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Chapter-2: Concepts of Value & Return BIB I, II & III

THE CONCEPTS OF RETURN AND VALUE


INTRODUCTION
A finance manager is required to make decisions on investment, financing and dividend in view of
the company's objectives. These decisions include for example, purchase of assets or procurement
of funds. Such investment/financing decisions affect the cash flow in different time periods, e.g., if
a fixed asset is purchased, it will require an immediate cash outlay and will generate cash inflows
during many future periods
These cash flows generated in different time periods may not be comparable due to the change in
shillings value of money. These cash flows can only be comparable by introducing the interest
factor, also known as the time value of money.

TIME PREFERENCE (VALUE) FOR MONEY


Time reference for money is an individual’s preference for possession of a given amount of money
now, rather than the same amount of money at some future time. This is because the, value of a sum
of money received today is more than its value received after some time. Conversely, the sum of
money received in future is less valuable than it is today.

REASONS FOR TIME PREFERENCE FOR MONEY


The three basic reasons that may be attributed to the individual’s time preference for money include;
(a) Risk and uncertainty. We live under risk or uncertainty. As an individual is not certain about
future cash receipts, he or she prefers receiving cash now. For example, the risk of not being in
a position so enjoys future consumption that may be caused by illness or death.
(b) Preference for consumption. Most people have subjective preference for present consumption
over future consumption of goods and services.
(c) Investment opportunities. Most individuals prefer present cash to future cash because of the
available investment opportunity to which they can put present cash to earn additional cash.

EXPRESSING THE CONCEPT OF TIME PREFERENCE FOR MONEY


The time value for money is generally expressed by an interest rate or time preference rate, the rate
which gives money its value, and facilitates the comparison of cash flows occurring at different time
periods to compensate for both time & risk.

This rate will be positive even in the absence of any risk. It maybe therefore called the risk-free rate.
The risk-free rate compensates for time. For example, if the time preference rate is 5%, the investor
can forego the opportunity of receiving 100 shillings if he’s offered 105 shillings after one year.
These two values are equivalent in value.

In reality, an investor will exposed to some degree of risk, therefore he would require a rate of return,
called the risk premium from the investment which is the interest rate demanded, above the risk-free
rate as compensation for risk, to account for the uncertainty of cash flows.

Therefore, a risk-premium rate is added to the risk- free time preference rate to derive required
interest rate. That is, RRR = Risk-free rate + Risk premium

Thus the RRR is the minimum annual interest rate earned by an investment that will induce the
investor to put money into a particular project that compensate them for both the time and risk.
Page 1 of 12
Prepared By Ddamba AbdulKarim ©2018
Department of Finance
Faculty of Finance
ESLSCA International Business School
Chapter-2: Concepts of Value & Return BIB I, II & III

METHODS OF ADJUSTING CASH FLOWS FOR TIME VALUE FOR MONEY


The whole concept of time value for money is about ascertaining the present value and future value
of money. There are two methods used for ascertaining the worth of money at different points of
time, namely, compounding and discounting. Compounding method is used to know the future value
of present money. Conversely, discounting is a way to compute the present value of future money.
1. COMPOUNDING METHOD
Compounding refers to the process of earning interest on both the principal amount, as well as
accrued interest by reinvesting the entire amount to generate more interest.

TECHNIQUE OF COMPOUNDING
Compounding is the method used in finding out the future values (FV) of the present investment
at a given interest rate at the end of a given period of time.
Calculating the Future Value (FV)
Future value (FV) is the value of a current investment at a specified date in the future based on an
assumed rate of growth over time.

