Lecture Note 8 This lecture note was originally written by a student and partly modified and certified by the course instructor.

Time Value of Money Time value of money expresses the purchasing power of money at a given period. For example, suppose you can buy one ball of Ga kenkey this year for GH¢1.00. Do you think the same ball of Ga kenkey would go for GH¢1.00 next year? In another example, imagine a neighbor borrows your block making machine for her construction business. Do you think it’s fair for her to return the machine to you next year without any compensation because she is a friend? Three major economic factors should be considered here which is all related to ‘time value of money’. 1. Opportunity cost: You missed the chance of making money from the machine within the year. In other words, you could have earned some interest had you sold your machine and put the money in a savings account. 2. Depreciation: The machine would be older next year and probably less productive compared to this year. 3. Inflation: The price of the machine might be higher next year than it is this year. If one considers all three factors above, then it is not fair for the neighbor to return the machine next year without any compensation. This course will consider only factor 1 and will primarily consider cases involving an individual/entity and the bank. Equivalence between the Present and Future value of a single amount of money Because of time value of money, the present value of a future amount of money, and vice versa is of great importance in business. For example, if you invested Ghc 1000 in an asset that offers an interest rate of 20% per year, you will be interested to know (today) what you will receive next year. Today, the Ghc 1000 is a Present value, and what you will receive next year is a Future value. On the other hand, if you are promised a certain amount two years to come (i.e. future value), you would be wondering the worth of that money today (i.e. present value). Perhaps you would want to borrow some money today so that you could pay it off with what you’ve been promised at the end of year 2. Let and be the present (current time period) and future (i.e. time period ) value of a single amount assuming interest rate will remain at within the period considered. Then, and are ( ) related by the formula: Note that this formula is for a single amount, and is the number of periods from the future period to whatever present time in mind. Usually, the present is time zero. However, there will be instances where for purposes of calculation sake one could assume say, time period 3 as the

present and later consider time period 3 as the future to be taken to time zero. This will become clear later. Illustrations: Example 1

Find the present value of the cash flow shown above when = 5%. ( (

) )

For the future amount Ghc 3000 at period 2, it has to move back two time periods to the present (period zero). Thus,

and therefore

(

)

However, for the future amount Ghc 2000 at period 1, The total present value of the cash flow above is:

and therefore

(

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(

(

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Example 2 Find the present value of the cash flow shown below if interest rate ( ) is 10% per year. Year 1 2 3 4 5

Cash 2000 5000 0 -2000 3000

Solution

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Types of Cash Flows 1. Uniform Cash Flows Amount of cash inflow or outflow is the same each time period.

Let

be the present value of the uniform cash flows above. Then: (

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When is large (say ), it will be too tedious to compute . In what follows, we seek a shortcut to find such that unlike equation (1) above which requires computations, only 1 computation would be needed to find . To do this, first form Equation (2) by dividing Equation (1) by (

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Next, subtract equation (2) from equation (1): By cancelling out like terms, we have: (

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Note that the emphasis is on finding . Therefore, we rearrange to make (

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the subject.

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Thus, the present value of a continuous uniform cash flow that begins at the end of period 1 to end of period is as shown in equation (3). In general, equation (3) can be used to find the present value of a continuous uniform cash flow that begins at any period (not necessarily at period one). The present value occurs one period before the occurrence of the first uniform value. Also, in the formula is equal to the number of uniform cash flows.

( ) , we can find the future value of all uniform cash flows by Note also that since simply replacing with that from equation (3). Then: [

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Example 1: In this example, we test the power of the shortcut. Find the net present value of the cash flow shown below with =5%.

Alternative 1: Brute-force approach (

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Alternative 2: Using the shortcut. *

It is clear that when

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is large, the shortcut is more convenient.

Example 2 The government of Ghana is to receive an amount of GH¢10,000 for the next 100 years. If interest rate is assumed to remain at 10% per year throughout the 100 years, find the net present value of all the cash flows. *

(

) (

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+

Example 3

Find the net present value of the cash flow shown above when =5%. First, we can find the present value of the uniform cash flows in period 2. ( ) [ ] ( )

then becomes the future value at period 2 whose present is sought at period 0. Thus (

)

Example 4 You borrowed GH¢10,000 from EcoBank at an interest rate of 10% to be repaid in 5 years. What is the equal amount to be saved each year in order to repay the loan in full at the end of 5 years? *

(

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( (

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( (

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Example 5

Find the net present value of the cash flow shown above. Assume = 5%. * *

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2. Arithmetic Gradient Cash Flow This is a type of periodic payment where payment at period is always increased by a constant amount over the payment at period . The diagram below depicts the arithmetic gradient cash flow. It is obvious the cash flow can be divided into 2 parts: a uniform part with an amount A, and a gradient part that start two periods from period 0 increasing by each period after.

Let and respectively be the present value of the uniform and gradient part. Let also the total present value of the arithmetic cash flow. Then:

We want a shortcut to compute

.

can be found using equation (3). Therefore, our focus is on . ( ) ( ) ( ) ( ) ( ) ( ) (

Form equation 2 by doing: (

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be

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Do (

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The first part of the right-hand-side is similar to the equation that led to the shortcut of equation (3) when is replaced with . Therefore, the equation above reduces to: [ Factor out (

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Note: 1. In general, . Where the sign changes to ( ) when the gradient part is decreasing. ( ) Also, once we have the present value, the future value can be obtained through 2.

occurs two period to the first gradient series.

Example 1

Find the present worth of a cash flow that begins with GH¢3000 in the first period and increases by GH¢500 per period for 10 years with interest of 5%. [ *

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Example 2 The income from Precious Metal Mining Corporation has been decreasing uniformly for four years.

If income in year 1 was GH¢300,000 and it decreased by GH¢30,000 per year to year 4, what is the present worth of income stream at 5% per year?

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3. Geometric Gradient Cash Flow This is similar to that of the arithmetic gradient cash flow except that payment at period is always increased by of the payment at period . That is: ( )[ ] The total present value of such cash flows (uniform plus gradient part) is given as: [ * Where;

(

)

]

+ = growth rate (rate of increase) = interest rate

Example The academic fees of the University of Ghana (UG) is set to increase by 10% per year for the next 4 years. You are a first year student and the fee is GH¢1,000 this year. Your guardian would be travelling for a while and would like to deposit an amount today in a fund that would be sufficient to pay the total of your tuition for the four years. How much should your guardian deposit today if the fund pays interest rate of: a. 10% and b. 5% Solution a. [

]

b. [

(

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]

4. Uniform Cash Flow in Perpetuity

When is forever (e.g. and endowment fund), equation (3) which is the present value of all future cash flows reduces to