Tanzania Institute of Accountancy

MODULE TITLE: BUSINESS MATHEMATICS AND STATISTICS

Module Code: GSU 07101

BPSAF I, BAC I & BPLM I

TOPIC THREE: ANNUITIES

Time value of money-Annuities

Money has time value. A shilling today is more valuable than a shilling a year
hence. Why?

There are several reasons:

o Individuals, in general, prefer current consumption to future

consumption.

o Capital can employ productively to negate positive returns. An

investment of one shilling today would grow to (1+r) a year hence (r is the
rate of return earned thon the investment).

o In an inflationary period, a shilling represents a greater real purchasing

power than a shilling a year hence.

Many financial problems involve cash flows occurring at different at points of

time. So for evaluating such cash flows an explicit consideration of the time
value of money is required.

Future value of a single amount (Fixed amount)

Suppose you have Tsh1,000 today and you deposit it with a financial
institution, which pays 10 per cent interest compounded annually, for a period
of 3 years.

The deposit would grow as follows:

Tsh

First year: Principal at the beginning 1,000

Interest for the year (1,000x 0.01) 100

Principal at the end 1,100

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Second year: Principal at the beginning 1,100

Interest for the year (1,100x 0.01) 110

Principal at the end 1,210

Third year: Principal at the beginning 1,210

Interest for the year (1,210x 0.01) 121

Principal at the end 1,331

Formula

The general formula for the future value of a single amount is:

FVn = PV (1 + r )
n

Where FVn Future value, PV = Present Value

nm
 r
FVn = PV 1 + 
 m

Future Value (FV) of a Single Sum Illustrated

The following simplified example illustrates the basic operation of the FV of a

single sum formula.

How much will I receive at the end of 3 years if I invest a single sum of Tsh 50
today at 8% interest compounded annually? In other words, at 8%, how large
will my Tsh 50 grow in 3 years.

Drawn from the perspective of the investor, the problem is illustrated below.
The investor deposits Tsh 50 (the PV) and this amount "accumulates" over 3
years at 8% to some larger amount (the FV) ...

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The arrow drawn pointing toward the time line (labeled "50.00") represents a
cash outflow from the investor. The arrow drawn pointing from the time line
(labeled “? FV") represents a cash inflow to the investor, in this case it is the
accumulated amount of the CD which the investor may withdraw at maturity.
The question mark denotes the fact that this is the unknown amount whose
value is the object of our calculation.

So now that we have identified our initial deposit, the term of the investment,
and the interest rate, we can summarize our inputs to the FV of a single sum
equation as...

PV = 50.00
i = 0.08
n=3

...and plugging these values into the equation...

...we calculate a FV of Tsh 62.99.

The mechanics of the calculation are illustrated below...

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So, what does it mean when we say that the future value of Tsh 50 in 3 years
at 8% is Tsh 62.99?

In other words, Tsh 50.00 today and Tsh 62.99 in three years are financially
equivalent.

Solving for Other Variables

While the equation discussed above allows us to calculate the FV of a single

sum, there are times when we need to know the value of one of the other
variables (n, i, or PV).

For a single sum, solving for any of the other TVOM variables is a simple
matter of rearranging the basic formula to isolate the variable being sought.

a. Compounding periods (n)

Knowledge of the following algebraic identity is necessary for isolating the

exponent n...

log x
If x = by then y=
log y

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Now by rearrangement of the FV of a single sum equation we can find the

number of compounding periods (n) in our original example as...

 FV   62.99 
log   log  
If x = by then n =  PV 
=  50 
=3
log (1 + i ) log (1.08)

b. Interest rate (i)

The following algebraic identity is helpful when solving for i...

x=x
1
n n

Now we can solve for the interest rate (i) in our original example as...

1 1
 FV  n  62.99  3
i=  −1 =   − 1 = 0.08
 PV   50 

If the compounding frequency is something other than annual, the interest rate
(i) determined above would need to be multiplied by the number of
compounding periods per year (m) in order to return the annual interest rate.

For example, the FV of Tsh 50 in 3 years at 8% under monthly compounding is

Tsh 63.51. In this case we would calculate an annual i as...

1 1
 FV  n  63.51  36
i=  −1 =   − 1 = 0.0067(12) = 0.08
 PV   50 

See the discussion on "Compounding Frequency" that follows for more

information on adjustments made to the values of i and n under non-annual
compounding frequencies.

c. Present Value (PV)

Rearranging to solve for the PV of a single sum is fairly straight forward...

