Time value of money

The time concept of money is a concept which tries to explain why individuals prefer to
have money now rather than receiving the same amount of money in the future. By the
virtue of passage of time money will change its value. Individuals prefer to have current
cash instead of the future cash due to various reasons. These are:1. Availability of investments opportunities i.e. its not clear whether the money will
still generates extra income.
2. Uncertainties of the future cash flows i.e. its not clear whether the money will still
be available in the future to be received and used by individuals, therefore
individuals prefer to receive the money now when there is certainty of receiving it.
3. In order to take advantage of the cash discount. Trading company will prefer to
have cash now in order to be able to purchase from their suppliers on cash so as to
receive the cash discounts if companies do not have money to purchase in cash then
they will forgo the discount.
4. In order for to use money for current consumption e.g. the need for money to pay
school fees, shelter, food and clothing.
5. Because of the uncertainty as to whether the individual will be there in the future to
enjoy the cash to be received in the future.
6. Because the value of money changes due to inflation. i.e. the purchasing power of
money decline as time passes by.
Importance of the Concept of Time Value of Money
The concept time value of money is important due to its application in the following
areas:1. The determination of the effective cost of borrowing. This is done by comparing
the amounts of cash to be received today inform of a loan and future benefits to
be derived from utilization of that loan.

2. In the determination of the true rate of return from a given investment i.e. the
time value of money its used to determine the return of various investors such
as preference shareholders and ordinary shares.
3. Its used in the valuation of the business i.e. the concept of time value of money
is used to determine the maximum price to be paid to acquire a given business
by computing the present value of the benefits to be derived from the business.
4. The valuation of financial instrument i.e. it is to determine the theoretical
value/intrinsic value of a given security by computing the present value benefits
to be realized from security.
5. It is used in the selection of the best source of finance this is done by
determining the source of finance which gives the benefits In present terms.
6. In the determination of the loan repayment arrangements. The concept of time
value of money is used to determine the instruments to be paid each period in
order to liquidate the loan borrowed.
The compound value or future value of a single amount.
The compound value refers to the future value of an amount called the principal when it
is invested over a number of specified periods earning interest at particular interest rate.
Compounding refers to the inclusion of the interest earned at the end of one period as
part of the principal in the next period e.g. assume you have invested Ksh 10000 in a
bank earning interest of 10%p.a. compute the future value of this investment after 3
years?
Period

Amt @ start of

period
10000

Interest %

Amt @ end of

10% *10000

period
1000+10000=

11000

10% *11000

11000
1100+11000=12

12100

10% *12100

100
1210+12100=13
310

The formulae form the future value is given by

FV=PV (1+r) n
Where: FV=future value
PV= present value
r= interest rate
n=number of periods
From the previous example;
FV=10000(1+0.1)3
=10000(1.1)3
=13310
Thus the function (1+r)

is called the future value interest factor ( FVIF) and when its

expressed at a particular discounting rate (r%) and for a given number of period (n) its
therefore written as FVIF r % n. This can be obtained from the future of a single amount
levels. Therefore the future value
FVIF 10% 3= 1.331
Hence FV= PV * FVIFr%n
Future/ compound value of an annuity
Annuity refers to equal periodic payments or receipts. Examples of annuities include salary,
insurance premium, retirement benefits, and rent e.t.c.
There two types of annuity:-

Ordinary annuity: this is that type of annuity where the receipt /payment came at the end of
each period. E.g. salary
An annuity Due: this is that annuity where receipt/payments come at the beginning of each
period e.g. rent.

