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DCRC CPA (T) REVIEWS

NOTES FOR MAY 2022

Topic Two: TIME VALUE OF MONEY (TVM)

Time value of money:

This is a key valuation concept in finance that states “a shilling today (now) is worth more than a shilling
in the future.”
Means the value of money is different at different point of time.
The time value of money is a key concept in investment decision.
TVM concept allows one to compare cash flows at two different points of time.
 What would you prefer? 20M today or 20M 3 years to come?
 Time allows opportunity to postpone consumption and earn interest.
 Interest plays an important role in determining the time value of money.
Reasons why money in the future is worth less than similar money today
a. Risk & Uncertainty
Uncertainty in the future lowers the value of money. Say for example non receipt of payments,
uncertainty about investor’s life or any other contingency which may result to no payment or
reduction of payment.
b. Preference on current consumption
Present consumption is more preferred than future consumption.
c. Foregone investment opportunity
Money received today can be invested and earn higher rate of return in the future.
d. Inflation
Money received today has higher purchasing power in an inflationary economy.

Role of time value of money in financial Management.

a. Assist in making investment decision/ capital budgeing
In an investment cash flows and inflows occur at different periods and cannot be compared with
each other directly. Hence the investor computes the present value of future inflows and compares
it to the present cash outflows to arrive at a decision
b. Asset replacement.
Involves creation of sinking fund such that sufficient amount will be accumulated after some time
to replace an asset.
c. Assist in retirement planning.

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Used to determine the sum of money that need to be paid every year (sinking fund).
d. Cost of capital determination.
Cost of capital is the rate that equates the present value of future cash flows expected from the
security to the current market price of the security.
e. Business valuation.
One approach to valuing business is through the determination of present value of future cash flows
expected from the business. (Discounted cash flows approach in valuing business).

Perspectives of time value of money.

At the heart of time value of money concept, there are two important principles which are compounding
and discounting.
 Compounding takes today’s cash flow to a future time (or bring cash flow from the past to the
present)
 Discounting brings future cash flow to the present time (or takes today’s cash flow to a previous
time)

Cash flow characteristics.

In order to compound or discount, it is important to know the type of cash flows that one is dealing with.
There are two basic types of cash flows:
 Single sum or Lump sum

 Multiple cash flows:

o Inequivalent amounts

o Equivalent amounts.

 Ordinary annuity

 Annuity due

 Perpetuity

 Growing annuity

 Growing perpetuity
It is important to understand the characteristics of cashflows so as to know which formulae should be
applied.

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1. Single sum or Lump sum cash flows.

A lump sum refers to a single cash flow that needs either to be compounded or discounted.
a. Compounding of a Lump sum.
The future value (FV) of a lump sum (PV) after n period with interest rate (r %) per period is given as :
FV=PV[1+r]n
[1+r]n: is the Future Value Interest Factor (FVIF)
When interest is compounded more than once a year, the formula changes to
𝑟
FV=PV[1 + 𝑚] 𝑛 ×𝑚

Where n is a number of years and m number of compounding in a year.

Example 1.
Assume that you deposit Tsh.1,000,000 at an interest rate of 7% for 2 years. How much will you have in
your account at the end of 2 years assuming
a. Using simple interest- Interest from the previous period is not reinvested
b. Using compound interest –interest from the previous period is reinvested

Example 2
How much would have been in your account if your parents had invested 500,000 on your birthday 20 years
ago in your fixed deposit account that pays an interest rate of 12% p.a?

Example 3
Imagine that you are a Tanzanian Investor and you have TZS 70,000,000 now. You are thinking of placing
your investment for seven years in a fixed deposit account in Kenya micro finance based in Nairobi that
pays an interest of 9% p.a. The institution only accepts Kenyan Shillings and the spot exchange rate between
Kenyan Shillings and Tanzanian Shillings is currently standing at TZS 22 = KES 1. It is further expected
that the rate after seven years will be TZS 28 = KES 1. What will be the value of your fixed deposit after
seven years?

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b. Discounting of lump sum.

PV = [FV /(1+r)n]
Where;
 The value (1+r)n is known as the present value interest factor (PVIF) which represent the value of
one shilling to be received n periods from now with interest rate r%

 For lump sum future value increases with both n and r while for present value decreases with both
n and r. This is true as long as the value of n and are greater than zero.

 We assume interest rate is going to remain constant over the given period. But still possible to
compute; present value or future value with changing interest rate.

Example 4.
Suppose you need 10,000,000 in two years. How much do you need today at the discount rate of 7% per
annum compounded annually?