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FV
PV =
(1 + i )n

...and using the values from our original example, we confirm the PV as...

FV 63.51
PV = = = 50.00
(1 + i ) n
(1 + 0.08)3

Compounding Frequency

But what if in our original example we were compounding quarterly rather than
annually?

In this case we must "synchronize" the values for i and n in order to

accommodate the non-annual compounding frequency.

We start by defining n, the number of compounding periods in the term, as

being equal to the product of two numbers: the number of compounding
periods in the year (m) and the number of years in the term (Y)...

n = my

Thus for a three year term (Y=3) with quarterly compounding (m=4), the
number of compounding periods (n) is 12 (4 x 3).

Now that we have modified n, we must adjust i.

i is almost always given as an annual nominal rate. If the compounding

frequency is something other than annual, then i must be made proportional to
the period in which it is being applied. Typically, this is accomplished by
dividing i by m. Since here we are compounding quarterly, i would be divided
by 4.

Taking all of this into account, if we rewrite the standard future value of a
single sum equation to incorporate the synchronization process, it looks like
this...

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mY
 i 
FV = PV 1 + 
 m

...and if in our original example above we had used quarterly rather

than annual compounding, the FV is calculated as...

mY 4 (3 )
 i   0.08 
FV = PV 1 +  = 501 +  = 63.41
 m  4 

Changing the compounding period from annual to quarterly increases the

future value by Tsh 0.42 over the 3-year period (Tsh 63.41 - Tsh 62.99). More
frequent compounding means more interest is being earned on interest
resulting in a greater accumulation (future value).

Under monthly compounding, the FV is even larger...

mY 12(3 )
 i   0.08 
FV = PV 1 +  = 501 +  = 63.51
 m  12 

...and larger still under daily compounding...

mY 365(3 )
 i   0.08 
FV = PV 1 +  = 501 +  = 63.5608
 m  365 

Future Value of an Annuity

Understanding annuities is crucial for understanding loans, and investments

that require or yield periodic payments. For instance, how much of a mortgage
can I afford if I can only pay Tsh1,000 monthly? How much money will I have
in my account if I deposit Tsh 2,000 at the beginning of each year for 30 years,
and earns an annual interest rate of 5%, but is compounded daily?

An annuity is a series of equal payments in equal time periods. Usually, the

time period is 1 year, which is why it is called an annuity, but the time period
can be shorter, or even longer. These equal payments are called the periodic
rent. The amount of the annuity is the sum of all payments.

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An annuity due is an annuity where the payments are made at the beginning
of each time period; for an ordinary annuity, payments are made at the end of
the time period. Most annuities are ordinary annuities.

Analogous to the future value and present value of a shilling, which is the
future value and present value of a lump-sum payment, the future value of an
annuity is the value of equally spaced payments at some point in the future.
The present value of an annuity is the present value of equally spaced
payments in the future.

The future value of an annuity is simply the sum of the future value of each
payment. The equation for the future value of an annuity due is the sum of the
geometric sequence.
The future value of an ordinary annuity (FVOA) is:

 (1 + r )n − 1
Formula FVOA = PV  
 r 

Example:
A person plans to deposit Tshs 1,000 in a tax-exempt savings plan at the end
of this year and an equal sum at the end of each following year. If interest is
expected to be earned at the rate of 6 percent per year compounded annually,
to what sum will the investment grow at the time of the fourth deposit?

Solution:
 (1 + r )n − 1  (1 + 0.06)4 − 1
FVOA = PV   = 1,000  = 1,000(4.37462) = Tsh 4,374.62
 r   0.06 

Example:
Suppose a corporation wants to establish a sinking fund beginning at the end
of this year. Annual deposits will be made at the end of this year and for the
following 9 years. If deposits earn interest at the rate of 8 percent per year
compounded annually, how much money must be deposited each year on order
to have Tsh 12 million at the time of the 10 deposit? How much interest will be
earned?

Solution:
n = 10
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i = 0.08
FVOA = Tsh12,000,000
PV= ?

