FINANCIAL MANAGEMENT (B1) TIME VALUE OF MONEY

FINANCIAL MANAGEMENT (B1)

TIME VALUE OF MONEY

Prepared By:
Emmanuel Christopher, MBA (Finance), B Com Acc (Hon), CPA (T) &
Godson Mkaro [MSc in Finance & Investment, BSc in Computer Science (Hons), ATEC II, CPBE, CPA (T)],
Goodhope Mkaro [MBA (Finance), B. Com (Acc) (Hons), PGD in Tax Management, CPB, CISI(UK), CPA (T)]
Ally Mshana MFA-OG, B. Com (Acc) (Hons), ATEC II, CPA(T)

Prepared By: Emmanuel Christopher: MBA in Finance, BCOM in Accounting, CPA (T) &
Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Contacts: +255 714 965 564 | +255 717 348 616 | info@covenantfinco.com | www.covenantfinco.com Page | 1
 FINANCIAL MANAGEMENT (B1) TIME VALUE OF MONEY

Examples on Time Value of Money

Example 1

Assume that you deposit Tsh 1M 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
c) Using annuity table that presumes compound interest

Example 2

How much would have been in your account if your parents had invested 50000 on your birth say
20 years ago in your fixed deposit account that pays an interest rate of 12% p.a?

Example 3

CFC wants to know how large would their deposit of TZS 100M be at the rate of 10% 5 years
form today…

Hint: The Rule of 72

- Given an interest rate of r% per period compounding once, it takes about 72/r periods for an
amount (PVo) to double

For example with 8% annual interest rate it will take about 9 years (72/8) for an amount to double

Example 4

How long does it take to double TZS 5M at a compound interest rate of 12% p.a?

Example 5

Suppose you need TZS 2M in 3 years to pay your college fee. If you can earn 8% on your money,
how much do you need today?

Example 6

Assume that you need 10M in two years. How much do you need today at the discount rate of 7%
per annum compounded annually?

Prepared By: Emmanuel Christopher: MBA in Finance, BCOM in Accounting, CPA (T) &
Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Contacts: +255 714 965 564 | +255 717 348 616 | info@covenantfinco.com | www.covenantfinco.com Page | 2
 FINANCIAL MANAGEMENT (B1) TIME VALUE OF MONEY

Example 7

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 after 4 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?

Example 8

Suppose you decide to deposit Shs 1million 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 9

Suppose you received a 10-years, Shs. 70million mortgage from a bank. The bank is charging you
a 6% interest rate per annum for this mortgage. How large your periodic payment need to be for
you to clear the mortgage in the 10 years:

✓ If you make one payment at the end of each year and interest compounds annually?
✓ If you make one payment at the end of each month and interest compounds monthly?

Example 10

Imacris has a TZS 100m fixed deposit at the bank. The interest rate is 6% per quarter compounded
quarterly for one year. What is the effective annual interest rate?

Example 11

The credit card company claims to charge 1.5% per month or 18% per year, but is this really annual
effective interest rate that the company is charging?

Example 12

You need 1 M today to finish paying your tuition fee at CFC and other NBAA registration
requirements. Mzee Biasharafaida lends you the TZS 1M and makes you promise to repay TZS
1.1M in 3 months.

Prepared By: Emmanuel Christopher: MBA in Finance, BCOM in Accounting, CPA (T) &
Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Contacts: +255 714 965 564 | +255 717 348 616 | info@covenantfinco.com | www.covenantfinco.com Page | 3
 FINANCIAL MANAGEMENT (B1) TIME VALUE OF MONEY

✓ What is the EAR that he is charging you

✓ Should you take the loan from him

Review Questions on TMV

1. What is meant by the term “opportunity cost rate”? What is meant by the term “opportunity
cost rate”? What is discounting? How is it related to compounding?

2. How does the present value of an amount to be received in the future change as the time is
extended and as the interest rate increases?

