LESSON THREE

Mathematics of Finance

Review of the Concept of the Time Value of Money (TVM)

The concept of the time value of money attempts to explain why people or investors
prefer current cash to future cash. This is attributable to the following factors.

1. Availability of viable investment opportunities i.e., the money received can be re-
invested to generate additional cash inform of investment income.
2. Uncertainty- cash is preferred now due to uncertainty of its availability and the
availability of the individual to enjoy the cash.
3. Decline in the purchasing power of money- the value of money will change due
to inflationary tendencies in the future.
4. Urgency of current needs – cash is required to meet immediate needs of the firm
or individuals i.e., the cash to buy raw materials for production, the cash to pay
for food and shelter.
5. Need to take advantage of cash discounts – a cash term of 3/10 net 30 days means
if an individual pays with in 10days he receives a 3% discount otherwise he has
up to 30 days to pay without a discount.
1. Future Value / Terminal Value of a Lump Sum Amount.
This refers to the total amount receivable in the future where a given amount of cash is
invested today (principal) for a given number of years at a given interest rate.

Future value = P (1+r) n

The factor (1+r) n is called the future value interest factor usually denoted as FVIFr%n.

Where P= principal or present value

r = interest rate

n = Number of periods of investments

F.V = future value / terminal value/ compound value of

Example One
Mr. Karanja has deposited sh. 1,000,000 in his fixed deposit account at Barclays bank for
a period of 5 years. The bank credits interest on fixed deposit accounts at the rate of 6%
per annum.

Required

Calculate how much Mr. Karanja will receive at the end of the five years.

Example Two

Ms. Muthoni has deposited sh.500,000 in her family bank fixed deposit account for a
period of three years. The bank pays interest on fixed deposit accounts at the rate of
4.5% per annum.

Required

Calculate how much Ms. Muthoni will receive on the lapse of the deposit period.

2. Future value of an annuity.

A lump sum is invested only once while an annuity refers to equal receipts or payments
from one period to another.

Future value of an annuity = Annuity x (1+r) n -1

Where the function (1+r) n -1 is referred to as future value annuity factor denoted
as

PVAFr%n,

Therefore, future value of an annuity = A X PVAFr%n,

Example One

Mr. Otieno has secured a five-year employment contract with USAID, an international
NGO. According to terms of the contract, Mr. Otieno will earn a monthly salary of sh.
250,000 per month. The required rate of return is 10%
Required

Calculate how much total Mr. Otieno will have received from this contract at the end of
five years.

Example Two

Mr. Rashid has signed a four-year contract with Bandari Football club. The terms of the
contract provide for a monthly salary of sh. 80,000. The market interest rate is 12%.

Required

Calculate the total amount Mr. Rashid will have received from this contract at the end
of the contract.

3. Present value of a lump sum amount.

Present value refers to the principle that needs to be invested today for a given number
of periods at a given interest rate to yield a given future value. The process of
computing present value is called Discounting and the interest rate used in discounting
is called the cost of capital/required rate of return.

Present value of lamp sum= F.V × 1

(1+r) n

The factor 1÷ (1=r) n is Present value interest factor denoted as PV1Fr%n

P.V = future value × PV1Fr%n

Example one

Mr. Mutuku a civil servant is due for retirement in 10 years from now. On retirement he
expects to receive a lumpsum retire package of sh. 4,500,000. The market interest rate is
expected to be 14%.

Required

Calculate how much Mr. Mutuku will receive he decides to retire to today.
Example Two

Mis Ltd has a four-year project which will generate the following cash flows.

Year 1 2 3 4

Cash flow 1,200,000 1,800,000 1,450,000 1,300,000

The discounting rate or cost of capital is 14%.

Determine the present value of the cash flows.

Solution

4. Present value of Annuity

This is the equivalent to the lamp sum today of equal future payments or receipts.

P.V of Annuity = Annuity × 1- (1+r)-n

PV of Annuity = Annuity × PVAFr%n

Example One

Mr. Otieno has secured a five-year employment contract with USAID, an international
NGO. According to terms of the contract, Mr. Otieno will earn a monthly salary of sh.
250,000 per month. The required rate of return is 10%

Required

Calculate the present value of Mr. Otieno salary from the employment contract.

Example Two

Mr. Rashid has signed a four-year contract with Bandari Football club. The terms of the
contract provide for a monthly salary of sh. 80,000. The market interest rate is 12%.

Required
Calculate present value of Mr. Rashid Salary from the contract with Bandari Football
club.

5. Present value of Annuity in perpetuity

As the number of periods approach perpetuity n = 0 – therefore

Present value of Annuity- A × 1

Example one

Mr. Abdi has invested in the shares of Safaricom plc. The company pays a constant
dividend of sh. 4 per share. The required rate of return by the shareholders is 12.5%

Required

Calculate the present value of the dividend receivable from the company.

6. Present value of growing Annuity in perpetuity (∞)

This refers to equal receipts or payment which will grow or increase at a constant rate
p.a in ∞.

PV of growing annuity in ∞ =Expected Annuity where g = Constant growth rate p.a in

∞

r-g

Example

A company expects to pay a DPS of ksh.8 p.a and the required rate of return is 15%.
Determine the maximum price to pay per share if: -

a) The dividend per share DPS is expected to remain constant.

b) The DPS will grow at 7% p.a in ∞
The maximum price to pay for an asset is equals the total present value of all the
expected future cash flows from asset.

a) In case of zero growth in DPS

Maximum price to pay =PV of Annuity in ∞ = Annuity × PVAFr%∞

= sh 8 ×1/0.15 = 8 × 6 2/3 = Ksh.53.30

b) In case of constant growth rate = PV of a growing annuity in ∞

=Annuity = 8/0.15-0.07 =Ksh.100

r-g