WISCONSIN INTERNATIONAL

UNIVERSITY COLLEGE - MBA

TIME VALUE OF MONEY AND
VALUATION OF SECURITIES

JUNE 2024
 Definition of Time Value of Money (TVM)

• "The time value of money is 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. It is founded on
the concept of interest and the opportunity cost of capital."

The time value of money (TVM) is a fundamental financial concept that

reflects the idea that money has a different value over time due to its potential
earning capacity.

• This principle is based on the notion that receiving money today is more
valuable than receiving the same amount in the future because of its potential
to generate returns.
 Definition of Time Value of Money (TVM)

• Time Value of Money (TVM) is a financial principle that recognizes the

inherent difference in value between a sum of money today and the same
amount of money in the future.

• The concept revolves around the idea that money has the potential to earn
returns or interest over time, making its current value higher than its future
value.

• TVM is fundamental in:

i. financial decision-making,
ii. investment analysis, and
iii. various aspects of personal and corporate finance.
 Definition of Time Value of Money (TVM)

• Textbook Definition:

• According to renowned finance textbook "Principles of Corporate Finance"

by Richard A. Brealey, Stewart C. Myers, and Franklin Allen (13th
edition), the Time Value of Money is defined as follows:

• "The principle that a dollar received today is worth more than a dollar
received in the future. The concept that recognizes the earning power of
money over time. The time value of money is a fundamental concept in
finance and is the foundation for many financial calculations and
investment decision-making processes."
 TIME VALUE OF MONEY
When you finish this chapter, you should be able to:

i. Explain how the time value of money works and discuss why it is such an
important concept in finance.

ii. Calculate the present value and future value of lump sums.

iii. Identify the different types of annuities and calculate the present value
and future value of both an ordinary annuity and an annuity due.

iv. You should also be able to calculate relevant annuity payments.

v. Calculate the present value and future value of an uneven cash flow
stream.

vi. Discuss the basics of loan amortization.

 Time Value of Money (TVM) Principle
• The value of money is not static; it varies over time, and this principle has
significant implications for financial decision-making.

• 1. Timing Significantly Impacts Value

The value of money is not solely determined by its face value; it's heavily
influenced by when that money is received or spent.

• 2. Opportunity Cost
The concept recognizes the opportunity cost associated with having money
tied up in one way rather than another. If funds are invested or used for
productive purposes, they have the potential to generate returns.

• 3. Influence of Interest Rates

Interest rates play a crucial role in TVM. Money has the potential to earn
interest, and the prevailing interest rates influence the value of future cash
flows.
 Time Value of Money (TVM) Principle

• 4. Present Value and Future Value

Present Value (PV) and Future Value (FV) are key calculations in TVM. PV
assesses the current worth of future cash flows, considering a discount rate,
while FV estimates the future value of current investments, incorporating a
compounding rate.

• 5. Decision-Making in Finance
TVM is foundational for financial decision-making. It guides choices related to
investments, loans, valuation, and various aspects of personal and corporate
finance.

• 6. Risk and Uncertainty

The time value of money also considers the inherent risk and uncertainty
associated with future cash flows. A dollar today is considered less risky than a
dollar in the future.
 Practical Implications

i. Investment Evaluation
• Assessing the potential returns of investments and comparing their present
and future values.

• ii. Loan Amortization

• Determining the periodic payments on loans and understanding the
distribution of interest and principal over time.

• iii. Retirement Planning

• Estimating the future value of savings and investments for retirement
planning.
 Practical Implications

• iv. Business Valuation

• Evaluating the value of cash flows and investments in business scenarios.

• v. Capital Budgeting
• Making decisions about long-term investments in projects by considering
the time value of money.

• vi. Discounted Cash Flow (DCF) Analysis

• Applying a discount rate to future cash flows to assess their present value
in financial models.
 Factors influencing Time Value of Money

• The Time Value of Money (TVM) is influenced by several factors that affect
the value of cash flows over time. These factors play a crucial role in
financial decision-making and are fundamental to various financial
calculations.

• i. Interest Rates
• The prevailing interest rates significantly impact the time value of money.
Higher interest rates increase the value of future cash flows less compared to
lower interest rates. Interest rates represent the opportunity cost of having
money today rather than in the future.

• ii. Inflation
• Inflation erodes the purchasing power of money over time. Inflation reduces
the real value of future cash flows. Therefore, when considering the time
value of money, it's crucial to account for the expected rate of inflation.
 Factors influencing Time Value of Money

• iii. Risk and Uncertainty

• The level of risk associated with future cash flows affects their present value.
Riskier cash flows are generally discounted more heavily in financial calculations.
Investors and decision-makers may require a higher rate of return for cash flows
with higher perceived risk.

• iv. Opportunity Cost

• The potential alternative uses of money influence its current value. Money can be
used for various purposes, such as investments or paying down debt. The
opportunity cost considers what could be gained by using the money in the best
alternative way.

• v. Time Period
• The length of time until a cash flow occurs impacts its present and future values.
The longer the time period, the greater the impact of compounding or discounting
on the value of money. Time is a critical factor in determining the time value of
money.
 Factors influencing Time Value of Money

• vi. Compounding Frequency

• The frequency at which interest is compounded affects the growth of future value.
More frequent compounding results in a higher future value. Common
compounding frequencies include annually, semi-annually, quarterly, or monthly.

• vii. Discount Rate

• The discount rate used in present value calculations determines the current worth of
future cash flows. The discount rate reflects the required rate of return or the cost of
capital. Different discount rates can be applied based on the nature and risk of the
cash flow.

• vii. Economic Conditions

• Overall economic conditions, including monetary policy, can impact interest rates
and inflation rates. Economic stability or instability can affect the reliability of
future cash flows, influencing the risk premium applied in financial calculations.
 Basic Definitions – Simple Interest

• Simple interest - Interest paid (earned) on only the original amount, or

principal, borrowed (lent).