3. ABC Inc. just paid a TZS 2000 dividend at the end of the current year (i.e., D0 = TZS 2000).
After the dividend is paid, the company’s dividends are expected to grow at a 50% annual rate
for each of the following two years, and then settle down to a steady state growth rate of 5%
annually. If investor’s required rate of return is 15% on this stock, what should a share sell for
today?

4. For each of the following, compute the future value; if TZS2000=1USD

Present value (TZS) Years Interest rate Future value in USD

2,250 4 18%
9,310 9 6
76,355 15 12
183,796 21 8

5. For each of the following, compute the present value;

Present value (TZS) Years Interest rate Future value USD

6 4% 15,451
8 12 51,557
16 22 886,073
25 20 550,164

Prepared By: Emmanuel Christopher: MBA in Finance, BCOM in Accounting, CPA (T) &
Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Contacts: +255 714 965 564 | +255 717 348 616 | info@covenantfinco.com | www.covenantfinco.com Page | 4
 FINANCIAL MANAGEMENT (B1) TIME VALUE OF MONEY

6. Solve for unknown interest rate in each of the following;

Present value TZS Years Interest rate Future value in TZS

221 3 307
425 9 761
25,000 15 136,771
40,200 30 255,810

7. Solve for unknown number of years in each of the following;

Present value Years Interest rate Future value

$ 250 4% $ 1,284
1,941 9 4,341
21,320 23 402,662
32,500 34 173,439

8. You plan to retire 33 years from now. You expect that you will live 27 years after retiring. You
want to have enough money upon reaching retirement age to withdraw TZS 180,000 from the
account at the beginning of each year you expect to live, and yet still have TZS 2,500,000 left
in the account at the time of your expected death (60 years from now). You plan to accumulate
the retirement fund by making equal annual deposits at the end of each year for the next 33
years. You expect that you will be able to earn 12% per year on your deposits. However, you
only expect to earn 6% per year on your investment after you retire since you will choose to
place the money in less risky investments. What equal annual deposits must you make each
year to reach your retirement goal?

9. Nerwin, Inc. is a furniture manufacturing company with50 employees. Recently, after a long
negotiation with the local labor union, the company decided to initiate a pension plan as a part
of its compensation plan.
The plan will start on January 1, 2003. Each employee covered by the plan is entitled to a
pension payment each year after retirement. As required by accounting standards, the
controller of the company needs to report the pension obligation (liability).

Onthe basis of a discussion with the supervisor of the Personnel Department and an actuary
from an insurance company, the controller develops the following information related to
the pension plan. Average length of time to retirement 15 yearsExpected life duration after
retirement 10 years

Prepared By: Emmanuel Christopher: MBA in Finance, BCOM in Accounting, CPA (T) &
Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Contacts: +255 714 965 564 | +255 717 348 616 | info@covenantfinco.com | www.covenantfinco.com Page | 5
 FINANCIAL MANAGEMENT (B1) TIME VALUE OF MONEY

10. You have just won the CPA-T Best graduate prize of TZS 11,000,000. Your winnings will be
paid to you in 26 equal 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?

11. Your sister is twenty years old today and she wishes to accumulate TZS 9,000,000 by her fifty-
fifth birthday so she can retire to her summer place on Lake Tahoe. She wishes to accumulate
the TZS 9,000,000 by making annual deposits on her twentieth through her fifty-fourth
birthdays. What annual deposit must your sister make if the fund will earn 8% interest
compounded annually?

12. You plan to make a series of deposits in an interest-bearing account. You will deposit $1,000
today, $2,000 in two years, and $8,000 in five years. If you withdraw $3,000 in three years and
$5,000 in seven years, how much will you have after eight years if the interest rate is 9 percent?
What is the future value of these cash flows?

13. You are valuing an investment that will pay you TZS26,000 per year for the first 9 years,
TZS34,000 per year for the next 11 years, and TZS47,000 per year the following 14 years (all
payments are at the end of each year). Another similar risk investment alternative is an account
with a quoted annual interest rate of 9.00% with monthly compounding of interest. What is the
value in today's dollars of the set of cash flows you have been offered?

