TIME VALUE OF MONEY AND

CASH FLOW DIAGRAMS

TCC 6103: CONSTRUCTION ECONOMICS
AND FINANCE

Dr. Muhumuza John Kakitahi

 WHAT IS MONEY? AND WHAT DOES IT SERVE?

➤ Money is any item/object/asset used in the

settlement of transactions and repayment of
debt (tax accrued for example).

➤ Money serves 4 functions (W.S. Jevons 1875)

1. a medium of exchange (for goods and

services),

2. a measure of value (or unit of account),

3. a standard of value (or standard of deferred

payment),

4. a store of value.

 THE CORE CONCEPT

The time value of money is a

financial concept that holds that
money in the present is worth more
than the same sum of money to be
received in the future.

Utilising money in the present is a

benefit that attracts value. For
someone else to utilise my money, it
is an opportunity cost and ideally
requires charging a fee - interest!
UNDERSTANDING INTEREST
➤ … payment from a borrower to a lender or from a deposit-receiving financial institution to a
depositor; an amount over and above the repayment of the principal sum at a particular rate for an
agreed period of time.
➤ … fee charged for the privilege of using someone else’s money; the amount of which
depends on the amount of money and, length of time over which it is borrowed. (Schaum’s
Outlines, Engineering Economics)
➤ The interest rate is a percentage charged for borrowing money for a specified period of time.
➤ Example: A contractor, GMET’21, takes out a loan of UgX 50M to be repaid in one lump sum
at the end of one year. What is the annual interest rate that corresponds to a lump-sum
payment of UgX 65M?
➤ Total amount of interest to be paid: UgX (65M - 50M) = UgX 15M.
➤ Annual interest rate is: UgX 15M x 100%. = 30%

UgX 50M

UNDERSTANDING INTEREST - CONTINUED

➤ There are two types of interest:
1. Simple Interest

Simple Interest, Is, = Principal, p, (amount borrowed/invested) x Annual Interest Rate, r, x

Duration of Loan/Investment, t.
➤ Example: A contractor, GMET’21, takes out a loan of UgX 50M to be repaid in one lump sum
at the end of two years. Suppose the contractor is charged a 10% simple interest rate per year,
how much will they pay at the end of the loan period?

Total simple interest, Is, = p (UgX 50M) x r (10%) x t (2 years) = UgX 10M.
Total amount to be repaid = UgX 50M + UgX 10M = UgX 60M

UNDERSTANDING INTEREST - CONTINUED

➤ There are two types of interest:
2. Compound Interest
This is the interest calculated on the amount that includes the principal plus accumulated
interest of any previous periods. This differs from simple interest which does not include
“interest on interest”.

Total accumulated amount, F, = p (1 + r) t

➤ Example: A contractor, GMET’21, deposits a saving of UgX 100M that pays interest at the
rate of 5% per year, compounded annually. Suppose all the deposits are allowed to
accumulate, how much will be available after 10 years?

Total accumulated amount, F, = p (UgX 100M) x (1 + r (5%)) 10 = UgX 162.89M.

➤ Comparison with Simple Interest: = UgX 100M + (UgX 100M x 5% x 10yrs) = UgX 150M.

 COMPOUNDING, PRESENT AND FUTURE VALUE OF MONEY

If we invest UgX 10M in a bank offering interest rate, i, 10% and assume annual
compound interest is applied, the worth of our investment will be as shown below:

AFTER YEAR PRESENT WORTH

rate rate i e If interest is compounded annually, asset will be
1 10,000,000 (1+10%)1 11,000,000
worth
Fv = Pv (1+i) n
$x(1+i) after1years 2 10,000,000 (1+10%)2 12,100,000
2 $x(1+i)

after 2 years after 3 years .... after n years

3 10,000,000 (1+10%)3 13,310,000

Assuming as rational actors we invest for gain through interest earned;

money in the present has “equal worth” to a larger amount in the future and, inversely,
money in the future has “equal worth” to a lesser present value.

 PRESENT VALUE, INFLATION AND TAXES

➤ So Money, as a storage of value, can earn interest. Value

increases with time, … with compound interest!

