Tanzania Institute Accountancy

Module Title: Business Mathematics and Statistics

Code: GSU 07101

BAC I & BPLM I

Time value of money-Annuities

Money has a time value. A shilling today is less valuable than a shilling a year before. Why?

There are several reasons:

i. Individuals, in general, prefer current consumption to future consumption.

ii. Capital can be employed productively to negate positive returns. An investment of one
shilling today would grow to (1+r) a year hence (r is the rate of return earned on the
investment).

iii. In an inflationary period, a shilling represents a greater real purchasing power than a
shilling a year hence.

Many financial problems involve cash flows occurring at different points in time. So for
evaluating such cash flows an explicit consideration of the time value of money is required.

Future Value of an Annuity

Understanding annuities is crucial for understanding loans, and investments that require or
yield periodic payments. For instance, how much of a mortgage can I afford if I can only pay
Tsh1,000 monthly? How much money will I have in my account if I deposit TSh 2,000 at the
beginning of each year for 30 years, and earn an annual interest rate of 5%, but is compounded
daily?

An annuity is a series of equal payments in equal periods. Usually, the time is 1 year, which is
why it is called an annuity, but the time can be shorter, or even longer. These equal payments
are called periodic rent. The amount of the annuity is the sum of all payments.

An annuity due is an annuity where the payments are made at the beginning of each time; for
an ordinary annuity, payments are made at the end of the time. Most annuities are ordinary
annuities.

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Analogous to the future value and present value of a shilling, which is the future value and
present value of a lump-sum payment, the future value of an annuity is the value of equally
spaced payments at some point in the future. The present value of an annuity is the present
value of equally spaced payments in the future.

The future value of an annuity is simply the sum of the future value of each payment. The
equation for the future value of an annuity due is the sum of the geometric sequence.

The Future Value Of An Ordinary Annuity (FVOA) is:

é (1 + r )n - 1ù
Formula FVOA = PV ê ú
ë r û

Where by

PV is the Value of each payment

R is the Rate of interest per period in decimals

N is the number of periods

FVOA is the Future Value Of An Ordinary Annuity

Example:
A person plans to deposit TShs 1,000 in a tax-exempt savings plan at the end of this year and an
equal sum at the end of each following year. If interest is expected to be earned at the rate of 6
per cent per year compounded annually, to what sum will the investment grow at the time of
the fourth deposit?

Solution:

é (1 + r )n - 1ù é (1 + 0.06 )4 - 1ù
FVOA = PV ê ú = 1,000 ê ú = 1,000(4.37462) = Tsh 4,374.62
ë r û ë 0.06 û

Example:
Suppose a corporation wants to establish a sinking fund beginning at the end of this year.
Annual deposits will be made at the end of this year and for the following 9 years. If deposits
earn interest at the rate of 8 per cent per year compounded annually, how much money must be
deposited each year to have TShs 12 million at the time of the 10 deposit? How much interest
will be earned?

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Solution:
n = 10
i = 0.08
FVOA = Tsh12,000,000
PV= ?

The money to be deposited each year (R) is calculated as follows:

FVOA 12,000,000 12,000,000

PV = = = = Tsh 828,354
é (1 + i ) - 1ù
n
é (1 + 0.08 ) - 1ù
10
14.48656
ê ú ê ú
ë i û ë 0.08 û

Interest Earned = FVOA – PV = 12,000,000 – 828,354 = Tsh 11,171,646

Example:
If at the end of each month, a saver deposited Tsh 100 into a savings account that paid 6%
compounded monthly, how much would he have at the end of 10 years?

Solution
PV = Tsh 100
r = 6% per year compounded monthly, which = .5% interest per month = .005
n = the number of compounding time periods = 120 in 10 years.
Substituting these values into the equation for the future value of an ordinary annuity:

é (1 + r )n - 1ù é (1 + 0.005)120 - 1ù
FVOA = PV ê ú = 100ê ú = Tsh 16,387.93
ë r û ë 0.005 û

Example:
A 20-year-old wants to retire as a millionaire by the time she turns 70. How much will she
have to save at the end of each month if she can earn 5% compounded annually, tax-free,
to have Tsh 1,000,000 by the time she is 70?

Solution:

Note that the equation for the future value of an annuity consists of 3 independent
variables and 1 dependent variable. In other words, if we know the value of 3 of the
variables, then we can determine the remaining variable.