The FV of the present investment can be both computed for a single cash inflows (lump sum) or a
series of cash inflows (annuity).

a) The FV of a single cash flow (Lump sum)


The future value of a lump sum, i.e. a single cash flow payment made at a particular time. The
future value can be computed by applying the compound interest formula which is as under:

FV of a Single Cash Flow = Amount * (𝟏 + 𝒊)𝒏


Where:
 FV = future value or compound value
 Amount = Present value or present investment
 i= rate of interest per annum or rate of return on the investment
 n = number of years for which compounding is done.
 The expression (𝟏 + 𝒊)𝒏 is the compound value factor (CFV) of a lump sum.
Note – 1: In compounding, interest on interest is earned.
Note – 2: It is very tedious to calculate the value of (1 + r) n so different combinations are
published in the form of the CVF tables. These may be referred for computation.
Illustration – One
Suppose your father gave you 100,000 shillings on your 18th birthday, and you deposit this
amount in a bank at 10% rate of interest for one year. How much sum would you receive after
one year?
Solution to illustration One
FV of a Single Cash Flow = 100,000 * (𝟏 + 𝟏𝟎%)𝟏
Which is 100,000 + (10% * 100,000) = 110,000 shillings
Exercise – One
What would be the future sum if you deposited 100,000 shillings in the bank at 10% for 2 years?

Page 2 of 12
Prepared By Ddamba AbdulKarim ©2018
Department of Finance
Faculty of Finance
ESLSCA International Business School
Chapter-2: Concepts of Value & Return BIB I, II & III

b) Future value of an annuity


An annuity is a fixed payment (or receipt) each year for a specified number of years. E.g., if you
rent a flat and promise to make a series of payments over an agreed period, you have created an
annuity. Alternatively, the premium payments of a life insurance policy, are an annuity.
Calculating the Future Value (FV) of an annuity
(𝟏+𝒊)𝒏 − 𝟏
FV of an Annuity (FVA) = PVA *
𝑖
Where,
 FVA = Future value of an annuity which has duration of n years.
 Amount = Constant periodic flow or an annuity
 i = Interest rate per period
 n = Duration of the annuity
 The term in brackets is the compound value factor of an annuity (CFVA).
Note: It is very tedious to calculate the value of (1 + r) n – 1 divided by i, is also termed as the
compound value factor of an annuity (CFVA). It would be difficult to solve the CFVA equations
manually if n is very large, either use a scientific calculator or a published table of the CFVA
values is available for various combination of the rate of interest ‘i’ and the time period ‘n’ to
facilitate our calculations.

Therefore, you get the FVA = Amount * CFVA

Illustration – One
Suppose 100,000 shillings is deposited at the end of each of the next three years at 10% interest
rate. What would be the future sum after the three years?

Solution to illustration One

(𝟏+𝟏𝟎%)𝟑 − 𝟏
FV of an Annuity (FVA) = 100,000 *
10%

FV of an Annuity (FVA) = 333,100/=

In conclusion
We have so far seen how the compounding technique can be used for adjusting for the time value of
money. It increases the investor’s analytical power to compare cash flows that are separated by more
than one period, given her interest rate per period, with the compounding technique, the amount of
present cash can be converted into an amount of cash of equivalent value to a decision maker.

Page 3 of 12
Prepared By Ddamba AbdulKarim ©2018
Department of Finance
Faculty of Finance
ESLSCA International Business School
Chapter-2: Concepts of Value & Return BIB I, II & III

2. DISCOUNTING METHOD
Discounting is the process of converting the future amount into its Present Value. The discounting
technique helps to ascertain the present value of future cash flows by applying a discount rate.

TECHNIQUES OF DISCOUNTING
Discounting method is used to determine the present value (PV) of money of a future cash flow or
a series of cash flows to its present worth.

The Present value


This is the current worth of a future sum of money or stream of cash flows given a specified rate of
return.

Calculating the Present Value (FV)


The PV of an investment can be both computed for a single cash inflows (lump sum) or a series of
cash inflows (annuity).

a) The PV of a single cash flow (Lump sum)


For calculating the present value of single cash flow, the following formula should be used;

𝟏
PV of a Single Cash Flow = FV * [ ]
(𝟏+𝒊)𝒏
Where:
 PV = Present value
 FV = Future value amount or a series of future cash flows
 i = rate of interest per annum
 n = number of years for which discounting is done.
 The term within brackets is the present value factor of a single cash flow, called the PVF.
Illustration – One
Suppose that an investor wants to find out the present value of 100,000 shillings to be received
after 15 years. Her interest rate is 10%

Solution to illustration One


𝟏
PV of a Single Cash Flow = 100,000 * [ ]
(𝟏+𝟏𝟎%)𝟏𝟓

PV = FV * PVF which is 100,000 * 0.239 = 23,900/=


Note-1: The present values decline for a given interest rate as the time period increases, similarly,
given the time period, present values would decline as the interest rate increases.