• The cedi amount of simple interest is a function of three variables: the

original amount borrowed (lent), or principal; the interest rate per time
period; and the number of time periods for which the principal is borrowed
(lent). The formula for calculating simple interest is

• SI = P0(r)(t)

• where SI = simple interest in cedis

• P0 = principal, or original amount borrowed (lent) at time period 0
• r = interest rate per time period
• t = number of time periods
 Basic Definitions – Compound Interest
For example, assume that you depositGHc1,000.00 in a savings account
paying 8 percent simple interest and keep it there for 10 years. At the end of 10
years, the amount of interest accumulated is determined as follows:

• GHc1,000(0.08)(10) = GHc800.00

• Compound interest - Interest paid (earned) on any previous interest

earned, as well as on the principal borrowed (lent).

• Compounding – the process of accumulating interest on an investment

overtime to earn more interest.

• Interest on interest – interest earning on the reinvestment of previous

interest payments.
 Interest on Interest
• Suppose you locate a two year investment that pays 25% per year. If you
invest GHc750,000.00, how much will you have at the end of the two
years.
• (a) How much of this is simple interest?
• (b) How much is compound interest?

• Ans
• (a) at the end of the first year you will have
750,000 (1+0.25)1 = GHc937,500.00

(b) if the first year earnings are reinvested, then the interest will be
compounded. At the end of the second year you will have
937,500 (1+0.25)1 = GHc1,171,875.00

The total interest earned is GHc1,171,875.00 - 750,000 = GHc421,875.00

For a two year simple interest – 937,500.00 – 750,000 = 187,500.00
187,500.00 * (2) = GHc375,000.00
421,875.00 – 375,000.00= GHc46,875.00
 Future value interest factor

• Future value (terminal value) - The value at some future time of a present
amount of money, or a series of payments, evaluated at a given interest rate.

• Future value – refers to the amount of money an investment will grow to

cover over a period of time at some given interest rate.

• FV = PV(1 + r)t

• FV = future value
• PV = present value
• r = period interest rate, expressed as a decimal
• t = number of periods
• Future value interest factor = (1 + r)t
 Future value

• Qu 1. You have just made your first GHc550,000.00

contribution to your Tier 2 retirement account. Assuming you
earn a 12% rate of return and make no additional
contributions. What will your account be worth when you
retire in 55 years? What if you wait 10 years before
contributing.

• Qu 2. You are expected to receive GHc125,000.00 in four

years. When you receive it, you will invest it for 11 more years
at 10% per year. How much will you have in 15 years.
 Future value
• Qu. 1

• To find the FV of a lump sum, we use:

• FV = PV(1 + r)t
• FV = GHc550,000 (1.12)55 =GHc280,126,333.00
• FV = GHc550,000(1.12)45 = GHc90,193,182.13

• Qu 2

• We need to find the FV of a lump sum. However, the money will only be
invested for six years, so the number
• of periods is six.
• FV = PV(1 + r)t
• FV = Ghc125,000(1.10)11 = GHc356,639.58
 Present Value

• Present value – The current value of a future amount of money, or a series

of payments, evaluated at a given interest rate

• FV = PV (1+r)t

• Rearranging to solve for PV

• PV = FV
(1+r)t

• The expression 1/(1 + r)t is called the discount factor. It measures the
present value of GHc1 received in year t.
 Present Values

• Qu1. The first copy of a Ghanaian movie ‘My Step Father’ was sold in
1960. In 2014, the estimated price of this movie in good condition was
about GHc15,000.00. This represented a return of 12% per year. For this to
be true, how much was the movie sold for when new.

• Qu2. Suppose a house at West Airport is worth GHc850,000.00. If you

have a mutual fund at an annual rate of return of 15% and want to purchase
this house at age 50 (you are now 30 years old). How much must you
invest today.
 Present Values
• Qu 1.

• To find the PV of a lump sum, we use:

• PV = FV
(1+r)t

• PV = GHc15,000 / (1.12)54 GHc32.99

• Qu. 2

• To find the PV of a lump sum, we use:

• PV = FV
(1+r)t

• PV = GHc850,000 / (1.15)20 = GHc51,935.23

 Interest Rates

• Interest rate – exchange rate between earlier money and later money

• Rearrange the basic PV equation and solve for r

– FV = PV(1 + r)t

r = (FV / PV)1/t – 1
 Calculating Interest Rates

• (1) Suppose the total cost of establishing a university in Ghana in

the next 10 years will be GHc2,500,000.00 You presently have
GHc450,000.00 to invest. What annual rate of interest must you earn
on your investment to cover the cost of establishing this university.

• (2) In 2013, Auto Parts Ghana Limited announced the average

vehicle selling price for a 4 wheel drive in Ghana was GHc150,000.
Five years earlier, the average price was GHc85,000. What was the
annual increase in vehicle selling price?
 Interest Rates - Answers
Ans (Qu1)
• FV = PV(1 + r)t
• Solving for r, we get:
• r = (FV / PV)1 / t – 1
• r = (GHc2,500,000 / GHc450,000)1/10 – 1
• r = 1.187060215 - 1
• r= 0.1870602147 = 18.71%

(Qu 2)
• FV = PV(1 + r)t
• Solving for r, we get:
• r = (FV / PV)1 / t – 1
• r = (GHc150,000 / GHc85,000)1/5 – 1
• r = 1.120300337 - 1
• R = 0.120300337 = 12.03%
 Number of periods

• FV = PV (1+r)t

• Start with basic equation and solve for t:

• t = ln (FV / PV)
ln (1 + r)
 Number of periods

Qu 1 You are trying to save to buy a new house at North Legon

valued at GHc750,000.00 You have GHc50,000.00 today that
can be invested at your bank. The bank pays 12% annual
interest on its accounts. How long will it be before you have
enough to buy the house.