Since r = 5% =0.05, and n = 50, FV= Tsh 1,000,000

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To find PV, we divide both sides of the equation for the future value of an annuity by this
interest factor

FVOA 1,000,000 1,000,000

PV = = = = Tsh 4,776.69
é (1 + i ) - 1ù
n
é (1 + 0.05 ) - 1ù
50
209.35
ê ú ê ú
ë i û ë 0.05 û
So she would have to save Tshs 4,776.69 per year, or Tshs 398.06 per month, to have Tshs
1,000,000 in 50 years—assuming, of course, that she could save it tax-free!

Example 1: Mr A deposited Tshs 700 at the end of each month of the calendar year 2010 in an
investment account with a 9% annual interest rate. Calculate the future value of the annuity on
December 31, 2011. Compounding is done monthly.
Solution

We have,

Periodic Payment PV = Tshs 700

Number of Periods n = 12
Interest Rate i = 9%/12 = 0.75%
Future Value, FVOA = Tshs 700 × {(1+0.75%)^12 -1}/1%
= Tshs 700 × {1.0075^12 -1}/0.01
≈ Tshs 700 × (1.0938069-1)/0.01
≈ Tshs 700 × 0.0938069/0.01
≈ Tshs 700 × 9.38069
≈ Tshs 6,566.48

Discussion Question
Question Zero.
Ghati is planning for his retirement 20 years away. When he retires he wants a lump sum of
Tsh300 000. His financial advisor suggested that 5% p.a. was a suitable interest rate to consider.
How much will he have to pay per month into his retirement fund (assume ordinary annuity)?

Question One.
Mr. Masanja deposits Tsh 150 into a bank account at the end of the month for 5 years at a rate of
7% compounded monthly. What will be the future value for Mr. Masanja?

Question Two.
The ABC concreting company set up a sinking fund to assist in buying a new truck in 5 years.
They can only afford Tsh 3000 a quarter which is paid into a savings account with an interest

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rate of 8% p.a. Assuming quarterly compounding, what will be the size of the sinking fund after
5 years? (Assume ordinary annuity)

Question Three.
John invests Tsh 500 per month, paid into a savings account for 10 years. What is the balance of
the account at the end of the period assuming an interest rate of 7% compounded monthly?

Question Four.
In 5 years, a printing machine is to be replaced. A new machine is expected to cost Tsh 33000.
Assuming an annual interest rate of 8% compounded monthly, what will be the size of each
monthly payment?

Sinking Fund
Definition:

Any account that is established for accumulating funds to meet future obligations or debts is
called a sinking fund.

The sinking fund payment is defined to be the amount that must be deposited into an account
periodically to have a given future amount.

To derive the sinking fund payment formula, we use algebraic techniques to rewrite the
formula for the future value of an annuity and solve for the variable PMT:

é (1 + r )n - 1ù
FVOA = PMT ê ú
ë r û

æ i ö
PMT = FVOAçç ÷
÷
è (1 + i )n
- 1 ø
Where

PMT is the Annuity Payment Amount

R is the Rate of interest per period in decimals

N is the number of periods

FVOA is the Future Value Of An Ordinary Annuity

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Where

A = Money Accumulated

P = Periodic Contribution to the sinking fund

r = Rate of Interest

n = number of years

m = number of payments per year

Example

How much must Harry save each month to buy a new car in three years if the car costs Tsh
12,000 and the interest rate is 6% compounded monthly?

Solution

æ 0.06 ö
ç ÷
æ i ö ç 12 ÷
PMT = FVOAçç ÷ = 12,000ç
÷ ÷ = 305.06
è (1 + i ) - 1 ø
n 3
æ
ç ç1 + 0.06 ö
ç ÷ - 1 ÷÷
èè 12 ø ø

Example

Mr. Ray has deposited Tsh 150 per month into an ordinary annuity. After 14 years, the annuity
is worth Tsh 85,000. What annual rate compounded monthly has this annuity earned during
the 14 years?

Solution

Use the FV formula: Here FV = Tsh 85,000, PMT = Tsh 150 and n, number of payments is
14(12)=168. Substitute these values into the formula.

By determining the point of intersection of the two graphs using a graphing calculator, we
obtain an approximate solution of 0.013 or 1.3% rate of return.