Note-2: You could also use the pre-computed present value factors in the PVF table, that is, PV
= Future Value * Present value factor (PVF)

Page 4 of 12
Prepared By Ddamba AbdulKarim ©2018
Department of Finance
Faculty of Finance
ESLSCA International Business School
Chapter-2: Concepts of Value & Return BIB I, II & III

b) Present value of an annuity


Sometimes instead of a single cash flow, an investor may have an investment opportunity of
receiving an annuity which is a constant periodic cash flows of same amount for a certain
specified number of years.
The present value of an annuity may be expressed as below:
(1+𝑖)𝑛 −1
Alternatively, the PVA = Amount * [ ]
𝑖∗(1+𝑖)𝑛

1 1
Alternatively, the PVA = Amount ∗ [ (𝑖 ) − ]
𝑖(1+𝑖)𝑛

Where,
 PVA = Present value of annuity which has duration of n years
 Amount = Constant periodic flow
 i = Discount rate.
 n = number of years for which discounting is done.
 The term within brackets is the present value factor of an annuity, called the PVFA and it is
a sum of single-payment value factors

Illustration about PV of an annuity


Suppose you receive an annuity of 5,000 shillings for four years, if the interest rate is 10%, what
would be the present value of the above annuity?
Solution to the above illustration
1 1
Therefore, the PVA = 5,000 * [ − ]
(0.10) 0.10(1+0.10)4
The PVA = 5,000 *(10 – 6.830) = 5,000 * 3.170 = 15,850 shillings
NB: It can be realized that the present value calculations of an annuity for a long period would
be extremely cumbersome without a scientific calculator, therefore, we can use a table of pre-
computed present values of an annuity.

c) Present value of an Uneven Cash flows


Investments made by a firm do not frequently yield constant periodic cash flows (annuity). In
most cases, the firm receives a stream of uneven cash flows. Thus the present value factors for
an annuity as given in the pre-computed tables cannot be used.

Formula for PVs of Uneven Cash flows

𝐴 𝐴 𝐴 𝐴
PV of uneven cash flows =
(1+𝑖)
+ (1+𝑖)2 + (1+𝑖)3 +… + (1+𝑖)𝑛

𝒏 𝑪𝒇𝒕
Alternatively it is = ∑𝒕=𝟏
(𝟏+𝒊)𝒕
Page 5 of 12
Prepared By Ddamba AbdulKarim ©2018
Department of Finance
Faculty of Finance
ESLSCA International Business School
Chapter-2: Concepts of Value & Return BIB I, II & III

Illustration about the PV of Uneven Cash flows


Consider an investor has an opportunity of receiving 1,000 shillings, 1,500/=, 800/=, 1,100/= and
400/= respectively at the end of one through five years. Find out the present value of this stream
of uneven cash flow. The investors required interest rate is 8%.
Solution to the above illustration
The present value is calculated as follows;
1000 1500 800 1100 400
PV of uneven cash flow =
(1+0.08)
+ (1+0.08)2 + (1+0.08)3 + (1+0.08)4 + (1+0.08)5
Solving for the above equation using PVFs table
The complication of solving this equation can be resolved by using the table of the pre-computed
present value factors (PVFs) and multiplying them with respective amounts as seen from the
calculations below;
PV = FV*PVF𝑛,𝑖

PV = 1000*PVF1,0.08 + 1500*PVF2,0.08 + 800*PVF3,0.08 +


1100*PVF4,0.08 +1100*PVF4,0.08 +400*PVF5,0.08
PV of Uneven Cash inflows = 3,927.60

d) Present value of an growing annuity


In financial decision making, there are number of situations where cash flows may grow at a
constant rate. E.g., in the case of companies, dividends are expected to grow at a constant rate.
Illustration about the PV of growing annuities
Assume that to finance your postgraduate studies in an evening college, you undertake a part-
time job for 5 years. Your employer fixes an annual salary of 1,000 with the provision that you
will get annual increment at the rate of 10%.
Solution to the above illustration
It means that you shall get the following amounts from year 1 through 5
Year End Amount of Salary PVF @ 12% PV of Salary
1 1000 0.893 893.0
2 1100 0.797 876.7
3 1210 0.712 861.5
4 1331 0.636 846.5
5 1464 0.567 830.1
6105 4308