Qu 2. You are expected to receive GHc100,000 from your

grandparents when you graduate from the university in two
years. You plan on investing it at 20% until you have
GHc500,000. How long will you wait from now?
 Number of periods
• Qu 1. To answer this question, we can use either the FV or the PV formula. Both will give the
same answer since they are the inverse of each other. We will use the FV formula, that is:
• FV = PV(1 + r)t
• Solving for t, we get: t = ln(FV / PV) / ln(1 + r)

• t = ln (GHc750,000 / GHc50,000) / ln 1.12 = ln 15 / ln 1.12 = 23.90 years

• Qu 2. To answer this question, we can use either the FV or the PV formula. Both will give the
same answer since
• they are the inverse of each other. We will use the FV formula, that is:

• FV = PV(1 + r)t
• Solving for t, we get: t = ln(FV / PV) / ln(1 + r)

• t = ln(GHc500,000 / GHc100,000) / ln(1.20)

• = ln 5 / ln 1.20 = 8.83 years

• So, the money must be invested for 8.83 years . However, you will not receive the money for
another two years. From now, you’ll wait:

• 2 years + 8.83 years = 10.83 years

 General Questions
• Qu 1. You have just received notification that you have won the
GHc500,000 award for the best student in the Annual Student Quiz
competition. However, the prize will be awarded on your 60th birthday, 40
years from now. What is the present value of your windfall if the
appropriate discount rate is 8%?

• Qu 2. You have just been offered a new job and the company has set aside
an amount of GH45,000.00 towards your pension. Assuming you were to
earn 10% rate of return and you also made no additional contributions.
What will your account be worth when you retire in 35 years?
 General Questions
Qu. 1
Given that: FV = 500,000 t = 40 years r = 8% = 0.08

• PV = FV 500,000 500,000 = GHs23,015.47

(1+r)t (1.08)40 21.72452

Qu. 2

Given that PV = 45,000 t = 35 r = 10% = 0.10

FV = PV(1 + r)t
FV = 45,000 (1.10)35
FV = 45,000 (28.1024368481)
FV = GHs1,264,609.66
 General Questions

• Qu 3. Assume the total cost of studying for your MBA at Harvard

University in the USA for one academic year will be GHc250,000.00 in 5
years. You presently have GHc50,000.00 to invest. What annual rate of
interest must you earn on your investment to cover the cost of your MBA
education at Harvard University?

• Qu 4. You expect to receive Ghc250,000 from your rich Uncle in the

United Kingdom at your graduation in two years. You plan to invest this
money at 25% until you have GHc750,000.00. How long will you wait
from now?
 General Questions
• Qu. 3
• Given that: FV = 250,000 PV = 50,000 t = 5 years
• r = (FV / PV)1/t – 1
• r = (250,000/50,000)1/5 – 1
• r = (5)0.2 – 1
• r = 1.3797296615 – 1
• r = 0.3797296615*100
• r = 37.97%

• Qu. 4
• Given that: FV = 750,000 PV = 250,000 r = 25% = 0.25

• t = ln (FV / PV) = In (750,000/250,000) = In (3) = 1.0986122887

ln (1 + r) In (1.25) In (1.25) 0.2231435513

• t = 4.9233432123 t = 4.923 years

• 4.923 years +2 years = 6.923 years
DISCOUNTED CASH FLOW VALUATION
 Lecture Outline

• Future and Present Values of Multiple Cash Flows

• Valuing Level Cash Flows: Annuities and

Perpetuities

• Comparing Rates: The Effect of Compounding

• Loan Types and Loan Amortization

 FUTURE VALUE WITH MULTIPLE
CASH FLOWS
• There are two ways to calculate future value of multiple cash flows:

(i) Compound the accumulated balance forward one period at a time; or

(ii) Calculate the future value of each cash flow and add them at the ending
period (i.e. net future cash flow)
 FUTURE VALUE WITH MULTIPLE
CASH FLOWS
Qu.1Assuming you have the capacity to deposit into your bank account
which pays 8% interest an amount of GHc40,000.00 at the end of
the next three years. Currently you have an amount of
GHc70,000.00 in the account. How much will you have in (a) three
years? (b) four years?

Qu. 2
• If you deposit GHc100,000.00 in one year into an investment
account with NTHC, GHc200,000.00 in two years, and
GHc300,000.00 in three years. How much will you have in three
years? How much of this is interest? How much will you have in
five years if you don’t add additional amounts? Assume a 7%
interest rate through.
 FUTURE VALUE WITH MULTIPLE
CASH FLOWS

• Soln. Qu.1

Year (o) t = 3 r = 8% PV = GHc70,000 FV = 70,000 (1.08)3 = GHc88,179.80

Year (1) t = 2 r = 8% PV = GHc40,000 FV = 40,000 (1.08)2 = GHc46,656.00

Year (2) t = 1 r = 8% PV = GHc40,000 FV = 40,000 (1.08)1 = GHc43,200.00

Year (3) t=0 r=8% PV = GHc40,000 FV = 40,000 (1.08)0 = GHc40,000.00

GHc218,035.80
Year (4) 218,035.80 (1.08) = GHc235,478.66
 FUTURE VALUE WITH MULTIPLE
CASH FLOWS
• Alternate solution to Qu. 1

At the end of the first year, you will have

GHc70,000.00 (1.08) + GHc40,000.00 = GHc115,600

At the end of the second year, you will have

GHc115,600 (1.08) + GHc40,000.00 = GHc164,848.00

At the end of the third year, you will have

GHc164,848.00 (1.08) + GHc40,000.00 = GHc218,035.80

At the end of the fourth year, you will have

GHc218,035.80 (1.08) = GHc235, 478.66
 PRESENT VALUE WITH MULTIPLE
CASH FLOWS
• There are two ways to calculate the present value of multiple
cash flows:

(i) discount the last amount back one period and add them as
you go; or

(ii) discount each amount to time zero and then add them (i.e., net
present value).

• The present value of an annuity of GHc per period for t

periods at r per cent interest:
 PRESENT VALUE WITH MULTIPLE CASH FLOWS
• Suppose you need GHc10,000.00 in one year and GHc20,000.00 more in
two years. If you earn 9% on your money, how much do you have to put up
today to exactly cover these amounts in the future. In other words, what is
the present value of the two cash flows at 9%.

