DFI501: FINANCIAL MANAGEMENT

THE TIME VALUE OF MONEY

One of the Central and important principle in the

discipline of finance
 AUTHORS

• Anthony, M., & Biggs, N. ( 2004). Mathematics for Economics and

finance: Methods and Modeling.
 
• Arnold, A., & Kumar, M. (2008). Corporate Financial Management
(3rd Ed.). Pearson Education.

• Berk, J., & Demerzo, P. ( 2011). Corporate Finance: The core (2nd
Ed.). Pearson Education.

• Brigham, E. F., & Ehrhardt, M. C. (2005). Financial Management:

Theory and Practice ( 11th Ed.). Thomson: South Western.
 Authors
• Copeland, T. E., & Weston, J. F., & Shstri, K., ( 2011). Financial
Theory and Corporate Policy ( 4th Ed.). Pearson Education.

• Higgins, R. C., (2012). Analysis for Financial Management ( 10th Ed.).

Mc Graw Hill: International Edition.

• Prasana , C., (2003). Financial Management: Theory and Practice

(5th Ed.). Mc Graw Hill.

• Ross,S.A., Westerfield, R. W., & Jaffe J., (2007). Corporate finance

( 7th Ed.). Mc Graw Hill.
Introduction
• The time value of money Means that the money
you hold in hand today is worth more than
money you expect to receive to receive in the
future ( A shilling today is worth more than a
shilling tomorrow)

• Similarly, money you must pay out today is a

greater burden than the same amount paid in the
future.
Introduction…….Continuation

• Interest rates are positive in part because

people prefer to consume now rather than
later. This indicates that money has time value
(The difference in value between money today
and money in the future)

• Why do people prefer to consume now?

Introduction…….Continuation

• Financial Management, adjusts for the time

value of money by calculating future value and
present value which constitute the two
concepts of the time value of money
( Compounding and Discounting)
 THE TIME LINE

• One of the most important tools in time value

analysis is the time line

• The time line shows the CASH FLOWS that

occur at the end of each year (This helps
visualize the cash flows, their timing and the
riskiness)
 THREE RULES OF TIME TRAVEL
• Financial Decisions require comparing or
combining cash flows that occur at different points
in time.
• Such rules that allow for this include:
1. It is only possible to compare or combine values
at the same point in time . To compare or
combine cash flows that occur at different points
in time, you first need to need to convert the cash
flows into the same units or move them to the
same point in time.
 THREE RULES OF TIME TRAVEL

2. To move a cash flow forward in time, you must

compound it ( Compounding(
3. To move cash flows back in time , we must
discount it ( Discounting)

• In the next slide, we discuss the two

fundamental concepts of TIME VALUE OF
MONEY, Compounding and Discounting of cash
flows
 Characteristics of Cash flows
1. A lump sum or single Amount
2. A stream of uneven cash flows
3. An annuity
4. A perpetuity
5. Growing Annuity into perpetuity
6. Growing Annuity for n periods of time
 FUTURE VALUE

• The process of going from todays, or present

values (PVs) to the future cash flows ( FVs) is
called compounding.

• A shilling in in hand today is worth more than a

shilling to be received in the future because if
you had it now , you could invest it, earn
interest and end up with more than one shilling
in the future.
 Terminology
1. K or r = Interest rate/Discounting rate

Interest rate Factor (1 k )

n

2.
3. FV= Future Value
4. PV=Present Value
5. PVoA=Present Value of Ordinary Annuity
F u t u r e Va l u e o f a L u m p s u m

PV (1 k )
n
FV 
 An Example
If you invest Sh. 15,0000 today, how much will
you have:
a) In 2 years at 9 percent?
b) In 7 years at 12 percent?
c) In 25 years at 14 percent?
P r e s e n t Va l u e o f a L u m p s u m

PV  FV (1 K )
n
 Example One

• Your aunt offers you a choice of Sh. 60,000 in

40 years or Sh. 850 today. If money is
discounted at 11 percent, which should you
choose?
 Example Two
You will receive Ksh. 20,000 three years from
now. The discount rate is 8 percent.

What is the value of your investment today?

 Annuiti es

• An Annuity is a stream of constant cash flow

( Payment or Receipt) occurring at regular
intervals e.g life insurance premiums
• These cash flows end after some number of
Payments e.g car loans and Mortgages
 Future value Annuity

(1 k )
n
1

FV Annuity  PMT *
k
 An Example
Your brother, James, will Join University in seven years, for his higher
education. His ambition is to pursue medicine at the University of Nairobi. The
Cost of education will be Sh. 1.5 Million per year for five years. Anticipating
James’s ambitions, your parents started investing Sh. 100,000 per year five
years ago and will continue to do so each year for the next seven years.

How much more will your parents have to invest each year for the next seven
years to have the necessary funds for the education of your brother? Use 12
percent as the appropriate interest rate throughout this problem The cost
assumed to come at the end of each year. The cost assumed to come at the
beginning of each year
 Present Value of Perpetuity
• A perpetuity is a stream of equal cash flow
that occur at regular intervals and last forever

• Example: The British Government bond known

as a consol
Present Value of Perpetuity

C
PV perpetuity k

Special Cases: Growing Cash Flows
1. Growing perpetuity
2. Growing Annuity
Growing perpetuity

PV  C 1

kg
 Growing Annuity

1  1 g n
PV  C1 * * 1  ( ) 
k  g  1 k 
 Applications of Time Value of Money

The time value of Money has many applications:

1. Setting up schedules for paying off loans

2. Decisions about whether to acquire new

equipment

3. Retirement planning
END