Time

Time Value
Value of
of
Money
Money
Alhassan Yusif Trawule

1
 The
The Time
Time Value
Value of
of Money
Money
 The Interest Rate
 Simple Interest
 Compound Interest
 Amortizing a Loan
 Compounding More Than
Once per Year
2
 The
The Interest
Interest Rate
Rate
Which would you prefer -- $10,000
today or $10,000 in 5 years?
years

Obviously, $10,000 today.

today

You already recognize that there is

TIME VALUE TO MONEY!!
MONEY

3
 Why
Why TIME?
TIME?

Why is TIME such an important

element in your decision?

TIME allows you the opportunity to

postpone consumption and earn
INTEREST.
INTEREST

4
 MEANING OF TIME
VALUE OF MONEY
 The idea that money available at the present
time is worth more than the same amount in
the future due to its potential earning
capacity.

 This core principle of finance holds that,

provided money can earn interest, any
amount of money is worth more the sooner
it is received.

5
 Types
Types of
of Interest
Interest
 Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
 Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).

6
 Simple
Simple Interest
Interest Formula
Formula

Formula SI = P0(i)(n)
SI: Simple Interest
P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
7
 Simple
Simple Interest
Interest Example
Example
 Assume that you deposit $1,000 in an
account earning 7% simple interest for
2 years. What is the accumulated
interest at the end of the 2nd year?
 SI = P0(i)(n)
= $1,000(.07)(2)
= $140
8
 Simple
Simple Interest
Interest (FV)
(FV)
 What is the Future Value (FV)
FV of the
deposit?
FV = P0 + SI
= $1,000 + $140
= $1,140
 Future Value is the value at some future
time of a present amount of money, or a
series of payments, evaluated at a given
9
interest rate.
 Simple
Simple Interest
Interest (PV)
(PV)
 What is the Present Value (PV)
PV of the
previous problem?
The Present Value is simply the
$1,000 you originally deposited.
That is the value today!
 Present Value is the current value of a
future amount of money, or a series of
payments, evaluated at a given interest
10
rate.
 Simple Interest -
Illustration 1
 Johnson borrowed GHC 5,000 from
his friend at a simple interest rate of
12% per annum for 3 years.
 Determine
 The Interest
 The Future value of the amount
11
 Simple Interest –
Illustrations 2 & 3
 Calculate the simple interest on
GHC 18,000 borrowed for 2 ½
years at 8% per annum.
 What is the simple interest on GHC
4,000 at 12% per annum for 4
months?

12
 Compound Interest
 Interest paid (earned) on any
previous interest earned, as well
as on the principal borrowed
(lent).

13
 Future
Future Value
Value
Single
Single Deposit
Deposit (Formula)
(Formula)
Assume that you deposit GHC 1,000 at a
compound interest rate of 7% for 2 years.
years
FV1 = P0 (1+i)1 = GHC1,000 (1.07)
= GHC1,070
Compound Interest
You earned GHC 70 interest on your GHC
1,000 deposit over the first year.
This is the same amount of interest you
14 would earn under simple interest.
 Future
Future Value
Value
Single
Single Deposit
Deposit (Formula)
(Formula)
FV1 = P0 (1+i)1 = GHC1,000 (1.07)
= GHC1,070
FV2 = FV1 (1+i)1 = P0 (1+i)(1+i)

= GHC 1,000(1.07)(1.07)
1,000 = = P0
(1+i)2
= GHC1,000(1.07)
1,000 2
= GHC
1,144.90
You earned an EXTRA GHC 4.90 in Year 2 with compound over
15 simple interest.
 General
General Future
Future
Value
Value Formula
Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.