• Sol.
• The present value of GHc20,000.00 in two years at 9% is
• = 20,000 = GHc16,833.60
(1.09)2

• The present value of GHc10,000 in one year is

10,000 = GHc9,174.30
(1.09)1

• Therefore the total present value is GHc16,833.60 + GHc9,174.30 =

GHc26,007.90
 PRESENT VALUE WITH MULTIPLE
CASH FLOWS
• Suppose we had an investment that was going to pay GHc1,000 at the end
of every year for the next five years. Suppose the interest rate is 6%

• To find the present value, we could discount each GHc1,000 back to the
present separately and then add them up.

• Sol.

• 1000/(1.06)1 +1000/(1.06)2 +1000/(1.06)3 + 1000/(1.06)4 + 1000/(1.06)5

943.40 + 890.00 + 839.62 + 792.09 + 747.26

• PV = GHc4,212.37
 Multiple Cash Flows - Questions

Qu.1 Suppose you invest GHc50,000.00 in a mutual fund today and

GHc60,000.00 in one year. If the fund pays 9% annually, how much will
you have in two years? How much will you have in 5 years if you make no
further deposits?

Qu.2 Suppose you plan to deposit GHc20,000.00 into an account in one year
and GHc15,000.00 into the account in three years. How much will be in the
account in five years if the interest rate is 8%?
 Multiple Cash Flows

Sol 1. FV = 50,000 (1.09)2 + 60,000 (1.09)1

• = 59,405 + 65,400
• = GHc124,805

How much will you have in 5 years

• 50,000 (1.09)5 + 60,000 (1.09)4
• = 76,931.20 + 84,694.90
• = Ghc161,626.10

Sol 2. FV = 20,000(1.08)4 + 15,000(1.08)2 =

27,209 + 17,496 = 44,705
 General Questions

Qu 1. You currently have GHc70,000.00 in a bank account earning 8%

interest. You think you will be able to deposit an additional GHc40,000 at
the end of each of the next three years. How much will you have in three
years?

Qu 2. Suppose you invest Ghc500 in a mutual fund today and Ghc600 in one
year. If the fund pays 9% annually, how much will you have in two years?
How much will you have in 5 years if you make no further deposits?
 General Questions

Qu 3. You are offered an investment that will pay you Ghc20,000 in one year,
GHC40,000 the next year, GHc60,000 the year after, and GHc80,000 at the
end of the following year. You can earn 12% on similar investments. How
much is this investment worth today?

Qu 4. You are considering an investment that will pay you GHc1000 in one
year, GHc2000 in two years and GHc3000 in three years. If you want to
earn 10% on your money, how much would you be willing to pay?
 General Questions

• Qu 1. Dorcas is 20-years old and a student of Wisconsin

International University College. She wants to save GHc3.00 a day
for her retirement. Every day she places Ghc3.00 in a drawer. At the
end of each year, she invests the accumulated savings
(GHc1,095.00) in a brokerage account with an expected annual
return of 12%.

• (1) If she keeps saving in this manner, how much will she have
accumulated at age 65?
• (2) If a 40-year-old investor began saving in this manner, how much
would he have at age 65?
• (3) How much would the 40-year-old investor have to save each
year to accumulate the same amount at 65 as the 20-year-old
investor?
 Solution
• (i) If she keeps saving in this manner, how much will she have accumulated
at age 65?

• t = 65 – 20 = 45 years PV = 1,095 r = 12% = 0.12

• FV = PV (1+r) = FV = 1095 (1.12)45
t

• FV = 179,566.43

• (ii) If a 40-year-old investor began saving in this manner, how much would he have at age 65?
• T = 65-40 = 25 years PV= 1,095 r = 12% = 0.12
• FV = PV (1+r)t = FV = 1095 (1.12)25
• FV = 18, 615.07

• (iii) How much would the 40-year-old investor have to save each year to accumulate the same
amount at 65 as the 20-year-old investor?

• FV = PV (1.12)25 = 1,095(1.12)45

• FV = 179,566.43 = 179,566.43
(1.12)25 17.00006441
• PV = 10,562.69
 General Questions

• Qu. 2 Mr. Mark Obeng is the CEO of Progress Ventures. He is currently 40

years old; and wants to begin saving for retirement, with the first payment
to come one year from now. He can save GHc5,000.00 per year; and you
advise him to invest it in the stock market, which you expect to provide an
average return of 9% in the future.

• a. If he follows your advice, how much money will he have at 65?

• b. How much will he have at 70?
• c. He expects to live for 20 years if he retires at 65 and for 15 years if he
retires at 70.

• If his investments continue to earn the same rate, how much will he be able
to withdraw at the end of each year after retirement at each retirement age?
 Solution
• a. If he follows your advice, how much money will he have at 65?

• t = 65-40 = 25 years
• FV = PV (1+r)t = FV = 5,000 (1.09)25
• FV = 43,115.60

• b. How much will he have at 70?

• T= 70-40 = 30 years
• FV = PV (1+r)t = FV = 5,000 (1.09)30
• FV = 66,338.39

• c. He expects to live for 20 years if he retires at 65

• PV = FV 43,115.60 PV = 7,693.12
(1+r)t (1.09)20

He expects to live for 15 years if he retires at 70.

• PV = FV 66,338.39 PV = 18,212.61
(1+r)t (1.09)15
 General Questions
• Qu 3. Mrs. Roberta Roberts has GHc42,180.53 in a brokerage
account, and she plans to contribute an additional
GHc5,000.00 to the account at the end of every year. The
brokerage account has an expected annual return of 12 percent.
If Roberta’s goal is to accumulate GHc250,000.00 in the
account, how many years will it take for Roberta to reach her
goal?

