LECTURE-2

TIMEVALUE OF MONEY

This 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 is the core principle of finance which holds that, provided money can earn interest, any
amount of money is worth more the sooner it is received.

Terminologies

1. Interest- Money that is loaned earns money for the lender and such money is called
interest.
2. Principal- The amount of money which is owed and upon which the interest is earned
is called principal.
3. Term- is the interval extending from beginning of the first compounding period to the
end of the last compounding period.
4. Compound interest- is interest charged on interest.
5. An annuity- is a series of periodic payments or receipts.

Assumptions Time Value of Money

There are several important assumptions underlying the TVOM equations and it would not be
prudent to perform calculations without being fully aware of their influence:

 Money is always invested and always productive so that returns can be reinvested at a
rate equal to r.
 Time periods are all of equal length.
 The interest rate is constant throughout the term.
 Annuities are simple, certain, discrete and ordinary.

Present value of a single sum

The equation below calculates the current (present) value of a single sum to be paid at a
specified date in the future. This value is referred to as the present value (PV) of a single
sum.

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From indices theory 1/xn can be written as x-n, then a more compact form of the equation can
be written as:

The PV of a single sum formula is used as a valuation mechanism. It tells us how much an
amount to be transacted in the future is worth today (or some date prior to the receipt or
payment date).

Illustration-1

A certain business has made a number of different investments and expects to receive ksh.
50,000 after 3 years.

Required:

Calculate the present value of the expected receipt if the interest is 10%

Solution

FV
PV 
1  r n
The future value is ksh. 50,000

r= 10% or 0.1

n = 3 years

50,000
PV = = ksh.37,565.74
1  0.13
In essence it means that the receipt of ksh.50,000 in three years is worth the same as the
receipt of ksh.37,565.74 today. The logic behind this assertion is that if we deposited ksh.
37,565.74 into an investment account paying 10% annually, it would grow to ksh.50,000 in
three years. In this case we should be indifferent as to our preference for one option over the
other because ksh.37,565.74 today or ksh.50,000 in three years is financially equivalent.

The (1+r)n is called the present value interest factor (PVIF) and is provided in the financial
tables as follows:

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Present value of a multiple sums

The equation below calculates the current (present) value of a series of sums to be paid at a
specified dates in the future. The PV is referred to as the present value (PV) of a multiple
sums.

FV1 FV2 FVn

PV    .....
1  r 1
1  r 2
1  r n
Illustration-2

A company has made several investments in the recent past and has been given the following
alternatives for receiving cash inflows against these investments;

 Receive ksh. 25,000 at the end of each of the years 1, 2 and 3

 Receive ksh. 75,000 at the end of year 3
 Receive ksh. 50,000 at the end of year 2 and ksh.25,000 at the end of year 3

Advise the company on the best alternative to take assuming the interest rate is 10%

Solution;

Option 1:

Year CF PVIF PV
1 25,000 0.909 22,725
2 25,000 0.826 20,650
3 25,000 0.751 18,775
Total 62,150

Option 2:

Year CF PVIF PV
1 75,000 0.751 56,325
Total 56,325

Option 3:

Year CF PVIF PV
1
2 50,000 0.826 41,300
3 25,000 0.751 18,775
Total 60,075

Option 1 is the best because it has a higher PV

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Future Value (FV) of a single sum

Rearranging the PV equation to solve for the FV of a single sum;

FV
PV 
1  r n
Therefore;

FV= PV (1+r)n this is the basic compound interest formulae

Illustration-3

A company has invested ksh.100,000 for 5 years at an interest rate of 15%

Required:

Determine the future value of the investment

Solution;

FV= 100,000(1+0.15)5 = ksh.201,136

Where compounding is done several times in a year:

mn
 r
FV  PV 1  
 m
Where:

n- The number of years (the term)

m- The number of compounding periods in a year (e.g. for quarterly, m = 4; monthly, m = 12

etc.)

r- The interest rate p.a

mn- the number of compounding periods in the term

Illustration-4

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A company is expecting to earn an interest of 12% p.a on ksh 500,000 it plans to invest at the
beginning of the year 2011. Determine the total worth of the investment if interest is
compounded and the investment is held for 6 years:

a) Annually- FV= PV (1+r)n

b) Semi-annually
c) Quarterly
d) monthly

Present value of an annuity

The formula below calculates the current value of a stream of equal payments made at regular
intervals over a specified period of time. This value is referred to as the present value (PV) of
an annuity.