The money to be deposited each year (R) is calculates as follows:

FVOA 12,000,000 12,000,000

PV = = = = Tsh 828,354
 (1 + i ) − 1
n
 (1 + 0.08) − 1
10
14.48656
   
 i   0.08 

Interest Earned = FVOA – PV = 12,000,000 – 828,354 = Tsh 11,171,646

Example:
If at the end of each month, a saver deposited Tsh 100 into a savings
account that paid 6% compounded monthly, how much would he have at
the end of 10 years?

Solution
PV = Tsh 100
r = 6% per year compounded monthly, which = .5% interest per month =
.005
n = the number of compounding time periods = 120 in 10 years.
Substituting these values into the equation for the future value of an
ordinary annuity:

 (1 + r )n − 1  (1 + 0.005)120 − 1
FVOA = PV   = 100  = Tsh 16,387.93
 r   0.005 

Example:
Calculating the Annuity Payment, or the Periodic Rent
A 20-year-old wants to retire as a millionaire by the time she turns 70.
How much will she have to save at the end of each month if she can
earn 5% compounded annually, tax-free, to have Tsh 1,000,000 by the
time she is 70?

Solution:

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Note that the equation for the future value of an annuity consists of 3
independent variables, and 1 dependent variable. In other words, if we
know the value of 3 of the variables, then we can determine the remaining
variable.

Since r = 5% =0.05, and n = 50, FV= Tsh 1,000,000

To find PV, we divide both sides of the equation for the future value of an
annuity by this interest factor

FVOA 1,000,000 1,000,000

PV = = = = Tsh 4,776.69
 (1 + i )n − 1  (1 + 0.05)50 − 1
209.35
   
 i   0.05 
So, she would have to save Tshs 4,776.69 dollars per year, or Tshs 398.06
per month, to have Tshs 1,000,000 in 50 years—assuming, of course, that
she could save it tax-free!
Example 1: Mr. A deposited Tshs 700 at the end of each month of calendar
year 2010 in an investment account of 9% annual interest rate. Calculate the
future value of the annuity on Dec 31, 2011. Compounding is done on monthly
basis.
Solution
We have,
Periodic Payment PV = Tshs 700
Number of Periods n = 12
Interest Rate i = 9%/12 = 0.75%
Future Value, FVOA = Tshs 700 × {(1+0.75%)^12 -1}/1%
= Tshs 700 × {1.0075^12 -1}/0.01
≈ Tshs 700 × (1.0938069-1)/0.01
≈ Tshs 700 × 0.0938069/0.01
≈ Tshs 700 × 9.38069
≈ Tshs 6,566.48

Example 1
An amount of Tsh10,000 was invested on Jan 1, 2011 at annual interest rate
of 8%. Calculate the value of the investment on Dec 31, 2013. Compounding is
done on quarterly basis.
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Solution
We have,
Present Value PV = Tsh 10,000
Compounding Periods n = 3 × 4 = 12
Interest Rate r = 8%/4 = 2%
Future Value FV = Tsh 10,000 × (1 + 2%)^12
= Tsh 10,000 × 1.02^12
≈ Tsh 10,000 × 1.268242
≈ Tsh 12,682.42

Example 2
An amount of Tsh 25,000 was invested on Jan 1, 2010 at annual interest rate
of 10.8% compounded on quarterly basis. On Jan 1, 2011 the terms or the
agreement were changed such that compounding was to be done twice a month
from Jan 1, 2011. The interest rate remained the same. Calculate the total
value of investment on Dec 31, 2011.

Solution
The problem can be easily solved in two steps:
STEP 1: Jan 1 - Dec 31, 2010
Present Value PV1 = Tsh 25,000
Compounding Periods n=4
Interest Rate r = 10.8%/4 = 2.7%
Future Value FV1 = Tsh 25,000 × (1 + 2.7%)^4
= Tsh 25,000 × 1.027^4
≈ Tsh 25,000 × 1.112453
≈ Tsh 27,811.33
STEP 1: Jan 1 - Dec 31, 2011
Present Value PV2 = FV1 = Tsh 27,811.33
Compounding Periods n = 2 × 12 = 24
Interest Rate r = 10.8%/24 = 0.45%
Future Value FV2 = Tsh 27,811.33 × ( 1 + 0.45% )^24
= Tsh 27,811.33 × 1.0045^24
≈ Tsh 27,811.33 × 1.113778
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≈ Tsh 30.975.64
Discussion Question
Question One.
Mr. Masanja deposits Tsh 150 into a bank account at the end of the month for
5 years at a rate of 7% compounded monthly. What will be the future value for
Mr. Masanja.
Ghati is planning for his retirement 20 years away. When he retires he wants a
lump sum of Tsh300, 000. His financial advisor suggested that 5% p.a. was a
suitable interest rate to consider. How much will he have to pay per month into
his retirement fund (assume ordinary annuity).
Question Two.
The ABC concreting company set up a sinking fund to assist in buying a new
truck in 5 years time. They can only afford Tsh 3000 a quarter which is paid
into a savings account with an interest rate of 8% p.a. Assuming quarterly
compounding, what will be the size of the sinking fund after 5 years? (Assume
ordinary annuity)