• Qu 4. Your parents are planning to retire in 18 years. They

currently have GHc250,000.00 and they would like to have
GHc1,000,000.00 when they retire. What annual rate of
interest would they have to earn on their GHc250,000 in order
to reach their goal, assuming they save no more money?
 General Questions
• Qu 3. PV = GHc42,180.53 Additional = GHc5,000.00 r = 12% FV = GHc250,000
• How many years will it take Roberta to reach her goal
• FV = PV (1+R)t

• PV + additional = GHc42,180.53 + GHc5,000 = GHc47,180.53

• FV = PV (1+R)t = GHc47,180.53 (1.12)t

• (1.12)t = 250,000 = t In (1.12) = In (5.2988) t = In (5.2988) t = 14.71 years

• 47,180.53 In (1.12)

• Qu. 4
• PV = 250,000 FV = 1,000,000 t = 18 years
• The annual rate of interest would be
• r = (FV/PV)1/t – 1 = (1,000,000/250,000) 1/18 - 1
• = (4 ) 1/18 – 1
• = 1.0800 – 1 = 0.800*100%
• r = 8%
• They should be having 8% p. a. on the GHc250,000
 QUESTIONS

• Qu. 1 Jonah Mends is the son of a shoe maker Mr. Ebo Mends and through
hard work he managed to successfully complete his MBA programme at
Wisconsin International University College (WIUC). Just after his
programme he was laid off from his work as a credit analyst. He therefore
had no choice than to go into a business he has grown to appreciate and has
being the source of his family livelihood, shoe making. He planned to
establish a Shoe factory in the next 5 years. The expected amount for this
project is GHc25,000,000.00. He presently has GHc10, 000,000.00 in his
savings account to invest. What annual rate of interest must he earn on his
investment to cover the cost of establishing this factory?

• Qu. 2 Assuming you have the capacity to deposit into your bank account
which pays 20% interest an amount of GHc75,000.00 at the end of the next
three years. Currently you have an amount of GHc250,000.00 in the account.
How much will you have in (a) three years?
 Solution
Qu 1

FV = PV (1 + r)t

Solving for r, we get:

r = (FV / PV)1 / t – 1
r = (GHc25,000,000.00 / GHc10,000,000.00)1/5 – 1
r = 1.201124434 - 1
r = 0.201124434
r = 20.11 %
 Solution

Year (o) t = 3 r = 20% PV = GHc250,000

FV = 250,000 (1.20)3 = GHc 432,000.00

Year (1) t = 2 r = 20% PV = GHc75,000

FV = 75,000 (1.20)2 = GHc 108,000.00

Year (2) t = 1 r = 20% PV = GHc75,000

FV = 75,000 (1.20)1 = GHc90,000.00

Year (3) t=0 r=20% PV = GHc75,000

FV = 75,000 (1.20)0 = GHc 75,000.00

= GHc705,000.00
 Questions

• Qu 3. Qu 2. You have just been offered a new job with Big Dreams
Ventures and the company has set aside an amount of GH250,000.00
towards your pension. Assuming you were to earn 15% rate of return and
you also made no additional contributions. What will your account be
worth when you retire in 30 years?

• Qu. 2 You have successfully completed your MBA programme and what to
establish a Shoe factory in the next 5 years. The expected amount for this
project is GHc12, 000,000.00 you presently have GHc5, 000,000.00 to
invest. What annual rate of interest must you earn on your investment to
cover the cost of establishing this factory?
 Questions
• Qu. 3

• To find the FV of a lump sum, we use:

• FV = PV(1 + r)t
• FV = GHc250,000 (1.15)30 =GHc16,552,942.99

• Qu 4.

• FV = PV (1 + r)t
• Solving for r, we get:
• r = (FV / PV)1 / t – 1
• r = (GHc12,000,000.00 / GHc5,000,000.000)1/05 – 1
• r = 1.191357898 - 1
• r = 0.191357898
• r = 19.14 %
 Questions

• Qu. 2 Mrs. Mavis Osei is the CEO of Ocean Ventures. She is currently 30
years old; and wants to begin saving for retirement, with the first payment
to come one year from now. She can save GHc10,000.00 per year; and you
advise her to invest it in the stock market, which you expect to provide an
average return of 12% in the future.

• a. If she follows your advice, how much money will he have at 65?
2 marks
• b. How much will she have at 70? 2 marks

• c. She expects to live for 30 years if she retires at 65 and for 25 years if she
retires at 70. 2 marks

• If her investments continue to earn the same rate, how much will she be
able to withdraw at the end of each year after retirement at each retirement
age?
 Solution
a. If he follows your advice, how much money will she have at 65?
t = 65-30 = 35 years
FV = PV (1+r)t = FV = 10,000 (1.12)35 FV = GHc527,996.20

b. How much will she have at 70?

T= 70-30 = 40 years
FV = PV (1+r)t = FV = 10,000 (1.12)40 FV = GHc930,509.70

c. She expects to live for 30 years if he retires at 65 and for 25 years if he

retires at 70.

PV = FV 527,996.20 527,996.20 PV = 17,623.42

(1+r)t (1.12)30 29.95992212

PV = FV 930,509.70 930,509.70 PV = 54,735.66

(1+r)t (1.12)25 17.00006441
ANNUITIES AND PERPETUITIES
 Annuities and Perpetuities
• Annuity - A series of equal payments or receipts occurring over a specified
number of periods. In an ordinary annuity, payments or receipts occur at
the end of each period; in an annuity due, payments or receipts occur at the
beginning of each period.

• Ordinary Annuity - An annuity is a series of equal payments or receipts

occurring over a specified number of periods. In an ordinary annuity,
payments or receipts occur at the end of each period.

• Annuity Due - In contrast to an ordinary annuity, where payments or

receipts occur at the end of each period, an annuity due calls for a series of
equal payments occurring at the beginning of each period.

• Perpetuity - An ordinary annuity whose payments or receipts continue

forever.
 Annuities and Perpetuities

Perpetuity: PV = C / r

Annuities:
 1 
1 −
 (1 + r ) t 
PV = C  
 r 
 

 (1 + r ) t − 1
FV = C  
 r 
 Annuities - Questions

Qu1. After carefully going over your budget, you have determined that you
can afford to pay GHc750 per month towards a new salon car. Your bank
will lend to you at 2.5% per month for 48 months. How much can you
borrow?