General Future Value Formula:

FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n) -- See Table I
16
 Valuation
Valuation Using
Using Table
Table II
FVIFi,n is found on a mathematical
Table.
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
17
5 1.338 1.403 1.469
 Using
Using Future
Future Value
Value Tables
Tables
FV2 = $1,000 (FVIF7%,2) =
$1,000 (1.145) =
$1,145 [Due to Rounding]
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
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 FV - Illustration

 Julie wants to know how

large her deposit of
GHS10,000 today will
become at a compound
annual interest rate of 10%
for 5 years.
years
19
 Story
Story Problem
Problem Solution
Solution
 Calculation based on general formula:
FVn = P0 (1+i)n FV5 = GHC 10,000
(1+ 0.10)5 = GHC 16,105.10

 Calculation based on Table I:

FV5 = GHC 10,000 (FVIF10%, 5)
= GHC10,000 (1.611)
= GHC16,110 [Due to Rounding]
20
 FV - Illustration
 Kwame borrowed GHC 24,000
from his father to start a
business. If the loan was given
to Kwame at a compound
interest rate of 5%, determine the
amount to be paid at the end of 4
years.
21
 FV - Illustration
 How much would GHC 20,000
amount to at 8% per annum
compounding interest over 8
years?
 Find the compound interest on
GHC 10,000 for 10 years at 5%
per annum
22
 Frequency
Frequency of
of
Compounding
Compounding
Where interest compounds more than once in a
year, the General Formula:
FVn = PV0(1 + [i/m])mn
n: Number of Years
m: Compounding Periods per Year i:
Annual Interest Rate FVn,m: FV at
the end of Year n
PV0: PV of the Cash Flow today

23
 Impact
Impact of
of Frequency
Frequency
Julie Miller has $1,000 to invest for 2
Years at an annual interest rate of
12%.
Annual FV2 = 1,000(1+
1,000 [.12/1])(1)(2)
= 1,254.40
Semi FV2 = 1,000(1+
1,000 [.12/2])(2)(2)
= 1,262.48
24
 Impact
Impact of
of Frequency
Frequency
Qrtly FV2 = 1,000(1+
1,000 [.12/4])(4)(2)
= 1,266.77
Monthly FV2 = 1,000(1+
1,000 [.12/12])(12)(2)
= 1,269.73
Daily FV2 = 1,000(1+
1,000 [.12/365])(365)(2)
= 1,271.20
25
 Impact of Frequency
 Johnson deposited GHC10,000 at a bank
which pays a compound interest of 15% per
annum. How much will Johnson have at the
end of three years if interest is paid:
 Semi-annually
 Quarterly
 Monthly

26
 Impact of Frequency
 Bank A offers 9% interest
compounded yearly on an
investment plan and Bank B
offers interest compounded
quarterly. As a rational investor,
which bank would you deposit
GHC 5,000 for 6 years?
27
 Continuous compounding
 Continuous compounding
involves the calculation and
accumulation of interest on an
ongoing basis.
 It is computed as:
 FV = PVe^i*n

28
 Continuous compounding
 Benson deposited GHC 5,000 in his
bank account for 3 years. If the interest
is 15% and is compounded
continuously, how much will the money
grow to at the end of the 3 years?
 Find the value of GHC 500 in 10 years if
interest rate of 10% per annum is
compounded continuously?
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 Double
Double Your
Your Money!!!
Money!!!

Quick! How long does it take to double

$5,000 at a compound rate of 12% per
year (approx.)?

We will use the “Rule-of-72”.

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 The
The “Rule-of-72”
“Rule-of-72”

Quick! How long does it take to double

GHC 5,000 at a compound rate of 12%
per year (approx.)?

Approx. Years to Double = 72 / i%

72 / 12% = 6 Years
[Actual Time is 6.12 Years]
31
 Present Value Single
Deposit
Assume that you need GHS1,000
in 2 years. Let’s examine the
process to determine how much
you need to deposit today at a
discount rate of 7% compounded
annually.
PV0 = FV2 / (1+i)2 = GHS1,000 / (1.07)2
= FV2 / (1+i)2 = GHS873.44
32
 General
General Present
Present
Value
Value Formula
Formula
PV0 = FV1 / (1+i)1

PV0 = FV2 / (1+i)2

etc.

