TIME VALUE OF MONEY APPLICATIONS

TIME VALUE OF MONEY APPLICATIONS

Time value of money concept explains that a shilling today is worth more than a shilling tomorrow, this explain the importance of obtaining money now rather than receiving the same amount of money later. This is because a shilling obtained today is free from any expectation of future uncertainties that might reduce its value and secondly the same amount of money held in hand can be invested to produce interest. (Crosson, 2008)

Present value and Future value techniques can be used in assessment of financial decisions and financial value in the financial market. The Future Value of money refers to value of present sum of, payments or receipts money at some time in the future. It is the amount of money that will grow from money invested at some given interest rate. It uses compounding technique in finding future cash flow of a given cash flow at a future date. (Carr,2006)

Present value refers to the current value of a future receipt or payment, it measures the value cash flow at the beginning of a given project. It uses discounting to find present value of cash flow at time zero. Both present value and Future value can be used by individuals and business managers of organization in making investment decisions. Time value of money has the following applications;

1. Capital budgeting decisions by organization.Net present value can be used to make a decision on whether the investment should be made or not. The decision criteria are that when the NPV is greater than zero the project should be accepted, if less than zero, the organization should reject the project. The NPV is found by subtracting the present value of cash out flows from present value of cash inflows.

2. Valuing stocks and bonds,  bonds being long term instruments used by businesses or government as a way of raising funds in an organization. most interest rates in bonds are paid semi annually, with stated maturity rate,

The basic equation for the value of a bond with n years to maturity and which pays interest ,I , annually is;

Where

B₀        =          current value of the bond (at time zero).

I           =          annual interest paid in shillings (coupon interest x face value)

n          =          number of years to maturity

M         =          par value (face value) in shillings

=          required return on a bond

3. Making personal decision when keeping money in a bank to determine whether the amount invested will earn the speculated amount of money.

EXAMPLES

• Present value of a lump sum

JK LTD  invested Ksh100, 000. The investment is expected to earn interest at a rate of 20% compounded annually. Determine the future value of the investment after 3 years.

Solution:

At end of Year 1, FV₁                =100,000 (1+0.2) =120,000

At end of Year 2_, FV₂            =120,000 (1+0.2) OR { 100,000(1+0.2) (1+0.2)}=144,000

At end of Year 3, FV₃     = 144,000(1+0.2) =100,000 ( 1+0.2) ( 1+0.2) (1+0.2)    = 172,800

Sharon wanted to know the maximum amount that she should invest in a project to give her sh. 1000 at the end of 4 years at the rate of 10%.

Solution

The PVIFA at 10% for 4 years (PVIFA_10%,4yrs) from Table A-2  is 3.1699.

Therefore, PVA = 3.1699X 1000 = Sh.3, 169.9

• Future value of a lumpsum

DILO LTD made invested shs100, 000 compounded annually at an interest rate of of 12%, the Future value is calculated as;

Solution.

• Future Value of annuity.

Using the above example of investment of DILO LTD to find out the Future value of annuity at the beginning of the year to find the value of Sh.100,000 investment annually at the beginning of each of the next 5 years at an interest of 12%.

REFERENCES

1. Crosson, S.V, and Needles,B.E (2008) Managerial Accounting (8^th Ed) Boston: Houghton Mifflin Company
2. Carr,Peter, Flesaker,Bjorn (2006) Robust Replication of Default contingent claims.