PV 

A 1  1  r 
n

r

Where:

PV-Present value

n- Term

A-Periodic payments or receipts (the annuity amount)

r-Interest rate

The PV of an annuity formula is used to calculate how much a stream of payments is worth
currently where "currently" does not necessarily mean right now but at some time prior to a
specified future date.

In practice the PV calculation is used as a valuation mechanism. It evaluates a series of

payments over a period of time and reduces or consolidates them into a single representative
value as of a certain date. The PV calculation is useful in a variety of situations including:

 Valuing a series of retirement payments;

 Calculating the lump sum value of lottery winnings;
 Establishing the purchase price of property sold for installment payments;
 Determining the value of periodic payments under an insurance contract or a
structured settlement;
 Pricing a coupon bearing bond (this is actually a composite calculation involving the
present value of the periodic interest payments (an annuity) and the return of principal
at maturity (a single sum).

The simplified formula is as follows:

PVA=A (PVIF)

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Where:

PVIF =
1  1  r  n

r

Illustration-5

A company has made some considerable investments in the recent past and has projected that
it will receive ksh 200,000 every year for 5 years. If the company has an interest rate of 8%,
calculate the present value of all these future cash inflows

Method 1

Year CF PVIF CF
1 200,000 0.926 185,200
2 200,000 0.857 171,400
3 200,000 0.794 158,800
4 200,000 0.735 147,000
5 200,000 0.681 136,200
PV 798,600

Method 2

PV 

A 1  1  r 
n

r

PVA=A (PVIF)

PVA=200,000 (3.993)

= Ksh. 798,600

2. Future Value of an Annuity

The future value of an annuity is the total future value of regular payments or receipts

A1  r   1
n
FV=
r

Or simply

FVA= A(FVIF)

Illustration-6

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What is the accumulated value of a ksh.25,000 payment to be made at the end of each of the
next three years if the prevailing rate of interest is 9% compounded annually? Or, put another
way, "How much will one have at the end of three years if one saves ksh.25,000 a year at
9%?"

Method 1

Year CF FVIF FV
1 25000 1 25000
2 25000 1.09 27250
3 25000 1.188 29700
PV 81950

Method 2

FV= 25000 (3.278)

FV= ksh. 81,950

Practice Questions:

Question-1

Dynamo Cosmetics ltd is evaluating a new fragrance- mixing machine. The machine requires an
initial investment of ksh 24,000,000 and will generate cash inflows of ksh 5,000,000 per year for 8
years.

Required:
For each of the discount rates 12%, 14% and 18%;
a) Calculate the present worth of the cash inflows from the machine
b) Indicate whether to accept or reject the machine under each interest rate
c) Explain your decision

Question-2
An individual is planning for his retirement which is due in the next 15 years. He wants to retire with
an annuity of ksh 3,000,000 pa for 20 years. He has two options of dealing with the situation:
 Plan-A; save a uniform amount yearly upto the 15th year
 Plan-B; deposit one large lump sum amount that would fit into the annuity requirements after
retirement
 Plan-C; Save a uniform amount monthly for 15 years
The interest rate that is applicable in his case is 12%

Required:

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 a) Determine the amount that the individual should save annually under plan A
b) Determine the lump sum amount that the individual should deposit under plan-B
c) Determine the amount that the individual should save monthly under plan C
Question-3
Use the information contained in the table below to answer the questions that follow

A B C
Year Cash flow Year Cash flow Year Cash flow
(ksh) (ksh) (ksh)
1 -2,000,000 1 10,000,000 1-5 1,000,000 per year
2 3,000,000 2-5 1,250,000 per year 6-10 1,600,000 per year
3 4,000,000 6 4,000,000 11 2,000,000
4 6,000,000 12 4,000,000
5 8,000,000
Total 19,000,000 19,000,000 19,000,000

The company uses 12% as cost of capital.

Required:
a) Calculate the present value of each of the cash flow A, B and C.

Which option would you recommend if you are an investor who has been presented with those three
options of investment cash flows? Explain your answer.

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