Exercise about growing annuity


A company paid a dividend of 60 shillings last year. The dividend stream commencing one year
is expected to grow at 10% annum for 15 years and then ends. If the discount rate is 21%, what
is the present value of the expected series?

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Prepared By Ddamba AbdulKarim ©2018
Department of Finance
Faculty of Finance
ESLSCA International Business School
Chapter-2: Concepts of Value & Return BIB I, II & III

e) Using the Present value of an annuity to compute for Loan Amortization


Amortization is the process of paying off a debt balance over time with regular, same and equal
payments. Amortization is most commonly encountered when dealing with either mortgage or
car loans but (in accounting) it can also refer to the periodic reduction in value of any intangible
asset over time.

The Loan Amortization Schedule


An amortization schedule is a table detailing each periodic payment on an
amortizing loan (typically a mortgage or car loan.

An illustrating about the loan amortization


Suppose you have a borrowed a 5-year loan of 100,000 shillings at 9% from your employer to
buy a motorcycle. If your employer requires equal end-of-year repayments, what will be the
annual installment, interest amount paid?

Solutions in preparing the loan amortization schedule


1. Step-1: Determine the periodic payment. With amortization, the periodic payment amount
consists of both
 Principal which is the loan balance that is still outstanding. As more principal is repaid,
less interest is due on the principal balance.
 Interest amount (what your lender gets paid for the loan). Over time, the interest portion
of each monthly payment declines and the principal repayment portion increases.

The periodic (Annual installment) payment is calculated using the formula;

Loan Amount
Loan payment =
Discount Factor

1 1
Discount factor = [ − ] or DF = 𝑃𝑉𝐹𝐴𝑖,𝑛
(𝑖) 𝑖(1+𝑖)𝑛

100,000
Therefore, the loan payment (annual installment) = = 25,709.25
3.890

By paying 25,706.94 shillings each year for 5 years, you shall completely pay-off your loan
with 9% interest rate.

2. Step-2: Calculate the interest charge amount for each period


This should be calculated basing on the loan balance or outstanding loan amount for the
previous period.

Interest for each period = interest rate * loan balance for the previous period
Which is = 9% * 100,000 = 9,000 for period one

Page 7 of 12
Prepared By Ddamba AbdulKarim ©2018
Department of Finance
Faculty of Finance
ESLSCA International Business School
Chapter-2: Concepts of Value & Return BIB I, II & III

3. Step-3: Calculate Principal repayment


Subtract the interest charge from your payment, the remainder is the amount of principal
you'll pay that period; for example; 25,709.25 – 9,000 = 16,709.25 in the first period.

4. Step-4: Compute for the outstanding loan balance


Reduce the loan balance by the amount of the principal you have paid
For example = Principal payment – outstanding balance for the previous period
Which is = 16,709.25 – 100,000 = 83,290.75 for period one

5. Step-5: Start over for the following period.


Use 83,290.75 as the loan balance in the second period

Below is the entire loan amortization schedule;

INPUT VARIABLES
Particulars Value
Loan Amount (Present Value) 100,000
Interest Rate (Annual) 9%
Loan Period 5
Payment (Annual) 25,709.25

Principal Outstanding
End of year Payment Interest
Repayment Balance
0 100,000.00
1 25,709.25 9,000.00 16,709.25 83,290.75
2 25,709.25 7,496.17 18,213.08 65,077.68
3 25,709.25 5,856.99 19,852.25 45,225.42
4 25,709.25 4,070.29 21,638.96 23,586.46
5 25,709.25 2,122.78 23,586.46 0.00

Loan Amortization Analysis


Analyze the trend that occurs over time. You can see that the loan’s principal (outstanding
balance) is reduced each period.
 Because the principal amount declines, the interest computed on the lower principal amount
also goes down.
 Over time, a growing amount of each annual payment goes toward principal.
 The principal portion of each payment increases over time.
 When you make extra payments, the principal amount of your loan reduces faster. The faster
you’re able to reduce principal, the less total interest you will pay over the term of the loan.

