TIME VALUE OF MONEY

The fundamental principle behind the concept of time value of money is that
money received today is worth more than the same money received after a
certain period of time. This is premised on the following reasons;
Risk and Uncertainty: Future is always uncertain and risky. Outflow of cash
is in our control as payments to parties are made by us. There is no certainty
for future cash inflows. Cash inflows is dependent out on our Creditor, Bank
etc. As an individual or firm is not certain about future cash receipts, it prefers
receiving cash now.
Inflation: In an inflationary economy, the money received today, has more
purchasing power than the money to be received in future. In other words, a
shilling today represents a greater real purchasing power than a shilling a year
hence.
Consumption: Individuals generally prefer current consumption to future
consumption.
Investment opportunities: An investor can profitably employ a shilling
received today, to give him a higher value to be received tomorrow or after a
certain period of time.

COMPOUNDING AND DISCOUNTING

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The whole concept of time value of money is about the present value and future
value of money.

Future value of money:

The worth of the money invested today in the future due to growth and interest
earned on it after a certain period. The technique used to determine this future
value is as known as compounding.

Compounding therefore refers to the process of earning interest on both the

principal amount, as well as accrued interest by reinvesting the entire amount
to generate more interest.

Compounding on the other hand is a method used in finding out the future
value of the present investment. The future value can be computed by applying
the compound interest formula which is as under:

Future value:

 
ℎ   =    1 + 
1 +   − 1
 =   

Where n = number of years
R = Rate of return on investment.

Illustration 1: If you deposit 55,650 in a bank which is paying a 12 per cent

rate of interest on a ten-year time deposit, how much would the deposit grow at
the end of ten years?

Solution:

 = ! 1 + " "  = ! # $%&%,%) *+,-. /

In this equation (1 + r)n is called the future value interest factor (FVIF).
where,
FVn= Future value of the initial flow n year hence
PV= Initial cash flow
R= Annual rate of Interest
n= number of yea

 = ! 1 + " "  = ! # $%&%,%) *+,-. /

 %) = 55,6501.12%) = 556503.106 =
ℎ
172,848.9

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Illustration 2:
Consider the annuity of shs 100 per year for five years at a discounting rate of
10%, Determine the future value of this annuity at the end of five years.
Solution
1 + 0.1; − 1
   =
ℎ
100 : < =
ℎ
610.51
0.1

Present Value is defined as the current value of the given future value, the
process of doing so is called discounting.

Discounting therefore is the process of converting the future amount into its
Present Value. The discounting technique helps to ascertain the present value
of future cash flows by applying a discount rate. The following formula is used
to know the present value of a future sum:

 %  &  G 
=>?@?AB CDEF? = + + + ⋯……….+
1 +  % 1 +   & 1 +   G 1 +  

Where 1,2,3,…..n represents future years

FV = Cash flows generated in different years,
R = Discount Rate

For calculating the present value of single cash flow and annuity the following
formula should be used:

Present value:
1

 
ℎ   =   
1 +  
1 +   − 1

 =   
1 +   

Where R = Discount Rate, n = number of years

You can also use discount factor to arrive at the present value of a future
amount by simply multiplying the factor with the future value. For
this purpose, you need to refer the present value table.

Illustration 3:

Find the present value of the following cash flow stream given the discounting
factor is 10%

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Year 1 2 3 4
Cash flows 100 200 200 300

Solution

100 200 200 300

=>?@?AB CDEF? = + + + = @K@LMM. NO
1 + 0.1% 1 + 0.1 & 1 + 0.1 G 1 + 0.1J

Illustration 4:

Consider the annuity of shs 100 per year for five years at a 10% discount rate.
Determine the present value of the annuity.

1 + 0.1; − 1
Present value of the a =
ℎ
100  =
ℎ
NO]. ^_
1 + 0.1; 0.1

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