Solution

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æ (1 + i )n - 1 ö æ (1 + i )14´12 - 1 ö æ (1 + i )168 - 1 ö
FV = PMT çç ÷
÷ 85,000 = 150çç ÷
÷ 85,000 = 150çç ÷
÷
è i ø è i ø è i ø
æ (1 + i )168 - 1 ö 85,000
ç ÷= = 566.67
ç i ÷ 150
è ø

Example

AZAM Industries established a sinking fund to accumulate Tsh 10,000 by depositing equal
amounts of money at the end of every 6 months for 2 years. If the fund was earning interest at
4% compounded semi-annually, calculate the following and construct a sinking fund schedule
to illustrate the details of the fund:
i) Size of the periodic sinking fund deposit.
ii) Sinking fund balance at the end of the 2nd payment period.
iii) Interest earned in the 3rd payment period.
iv) The amount by which the sinking fund increased in the 3rd payment period

Solution
i) This sinking fund is an ordinary simple annuity
FV = Tsh 10,000 t = 2 years i = j/m == 0.04/2 = 0.02
n = 2 deposites per year x 2 years = 4 semi - annual deposits
æ (1 + i )n - 1 ö
From FV = PMT çç ÷
÷
è i ø
æ (1 + 0.02 )4 - 1 ö
10,000 = PMT çç ÷
÷
è 0 . 02 ø
= PMT (4.1216 )
PMT = 2,426.24
Therefore, the periodic sinking fund is Tsh 2,426.24

ii) The sinking fund balance at the end of any given period is the future value of the
periodic deposits made until the end of that period.
At the end of the 2nd payment period, n = 2.
Let the future value at the end of the 2nd payment period be FV2
æ (1 + i )n - 1 ö
FV = PMT çç ÷
÷
è i ø
From
æ (1 + 0.02 )2 - 1 ö
FV2 = 2426.24çç ÷ = 2426.24(2.02 ) = 4,901.00
0.02 ÷
è ø

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Therefore, the Sinking fund balance at the end of the 2nd payment period is Tsh 4,901.00

iii) Interest that is earned in any period is on the amount that is available in the fund at the
beginning of that period, which is the same as the amount that is available at the end of
the previous period.
To calculate the interest earned in the 3rd period, we need to determine the fund balance
at the end of the 2nd period.
From (ii) we know that the fund balance at the end of the 2nd period
FV2 = Tsh 4,901.00

Interest on this amount = i ´ FV2 = 0.02 ´ 4,901.00 = 98.02

Therefore, Tsh 98.02 was the interest earned by the fund in the 3rd payment period.

iv) The amount by which the sinking fund increased in a period is the interest earned
during that period plus the deposit made in that period

The amount by which the sinking fund increased = Interest earned in the 3rd period + PMT
= 4,901.00 ´ 0.02 + 2,426.24
= Tsh 2,524.26

Amortization
Amortization is the process of paying off a balance over time with regular, equal payments.
This is most common with monthly payments on loans, but amortization is an accounting term
that can apply to other types of balances.

Example

Assume that you have taken out an amortized loan for Tsh 10,000 to buy a new car. The yearly
interest rate is 18% and you have agreed to pay off the loan in 4 years. What is your monthly
payment?

Solution

é1 - (1 + i )- n ù
From; PV = PMT ê ú
ë i û

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æi ö
PV ç ÷
PMT = èmø
- nm
æ i ö
1 - ç1 + ÷
è mø
Where
PV =10,000
i= 0.18
n=4
m= 12

Discussion Questions
Question 1
Chacha buys a car costing Tsh 19,300. He agrees to make payments at the end of each monthly
period of 5 years. He pays 6% interest compounded monthly.
a) What is the total amount of each payment?
b) Find the total amount of interest paid.

Question 2
The price of a home is Tsh 155,000. The required down payment is 10% and you qualify for a 30-
year fixed mortgage at 5.5%
a) Determine the down payment and the loan amount.
b) Find the monthly mortgage payment
c) How much total interest will be paid?

Question 3
James obtains a loan for his brand-new car. His car costs Tsh 18,000,000 and he puts Tsh
1,000,000 down and amortizes the rest with equal monthly payments over 5 years at 6% to be
compounded monthly.
a) What is the total amount of each payment?
b) Find the total amount of interest paid.

