment increases.Whenever anyone quotes an interest rate, you can be fairly sure that it is a nominal, not a real rate. It sets the actual
number of dollars you will be paid with no offset for future inflation.
• If you deposit $1,000 in the bank at a nominal interest rate of 6 percent, you will have $1,060 at the end of the year. But this does not mean
you are 6 percent better off.
• Suppose that the inflation rate during the year is also 6 percent. Then the goods that cost $1,000 last year will now cost $1,000 × 1.06 = $1,060,
so you’ve gained nothing:
• Real future value of investment = $1,000 × (1 + nominal interest rate)
• (1 + inflation rate)
• = $1,000 × 1.06
1.06 = $1,000
• In this example, the nominal rate of interest is 6 percent, but the real interest rate

• The real rate of interest is calculated by 1 + real interest rate = 1 + nominal interest rate
1 + inflation rate
• In our example both the nominal interest rate and the inflation rate were 6 percent. So
• 1 + real interest rate = 1.06 =1
1.06
• real interest rate = 0
• Real interest rate ≈ nominal interest rate – inflation rate

16