Question Three.
John invests Tsh 500 per month, paid into a savings account for 10 years.
What is the balance of the account at the end of the period assuming an
interest rate of 7% compounded monthly?

Question Four.
In 5 years, a printing machine is to be replaced. A new machine is expected to
cost Tsh 33000. Assuming an annual interest rate of 8% compounded monthly,
what will be the size of each monthly payment?
Present Value of a Single Sum of Money
Present value of a future single sum of money is the value that is obtained
when the future value is discounted at a specific given rate of interest. In the
other words present value of a single sum of money is the amount that, if
invested on a given date at a specific rate of interest, will equate the sum of the
amount invested and the compound interest earned on its investment with the
face value of the future single sum of money.

Formula and Definition

The equation below calculates the current value of a single sum to be paid at a
specified date in the future. This value is referred to as the present value (PV)
of a single sum.
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FV
PV =
(1 + i )n
Where:

PV = present value
FV = future value
n = number of compounding period
i = interest rate

If we remember that 1/xn can be written as x-n, then a more compact form of
the equation can be written as:

PV = FV (1 + i )
−n

The PV of a single sum formula is used as a valuation mechanism. It tells us

how much an amount to be transacted in the future is worth today (or some
date prior to the receipt or payment date).

Present Value (PV) of a Single Sum Illustrated

The following simplified example illustrates the basic operation of the PV of a

single sum formula.

What is the current value (PV) of a CD that will pay Tsh 100 in 3 years if the
prevailing interest rate is 5% compounded annually? In other words, how
much do I need to deposit to have Tsh 100 in 3 years?

Drawn from the the perspective of the investor, the problem is illustrated
below. The investor will receive Tsh 100 in three years time (the FV) and this
amont is "discounted" back to today at 5% in order to calculate the required
deposit (the PV)...

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So now that we have identified how much we will receive at maturity, the term
of the investment, and the interest rate, we can summarize our inputs to
the PV of a single sum equation as...

FV = 100.00
i = 0.05
n=3

...and plugging these values into the equation...

FV 100
PV = = = 86.38
(1 + i ) n
(1 + 0.05)3

...we calculate a PV of Tsh 86.38.

The mechanics of the calculation are illustrated below...

So, what does it mean when we say that the present value of Tsh 100 in 3
years at 5% is Tsh 86.38?

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In essence it means that the receipt of Tsh 100 in three years is worth the
same as the receipt of Tsh 86.38 today.

Example:
You want to buy a house 5 years from now for Tsh 150,000. Assuming a 6%
interest rate compounded annually, how much should you invest today to yield
Tsh 150,000 in 5 years?

FV = 150,000
i = 0.06
n=5

Future Value (FV) 150,000 150,000

Present Value (PV) = = = = Tsh 112,088.73
(1 + i) n
(1 + 0.06) 1.33825576
5

Example:
You find another financial institution that offers an interest rate of 6%
compounded semiannually. How much less can you deposit today to yield Tsh
150,000 in five years?

Solution
Interest is compounded twice per year so you must divide the annual interest
rate by two to obtain a rate per period of 3%. Since there are two compounding
periods per year, you must multiply the number of years by two to obtain the
total number of periods.

FV = 150,000
i = 0.06 / 2 = .03
n = 5 * 2 = 10

PV = 150,000 [ 1 / (1 + .03)10] = 150,000 (1 / 1.343916379) = 111,614.09

Example :
Calculate the present value on Jan 1, 2011 of Tsh 1,500 to be received on Dec
31, 2011. The market interest rate is 9%. Compounding is done on monthly
basis.