Example 5.
Imagine that you are a Tanzanian Investor and you want to accumulate TZS 100,000,000 in five years. How
much in terms of TZS should you place in an account today in a Kenyan micro finance based in Nairobi
that pays an interest rate of 9%p.a. Note: The institution only accepts Kenyan shillings and the spot
exchange rate between Kenyan Shillings and Tanzanian Shillings is currently standing at TZS 33/KES. It
is further expected that the rate after five years will be TZS 25/KES

2. Multiple cash flows.

Multiple cash flows refers to more than one cash flow that needs to be compounded or discounted.

a. Multiple cash flows of unequal amount each period

The future value is found by determining the future value of each cash flow at the specified future date and
then add all the individual future values to find the total future value.
The present value is found by determining the present value of each cash flow at the specified present date
and then add all the individual present values to find the total present value.

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Example 6.
You have approached a loan shark for a loan to enable meet your studying costs. Your proposal is to repay
the amount using some money that you expect to earn from your part-time businesses. This will be shs.
1.2M after one year, shs. 1M after two years and shs. 2M on the 4th years. The loan shark tells you that the
interest rate on this type of arrangement is 20 percent per annum. How much should you expect to receive
from the loan shark now?

b. Multiple cash flows of equal amount each period

Equal periodic cash flows occurring after equal interval of time for a specified period of time are known as
annuities.
There are two types of annuities.
 Ordinary annuity
 Annuity Due

i. Ordinary Annuity.
It is an annuity that occurs at the end of each year. Note that the word end of the year does not mean the
end of the calendar year, it means from where you are starting from
Examples of ordinary annuity include;
 Student loan payments
 Salary

Future value of an Ordinary annuity. The future value of an ordinary annuity is given by:
𝐴[(1+𝑟)𝑛 −1]
FVOA = 𝑟

Where:
FVOA= Future value of an ordinary annuity
n=Number of periods
r=Interest rate
A=Annuity.

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Present value of an Ordinary annuity. The present value of an ordinary annuity is given by:
𝐴 [1−(1+r)−𝑛 ]
PVOA = 𝑟

Where:
PVOA= Present value of an ordinary annuity
n=Number of periods
r=Interest rate
A=Annuity
ii. Annuity due
It is an annuity that occurs at the beginning of each period.
Examples of annuity due include;
 House rent
 Insurance premium
Note: With an annuity due, there is always one extra compounding period and one less discounting period.
Due to this, to get the present value or future value of an annuity just multiply ordinary annuity formulas
by (1+r).

Future value of an Annuity due.The future value of an annuity due

𝐴[(1+𝑟)𝑛 −1]
FVAD = (1+r)
𝑟

Where:
FVAD = Future value of an annuity due
n=Number of periods
r=Interest rate
A=Annuity

Present value of an Annuity due:

𝐴 [1−(1+r)−𝑛 ]
PVAD = 𝑟
(1 + r)

Where:
PVAD = Present value of an annuity due
n=Number of periods
r=Interest rate
A=Annuity

Example 7

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Suppose you decide to deposit Tshs.1, 000,000 each month in an account carrying 1% interest rate per
month. How much are you going to have in the account at the end of 4 months if:
(a) The deposit is made at the beginning of the month?
(b) The deposit is made at the end of the month?

Example 8
Suppose you receive a 10-years, Shs.70 million mortgage from a bank. The bank is charging you a 6%
interest rate per annum for this mortgage. How large your periodic payment needs to be for you to clear the
mortgage in the 10 years:
a. If you make one payment at the end of each year and interest compounds annually?
b. If you make one payment at the end of each month and interest compounds monthly?

iii. Perpetuity.
Perpetuity is an annuity with an infinite period. Eg Interest received on irredeemable bonds or dividend
𝐶𝐹1
received on irredeemable preference shares. PVp =
𝑟

Where: CF1 is the cash flow of period one.

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Example 9
Assume that you have invested in an irredeemable 10% bond of TZS 100,000. What should be the intrinsic
price of the bond given that the discount rate is 12%? Assume that the current market price of the bond is
TZS 90,000. Has it been overpriced or underpriced?

Present value of a growing Annuity

Given by formula:
(1 + g)𝑛
1−
(1 + r)𝑛
Present Value=(1+g)[ r−g
]

Example 10.
You have the right to harvest a teak plantation for the next 20 years over which you expect to get 10,000
cubic feet of teak per year. The current price per cubic feet of teak is Tshs.500, but it is expected to increase
at a rate of 8% per year. The discount rate is 15%. What is the present value of the teak that you can harvest
from the teak forest?

Present value of a growing perpetuities

CF0 (1+g) CF1
Present Value of growing perpetuity= or =
(r−g) (r−g)

Example 11.
A company plans to pay a dividend of TZS 2500 one year from now. Dividend grows at a rate of 7% a year
and ordinary shareholders require 17% as return on their investment. By how much should a share sell
today?
Continuous compounding:
This involve compounding of interest of an infinite number of of times per year at interval of microsecond
the smallest time period imaginable.
FV=𝐴𝑒 rxn
Where e is an exponential function with value of 2.718
Rule of 72.
 It takes 72𝑟periods for an amount invested at a certain rate to double.
 It assists to know how long for an amount invested takes to double.