Question 4
Student borrowers now have more options to choose from when selecting repayment plans. The
standard plan repays the loan in 10 years with equal monthly payments. The extended plan
allows from 12 to 30 years of repaying the loan. A student borrows Tsh 10 million at 10%
compounded monthly:
a) Find the monthly payment and the total interest paid under the standard plan
b) Find the monthly payment and the total interest paid under the extended plan for 20
years

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Question 5
Jessca’s parents will be paying her college tuition of Tsh 20,000,000 for four years. If they
currently have the money invested at 6% compounded annually, how much money do they
need to have in the account to pay the tuition?

PAYBACK
Payback (PB) is one of the most popular and widely recognized traditional methods of
evaluating investment proposals. Payback is the number of years required to recover the
original cash outlay invested in a project.

In payback, there are two cases to be considered:-

Equal(Even) cash flows: If the project generates constant annual cash flows, the payback period
can be computed by dividing the cash outlay by the annual cash inflow. That is:

Initial Investment C
Payback = = 0
Annual Cash Inflow C

Example 1: Assume that a project requires an outlay of Ths 50,000 and yields an annual cash
inflow of Tsh 12,000 for 7 years. The payback period for the project is

Solution

50,000
Payback = = 4 years
12,000

Example 2:
Company C is planning to undertake a project requiring an initial investment of Tsh 105
million. The project is expected to generate Tsh 25 million per year for 7 years. Calculate the
payback period of the project.

Solution
Payback Period = Initial Investment ÷ Annual Cash Flow = Tsh 105M ÷ Tsh 25M = 4.2 years

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Unequal (Uneven) cash flows: In case of unequal cash flows, the payback period can be found
out by adding up the cash inflows until the total is equal to the initial cash outlay.

That is:

Unrecoverd cost at start of the year

Payback period = Years before full recovery +
Cash flow during the year

Example 1: Suppose that a project requires a cash outlay of Tsh 20,000, and generates cash
inflows of Tsh 8,000; Ths 7,000; Tsh 4,000 and Tsh 3,000 during the next 4 years. What is the
project’s payback?

When we add up the cash inflows, we find that in the first three years, Ths 19,000 of the original
outlay is recovered. In the fourth year cash inflow generated is Tsh 3,000 and only Tsh 1,000 of
the original outlay remains to be covered. Assuming that the cash inflows occur evenly during
the year, the time required to cover Tsh 1,000 will be (Tsh 1,000/Tsh 3,000) x 12 months = 4
months. Thus, the payback period is 3 years and 4 months.

Example 2:
Company C is planning to undertake another project requiring an initial investment of Tsh 50
million and is expected to generate Tsh 10 million in Year 1, Tsh 13 million in Year 2, Tsh 16
million in year 3, Tsh 19 million in Year 4 and Tsh 22 million in Year 5. Calculate the payback
value of the project.

Solution
(cash flows in millions) Cumulative
Year Cash Flow Cash Flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30

Payback Period
= 3 + (Tsh 11M ÷ Tsh 19M)
≈ 3 + 0.58
≈ 3.58 years

Decision Rule

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Accept the project only if its payback period is LESS than the target payback period.

Discussion Questions
Question 1

The initial investment in a pollution prevention project is Tsh 10,000. The projected savings are
Tsh 4,000 for the first year, Tsh 4,000 for the second year, Tsh 2,500 for the third year, Tsh 2,000
for the fourth year, and Tsh 2,000 for the fifth year.

Question 2

The Delta company is planning to purchase a machine known as Machine X. Machine X would
cost Tsh 25,000 and would have a useful life of 10 years with zero salvage value. The expected
annual cash inflow of the machine is Tsh 10,000.

Required: Compute the payback period of machine X and conclude whether or not the machine
would be purchased if the maximum desired payback period of Delta company is 3 years.

Question 3

Due to increased demand, the management of Pepsi Beverage Company is considering

purchasing new equipment to increase production and revenues. The useful life of the
equipment is 10 years and the company’s maximum desired payback period is 4 years. The
inflow and outflow of cash associated with the new equipment is given below:

Initial cost of equipment: Tsh 37,500

Annual cash inflows:

Sales: Tsh 75,000

Annual cash Outflows:

Cost of ingredients: Tsh 45,000

Salaries expenses: Tsh 13,500

Maintenance expenses: Tsh 1,500

Non-cash expenses:

Depreciation expense: Tsh 5,000

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Required: Should Pepsi Beverage Company purchase the new equipment? Use the payback
method for your answer.