Illustration:
An investor intends to deposit KSh.20000 at the end of every year for the next 3 years. If
the interest is 10%, compute the future value of this annuity.
FV=PV (1+r) n
Yr
1

20000(1.1)2 = 24200

20000(1.1)1 =22000

20000(1.1)0=20000
= 66200

In formulae form the future value of an ordinary annuity is given as

FVa = A {(1+r) n -1/r}
=20000{(1.1)3 -1/0.1}
=66200
The function A {(1+r) n -1/r} is known as future value interest factor of annuity(FVIFA) and
when a given discounting rate r% for a given no of periods (n) its written as FVIFA r% n. it
can be obtained from the future value of annuity table. E.g. FVIFA 10% 3=3.310
Now assume that the investor above, he was depositing the amount at the beginning of the
period and determine the future value of that annuity.
= FV=PV (1+r) n

Yr
0

0000(1.1)3= 26620

0000(1.1)2=24200

0000(1.1)1 =22000
=72820

NB: there is no formula for calculating the future value of annuity due. The future value
tables normally give the formulae give the formulae for calculating an ordinary annuity, in
order for calculating the Value of annuity due, to some adjustments have to be made the
formula of calculating the future value of an ordinary annuity. The adjustment would
involve multiplying the formulae with (1+r) therefore the future value for annuity due is
FVa = A {(1+r) n -1/r} (1+r)
=20000*3.31*1.1
=72820
The Present Value of a Single Amount.
This refers to the amount which require to be deposited today (the principal) and be
invested over a specified periods at a particular interest rate. The process of computing the
present value is known as discounting and the interest rate used to compute the present
value is known as the discounting rate / cost of capital/the required rate of return/
opportunity cost.
PV=FV*1/ (1+r) n
And the function 1/ (1+r) n or (1+r) -n is known as the present value of interest factor.(PVIF)
and when expressed at a particular interest rate r% for a given the number of periods(n) its
written as PVIFr%n and can be found in the tables. Thus the formulae is given as
PV=FV*PVIF r%n
For example:
Assume that you intend to receive Shs 500000 in four years time. Determine the present
value of these future receipts if the discounting rate is 12%
PV=FV*1/ (1+r) n

Therefore: 500000*1/ (1+0.12)4

500000*0.6355
=317750
EXAMPLE 2
Consider a project which is expected to generate the following flows.
YEAR

80

60

40

C.F shs 000 100

If the discounting rate is 14%, determine the present value of the cash flows from the
project.
Yr

Cash flows

PVIF 14% n

PV

100000

0.8772

87720

80000

0.7695

61560

60000

0.6750

40500

40000

0.5921

23684

Total

213464

Present Value of an Annuity

This refers to an amount which requires to be deposited today in subsequent period in equal
installments for a specified number of periods at a particular discounting rate for it to yield
a particular future value. E.g. Mrs. Korir wishes to deposit Shs. 30000 at the end of each
year for the next 5 years. If the discounting rate is 16%, compute the present value of this
annuity.
Yr

CF

PVIF 16%n

PV

30000

0.8621

25863

30000

0.7432

22296

30000

0.6407

19221

30000

0.5523

16569

30000

0.4761

14283

Total

98232

In formula form the present value of an ordinary annuity is given as

PVa=A {1-(1+r)-n /r}

30000{1-(1+0.16)-5 /0.16}
30000*3.2743= 98229
The function 1-(1+r)-n /r is known as the present value interest factor of an annuity and
when its expressed at a given discounting rate(r %) for a given no of periods(n) its written
as PVIFA r% n and can be obtained from the annuity table.
PVa=A*PVIFA r% n
Now assume that Mrs. Korir was depositing at the beginning of each year. Determine the
annuity due.
Yr

CF

PVIF 16% n

PV

30000

1.000

30000

30000

0.8621

25863

30000

0.7432

22296

30000

0.6907

19221

30000

0.5523

16569

Total

113949

PVa due= A*PVIFAr %( 1+r)