Page 8 of 12
Prepared By Ddamba AbdulKarim ©2018
Department of Finance
Faculty of Finance
ESLSCA International Business School
Chapter-2: Concepts of Value & Return BIB I, II & III

THE CONCEPT OF NET PRESENT VALUE (NPV)


As earlier discussed, a firm’s financial objective should be to maximize the shareholder’s wealth.
Wealth is defined as the net present value (NPV).

Net present value (NPV) of a financial decision is the difference between the present value of cash
inflows and the present value of cash outflows.

The formula for computing for the NPV

𝑪𝒇𝟏 𝟐 𝑪𝒇 𝑪𝒇
𝒏
NPV = [ 𝟏 ] + [ 𝟐 ] + … + [ ] - 𝐶𝑓0
(𝟏+𝒌) (𝟏+𝒌) (𝟏+𝒌)𝒏

𝒏 𝑪𝒇𝒕
Alternatively, the NPV = ∑𝒕=𝟏 - 𝐶𝑓0
(𝟏+𝒊)𝒕

Where;
 Cf is cash inflow in period t
 Cf0 is cash outflow today,
 i is the opportunity cost of capital and
 t is the time period.

Illustration
Suppose you invest 200,000 shillings in a certain company that earns, say, 15% dividend a year.
Assume you obtain 245,000 shillings after one year, what is the net present value of the investment?

Solution

NPV = PV of cash inflows – PV of cash outflows


NPV = 245,000 * (PVF in year one at 15%) – 200,000
NPV = (245,000*0.870) – 200,000
NPV = 213,150 – 200,000

This means that the land is worth 213,000 and doesn’t mean that your wealth will increase by
213,500 shillings.

Therefore, the net increase in your wealth or net present value is 213,150 – 200,000 = 13,150, hence
its worth investing in that land.

Page 9 of 12
Prepared By Ddamba AbdulKarim ©2018
Department of Finance
Faculty of Finance
ESLSCA International Business School
Chapter-2: Concepts of Value & Return BIB I, II & III

PRESENT VALUE AND RATE OF RETURN


A return is the gain or loss on an investment after the cost of the investment over a specified time
period. It comprises any change in value and interest or dividends or other such cash flows which
the investor receives from the investment. It may be measured either in absolute terms (e.g., dollars)
or as a percentage of the amount invested. A loss instead of a profit is described as a negative return.
Rate of return is a profit on an investment over a period of time, expressed as a proportion of the
original investment. The time period is typically a year, in which case the rate of return is referred
to as annual return.
a) Computing for the rate of return for a lump sum for a single year
(Current value − original value)
Rate of return for a Lump sum = * 100
original value
Where;
 Current value: the current value of the item.
 Original value: the price at which you purchased the item.
Illustration about the rate of return for lump sum
Assume the bank offers you to deposit 100,000 shillings and promises to pay you 112,000
shillings. What interest would you earn?
Solution to the above illustration
(Current value − original value)
Rate of return for a Lump sum = * 100
original value

(112,000− 100,000)
Rate of return = * 100 = 12%
100,000

b) Calculating the rate of return for an annuity

(Original value)
Rate of return = 𝑷𝑽𝑭𝟓,𝒊 of
Current value
i). Illustration-1 about the rate of return for an annuity
What rate of interest would you earn if you deposit 1,000 shillings today and receive 1,762
at the end of five years?
Solution to the above illustration
(Original value)
Rate of return = 𝑷𝑽𝑭𝟓,𝒊 =
Current value

1,000
Rate of return = 𝑷𝑽𝑭𝟓,𝒊 = * 0.576
1,762

Now you refer to table C of pre-computed PVFs. Since 0.576 is a PVF at interest rate for 5
years, look across the row for period 5 and rate column, until you find this value. You will
notice this factor in the 12% column. Thus you will earn 12% on your 1,000 shillings.
Page 10 of 12
Prepared By Ddamba AbdulKarim ©2018
Department of Finance
Faculty of Finance
ESLSCA International Business School
Chapter-2: Concepts of Value & Return BIB I, II & III

ii). Illustration-2 about the rate of return for an annuity


Assume you borrow 70,000 shillings from housing finance to buy a flat. You will be required
to mortgage the flat and pay 11,396.93 annually for five years. What interest rate would you
be paying?