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Solution
We have,
Future Value FV = Tsh 1,500
Compounding Periods n = 12
Interest Rate i = 9%/12 = 0.75%
Present Value PV = Tsh 1,500 / ( 1 + 0.75% )^12
= Tsh 1,500 / 1.0075^12
≈ Tsh 1,500 / 1.093807
≈ Tsh 1,371.36

Example:
A friend of you has won a prize of Tsh 10,000 to be paid exactly after 2 years.
On the same day, he was offered Tsh 8,000 as a consideration for his
agreement to sell the right to receive the prize. The market interest rate is 12%
and the interest is compounded on monthly basis. Help him by determining
whether the offer should be accepted or not.

Solution
Here you will compute the present value of the prize and compare it with the
amount offered to your friend. It will be good to accept the offer if the present
value of the prize is less than the amount offered.
So,
Future Value FV = Tsh 10,000
Compounding Periods n = 2 × 12 = 24
Interest Rate i = 12%/12 = 1%
Present Value PV = Tsh 10,000 / ( 1 + 1% )^24
= Tsh 10,000 / 1.01^24
≈ Tsh 10,000 / 1.269735
≈ Tsh 7,875.66

Solving for Other Variables

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While the equation discussed above allows us to calculate the PV of a single

sum, there are times when we need to know the value of one of the other
variables (n, i, or FV).

For single sums, solving for any of the other TVOM variables is simply a matter
of rearranging the basic formula to isolate the variable being sought.

a. Compounding periods (n)

Knowledge of the following algebraic identity is necessary for isolating the

exponent n...

log x
If x = by then y=
log y

Now by rearrangement of the PV of a single sum equation we can find the

number of compounding periods (n) in our original example as...

 PV   86.38 
log   log  
If x = by then n =  FV 
=  100 
=3
log (1 + i ) log (1.05)

b. Interest rate (i)

The following algebraic identities are helpful when solving for i...

1 1
1 −
n
x=x n
and n = x n
x

Now we can solve for the interest rate (i) in our original example as...

1 1
− −
 PV  n  86.38  3
i=  −1 =   − 1 = 0.05 = 5%
 FV   100 

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If the compounding frequency is something other than annual, the interest rate
(i) determined above would need to be multiplied by the number of
compounding periods per year (m) in order to return the annual interest rate.

For example, the PV of Tsh 100 in 3 years at 5% under monthly compounding

is Tsh 86.10. In this case we would calculate an annual i as...

1 1
− −
 PV   86.10  12 (3 )
− 1 = 0.0042(12) = 0.05 = 5%
n
i=  −1 =  
 FV   100 

See the discussion on "Compounding Frequency" that follows for more

information on adjustments made to the values of i and n under non-annual
compounding frequencies.

Future Value (FV)

Rearranging to solve for the FV of a single sum is fairly straight forward...

FV = PV (1 + i )
n

...and using the values from our original example, we confirm the FV as...

FV = PV (1 + i ) = 86.38(1 + 0.05) = 100.00

n 3

Compounding Frequency

The PV of a single sum equation at the top of the page

assumes annual compounding.

But what if in our original example we were compounding quarterly rather than
annually?

In this case we must "synchronize" the values for i and n in order to

accommodate the non-annual compounding frequency.

We start by defining n, the number of compounding periods in the term, as

equal to the product of two numbers: the number of compounding periods in
the year (m) and the number of years in the term (Y)...
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n = mY

Thus, for a three-year term (Y=3) with quarterly compounding (m=4), the
number of compounding periods (n) is 12 (4 x 3).

Now that we have modified n, we must adjust i.

i is almost always given as a annual nominal rate. If the compounding

frequency is something other than annual, then i must be made proportional to
the the period in which it is being applied. Typically, this is accomplished by
dividing i by m. Since here we are compounding quarterly, i would be divided
by 4.

Taking all of this into account, if we rewrite the standard present value of a
single sum equation to incorporate the synchronization process, it looks like
this...

− mY
 i 
PV = FV 1 + 
 m

...and if in our original example above we had used quarterly rather

than annual compounding, the present value PV is calculated as...

−mY −4 (3 )
 i   0.05 
PV = FV 1 +  = 1001 +  = 86.15
 m  4 

Changing the compounding period from annual to quarterly reduces the

present value by Tsh 0.23 over the 3-year period (Tsh 86.38 - Tsh 86.15). More
frequent compounding means less money is required up front (i.e., at "present")
in order to grow to a specified amount in the future.

Under monthly compounding, the PV is even smaller...