=30000*PVIFA 16%5 (1+0.16) =30000*3.2743*1.16=113949

Present Value of Deferred Annuities

A deferred annuity is that annuity that comes in between the periods i.e. the cash flows in
the early periods of the projects might be non-annuity cash flows but they become annuities
towards the end of the project life.
Example 1
The present value of a deferred annuity is calculated using the following steps.
compute the present value of the equal cash flows in the normal way e.g. period 1&2 above
=25619.
Determine the present value interest factor of an annuity at a given discounting rate at the
end of an annuity period e.g. PVIFA,10%5=3.7908
Determine the present value interest factor of annuity at a given discounting rate at the
beginning of the annuity period e.g. PVIFA,10% 2=1.7355
Compute the present value of the annuities between the two periods by taking the
difference. A (PVIFA, 10%5-PVIFA, 10%2).(step 1& 3)
Add the present value of step 1 to the present value of step 4 above. 25619+61659=87278
Example 2&3
Present value of an annuity in perpetuity
An annuity in perpetuity is that that does not have an end. E.g. if a company is assured to
be a going concern and it is expected to pay constant dividends of sh.10per share each year
and this will constitute annuity in perpetuity.
The present value of annuity in perpetuity is given as;
PVA=A/r=A* 1/r
The function 1/r is called the present value interest factor of an annuity in perpetuity
(PVIFA)

Assuming the cost of capital is 20% determine the value of the ordinary share for the
company above which promises to pay shs 10 as dividends per share.
Soln.
PVA=A*1/r=10*1/0.2
Present value of a growing annuity in perpetuity
This refers to an annuity which increases from one period to another at a constant growing
rate (g) in perpetuity e.g. if a company is paying dividends of Sh.5 per share p.a. which is
expected to increase by 10% in perpetuity assuming the company is a going concern then
this will constitute a constant growing annuity in perpetuity is calculated using;
PVA=A*1/(r-g)
Present value of a growing annuity with definite period.
Multi period compounding
Normally a year is taken to be standard measure of time .i.e. 1 yr is equivalent to 1 standard
period. Within this one year there can be many periods depending on how many times in a
year interest is paid or received.
Multi-period compound refers to a situation where interest is paid or received more than
once in a year e.g. if interest is paid semi- annually then there will be 2 periods in an year
of six months each. If interest is paid weekly then three will be 52 periods in a year.
The number of periods in a year is used to compute the effective interest rate per annum.
Also the no of periods in a year can be used to compute the future value of a given
investment, provided the following variables are available.
The nominal interest/ discounting rate. This refers to the interest rate per annum. If interest
is paid /received only once in a year.
The number of periods for investment. This can be computed as
Effective no of periods for investment=m*n

Where m is the number of periods p.a. and n is the number of years for the
investment. e.g. if an investment has 4 yrs an interest rate is paid after every 3
months
M=12/3=4

n=4

m*n=4*4=16 periods

The effective interest rate p.a. for a given investment can be calculated using the
formula.
= {1+r/m} m -1
Example
Quiz:
Mr. Ujuzi intends to retire from active employment in the next 20 years. Currently
he has 2 options.
Retire from employment and forgo Sh. 250000 p.a. salary for next 20yrs.
Go into business whose financial information is as follows.
He will require Sh. 2375000 now to start off the business
The business will have a 20 years economic life and it will generate the following cash
flows.
Year

1-5

16-20

Cf. p.a

625000

500000

The salvage value of the business at the end of the 20years will be Sh 750000. The cash
flows will be received at the end of each year.
the business will require additional operating costs which will be incurred as follows
Year

1-5

Annual oper. cos.50000

6-10

11-17

18-20

75000

100000

All the operating expenses will be paid at the beginning of each year. The appropriate
discounting rate is 10%. Required advice Mr. Ujuzi whether to retire or not.

Amortized loans
One application of compound interest concept involves loans that are to be paid of in
installments over time eg mortgage, car loans etc. if a loan is to be re-paid in equal periodic
amounts, it is to be an amortized loan.
Illustration
A firm borrows sh.200,000 to be repaid in three equal installments at the end of each year.
The bank is to receive 20% on the loan outstanding at the end of every year. Prepare a loan
amortization schedule.
REVIEW OF CAPITAL BUDGETING TECHNIQUES
Capital budgeting (investment) decisions may be defined as the firm's decisions
to invest its current funds most efficiently in the long-term assets in
anticipation of an expected flow of benefit over a series of years. The firm
therefore:
(a)
(b)
(c)
2.

exchanges current funds for future benefits

invests the funds in long-term assets
expects future benefit over a series of years

INVESTMENT APPRAISAL TECHNIQUES

The investment appraisal techniques can be categorised into two groups:
(a)

Discounted Cashflow methods

i.
ii.
iii.