Qu2. Suppose you won a national quiz competition GHc10,000,000.00 The

money is paid in equal annual installments of GHc333,333.33 over 30
years. If the appropriate discount rate is 7%, how much is the award
actually worth today?
 Annuities - Solution
 1 
1 − 
(1 + r ) t
PV = C  =
 r 

 

 1 
1 − (1.025) 48 
PV = 750  
 .025 
 
PV = 20,829

PV = 333,333.33[1 – 1/1.0530] / .05 = 5,123,999.95

 Finding the Payment
Qu1.

Suppose you want to borrow GHc20,000 for a new car. You can
borrow at 8% per year, compounded monthly (8%/12 =
0.66667% per month). If you take a 4 year loan, what is your
monthly payment?
 Finding the Payment

 1 
1 − (1 + r ) t 
PV = C  =
 r 
 

 1 
1 − (1.08) 48 
20,000 = C   = 20,000 = C (56.3397) = C = 488.26
 0.08 

 

 Finding the Number of Payments

• Qu2.You ran a small supermarket in your community. You borrowed from

the Community Bank an amount of GHc1,000.00 for the expansion of the
supermarket.

• You can only afford to make the minimum payment of Ghc20.00 per
month. The interest rate on the credit card is 1.5% per month. How long
will you need to pay off the GH1,000.00?
 Finding the Number of Payments
 1 
1 − (1 + r ) t 
PV = C   =
 r 

 


 1 
 1 − 
(1.015) t
1,000 = 20   = t = In1 / 0.25 / In1.015 = 93.111months = 7.76 years
 0.015 
 
Divide both size by 20

1000 =  1   1 
1 − (1.015) t  1 − (1.015) t 
20
  50 =  
 0.015   0.015 
   
 Annuity: Finding the Rate
• Trial and Error Process

– Choose an interest rate and compute the PV of the payments based on

this rate

– Compare the computed PV with the actual loan amount

– If the computed PV > loan amount, then the interest rate is too low

– If the computed PV < loan amount, then the interest rate is too high

– Adjust the rate and repeat the process until the computed PV and the
loan amount are equal
 Perpetuity
• The Ghana Commercial Bank wants to sell preferred stock at Ghc100 per
share. A very similar issue of preferred stock already outstanding has a
price of GHc40 per share and offers a dividend of Ghc1 every quarter.
What dividend would the Ghana Commercial Bank have to offer if its
preferred stock is going to sell?

• Perpetuity formula: PV = C / r

– First, find the required return for the comparable issue:

• 40 = 1 / r
• r = .025 or 2.5% per quarter

– Then, using the required return found above, find the dividend for new
preferred issue:
• 100 = C / .025
• C = 2.50 per quarter
 EFFECTIVE ANNUAL RATES AND COMPOUNDING

• Effective Annual Rate is the interest rate expressed as if it were

compounded once per year.

• The annual rate of interest actually being earned, as opposed to the quoted
rate. Also called the “equivalent annual rate.”

• The effective annual rate, abbreviated EFF%, is also called the equivalent
annual rate (EAR).

• This is the rate that would produce the same future value under annual
compounding as would more frequent compounding at a given nominal
rate.

• If a loan or an investment uses annual compounding, its nominal rate is also

its effective rate. However, if compounding occurs more than once a year,
the EFF% is higher than nominal rate.
 EFFECTIVE ANNUAL RATES AND COMPOUNDING

a. Suppose you are thinking of opening a savings account with a bank and
the following rates are offered by the following banks.

• Bank A: 15% compounded daily

• Bank B: 15.5% compounded quarterly

• Bank C: 16 % compounded annually

b. Which of the above rates will be preferred if the deal is for a loan facility.
 Calculating and comparing effective annual rates
• To begin with, Bank C is offering 16% per year and there is no
compounding during the year, this is the effective rate.

• Bank B is actually paying .155/4 = .03875 or 3.875% per quarter. At this

rate, an investment of Ghc10,000 for four quarters would grow to;
10,000*1.038754 = GHc11,642

• The EAR, therefore, is 16.42%. For a saver, this is much better than the
16% rate Bank C is offering: for a borrower, it’s worse.

• Bank A is compounding everyday. This means a daily interest calculation

• .15/365 = .000411 This is .0411% per day. At this rate, an investment of
GHc10,000 for 365 periods would grow to: 10,000*1.000411365
=GHc11,618. The EAR is 16.18%.

• This is not as good as Bank B 16.42% for a saver, and not as good as Bank
C’s16% for a borrower.
 Calculating and comparing effective annual rates
• The EAR can be computed in three steps;

• First divide the quoted rate by the number of times that the interest rate is
compounded.

• Then add 1 to the result and raise it to the power of the number of times the
interest is compounded.

• Finally, subtract 1

• If we let m be the number of times the interest is compounded during the

year, these steps can be summarised simply as:

• EAR = [1+ (Quoted rate/m)]m - 1

 Effective Annual Rates

m
 APR 
EAR = 1 +  −1
 m 

Qu. A bank is offering 12% compounded quarterly. If you

put GHc100,000 in an account, how much will you have at
the end of one year? What is the EAR? How much will you
have at the end of two years?
 Quoting a rate

Qu. Suppose a lender wants to actually earn 18% on a particular

loan. A monthly compounding rate is quoted. What is this
monthly rate quoted?

Soln. In this case the 18% is the EAR and is the result of a
monthly compounding rate. Let r be the quoted rate.
 Quoting a rate

• EAR = [1+(Quoted rate/m)]m – 1

• .18 = [1+(r/12)]12 – 1
• 1 + .18 = [1+(r/12)]12
• 1.18 = [1+(r/12)]12
• 1.181/12 = 1+ (r/12)
• 1.18.08333 = 1 + (r/12)
• 1.0139 = 1 + (r/12)
• r = .0139*12
• r = 16.68%

• Thus the quoted rate is 16.68%, compounded monthly.

