Time Value of Money

• Financial decisions is concerned with determining how the

values will be affected by the expected outcomes ( payoffs
associated with alternative choices)
• Example if you invest 5500 today you have two alternatives;
to get 7020 after 5 years or 8126 after 8 years
• Given this scenario, which alternative will one prefer?
• All being equal a shilling received today is worth more than a
shilling receive at a later date
• If you receive it today you can re- invest it to earn a positive
return
• To determine the investment that is more valuable we need
to compare the value of payoffs at the same point in time
• Determine the current value of 7020/=in five years’ time and
8126/=in eight years’ time.
 Time Value of Money
• The concept used to revalue these payoffs is the
time value of money.
• Financial managers and Investors both must have a
clear understanding of the time value of money
and its effect on the value of the asset
• Hence the principle of time value of money is
principles and computations used to value cash
payoffs at different times so they are stated in Sh.
of the same time period
• It is used to count Sh. of one time period to those
of another time period
• The concept of time value of money is a very
important tool in finance
 Tools in Time Value of money
• Cash flow time lines; this help visualize when cash
flows associated with particular situation occurs
• Periods are usually years but can be semi – annual
quarterly and even monthly ( used as intervals)
• Future value
• A shilling in hand today is worth more than a shilling
to be received in future
• This is because if you have the money now , you can
invest it and earn interest and end up with more
than one shilling in future
• To convert todays values to future values its referred
to as compounding
 Example
• Deposit Sh.1000/= in a bank at 10% pa.
• How much do you earn at end of year i
• How much do you earn at end of year 5?
• At the of N years
• P (1+r)n
• Where
• P= Principal
• R= rate of return
•
• N= number of periods
• The table can be used to get the factor
• If compounding is done semiannually or quarterly then the formula changes
• FV= P (1+r/m)nm
• Where;
• M is the number of compounding periods or the number times
compounding is done
 Future Value of Annuity
• Annuity is a series of equal payments made in fixed equal length interval for a
specified number of periods
• Example;
• Pay 1000/= at end of each year for the next 5 years. This is referred to as 5
year annuity
• These annuities can be at the end or at the beginning of each year.
• If at end they are ordinary annuity or deferred annuity
• If at beginning then annuity due

• P (1+r)0+ P(1+r)1+ p(1+r)n-1

• Calculated as follows
• PMT ( 1+r)n-1 if payments is made at beginning of the year ( 1+r)n-1 (1+r)
• r r
Present Value
• Present value (1/ (1+n)n
• Present value of annuity (1-1/ (1+r)n )/r
•