(b)

Net present value method

Internal rate of return
Profitability index

Non-discounted cashflow method

i.
ii.

Accounting rate of return

Payback period

DISCOUNTED CASHFLOW METHODS

1.

Net Present Value (NPV)

This is defined mathematically as the present value of cashflow less the
initial outflow.

Ct
t Io
t =1 (1 + K )

NPV =
Where

Ct is the cashflow
K is the opportunity cost of capital
Io is the initial cash outflow
n is the useful life of the project

Decision Rule using NPV

The decision rule under NPV is to:
-

Accept the project if the NPV is positive

Reject the project if NPV is negative

Note: if the NPV = 0, use other methods to make the decision.

2.

Internal Rate of Return (IRR)

The internal rate of return of a project is that rate of return at which the
projects NPV = 0
Therefore IRR occurs where:

Ct
- =0
t Io
t=1 (1+ r )

NPV =

Where r = internal rate of return

Note that IRR is that ratio of return that causes the present value of
cashflows to be equal to the initial cash outflow.
Decision Rule under IRR
If IRR > opportunity cost of capital - accept the project
-

IRR < opportunity cost of capital - reject the project

IRR = opportunity cost of capital - be indifferent

3.

Profitability Index
This is a relative measure of projects profitability.
following formula.

It is given by the

PI =

Ct

t
t=1 (1 + K )
Io

Decision Rule
If

PI > 1 - Accept the project

PI < 1 - Reject the project
PI = 1 - Be indifferent

NON-DISCOUNTED CASHFLOW METHODS

1.

Accounting rate of return (ARR)

ARR =

Average annual income

Average investment

Where Average annual income = Average cashflows Depreciation

Average investment = 1/2 (Cost of investment - Salvage value)
(assuming straight line depreciation method).
Projects with higher ARR are preferable.
2.

Average

Payback Period
This is defined as the time taken by the project to recoup the initial cash
outlay.
The decision rule depends on the firms target payback period (i.e. the
maximum period beyond which the project should not be accepted.

ILLUSTRATION
A company is considering two mutually exclusive projects requiring an initial cash
outlay of Sh 10,000 each and with a useful life of 5 years. The company required
rate of return is 10% and the appropriate corporate tax rate is 50%. The projects
will be depreciated on a straight line basis. The before depreciation and taxes
cashflows expected to be generated by the projects are as follows.

YEAR
1
Project A Shs 4,000
Project B Shs 6,000

2
4,000
3,000

3
4,000
2,000

4
4,000
5,000

5
4,000
5,000

Required:
Calculate for each project
i.
The payback period
ii.
The average rate of return
iii. The net present value
iv.
Profitability index
v.
The internal rate of return
Which project should be accepted? Why?
Suggested Solution
Computation of after tax cashflows
Depreciation

10,000 - 0 =
5

Sh 2,000

Project A
Annual Cashflow
Cashflows before depreciation
4,000
Less Depreciation
2,000
Profits before taxes
2,000
Less taxes (50%)
1,000
Profits after tax
1,000
Add back depreciation
2,000
Cashflows after taxes
3,000
Project B
Year

4
5
Cashflow before depreciation
Less depreciation
Profits before taxes
Less taxes (50%)
Profits after taxes
Add back depreciation
Net cashflows after taxes

1
6,000
2,000
4,000
2,000
2,000
2,000
4,000

3,000
2,000
1,000
500
500
2,000
2,500

2,000
2,000
0
0
0
2,000
2,000

2
5,000
2,000
3,000
1,500
1,500
2,000
3,500

3
5,000
2,000
3,000
1,500
1,500
2,000
3,500

i.