14. Deryl wishes to save money to provide for his retirement. Beginning one year from now, he
will begin depositing the same fixed amount each year for the next 30 years into a retirement
savings account. Starting one year after making his final deposit, he will withdraw
TZS100,000 annually for each of the following 25 years (i.e. he will make 25 withdrawals in
all). Assume that the retirement fund earns 12% annually over both the period that he is
depositing money and the period he makes withdrawals. In order for Deryl to have sufficient
funds in his account to fund his retirement, how much should he deposit annually (rounded to
the nearest dollar)?

15. 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

Prepared By: Emmanuel Christopher: MBA in Finance, BCOM in Accounting, CPA (T) &
Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Contacts: +255 714 965 564 | +255 717 348 616 | info@covenantfinco.com | www.covenantfinco.com Page | 6
 FINANCIAL MANAGEMENT (B1) TIME VALUE OF MONEY

large does your monthly deposit needs to be for you to achieve your objective assuming interest
compounds monthly?

16. A bank offers three different accounts which are similar in all respects – including the level of
riskness – except in the interest rates and the way interest compounds.
- CLASSICS Account carries 7.9 percent interest that compounds annually
- ROYAL Account carries 7.8 percent interest that compounds semi-annually, and
- PRINCESS Account carries 7.5 percent interest that compounds monthly.
a) Which account you will recommend to a friend? Why?
b) Will your answer change if the friend has a 20-year investment horizon? Why?

17. Time Value of Money – The Concept of Equivalent Annual Cost

Covenant Co services custom cars and provides its clients with a courtesy car while servicing is taking
place. It has a fleet of 10 courtesy cars which it plans to replace in the near future. Each new courtesy
car will cost TZS15,000,000. The trade-in value of each new car declines over time as follows:

Age of courtesy car (years) 1 2 3

Trade-in value (TZS/car) 11,250,000 9,000,000 6,200,000

Servicing and parts will cost TZS1,000,000 per courtesy car in the first year and this cost is expected to
increase by 40% per year as each vehicle grows older. Cleaning the interior and exterior of each
courtesy car to keep it up to the standard required by Covenant's clients will cost TZS500,000 per car
in the first year and this cost is expected to increase by 25% per year.
Covenant Co has a cost of capital of 10%. Ignore taxation.

REQUIRED

(a) Using the equivalent annual cost method, calculate whether Covenant Co should replace its fleet after
one year, two years, or three years. (12 marks)

2.1. Loan Types and Loan Amortization

I. Pure discount loans

It is the simplest form of loan in which the borrower receives money today and repays a single
lump sum at some time in the future.

Are very common when the loan term is short, say, a year or less. In recent years, they have
become increasingly common for much longer periods.

QUESTION 1

Suppose a borrower was able to repay shs 25,000 in five years.

Prepared By: Emmanuel Christopher: MBA in Finance, BCOM in Accounting, CPA (T) &
Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Contacts: +255 714 965 564 | +255 717 348 616 | info@covenantfinco.com | www.covenantfinco.com Page | 7
 FINANCIAL MANAGEMENT (B1) TIME VALUE OF MONEY

If we acting as the lender, wanted a 12% interest rate on the loan, how much would we be willing
to lend? Or what value would we assign today to that shs 25,000 to be repaid in five years?

QUESTION 2

If a T-bill promises to pay shs 10,000 in 12 months, and the market interest rate is 7%, how much
will the bill sell for in the market?

Interest-Only Loans

It is a loan which has a repayment plan that calls for the borrower to pay interest each period and
repay the entire principal at some point in the future.In the perpetuity, the borrower pays interest
every period forever and never repays any principal. Most corporate bonds have the general form
of interest-only loan.If there is just one period, a pure discount loan and the interest-only loan are
the same thing.

