Chapter 3: Time Value of Money

Meaning:
Time value of money means that value of a unit of
money is different in different time periods.
Rationale:
Inflation
Investment opportunity
Consumption preference
Common point of time
Risk/uncertainty
Logical and meaningful comparison
Techniques (Compounding/Discounting)
Compounding: Here interest is compounded
when the amount earned on an initial deposit.

Example: Mr. X invests in a saving bank account

Tk.1,000 at 5% interest compounded annually.
What will be the amount after 3 years?
Year 1 2 3

Beginning amount 1,000 1,050 1,102.50

Interest rate .05 .05 .05

Amount of interest 50 52.50 55.125

Beginning principal 1,000 1,050 1,102.50

Ending principal 1,050 1,102.50 1,157.625

A P(1 i) n

A 1,000(1 .05) 1,157.625

3
Compound Value Interest Factor (CVIF)
Use Table A-1
Tk. 1,000 at 5% interest for 5 years, the
CVIF is 1.158.
Multiply 1,000 with 1.158
The compounded sum is Tk. 1158.

Semi-annual compounding:
 i mn
A P(1 )
m
 .06 2*2
A 1,000(1 ) 1,000(1 .03) 4 1,125.51
2

.06 4*2
A 1,000(1 ) 1,000(1 .015)8 1,126.49
4
Future compounding of a series of payment

End of the Amount No. of years CVIF from Future

Year (1) Deposited compounded Tab. A-1(4) Value(5)=(2)
(2) (3) [at 5%] *(4)
1 500 4 1.216 608.00

2 1,000 3 1.158 1,158.00

3 1,500 2 1.102 1,654.50

4 2,000 1 1.050 2,100.00

5 2,500 0 1.000 2,500.00

Total 8,020.50
Compound Sum of an annuity

End of year Amount No. of years CVIF (4) [at Future

(1) deposited(2) compounde 5%] value(5)=(2)
d (3) *(4)
1 2,000 4 1.216 2,432

2 2,000 3 1.158 2,316

3 2,000 2 1.102 2,206

4 2,000 1 1.050 2,100

5 2,000 0 1.000 2,000

Total 11,054
A=CVIF*P
A=5.526*2000=11054 (Using Tab. A-2)
Present Value or Discounting Technique

The procedure of finding out the present

value is discounting.
Given a positive rate of interest, the
present value of future money will always
be lower.
Future value is multiplied by a discount
rate/the cost of capital/an opportunity
cost/cut-off rate.
Example: Mr. X will get Tk. 1,060 after 1 year from
now. He knows he can earn 6% interest on his
investment. What amount will he be prepared to
invest for this opportunity?
A P(1 i) n
1

1060 P(1 .06) 1,000

1
P=Ax(PVIF)
P=1060(.943)=1,000
EXAMPLE:
Year Cash Flows

1 500

2 1000

3 1500

4 2000

5 2500
Year End (1) Cash Flows (2) PV Factor (3) PV (2x3)

1 500 .909 454.50

2 1,000 .826 826.00

3 1,500 .751 1,126.50

4 2,000 .683 1,366.00

5 2,500 .621 1,552.50

Total 5,325.50
Example 2.7
Mr. X wishes to determine the present value of the
annuity consisting of cash inflows of Tk. 1,000 per year
for 5 years. The rate of interest he can earn from his
investment is 10%.
Year End Cash Flows PV Factor PV

1 1000 .909 909

2 1000 .826 826

3 1000 .751 751

4 1000 .683 683

5 1000 .621 621

Total 3790
Present Value(PV)=CxADF
=1000x3.791
=3791
A financial manager is often interested in determining
the size of annual payments to accumulate a future
sum to repay an existing liability at some future date
or to provide funds for replacement of an existing
machine/asset after its useful life.
Example: Company XYZ is establishing a sinking
fund to retire Tk. 5,00,000, 8% debenture, 10 years
from today. The company plans to put a fixed amount
into the fund each year for 10 years. The first
payment will be made at the end of current year. The
company anticipates that the funds will earn 6% a
year. What equal contributions must be made to
accumulate Tk. 5,00,000, 10 years from now?
Solution:
The solution to this problem is closely related to the
process of finding the compounded sum of an annuity.
Table A-2 indicates that the annuity factor for 10 years
will accumulate to Tk. 13.181.
Annuity Payment is: 5,00,000/13.181=37,933.39.
Amortization is paying off a debt over time in
equal installments. Part of each payment goes
toward the loan principal, and part goes
toward interest. With a mortgage, the amount
going toward principal starts out small, and
gradually grows larger month by month.
Example: Mr. X plans to borrow Tk. 5,00,000
from a commercial bank. Rate of interest is
15% p.a. The loan is to be paid in quarterly
installment over 4 years. What will be the size
of installment? If he wants to repay the whole
remainder amount of loan after one year, what
amount will have to be paid?
PV of annuity=5,00,000/11.870
PMT=42,123
Period Beginning Annuity Principal Interest End of the
Balance Period
Balance
1 5,00,000 42,123 23,373 18,750 4,76,627

2 4,76,627 42,123 24,249 17,874 4,52,378

3 4,52,378 42,123 25,158 16,964 4,27,220

4 4,27,220 42,123 26,102 16,021 4,01,118