General Present Value Formula:

PV0 = FVn / (1+i)n
or PV0 = FVn (PVIFi,n) -- See Table II
33
 Valuation
Valuation Using
Using Table
Table IIII
PVIFi,n is found on any mathematical
Table
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
34
 Using
Using Present
Present Value
Value Tables
Tables
PV2 = GHC 1,000 (PVIF7%,2)
= GHC 1,000 (.873)
= GHC 873 [Due to Rounding]
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
35
5 .747 .713 .681
 EXAMPLE

Abigail wants to know how

large of a deposit to make
so that the money will
grow to GHS10,000 in 5
years at a discount rate of
10%.
36
 Story
Story Problem
Problem Solution
Solution
 Calculation based on general formula:
PV0 = FVn / (1+i)n
PV0 = GHC 10,000 / (1+ 0.10)5
= GHC 6,209.21
 Calculation based on Table I:
PV0 = GHC 10,000 (PVIF10%, 5)
= GHC 10,000 (.621)
= GHC 6,210.00 [Due to Rounding]
37
 Illustrations
 You are to receive GHC 4,000 in 4 years'
time. If the current interest rate is 15%,
what is the present value of the amount?
 You want to have GHC 10,000 in your
account to start a project in 4 years. If
you can earn 10% compounded quarterly
on your deposit, how much do you have
to put in your account today?

38
 Annuities
Annuities
 An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.
 Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period.
 Annuity Due:
Due Payments or receipts
occur at the beginning of each period.

39
 Examples of Annuities

 Student Loan Payments

 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings
40
 Parts
Parts of
of an
an Annuity
Annuity
(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

GHC100 GHC 100 GHC100

Today Equal Cash Flows

41
Each 1 Period Apart
 Parts
Parts of
of an
an Annuity
Annuity
(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

GHC100 GHC100 GHC100

Today Equal Cash Flows

Each 1 Period Apart
42
 Hint on Annuity Valuation
The future value of an ordinary
annuity can be viewed as
occurring at the end of the last
cash flow period, whereas the
future value of an annuity due
can be viewed as occurring at
the beginning of the last cash
flow period.
43
 Valuation using Tables
(Ordinary Annuity –FVA)
FVAn = R (FVIFAi%,n)
FVA3 = GHS1,000 (FVIFA7%,3)
= GHS1,000 (3.215)
Period 6%= GHS3,215
7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
44
 Valuation using Tables
(Annuity Due –FVAD)
FVADn = R (FVIFAi%,n)(1+i)
FVAD3 = GHS1,000 (FVIFA7%,3)(1.07)
= GHS1,000 (3.215)(1.07)
= GHS
Period 6%3,440 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
45
  Kwesi Mensah deposits GHC 4,000 at the
end of every year into a savings account for 5
years. If the bank pays 10% interest on such
deposits, how much will the deposits grow to
at the end of the 5th year?
 A firm deposits GHC 20,000 at the end of
each of the 3 years in a savings account that
pays 10% interest per year. What is the value
of the account at the end of 3 rd year, using
annuity table.
46
 Overview
Overview View
View ofof an
an
Annuity
Annuity Due
Due --
-- FVAD
FVAD
Cash flows occur at the beginning of the period
0 1 2 3 n-1 n
i% . . .
R R R R R

FVADn = R(1+i)n + R(1+i)n-1 + FVADn

... + R(1+i)2 +
R(1+i)1 = FVAn (1+i)
47
 Valuation
Valuation Using
Using Table
Table III
III
FVADn = R (FVIFAi%,n)(1+i)
FVAD3 = $1,000 (FVIFA7%,3)(1.07)
= $1,000 (3.215)(1.07) = $3,440
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
48
 Hint on Annuity Valuation
The present value of an ordinary
annuity can be viewed as
occurring at the beginning of the
first cash flow period, whereas
the future value of an annuity
due can be viewed as occurring
at the end of the first cash flow
period.
49
 Valuation
Valuation Using
Using Table
Table IV
IV
PVAn = R (PVIFAi%,n) PVA3 =
$1,000 (PVIFA7%,3) = $1,000
(2.624) = $2,624
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
50
 Valuation
Valuation Using
Using Table
Table IV
IV
PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = $1,000 (PVIFA7%,3)(1.07)
= $1,000 (2.624)(1.07) = $2,808
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
51
 Annuity - Illustrations
 Xtra wishes to undertake an investment which is expected
to yield GHC 800 for the next 4 years. Determine the
present value of the policy if the current interest rate is 14%
and the cash flows occur:
 At the end of the year
 At the beginning of the year
 Your daughter is expected to enter the university next year.
It is estimated that she will need GHC 10,000 each year for
the four year university education. You are planning to
deposit a lump sum in an account that will yield 10% per
annum to cater for her university education. How much
should be deposited?