QUESTION 3

With a three-year, 10%, interest-only loan of shs 1000. What amount will the borrower repay each
year? What is the value of loan today?

II.Amortized loans
• With pure discount or interest only loan, the principal is repaid all at once
• With an amortized loan, the lender may require borrower to repay part of loans over time.
• The process of paying off a loan by making regular principal reduction is called amortizing
the loan.

a. Amortization with equal principal payments

A simple way of amortizing is to have borrower pay the interest each period plus some fixed
amount of principal.The approach is common with medium-term business loans.

QUESTION 4

Suppose a business takes out a shs 5000 five year loan at 9%. The loan agreement calls the
borrower to pay interest on the loan balance each year and to reduce the loan balance each
year by shs 1000

Prepare the amortization schedule.

b. Amortization with equal payments

Prepared By: Emmanuel Christopher: MBA in Finance, BCOM in Accounting, CPA (T) &
Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Contacts: +255 714 965 564 | +255 717 348 616 | info@covenantfinco.com | www.covenantfinco.com Page | 8
 FINANCIAL MANAGEMENT (B1) TIME VALUE OF MONEY

• The most common way of amortizing a loan is to have borrower make a single, fixed
payment every period.
• Almost all consumer loans such as car loans and mortgages work this way.

QUESTION 5

Suppose you borrow shs 10,000. You are going to repay the loan by making equal annual
payments for five years. The interest rate on the loan is 14% per year. Prepare the amortization
schedule for the loan. How much interest will you pay over the life of the loan?

NBAA May 2015 QUESTION 3

(a) You have been recently appointed as the Finance Director of Haneti Company, a company
specializing in processing milk products. The Managing Director of Haneti Company has
approached you for advice. On 31st December 2015 the company will be replacing its three
existing company cars with brand new vehicles. The Managing Director wishes to know
whether he should replace these new vehicles after every one year, two or three years from
now on. He has provided the following background information.
1. Each new car will cost Tshs 22 million.
2. Resale values for each car (assumed to be received in cash on the last day of the year to
which they relate) are estimated to be Tshs 14 million after one year, Tshs 8.4 million after
three years.
3. Annual running costs for each car (assumed to be paid on the last day of the year to which
they relate) are estimated at Tshs 13.2 million in the first year of ownership, Tshs 15.2
million in the second year and Tshs 18.4 million in the third year.
4. The company uses a discount rate of 10% in appraisal of such investment
5. For the purpose of advice to be given to the Managing Director, taxation and inflation can
be ignored

REQUIRED:

Using appropriate calculations, advice the Managing Director of the optimal replacement
policy for these new company cars (10 marks)

(b) KorongoMbaka wishes to choose the best of two equally costly cash flow streams: Annuity
X and annuity Y. X is an annuity due with a cash inflow ofTshs 9,000 for each of 6 years.
Y is an ordinary annuity with a cash inflow of Tshs 10,000 for each of 6 years. Assume
that Korongo can earn 15 percent on his investment.
Prepared By: Emmanuel Christopher: MBA in Finance, BCOM in Accounting, CPA (T) &
Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Contacts: +255 714 965 564 | +255 717 348 616 | info@covenantfinco.com | www.covenantfinco.com Page | 9
 FINANCIAL MANAGEMENT (B1) TIME VALUE OF MONEY

REQUIRED:
(i) On a purely subjective basis, which annuity do you think is more attractive? Why?
(ii) Find the future value at the end of 6 years for both annuity X and Y
(iii) Use your findings in part b (ii) to indicate which annuity is more attractive. Compare
your findings to your subjective response in part b (i).

Prepared By: Emmanuel Christopher: MBA in Finance, BCOM in Accounting, CPA (T) &
Godson Mkaro (Jr): MSc Finance & Investment, BSc. Computer Science, ATEC II, CPBE, CPA (T),
Contacts: +255 714 965 564 | +255 717 348 616 | info@covenantfinco.com | www.covenantfinco.com Page | 10