Payback Period (PB)

Project A =

10,000
3,000

3 1/3 years

Project B
Sh 4,000 + Sh 2,500 + Sh 2,000 = Sh 8,500 is recovered in three years. The
remaining amount of Sh 10,000 - 8,500 = 1,500 is to be recovered in the fourth year.
Thus PB

3 years +

1,500

=
3 3/7 years
3,500

According to PB Project A is better.

ii.

Average Rate of Return (ARR)

Project A
Average income

5 x 1,000 =

Shs 1,000

5
Average investment = 10,000/2
ARR =

1,000
5,000

Shs 5,000

0.20 or 20%

Project B
Average income =

2,000 + 500 + 0 + 1,500 + 1,500

5

Shs 1,100

5,500
5

ARR

1,100
5,000

0.22 or 22%

According to ARR Project B is better.

iii.

Net Present Value Method

Project A
NPV =
=
Project B

Annual Cashflows x PVIFA 10%, 5 years - Initial Cost (where

PVIFA is the Present Value Interest Factor of annuity)
3,000 x 3.791 - 10,000 = Sh 1,373

NPV can
Year
1
2
3
4
5

be computed using the following table:

Cashflows
PV.F 10%
PV
4,000
0.9093,636
2,500
0.8262,065
2,000
0.7511,502
3,500
0.6832,390.5
3,500
0.621 2,173.5
Total PV 11,767
Less initial cost
10,000
NPV 1,767

Project B is better because it has a higher NPV.

iv.

Profitability index (PI)

Project A
PI

11,373
10,000

1.1373

11,767
10,000

1.1767

Project B
PI

Project B is better since it has a higher PI.

v.

The Internal Rate of Return

Project A
NPV =
PVIFA

3,000

r%, 5years

PVIFA

10,000
3,000

r%, 5years

- 10,000 = 0

3.333

From the table r lies between 15% and 16%. We use linear interpolation to compute
the exact rate.
PVIFA 15% =
3.352
PVIFA required = 3.333
Difference
0.019
IRR =

PVIFA 15% =
3.352
PVIFA 16% =
3.274
Difference
0.078

15% + (16 - 15)

(0.019) = 15.24%
0.078

Project B
We use trial and error method since the cashflow are uneven:

NPV at 16% = 10,186 - 10,000

=
186
NPV at 17% = 9,960.5 - 10,000

(39.5)

Using Similar Triangle

IRR - 16
186

17 - IRR
39.5

39.5 (IRR - 16) =

39.5 IRR - 632 =
225.5 IRR =
IRR

186 (17 - IRR)

3,162 - 186 IRR

3.794
16.8%

Project B is better because it has a higher IRR.

Generally, Project B should be selected because the discounted
cashflow methods supports this decision.
Note: The methods discussed so far assume that investment
decisions are made under conditions of certainty. In real life,
however, this is not the case and therefore we shall consider risk and
other complications in the following sections.
3.

PROJECTS SELECTION UNDER CAPITAL RATIONING

If a firm rations capital its value is not being maximised. A value maximizing
firm would invest in all projects with positive NPV. The firm may however want

to maximize value subject to the constraint that the capital ceiling is not to be
exceeded.
A linear programming method can be used to solve constrained maximization
problems. The objective should be to select projects subject to the capital
rationing constraint such that the sum of the projects NPVs is maximized.
Illustration
Management is faced with eight projects to invest in. The capital expenditures
during the year has been rationed to Sh 500,000 and the projects have equal
risk and therefore should be discounted at the firm's cost of capital of 10%.
Project
1
2
3
4
5
6
7
8

Cost
Project
t = 0(Shs) Life
400,000
20
250,000
10
100,000
8
75,000
15
75,000
6
50,000
5
250,000
10
250,000
3

Cashflow NPV at the

per year
10% cost
58,600
98,895
55,000
87,951
24,000
28,038
12,000
16,273
18,000
3,395
14,000
3,071
41,000
1,927
99,000
(3,802)

Required:
Determine the optimal investment sets.
Max Z = 98,895 X1 + 87,951 X2 + 28,038 X3 + 16,273 X3 + ... + (3,802) X8
St 1 =
2

400,000 X1 + 250,000 X2 + 100,000 X3 + ... + 250,000 X8 500,000

1 < X1, X2, X3 ... X8 > 0

The Optimal Budget:

Project
Cost
2
250,000
3
100,000
4
75,000
5
75,000
500,000
4.