−mY −12 (3 )
 i   0.05 
PV = FV 1 +  = 1001 +  = 86.10
 m  12 

...and smaller still under daily compounding…

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−mY −365(3 )
 i   0.05 
PV = FV 1 +  = 1001 +  = 86.0717
 m  365 

Discussion Question
Question 1
Mr. and Mrs. Chacha wish to have an annuity for when their daughter goes to
university.They wish to invest into an annuity that will pay their daughter
Tsh1000 per month for 4 years. What is the present value of the annuity given
that current interest rates are 8% p.a?
Question 2
Vanessa borrows Tsh 20 000 to buy a car. He wishes to make monthly
payments for 4 years. The interest rate he is charged is 10.5% p.a. What is the
size of each monthly payment?

Sinking Fund

Definition:

Any account that is established for accumulating funds to meet future

obligations or debts is called a sinking fund.

The sinking fund payment is defined to be the amount that must be deposited
into an account periodically to have a given future amount.

To derive the sinking fund payment formula, we use algebraic techniques to

rewrite the formula for the future value of an annuity and solve for the variable
PMT:

 (1 + r )n − 1
FVOA = PMT  
 r 

 i 
PMT = FVOA 

 (1 + i )n
− 1 

Example

How much must Harry save each month in order to buy a new car in three
years if the car costs Tsh 12,000 and interest rate is 6% compounded monthly?

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Solution

 
 0.06 
 i   
PMT = FVOA  = 12,000

12
 = 305.06
 (1 + i ) − 1 
n 3

 1 + 0 .06 
  − 1 
 12  

Example

Mr. Ray has deposited Tsh 150 per month into an ordinary annuity. After 14
years, the annuity is worth Tsh 85,000. What annual rate compounded
monthly has this annuity earned during the 14 year period?

Solution

Use the FV formula: Here FV = Tsh 85,000, PMT = Tsh 150 and n, number
of payments is 14(12)=168. Substitute these values into the formula.

By determining the point of intersection of the two graphs using a graphing

calculator, we obtain an approximate solution of 0.013 or 1.3% rate of
return.

Solution

 (1 + i )n − 1   (1 + i )1412 − 1   (1 + i )168 − 1 
FV = PMT  
 85,000 = 150 
 85,000 = 150 

 i   i   i 
 (1 + i )168 − 1  85,000
 = = 566.67
 i  150
 

Example

AZAM Industries established a sinking fund in order to accumulate Tsh 10,000

by depositing equal amounts of money at the end of every 6 months for 2 years.
If the fund was earning interest at 4% compounded semi-annually, calculate
the following and construct a sinking fund schedule to illustrate details of the
fund:
i) Size of the periodic sinking fund deposit.
ii) Sinking fund balance at the end of the 2nd payment period.
iii) Interest earned in the 3rd payment period.
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iv) Amount by which the sinking fund increased in the 3rd payment period

Solution
i) This sinking fund is an ordinary simple annuity
FV = Tsh 10,000 t = 2 years i = j/m == 0.04/2 = 0.02
n = 2 deposites per year x 2 years = 4 semi - annual deposits
 (1 + i )n − 1 
From FV = PMT  

 i 
 (1 + 0.02)4 − 1 
10,000 = PMT  

 0 .02 
= PMT (4.1216)
PMT = 2,426.24
Therefore, the periodic sinking fund is Tsh 2,426.24

ii) The sinking fund balance at the end of any given period is the future
value of the periodic deposits made until the end of that period.
At the end of the 2nd payment period, n = 2.
Let the future value at the end of the 2nd payment period be FV2
 (1 + i )n − 1 
FV = PMT  

 i 
From
 (1 + 0.02)2 − 1 
FV2 = 2426.24  = 2426.24(2.02) = 4,901.00

 0 .02 
Therefore, Sinking fund balance at the end of the 2nd payment period is Tsh
4,901.00

iii) Interest that is earned in any period is on the amount that is available in
the fund at the beginning of that period, which is the same as the
amount that is available at the end of the previous period.
To calculate the interest earned in the 3rd period, we need to determine
the fund balance at the end of the 2nd period.
From (ii) we know that the fund balance at the end of the 2nd period
FV2 = Tsh 4,901.00

Interest on this amount = i  FV2 = 0.02  4,901.00 = 98.02

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Therefore, Tsh 98.02 was the interest earned by the fund in the 3rd payment
period.

iv) The amount by which the sinking fund increased in a period is the
interest earned during that period plus the deposit made in that period

The amount by which t he sinking fund increased = Interest earned in the 3rd period + PMT
= 4,901.00 0.02 + 2,426.24
= Tsh 2,524.26

Amortization
Amortization is the process of paying off a balance over time with regular, equal
payments. This is most common with monthly payments on loans, but
amortization is an accounting term that can apply to other types of balances.