QUOTING INTEREST RATES:

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Interest rates and rates of return are normally quoted on per annum basis. In some cases interest rates are
quoted for periods other than a year
-Converting other period rates to annual rates
-The annual percentage rate (APR) =ipx p
ip is per period rate and p is a number of periods.
 The above relationship is used only if an interest is compounded annually
 If an interest rate is compounded more than once in a year, then there is a need to compute Effective
annual rate(EAR) The EAR will be greater than ip× p due to the fact that there is reinvestment of
interest (compounding) occurs more than once in a year.

The equivalent annual return(rate)- this is obtained by adjusting the nominal interest rate by the number of
compounding periods per year as displayed in the relationship below:
r
EAR = (1 + )𝑝 − 1
𝑝

Where:
r=annual rate
p=Number of compounding.
Note: Although there is EAR, periodic rate still remains (r/p) and not (EAR/P) periodic rate is applied
directly on periodic CFs and this takes care of frequent compounding.

Example 12:
Charles has a TZS 200M fixed deposit at the bank. The interest rate is 6% compounded quarterly for one
year. What is the effective annual interest rate?

Example 13:
A borrower offers 16% nominal rate of interest with quarterly compounding. What is the effective rate of
interest?

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Deferred Annuity concept

Deferred annuity means that the equal annual payments begin after a specified number of periods and not
from the first period.
For example, an ordinary annuity of six instalments deferred for 3 years means that the first payment will
occur only at the beginning of the fourth year and that no payments will occur in the first three years.
(a) Future Value of a deferred annuity The deferred period is not taken into account while calculating the
future value of a deferred annuity just like in case of an ordinary annuity which is not deferred.
(b) Present Value of Deferred Annuity While computing present value of deferred annuity, we compute the
present value of ordinary annuity as if the cash flow has occurred for the entire period; deduct present value
of cash flows not received/ paid during the deferred period; balance is the present value of cash flows
actually received/ paid subsequent to deferral period.

APPLICATIONS OF TIME VALUE OF MONEY IN FM

The value of money concept used to evaluate cash flows in the following scenarios:-
a.) sinking fund
b) Annuity
c) Retirement Planning
d) Capital recovery plans

Sinking Fund
Sinking fund is a fund which is created by contributing fixed amounts at regular fixed intervals so that a
decided sum is accumulated at the end of the specified period.
It is generally created by borrowers: E.g. Companies create sinking fund to repay debentures or bonds on
maturity. Borrower may pay interest at regular intervals during the life of the loan but may not have
sufficient provision to repay the principal on maturity of the loan. Hence sinking funds are created to make
provision for repayment of loan on maturity.
Time value of money is taken into account to calculate the amount that needs to be contributed to the sinking
fund so that funds are available to repay loan on maturity.
Formular
Annuity= FV* 1/Coumpounding Factor
Example 14:
PQR Plc intends to establish a sinking fund to repay TZS 10 Million 7% debentures 10 years from today.
The first payment will be made at the end of current year. The company expects that the funds will earn 6%
interest per year.

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Required:
What equal annual contribution should be made to accumulate TZS 10 Million?

Steps in solving TVM problems:

I. Read the problem thoroughly
II. Create a time line
III. Put cash flows and arrows on a time line
IV. Determine if it is PV or FV problem
V. Determine if the problem involves Single CF, Annuity or Mixed
VI. Solve the problem.
QN 1
You have just won the CPA-T Best graduate prize of TSHS 11,000,000 by the National Board of
Accountants and Auditors. Your winnings will be paid to you in 26 equals annual installments with the first
payment made immediately. If you had the money now, you could invest it in an account with a quoted
annual interest rate of 9% with monthly compounding of interest. What is the present value of the stream
of payments you will receive?
QN 2
You are planning to retire 15 years from now. You have estimated that you will have 25 years to live after
your retirement. Your objective is to set up an individual retirement fund that will provide shs. 800,000
each month to meet your living costs after retirement. Your investigation has shown that it is possible to
set up the fund by depositing a fixed amount from your salary in a special retirement account that earn 4.8%
p.a. You have also estimated that this interest rate will remain constant for the first 15 years and then
increase to 6% p.a. thereafter. How large does your monthly deposit needs to be for you to achieve your
objective assuming interest compounds monthly your monthly deposit needs to be for you to achieve your
objective assuming interest compounds monthly?

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QN 3
Suppose you wish to m retire forty years from today. You determine that you need tzs 500,000/= per year
once you retire with the first retirement fund withdrawn one year from the day you retire. You estimate that
you will earn 6% per year on your retirement fund and that you will need funds up to and including your
25th bairthday after retirement.
a)how much must you deposit in an account so that you have enough funds for retirement?
b) how much must you deposit each year in an account starting one year from today, so that you have
enough fund for retirement.?

CPA Elisha Fabian; 0656 941817