Solution:

Step 1: To compute the payback period of the equipment, we need to work out the net annual
cash inflow by deducting the total cash outflow from the total cash inflow associated with the
equipment.

Computation of net annual cash inflow:

Tsh 75,000 – (Tsh 45,000 + Tsh 13,500 + Tsh 1,500)

= Tsh 15,000

Step 2: Now, the amount of investment required to purchase the equipment would be divided
by the amount of net annual cash inflow (computed in step 1) to find the payback period of the
equipment.

= Tsh 37,500/ Tsh 15,000

=2.5 years

Depreciation is a non-cash expense and has therefore been ignored while calculating the
payback period of the project.

According to the payback method, the equipment should be purchased because the payback
period of the equipment is 2.5 years which is shorter than the maximum desired payback period
of 4 years.

Example 4:

The management of Health Supplement Inc. wants to reduce its labour cost by installing a new
machine. Two types of machines are available in the market – machine X and machine Y.
Machine X would cost Tsh 18,000 and machine Y would cost Tsh 15,000. Both machines can
reduce annual labour costs by Tsh 3,000.

Required: Which is the best machine to purchase according to the payback method?

Solution:

Payback period of machine X: Tsh 18,000/ Tsh 3,000 = 6 years

Payback period of machine y: Tsh 15,000/ Tsh 3,000 = 5 years

According to the payback method, machine Y is more desirable than machine X because it has a
shorter payback period than machine X.

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Unrecoverd cost at start of the year

Payback period = Years before full recovery +
Cash flow during the year

Example 5:

An investment of Tsh 200,000 is expected to generate the following cash inflows in six years:

Year 1: Tsh 70,000

Year 2: Tsh 60,000
Year 3: Tsh 55,000
Year 4: Tsh 40,000
Year 5: Tsh 30,000
Year 6: Tsh 25,000

Required: Compute the payback period of the investment. Should the investment be made if
management wants to recover the initial investment in 3 years or less?

Solution:

(1). Because the cash inflow is uneven, the payback period formula cannot be used to compute
the payback period. We can compute the payback period by computing the cumulative net cash
flow as follows:

Initial Investment: Tsh 200,000

Year Cash Inflow (Tsh) Cumulative Cash
Inflow(Tsh)
1 70,000 70,000
2 60,000 130,000
3 55,000 185,000
4 40,000 225,000
5 30,000 255,000
6 25,000 280,000

Payback period = 3 + (15,000*/40,000)

= 3 + 0.375

= 3.375 Years

*Unrecovered investment at the start of 4th year:

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= Initial cost – Cumulative cash inflow at the end of 3rd year

= Tsh 200,000 – Tsh 185,000 = Tsh 15,000

The payback period for this project is 3.375 years which is longer than the maximum desired
payback period of the management (3 years). The investment in this project is therefore not
desirable.

NET PRESENT VALUE

The net present value (NPV) method is the classic economic method of evaluating investment
proposals. It is a DCF (Discounted Cash Flow) technique that explicitly recognizes the time
value of money. It correctly postulates that cash flows arising at different periods differ in value
and are comparable only when their equivalents – present values – are found out. The following
steps are involved in the calculation of NPV:

Cash flows of investment projects should be forecasted based on realistic assumptions.

An appropriate discount rate should be identified to discount the forecasted cash flows.

The present value of cash flows should be calculated

The net present value should be found by subtracting the present value of cash outflows from
the present value of cash inflows.

Decision Rule

Accept the project only if NPV is positive ( i.e., NPV>0)

Reject the project only if NPV is negative ( i.e., NPV<0)
May accept or reject the project when NPV is zero

In NPV, there are two cases to be considered:-

The formula for the net present value can be written as follows when there is an Even Cash
Inflow:

é1 - (1 + k )- n ù
NPV = R ê ú - Initial Investment
ë k û

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In the above formula,

R is the net cash inflow expected to be received in each period;
k is the required rate of return per period;
n are the number of periods during which the project is expected to operate and generate cash
inflows.

Example 1: Even Cash Inflows:

Calculate the net present value of a project which requires an initial investment of Tsh 243,000
and it is expected to generate a cash inflow of Tsh 50,000 each month for 12 months. Assume
that the salvage value of the project is zero. The target rate of return is 12% per annum.