52
 Perpetuity
 This is an annuity that provides the owner with an
indefinite cash flows
 It is computed as follows:
PV = Annuity = A
Discount rate K
Where there is a constant growth rate, it changes to
PV = Amount
k-g

53
 Perpetuity - Illustration
 What is the present value of an
annuity to perpetuity of GHC 500
per annum at 5%?
PV = GHC 500
0.05
= GHC 10,000
54
 Perpetuity - Illustration
 What is the present value of GHC 2,500 paid into a
fund every year in perpetuity if the rate of interest is
8%, and assuming the amount will grow at a constant
rate of 3%?
PV = Amount
K–g
where g is the growth rate
= GHC 2,500
0.08 – 0.03
= GHC 50,000
55
 Perpetuity - Illustration
 Suppose a businessman wishes to endow
a chair in finance at the School of
Business. The rate of interest is 15%. If the
goal is to provide GHC 200,000 a year in
perpetuity, but due to inflation, this
amount will grow at an average of 6% a
year. What is the amount that must be set
aside today?

56
 SINKING FUND
 Another application of time value of
money is determining the annuity amount
that must be deposited each year to
produce a certain lump sum in the future.
This arrangement is usually called sinking
fund.
 For example, a sinking fund may involve a
required annual payment designed to
provide funds for the retirement of a bond.
57
 SINKING FUND

58
 Effective
Effective Annual
Annual
Interest
Interest Rate
Rate
Effective Annual Interest Rate
The actual rate of interest earned
(paid) after adjusting the nominal
rate for factors such as the number
of compounding periods per year.

(1 + [ i / m ] )m - 1

59
 Effective
Effective Annual
Annual Interest
Interest
Rate
Rate
BW has a $1,000 CD at the bank. The
interest rate is 6% compounded quarterly
for 1 year. What is the Effective Annual
Interest Rate (EAR)?
EAR
EAR = ( 1 + 6% / 4 )4 - 1 =
1.0614 - 1 = .0614 or 6.14%!
Or FV = 1,000 (1 + 0.06/4)^4

60
 Effective Interest Rate -
Illustration
 What is the effective interest rate if GHC 500 is deposited at a
bank at an interest rate of 20% compounded semi-annually?
 A firm deposits money in a bank that pays a 10% nominal rate.
Determine the effective interest rate if it is compounded:
 Annually
 Semi-annually
 Quarterly
 Monthly
 Daily

61
 Effective Interest Rate -
Illustration
 A firm deposits money in a bank that pays 20% nominal
rate. Calculate the effective interest rate if compounding
is continuous.
 Which of the following would you prefer? Justify your
response
 An investment paying 12% interest compounded
quarterly
 An investment paying 11.7% compounded monthly
 An investment paying 11.5% interest compounded
continuously

62
 LOAN AMORTIZATION
 This is where the lender require the
borrower to pay instalment over the life of a
loan, each of which includes both interest
and the repayment of principal.
 The process of paying off a loan by making
regular principal deductions is called
amortizing the loan. Mortgage loans, car
loans and many other business loans are
amortized using this type of instalment
63
basis.
 EXAMPLE

64
 Steps
Steps to
to Amortizing
Amortizing aa Loan
Loan
1. Calculate the payment per period.
2. Determine the interest in Period t.
(Loan Balance at t-1) x (i% / m)
3. Compute principal payment in Period t.
(Payment - Interest from Step 2)
4. Determine ending balance in Period t.
(Balance - principal payment from Step
3)
65 5. Start again at Step 2 and repeat.
66
 LOAN AMORTIZATION
SCHEDULE
A B C D E
PAYMENT NO. DATE BEGINNING BAL TOTAL PAYMENT INTEREST PAID PRINCIPAL PAID ENDING BAL.
(A X 0.10) B- C A- D
GHS GHS GHS GHS GHS
1 300,000.00 79,134.79 30,000.00 49,134.79 250,865.21
2 250,865.21 79,134.79 25,086.52 54,048.27 196,816.94
3 196,816.94 79,134.79 19,681.69 59,453.10 137,363.85
4 137,363.85 79,134.79 13,736.38 65,398.41 71,965.44
5 71,965.44 79,134.79 7,196.54 71,938.25 27.19