 Annual Percentage Rate (APR)
• Annual Percentage Rate (APR) is stated annual rate charged on the credit
account or loan.it is calculated the periodic rate (the interest rate per period)
multiplied by the number of periods in one year.

• For example, a bank credit card that charges1.5% per month would have an
APR of 18% (1.5% per month x 12 per year.)

• For example, an APR of 12% on a loan calling for monthly payment is

really 1% per month, the EAR on such loan is:

EAR = [1 + (APR/12)12 – 1

= 1.0112 – 1 = 12.6825%
 What rate are you paying?
• Given that a credit card issuer is quoting an interest rate of 18% APR and
monthly payments are required. What is the actual interest rate you pay on
the credit card?

• An APR of 18% with monthly payments is really .18/12 = .015 or 1.5% per
month.

• The EAR is thus:

• EAR = [1+(Quoted rate/m)]m – 1
• EAR = [1 + (.18/12)]12 – 1
• = 1.01512 – 1
• = 1.1956 – 1
• = 19.56%

• This is the rate you actually pay

 Loan Amortization
• Loan amortization refers to a borrower making equal
periodic payments over time to fully repay a loan.

• To amortize a loan (i.e. to calculate the periodic payment that

pays off the loan), you must know:

(a) the total amount of loan (the amount borrowed),

(b) the term of the loan,
(c) the frequency of payment, and
(d) the interest rate.
 Loan Amortization
• (i) Pure Discount Loans

• The pure discount loan is the simplest form of loan. With such a loan, the
borrower receives money today and repays a simple lump sum at some time
in the future.

• A one-year, 10% pure discount loan, for example, would require the
borrower to repay GHc1.10 in one year for every cedi borrowed today.
Pure discount loans are common when the loan term is short.

• Suppose a borrower was able to repay GHc250,000 in five years. If the

lender wants a 12% interest rate on the loan, how much would we be
willing to lend?
• Present value (PV) = FV/ (1 + r)t
• = 250,000 /1.125
• = 250,000/1.7623
• = 141,186
 Loan Amortization
• (ii) Interest – only Loans

• A second type of loan repayment plan calls for the borrower to pay interest each
period and to repay the entire principal (the original loan amount) at some point in
the future. Loans with such a repayment plan are called interest – only loans

• (iii) Amortized loans

• Loan amortization refers to a borrower making equal periodic payments over time
to fully repay a loan. To amortize a loan (i.e., to calculate the periodic payment that
pays off the loan) you must know the total amount (the amount borrowed), the term
of the loan, the frequency of payment, and the interest rate.

• With an amortized loan, the lender will require the borrower to repay parts of the
loan amount over time. The process of providing for a loan to be paid off by
making regular principal reduction is called amortizing the loan.

• A simple way of amortising a loan is to have the borrower pay the interest each
period plus some fixed principal amount.
 Loan Amortization
• Suppose a business applies for a loan of GHc50,000, five-year loan at 9%.
The loan agreement calls for the borrower to pay the interest on the loan
balance each year and to reduce the loan balance each year by GHc10,000.
• Because the loan amount declines by GHc10,000 each year, it is a fully
paid in five years.
• In this case, the loan balance goes down, resulting in a lower interest
charge each year, whereas the GHc10,000 principal reduction is constant.
• The interest in the first year will be:
• 50,000 * .09 = 4,500
• The total payment will be 10,000 + 4,500 = GHc14,500
• In the second year, the loan balance is GHc40,000, so the interest is
• 40,000*.09 = 3,600
• The total payment will thus be 10,000 + 3,600 = GHc13,600
 Loan Amortization
• Loan Amortization

YEAR Beginning Total Interest Principal Ending

Balance Payment Paid Paid Balance

1 50,000.00 14,500.00 4,500.00 10,000.00 40,000.00

2 40,000.00 13,600.00 3,600.00 10,000.00 30,000.00

3 30,000.00 12,700.00 2,700.00 10,000.00 20,000.00

4 20,000.00 11,800.00 1,800.00 10,000.00 10,000.00

5 10,000.00 10,900.00 900.00 10,000.00 0

TOTAL 63,350.00 13,500.00 50,000.00

 Loan Amortization
• For amortized loan, we first need to determine the payment
• 50,000 = C * {[1-(1/1.095)] / .09}
• = C * [(1 - .6499) / .09]
• = C = 50,000 / 3.8897
• = GHc12,854.60

• The borrower will therefore make five equal payments of GHc12,854.60.

• In the first year, the interest is GHc4,500 because the total payment is
GHc12,854.60, the principal paid in the first year will be:

• Principal paid = 12,854.60 – 4,500 = 8,354.60

• The ending loan balance is thus:
• Ending balance = 50,000 – 8,354.60 = 41,645.40
• The interest in the second year is 41,645.40 *.09 = 3,748.10 and the loan
declines by
• 12,854.60 – 3,748.10 = 9,106.50
 Loan Amortization
• Loan Amortization

YEAR Beginning Total Interest Principal Ending

Balance Payment Paid Paid Balance

1 50,000.00 12,854.60 4,500.00 8,384.60 41,645.40

2 41,645.40 12,854.60 3748.10 9,106.50 32,538.80

3 32,538.80 12,854.60 2,928.50 9,926.10 22,612.70

4 22,612.70 12,854.60 2,035.10 10,819.50 11,793.20

5 11,793.20 12,854.60 1,061.40 11,793.20 0

Total 64,273.00 14,273.10 50,000.00

 QUESTIONS
• Qu. 1. Odotobri Rural Bank is charging 12.2 % compounded monthly on
its business loans. Nyarkrom Rural Bank is also charging 12.4%
compounded semi-annually. As a potential borrower, which bank would
you go to for a new loan?

• Qu. 2 Good Shepherds Financial Services wants to earn an effective

annual return on its consumer loans of 17% per year. The non-bank
institution uses daily compounding on its loans. What interest rate is the
non-bank institution required to report to potential borrowers? Explain why
this rate is misleading to an uninformed borrower.