Solution

We have,
Initial Investment = Tsh 243,000
Net Cash Inflow per Period = Tsh 50,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%

é1 - (1 + 1%)-12 ù
NPV = Tsh 50,000ê ú - Tsh 243,000
ë 1% û
é1 - (1.01) ù
-12
NPV = Tsh 50,000ê ú - Tsh 243,000
ë 0.01 û
é1 - 0.887449 ù
NPV = Tsh 50,000 ê ú - Tsh 243,000
ë 0.01 û
é 0.112551 ù
NPV = Tsh 50,000 ê ú - Tsh 243,000
ë 0.01 û

é 0.112551ù
NPV = Tsh 50,000 ê ú - Tsh 243,000
ë 0.01 û

NPV = Tsh 50,000(11.2551) - Tsh 243,000

NPV = Tsh 562,754 - Tsh 243,000

NPV = Tsh 319,754

The formula for the net present value can be written as follows when Uneven Cash Inflows:

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é C1 C2 C3 Cn ù n
Cn
NPV = ê + + + ..... + ú - C = å
t =1 (1 + k )
- C0
ë (1 + k ) (1 + k ) (1 + k ) (1 + k ) û
1 2 3 n 0 t

Where;
k is the target rate of return per period;
C1 is the net cash inflow during the first period;
C2 is the net cash inflow during the second period;
C3 is the net cash inflow during the third period, and so on ...

Example 1: When cash inflows are uneven:

Assume that project X costs Tsh 2,500 now and I expected to generate year-end cash inflows of
Tsh 900, Tsh 800, Tsh 700, Tsh 600 and Tsh 500 in years 1 through 5. The opportunity cost of the
capital may be assumed to be 10 per cent. Determine the NPV of the project X.
Solution:

é Tsh 900 Tsh 800 Tsh 700 Tsh 600 Tsh 500 ù
NPV = ê + + + + - Tsh 2,500
ë (1 + 0.01)
1
(1 + 0.01)2 (1 + 0.01)3 (1 + 0.01)4 (1 + 0.01)5 úû

= [Tsh 900 (NPF1,0.01 ) + Tsh 800 (NPF2, 0.01 ) + Tsh 700 (NPF3, 0.01 ) + Tsh 600 (NPF4,0.01 ) + Tsh 500 (NPF5, 0.01 )] - Tsh 2,500

= [Tsh 900(0.909) + Tsh 800(0.826) + Tsh 700(0.751) + Tsh 600(0.683) + Tsh 500(0.620)] - Tsh 2, 500

= Tsh 2,725 - Tsh 2, 500 = +Tsh 225

Project X’s present value of cash inflows (Tsh 2,725) is greater than that of cash outflows (Tsh
2,500). Thus, it generates a positive net present value (NPV = + Tsh 225). Project X adds wealth
to the owners; therefore, it should be accepted.

Example 2: Uneven Cash Inflows:

An initial investment of Tsh 8,320 thousand on plant and machinery is expected to generate
cash inflows of Tsh 3,411 thousand, Tsh 4,070 thousand, Tsh 5,824 thousand and Tsh 2,065
thousand at the end of the first, second, third and fourth year respectively. At the end of the
fourth year, the machinery will be sold for Tsh 900 thousand. Calculate the net present value of
the investment if the discount rate is 18%. Round your answer to the nearest thousand
Tanzanian Shillings.

Solution

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PV Factors:
Year 1 = 1 ÷ (1 + 18%)^1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)^2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)^3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)^4 ≈ 0.5158

The rest of the calculation is summarized below:

Year 1 2 3 4
Net Cash Inflow Tsh 3,411 Tsh 4,070 Tsh 5,824 Tsh 2,065
Salvage Value Tsh 900
Total Cash Inflow Tsh 3,411 Tsh 4,070 Tsh 5,824 Tsh 2,965
× Present Value Factor 0.8475 0.7182 0.6086 0.5158
Present Value of Cash Flows Tsh 2,890.68 Tsh 2,923.01 Tsh 3,544.67 Tsh 1,529.31
Total PV of Cash Inflows Tsh 10,888
− Initial Investment − Tsh 8,320
Net Present Value Tsh +2,568 thousand

Discussion Questions.
Question 1.