67
 Amortizing
Amortizing aa Loan
Loan Example
Example
Julie Miller is borrowing $10,000 at a
compound annual interest rate of 12%.
Amortize the loan if annual payments are
made for 5 years.
Step 1: Payment
PV0 = R (PVIFA i%,n)
$10,000 = R (PVIFA 12%,5)
$10,000 = R (3.605)
68
R = $10,000 / 3.605 = $2,774
 Amortizing
Amortizing aa Loan
Loan Example
Example
End of Payment Interest Principal Ending
Year Balance
0 --- --- --- $10,000
1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000

[Last Payment Slightly Higher Due to Rounding]

69
 Usefulness of Amortization

1. Determine Interest Expense --

Interest expenses may reduce
taxable income of the firm.
2. Calculate Debt Outstanding --
The quantity of outstanding
debt may be used in financing
the day-to-day activities of the
70
firm.
 Amortization - Illustration
 Kwaku Manu borrowed GHC 5,000 from
a bank at an interest rate of 8% p.a and
agrees to pay equal instalments over five
years.
 Required:
 Determine the size of the payments
 Set up an amortization schedule for the
loan
71
 Amortization - Illustration
a. Size of payment
A = PMT
PVIFA(k,n)
= GHC 5,000
PVIFA (8%,5)
= GHC 5,000
3.993
= GHC 1,252.19
72
 Amortization schedule
Year Payment Int. Paid Principal Principal at
(8%) paid start
GHC GHC GHC GHC
0 - - - 5,000
1 1,252.82 400 852.82 4,147.18
2 1,252.82 331.77 921.05 3,226.13
3 1,252.82 258.09 994.73 2,231.40
4 1,252.82 178.51 1,074.31 1,257.09
5 1,252.82 92.57 1,160.25 (3.16)
6,264.10 1,260.94 5,003.16 -

73
 Amortization - Illustration
 Fred borrowed GHC 8,000 from his
bank at an interest rate of 12% and
agreed to pay equal instalments over
four years. You are required to:
 Determine the size of the payments
 Set up an amortization schedule for
the loan

74
 Amortization - Illustration
 Xtra Limited is financing a truck with a loan of GHC
10,000 to be repaid in 5 annual end-of-year
instalments of GHC 3,197.96. What annual interest
rate is the company paying?

75
 Steps
Steps to
to Solve
Solve Time
Time Value
Value
of
of Money
Money Problems
Problems
1. Read problem thoroughly
2. Create a time line
3. Put cash flows and arrows on time line
4. Determine if it is a PV or FV problem
5. Determine if solution involves a single CF,
annuity stream(s), or mixed flow
6. Solve the problem
7. Check with financial calculator (optional)
76
 Mixed
Mixed Flows
Flows Example
Example
Julie Miller will receive the set of cash
flows below. What is the Present Value
at a discount rate of 10%.
10%

0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
PV0
77
 How
How to
to Solve?
Solve?

1. Solve a “piece-at-a-time”
piece-at-a-time by
discounting each piece back to
t=0.
2. Solve a “group-at-a-time”
group-at-a-time by first
breaking problem into groups of
annuity streams and any single cash
flow groups. Then discount each
group back to t=0.
78
 Mixed cash flows
Your friend is undertaking an investment with the following cash
flows for 4 years
Year Cashflow
1 1,000
2 1,500
3 2,000
4 3,000
You are required to compute the present value of the
expected cash flows if your friend requires 14% return on
all his investments

79
 PV = CF1 + CF2 + CF3 + CF4
(1 + k) (1 + k)^2 (1 + k)^3 + (1 + k)^4
= 1,000 + 1,500 + 2,000 + 3,000
(1 + 0.14) (1 + 0.14)^2 (1 + 0.14)^3 + (1 + 0.14)^4
= 877.19 + 1,154.2 + 1,349.53 + 1,776.19
= GHC 5,157.11

80