NPV
87,951
28,038
16,273
3,395
135,657

ABANDONMENT VALUE
It has been assumed so far that the firm will operate a project over its full
physical life. However, this may not be the best option - it may be better to
abandon a project prior to the end of potential life. Any project should be
abandoned when the net abandonment value is greater than the present value
of all cash flows beyond the abandonment year, discounted to the abandonment
decision point. Consider the following example:

Project A has the following cashflows over its useful life of 3 years. The market
value (Abandonment value) has also been given.
Year
0
1
2
3

Cash Abandonment
flow
value
Sh`000'
Sh`000'
(4,800)
4,800
2,000
3,000
1,875
1,900
1,750
0

Required:
Determine when to abandon the project assuming a discount rate of 10%.
Suggested Solution:
If the project is used over its life, the NPV is negative as shown below:
NPV =

2,000 x PVIF

10%, 1year

+ 1,875 X PVIF

10%, 2years

+ 1,750 X PVIF

2,000 x 0.909 + 1,875 x 0.826 + 1,750 x 0.751 - 4,800

Shs -119

10%, 2 yrs

- 4,800

The project should not be accepted. However, if the project is abandoned after 1
year the NPV would be
NPV =
=

2,000 x 0.909 + 3,000 x 0.909 - 4,800

Sh -255

If abandoned after 2 years

NPV =

2,000 x 0.909 + 1,875 x 0.826 + 1,900 x 0.826 - 4,800

=
Sh 136

The NPV is positive if the project is abandoned after 2 years and therefore this is the
optimal decision.
Note that abandonment value should be considered in the capital budgeting process
because, as our example illustrates, there are cases in which recognition of
abandonment can make an otherwise unacceptable project acceptable. This type of
analysis is required to determine projects economic life.
5.

RISK ANALYSIS IN CAPITAL BUDGETING

The Risk associated with a project may be defined as the variability that is
likely to occur in the future returns from the project. Risk arises in investment
evaluation because we cannot anticipate the occurrence of the possible future
events with certainty and consequently, cannot make any correct prediction
about the cashflow sequence.
Attitudes towards Risk
Three possible attitudes towards Risk can be identified. These are:
(a)
(b)
(c)

Risk aversion
Desire for Risk
Indifference to Risk

A Risk averter is an individual who prefers less risky investment. The basic
assumption in financial theory is that most investors and managers are risk
averse.
Risk seekers on the other hand are individuals who prefer risk. Given a choice
between more and less risky investments with identical expected monetary
returns, they would prefer the riskier investment.
The person who is indifferent to risk would not care which investment he or she
received.
To illustrate the attitudes towards risk assume two projects are available. The
cashflows are not certain but we can assign probabilities to likely cashflows as
shown below.
States of nature
Optimistic prediction
Moderate prediction
Pessimistic prediction

Project A's
cashflow
Sh 900,000
600,000
300,000

Project B's Probability

cashflow
600,000
0.2
600,000
0.6
600,000
0.2

The expected cashflow would be computed as follows:

Project A
Expected cashflow =
900,000 (0.2) + 600,000 (0.6) + 300,000 (0.2)
=
Sh 600,000
Project B
Expected cashflow =
600,000 (0.2) + 600,000 (0.6) + 600,000 (0.2)
=
Sh 600,000
Therefore, the two projects have the same expected cashflows (Sh 600,000).
However, Project A is a riskier project since there is a chance that the cashflow
will be Sh 300,000. Project B on the other hand is a less risky project since we
are sure that Sh 600,000 will be received.
A risk seeker would choose Project A while a risk averter would choose Project
B. A risk neutral decision maker would be indifferent between the two projects
since the expected cashflows are equal.