The management of Fine Electronics Company is considering purchasing equipment to be

attached to the main manufacturing machine. The equipment will cost Tsh 6,000 and will
increase annual cash inflow by Tsh 2,200. The useful life of the equipment is 6 years. After 6
years it will have no salvage value. The management wants a 20% return on all investments.

Required:

1. Compute net present value (NPV) of this investment project.

2. Should the equipment be purchased according to NPV analysis?

Question 2.

Smart Manufacturing Company is planning to reduce its labour costs by automating a critical
task that is currently performed manually. The automation requires the installation of a new
machine. The cost to purchase and install a new machine is Tsh 15,000. The installation of the
machine can reduce annual labour costs by Tsh 4,200. The life of the machine is 15 years. The
salvage value of the machine after fifteen years will be zero. The required rate of return for

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Smart Manufacturing Company is 25%. Should Smart Manufacturing Company purchase the
machine?

Question 3.

A project requires an initial investment of Tsh 225,000 and is expected to generate the following
net cash inflows:

Year 1: Tsh 95,000

Year 2: Tsh 80,000

Year 3: Tsh 60,000

Year 4: Tsh 55,000

Required: Compute the net present value of the project if the minimum desired rate of return is
12%.

Profitability Index ( or Benefit - cost ratio)

Profitability Index (PI) is the ratio of the present value of cash inflows, at the required rate of
return, to the initial cash outflow of the investment. The formula for calculating the benefit-cost
ratio or profitability index is as follows:

n
Ct
PV of cash inflows PV(C t )
å (1 + k )
t =1
t
PI = = =
Initial cash outlay C0 C0

Or

NPV of cash inflows NPV(C t )

PI = 1 + = 1+
Initial cash outlay C0

Decision rule
Accept the project when PI is greater than one PI >1
Reject the project when PI is greater than one PI <1
May accept the project when PI is equal to one PI = 1

Example 1

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The initial cash outlay of a project is Tsh 100,000 and it can generate cash inflow of Tsh 40,000,
Tsh 30,000, Tsh 50,000 and Tsh 20,000 in years 1 through 4. Assume a 10 per cent rate of
discount.

Solution

The PV of cash inflows at a 10 per cent discount rate is:

é Tsh 40,000 Tsh 30,000 Tsh 50,000 Tsh 20,000 ù

PV = ê + + +
ë (1 + 0.01)1
(1 + 0.01)2
(1 + 0.01)3
(1 + 0.01)4 úû
= [Tsh 40,000(NPF1, 0.01 ) + Tsh30,000 (NPF2, 0.01 ) + Tsh 50,000(NPF3, 0.01 ) + Tsh 20,000(NPF4, 0.01 )]

= [Tsh 40,000(0.909) + Tsh 30,000(0.826) + Tsh 50,000(0.751) + Tsh 20,000(0.683)]

NPV = Tsh 112,350 - Tsh 100,000 = +Tsh 12,350

Tsh 112,350 Tsh 12,350

Therefore, PI = = 1.1235 or PI = 1 + = 1 + 0.1235 = 1.1235
Tsh 100,000 Tsh 100,000

Discussion Questions
Question 1

Company C is undertaking a project at a cost of Tsh 50 million which is expected to generate

future net cash flows with a present value of Tsh 65 million. Calculate the profitability index.

Question 2

Company C is considering two mutually exclusive projects with the same initial cost of Tsh
20,000 and a cost of capital of 11%. Detailed information about the projects’ future cash flows is
presented in the table below.

Use PI to decide which project should be accepted.

Internal Rate of Return (IRR)

Internal rate of return (IRR) is the discount rate at which the net present value of an investment
becomes zero. In other words, IRR is the discount rate which equates the present value of the
future cash flows of an investment with the initial investment. It is one of the several measures
used for investment appraisal.

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IRR Calculation
The calculation of IRR is a bit more complex than other capital budgeting techniques. We know
that at IRR, the Net Present Value (NPV) is zero, thus:
NPV = 0; or
PV of future cash flows − Initial Investment = 0; or

é C1 C2 C3 ù
ê 1
+ 2
+ + ....ú - Initial Investment(C 0 ) = 0
ë(1+ r ) (1+ r ) ( 1 + r )3 û
Where,
r is the internal rate of return;
C1 is the period one net cash inflow;
C2 is the period two net cash inflow,
C3 is the period three net cash inflow, and so on ...