➤ Money invested today for a return, creates a larger

amount in the future. Value increases from the present
to the future and, decreases from the future to the
present.

➤ Two factors affect benefits derived from value gained

from investments: Inflation and Taxes.
1. Inflation (annual increase in cost of goods and services)
erodes value (purchasing power) as costs increase.
2. Taxes, out of an existing national regulatory framework,
will be applied to interest earned from investments.

PRESENT VALUE, INFLATION AND TAXES - CONTINUED

➤ INFLATION:
The future worth of a commodity, F, after a period of n years, will be affected by the
annual inflation rate of λ. This is represented below; P is the present worth of the
commodity.

So, F, = P (1 + λ) n

➤ Example: A 50-Kg bag of cement presently costs UgX 30,000. In an economy experiencing
annual inflation at 5%, what will the price of the same bag of cement be in five years?

The future price of cement, F, = P (UgX 30,000)(1 + λ (5%)) = UgX 38,289.

5

➤ Question: What will UgX 20M be worth ten years from now, in terms of today’s Ugandan Shilling;
if the Ugandan economy is experiencing an annual inflation rate of 10%? (UgX 12.28M in today’s
UgX!?)

PRESENT VALUE, INFLATION AND TAXES - CONTINUED

➤ INFLATION:

i, is being compounded at the same time that inflation, λ is occurring, then

If interest,

the Future Worth, F can be computed as:

F= P {(1+i)/(1 + λ)} n

➤ Example: The contractor, GMET’21, has decided to invest UgX 120M in a 10-year
Government Treasury Bill that pays 14% per year, compounded annually. What will the final
value of this investment be in terms of today’s shillings, if annual inflation rate continues at
5%?

The final value of investment, F, = (UgX 120M){(1+14%)/(1 +(5%)} 10

= UgX 273.11M

 PRESENT VALUE, INFLATION AND TAXES - CONTINUED

➤ TAXES:
Usually, governments tax interest earned on investments. If effects of taxation, t, and inflation, λ, are
included in compound interest calculations, the composite interest rate, θ, is:

θ= (i - λ)(1 - t)
(1 + λ)
Example: The contractor, GMET’21, who decided to invest UgX 120M in a 10-year Government
Treasury Bill paying 14% per year, compounded annually, would be subjected to 20% annual tax on
earnings. What will the final value of this investment be in terms of today’s shillings, if annual
inflation rate continues at 5%?

The composite interest rate, θ, = (14% - 5%)(1 - 20%) = 0.0686

(1 + 5%)

Final Value of Investment, F, = UgX 120M (1 - 0.0686)10 = UgX 58.96M (less real purchasing power!)

Cash flow: the NET between total inflows (receipts) and total outflows
(disbursements).
Annual determinations, used in project evaluations and investment alternatives.

CASH FLOW ACTIVITY ACCOUNTS ANALYSED
OPERATING ACTIVITIES Operating assets and
liabilities which include the
most current asset and liability
accounts.
INVESTING ACTIVITIES Long - Term assets
FINANCING ACTIVITIES Long - Term liabilities and
stockholders’ equity
WHAT THE ACTIVITY PRESENTS
The net cash flows generated, or used, by the business in their core
operations. We will use the indirect method of presenting operating
activities. This method reconciles net income to net cash flow from
operating activities.
The cash inflows and outflows from sales and purchases of long-term
assets, such as equipment, patents, and long-term investments.
The cash inflows and outflows from issuance of debt; repayment of
debt; issuance of stocks; dividends paid; and stock repurchases.
LET’S SOLVE SOME PROBLEMS …

➤ A mechanical engineering plant will cost UgX 150M when purchased and
annual maintenance of the plant amounts to UgX 10M. The plant generates
revenues of UgX 20M per year for 5 years and the salvage value is expected
to be UgX 30M. Illustrate this scenario using a cash flow diagram.

➤ Read and solve the problems from Pages 6 - 11 of Schaum’s Outlines

Engineering Economics; by Sepulveda, J.A., Souder, W.E., Gottfried, B.S.