• Qu. 3 Precise Financial Services charges an interest rate of 6% per month

on loans to its customers. By law Precise Financial Service is require to
report an APR to consumers. What rate should Precise Financial Services
report? What is the effective annual rate?
 Questions

• Soln1.

• Qu. 1 For discrete compounding, to find the EAR, we use the equation:

• EAR = [1 + (APR / m)]m – 1

• So, for each bank, the EAR is:

• Odotobri Rural Bank : EAR = [1 + (.122 / 12)]12 – 1 = 12.91%

• Nyarkrom Rural Bank : EAR = [1 + (.124 / 2)]2 – 1 = 12.78%

• Notice that the higher APR does not necessarily mean the higher EAR. The
number of compounding periods within a year will also affect the EAR.
 Questions

• Soln 2. The reported rate is the APR, so we need to convert the EAR to an
APR as follows:

• EAR = [1 + (APR / m)]m – 1

• APR = m[(1 + EAR)1/m – 1]

• APR = 365[(1.17)1/365 – 1] = 15.70%

• This is deceptive because the borrower is actually paying annualized

interest of 17% per year, not the 15.70% reported on the loan contract.
 Questions
• Soln 3. The APR is simply the interest rate per period times the number of
periods in a year. In this case, the interest rate is 6% percent per month, and
there are 12 months in a year, so we get:

• APR = 12(6%) = 72%

• To find the EAR, we use the EAR formula:

• EAR = [1 + (APR / m)]m – 1

• EAR = (1 + .06)12 – 1 = 101.22%

• Notice that we didn’t need to divide the APR by the number of

compounding periods per year. We do this division to get the interest rate
per period, but in this problem we are already given the interest rate per
period.
 Questions
• In order to put up a stadium for the upcoming African Athletics
Championship, the Ministry of Youth and Sports has contracted a loan of
GH¢3,500,000 from Ghana Commercial Bank.

• This loan would be paid back in equal annual instalments which begin one
year from the date the loan is granted and continue to be payable yearly for
a total of 5 years. Interest on the loan is 27%.

• a. What is the amount of the loan repayment?

• b. Construct an amortization schedule for this payment.

 Questions
• The Ghana Basket Ball Association has secured a new plot of land and has
proposed the construction of a new basket ball pitch.

• The Ministry of Youth and Sport has successfully negotiated a five year
loan with the Republic of China to finance the project. The project is
expected to cost GHc15,000,000.00.

• This loan would be paid back in equal annual instalments which begin one
year from the date the loan is granted and continue to be payable yearly for
a total of 5 years. Interest on the loan is 10%.

• i. What is the amount of the loan repayment?

• ii. Construct an amortization schedule for this payment.

 Solutions
• i. What is the amount of the loan repayment?

• FV = PV(1 + r)t
• FV = 15,000,000.00 (1.10)1
• FV = GHc16,500,000.00

• ii. Construct an amortization schedule for this payment.

• 16,500,000 = C * {[1-(1/1.105)] / .10}

•
• = C * [(1 – 0.6209) / .10]

• = C = 16,500,000 / 3.7910

• C = GHc4,352,413.61
 Solutions
• Construct an amortization schedule for this payment.

Beginning Total Payment Interest Paid Principal Paid Ending

Balance Balance
Year

1 16,500,000.00 4,352,413.61 1,650,000.00 2,702,413.61 13,797,586.39

2 13,797,586.39 4,352,413.61 1,379,758.64 2,972,654.97 10,824,931.42

3 10,824,931.42 4,352,413.61 1,082,493.14 3,269,920.47 7,555,010.95

4 7,555,010.95 4,352,413.61 755,501.10 3,596,912.51 3,958,098.44

5 3,958,098.44 4,352,413.61 395,809.84 3,956,603.77 1,494.67

Total 21,762,068.81 5,263,562.72 16,498,505.33

 GENERAL QUESTIONS

• Qu 1

• (a) Five banks offer nominal rates of 6% on deposits; but A pays interest
annually, B pays semiannually, C pays quarterly, D pays monthly, and E
pays daily. What effective annual rate does each bank pay? If you deposit
GHc5,000.00 in each bank today, how much will you have at the end of (i)
1 year? (ii) 2 years?

• (b) Bank A pays 8 percent interest, compounded quarterly, on its money

market account. The managers of Bank B want its money market account
to equal Bank A’s effective annual rate, but interest is to be compounded on
a monthly basis. What nominal, or quoted, rate must Bank B set?
 GENERAL QUESTIONS
• Qu 2. Mrs. Melody Ofori wants to invest today in order to be assured that
there are adequate funds for her son’s college education. She estimates that
her son will need GHc20,000.00 at the end of 18 years; GHc25,000.00 at
the end of 19 years; GHc30,000.00 at the end of 20 years; and
GHc40,000.00 at the end of 21 years.

• How much will Madam Melody have to invest in a fund today if the fund
earns the following interest rate?

• 6% per year with annual compounding

• 6% per year with quarterly compounding
• 6% per year with monthly compounding
 GENERAL QUESTIONS

• Qu. 3 Zara Brown is newly married and is already preparing for a surprise
trip to Dubai with her husband on their tenth wedding anniversary. Zara
plans to invest GHc5,000.00 per year until the anniversary (end of year 10)
and plans to make her first GHc5,000.00 investment on their first
anniversary.

• If she earns an 8% rate on her investment, how much will she have saved
for their trip if the interest is compounded in each of the following ways?

• Monthly
• Quarterly
• Annually
 GENERAL QUESTIONS

• Qu. 4 Joe Smart borrowed GHc150,000.00 at a 14% annual

interest rate to be repaid over three years. The loan is
amortized into three equal annual end-of year payments.

• Calculate the annual end of year loan payment

• Prepare a loan amortization schedule showing the interest and

principal breakdown of each of the three loan payments.

• Explain why the interest portion of each payment declines with

the passage of time.