Solution,
Note that 70,000 shillings is the present value of a 15 year annuity of 11,396.93 shillings.

70,000
That is, 𝑷𝑽𝑨𝑭𝟏𝟓,𝒊 = = 6.142
11,396.93

Now look in table D, for the pre-computed PVAFs in the 15th year row and interest rate
columns, until you get the value 6.142 in the 14% column. Thus housing finance is charging
14% interest from you.

c) Calculating the rate of return for uneven series of cash flows


Finding the rate of return for an uneven series of cash flows is a bit difficult, by practice and
using trial and error, you can find it

Illustration
Assume a friend wants to borrow from you 1,600/= today and would return 700/=, 600/=, and
500/= in year one through year three as principal plus the interest. What rate of return would you
earn?

Solution
You should recognize that you earn that rate of return at which the present value of 700/=, 600/=,
and 500/= received, respectively after one, two and three is 1,600/=

Suppose, based on a random personal choice, this rate is 8%. When you calculate the present
values of cash flows at 8%, you get the following amounts;

Cash Flow PV of Cash Flow


PVs of
Year Amount Received PVF @ 8% Salary
1 700 0.926 648.20
2 600 0.857 514.20
3 500 0.794 397.00
1,559.40

Page 11 of 12
Prepared By Ddamba AbdulKarim ©2018
Department of Finance
Faculty of Finance
ESLSCA International Business School
Chapter-2: Concepts of Value & Return BIB I, II & III

Since the present value at 8% is less than 1,600 shillings, it means that your friend is allowing
you a lower rate of return, so you try 6%. You obtain the following results;

Cash Flow PV of Cash Flow


Year Amount Received PVF @ 6% PVs of Salary
1 700 0.943 660.00
2 600 0.890 534.00
3 500 0.840 420.00
1,614.00

The present value at 6% is slightly more than 1,600 shillings, it means that your friend is offering
you approximately 6% interest. In fact, the actual rate would be slightly higher than 6% interest.

At 7%, the present values of cash flows is 1,586.30 shillings as seen from the following table;
Cash Flow PV of Cash Flow
Year Amount Received PVF @ 7% PVs of Salary
1 700 0.935 654.50
2 600 0.873 523.80
3 500 0.816 408.00
1,586.30

Apply interpolation using 6% and 7% rates as follows to calculate the correct rate
That is, estimate the known variables using the know variables. Therefore you can interpolate as
follows to calculate the actual rate.

The interpolation formula


𝑁𝑃𝑉𝑎
Rate of return for an uneven series of cash flows = 𝑟𝑎 + (𝑟𝑏 − 𝑟𝑎 ) *
𝑃𝑉𝑎 − 𝑃𝑉𝑏

Where;
 𝑟𝑎 is the lower discount rate chosen
 𝑟𝑏 is the higher discount rate chosen
 𝑁𝑃𝑉𝑎 is the NPV at is the lower discount rate chosen
 𝑃𝑉𝑎 is the total present values of cash inflows at the lower discount rate chosen
 𝑃𝑉𝑎 is the total present values of cash inflows at the lower discount rate chosen

1,614 −1,600
Rate of return = 6% + (7%-6%) * = 6.5%
1,614 −1,586

Therefore, at 6.5%, rate of return, the present value of 700/=, 600/=, and 500/= occurring
respectively in year one through three is equal to 1,600/=

Page 12 of 12
Prepared By Ddamba AbdulKarim ©2018
Department of Finance
Faculty of Finance
ESLSCA International Business School