Decision Rule

A project should only be accepted if its IRR is NOT less than the target internal rate of return.
When comparing two or more mutually exclusive projects, the project having the highest value
of IRR should be accepted.

But the problem is, that we cannot isolate the variable r (=internal rate of return) on one side of
the above equation. However, there are alternative procedures which can be followed to find
IRR. The simplest of them is described below:
1. Guess the value of r and calculate the NPV of the project at that value.
2. If NPV is close to zero then IRR is equal to r.
3. If NPV is greater than 0 then increase r and jump to step 5.
4. If NPV is smaller than 0 then decrease r and jump to step 5.
5. Recalculate NPV using the new value of r and go back to step 2.

Example
A project costs Tsh 16,000 and is expected to generate cash inflows of Tsh 8,000, Tsh 7,000 and
Tsh 6,000 at the end of each year for the next 3 years. Find the rate of return of the project.

Solution
We know that IRR is the rate at which a project will have a zero NPV. As the first step, we try
(arbitrarily) a 20 per cent discount rate. The project’s NPV at 20 per cent is:

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NPV = [Tsh 8,000(PVF1, 0.20 ) + Tsh 7,000(PVF2, 0.20 ) + Tsh 6,000(PVF3,0.20 )] - Tsh 16,000

= [Tsh 8,000 ´ 0.833 + Tsh 7,000 ´ 0.694 + Tsh 6,000 ´ 0.579] - Tsh 16,000

= Tsh 14,996 - Tsh 16,000 = -Tsh 1.004

A negative NPV of Tsh 1.004 at 20 per cent indicates that the project’s true rate of return is
lower than 20 per cent.

Let us try 16 per cent as the discount rate. At 16 per cent, the project’s NPV is:

NPV = [Tsh 8,000(PVF1, 0.16 ) + Tsh 7,000(PVF2, 0.16 ) + Tsh 6,000(PVF3,0.16 )] - Tsh 16,000

= [Tsh 8,000 ´ 0.862 + Tsh 7,000 ´ 0.743 + Tsh 6,000 ´ 0.641] - Tsh 16,000

= Tsh 15,943 - Tsh 16,000 = -Tsh 57

Since the project’s NPV is still negative at16 16 cent, a rate lower than 16 per cent should be
tried.

Let us try 15 per cent as the discount rate. At 15 per cent, the project’s NPV is:

NPV = [Tsh 8,000(PVF1, 0.15 ) + Tsh 7,000(PVF2, 0.15 ) + Tsh 6,000(PVF3, 0.15 )] - Tsh 16,000

= [Tsh 8,000 ´ 0.870 + Tsh 7,000 ´ 0.756 + Tsh 6,000 ´ 0.658] - Tsh 16,000

= Tsh 16,200 - Tsh 16,000 = +Tsh 200

The true rate should be between 15 – 16 per cent. We can find a close approximation of the rate
of return by the method of linear interpolation as follows:

PV required Tsh 16,000

200

PV at a lower rate, 15% Tsh 16,200

257

PV at a higher rate, 16% Tsh 15,943

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r = 15% + (16% - 15%)*200/257

= 15% + 0.80%

= 15.8%

Discussion Questions

Question 1
Find the IRR of an investment having an initial cash outflow of Tsh 213,000. The cash inflows
during the first, second, third and fourth years are expected to be Tsh 65,200, Tsh 96,000, Tsh
73,100 and Tsh 55,400 respectively.

Question 2
Assume Company XYZ must decide whether to purchase a piece of factory equipment for Tsh
300,000. The equipment would only last three years, but it is expected to generate Tsh 150,000 of
additional annual profit during those years. Company XYZ also thinks it can sell the equipment
for scrap afterwards for about Tsh 10,000. Using IRR, Company XYZ can determine whether the
equipment purchase is a better use of its cash than its other investment options, which should
return about 10%.

Solution

Here is how the IRR equation looks in this scenario:

Tsh 150,000 Tsh 150,000 Tsh 150,000 Tsh 10,000

0 = - Tsh 300,000 + + + +
(1 + .2431) 1 (1 + .2431) 2 (1 + .2431) 3 (1 + .2431) 4

The investment’s IRR is 24.31%, which is the rate that makes the present value of the
investment's cash flows equal to zero. From a purely financial standpoint, Company XYZ
should purchase the equipment since this generates a 24.31% return for the Company --much
higher than the 10% return available from other investments.

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