Example

Assume that you have taken out an amortized loan for Tsh 10,000 to buy a
new car. The yearly interest rate is 18% and you have agreed to pay off the loan
in 4 years. What is your monthly payment?

Solution

1 − (1 + i )− n 
From; PV = PMT  
 i 
i 
PV  
PMT = m
− nm
 i 
1 − 1 + 
 m
Where
PV =10,000
i= 0.18
n=4
m= 12

Discussion Questions

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Question 1
Chacha buys a car costing Tsh 19,300. He agrees to pay make payments at the
end of each monthly period of 5 years. He pays 6% interest compounded
monthly.
a) What is the total amount of each payment?
b) Find the total amount of interest paid.

Question 2
The price of a home is Tsh 155,000. The required down payment is 10% and
you qualify for a 30-years fixed mortgage at 5.5%
a) Determine the down payment and the loan amount.
b) Find the monthly mortgage payment
c) How much total interest will be paid?

Question 3
James obtain a loan for his brand-new car. His car costs Tsh 18,000,000 and
he puts Tsh 1,000,000 down and amortizes the rest with equal monthly
payments over a 5-year period at 6% to be compounded monthly.
a) What is the total amount of each payment?
b) Find the total amount of interest paid.Question 4
Student borrowers now have more options to choose from when selecting
repayment plans. The standard plan repays the loan in 10 years with equal
monthly payments. The extended plan allows from 12 to 30 years repaying the
loan. A student borrows Tsh 10 million at 10% compounded monthly:
a) Find the monthly payment and the total interest paid under the standard
plan
b) Find the monthly payment and the total interest paid under the extended
plan for 20 years

Question 5
Jessca’s parents will be paying her college tuition of Tsh 20,000,000 per for
four years. If they currently have the money invested at 6% compounded
annually, how much money do they need to have in the account to pay the
tuition?

PAY BACK

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The pay back (PB) is the one of the most popular and widely recognized
traditional method of evaluating investment proposals. Pay back is the number
of years required to recover the original cash outlay invested in a project.

In pay back, there are two cases to be considered: -

Equal (Even) cash flows: If the project generates constant annual cash flows,
the payback period can be computed by dividing cash outlay by the annual
cash inflow. That is:

Initial Investment C
Payback = = 0
Annual Cash Inflow C

Example 1: Assume that a project requires an outlay of Ths 50,000 and yields
annual cash inflow of Tsh 12,000 for 7 years. The payback period for the
project is

Solution

50,000
Payback = = 4 years
12,000

Example 2:
Company C is planning to undertake a project requiring initial investment of
Tsh 105 million. The project is expected to generate Tsh 25 million per year for
7 years. Calculate the payback period of the project.

Solution
Payback Period = Initial Investment ÷ Annual Cash Flow = Tsh 105M ÷ Tsh
25M = 4.2 years

Unequal (Uneven) cash flows: In case of unequal cash flows, the payback
period can be found out by adding up the cash inflows until the total is equal
to the initial cash outlay.

That is:

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Unrecoverd cost at start of the year

Payback period = Years before full recovery +
Cash flow during the year

Example 1: Suppose that a project requires a cash outlay of Tsh 20,000, and
generates cash inflows of Tsh 8,000; Ths 7,000; Tsh 4,000 and Tsh 3,000
during the next 4 years. What is the project’s payback?

When we add up the cash inflows, we find that in the first three years Ths
19,000 of the original outlay is recovered. In the fourth-year cash inflow
generated is Tsh 3,000 and only Tsh 1,000 of the original outlay remains to be
covered. Assuming that the cash inflows occur evenly during the year, the time
required to cover Tsh 1,000 will be (Tsh 1,000/Tsh 3,000) x 12 months = 4
months. Thus, the payback period is 3 years and 4 months.

Example 2:
Company C is planning to undertake another project requiring initial
investment of Tsh 50 million and is expected to generate Tsh 10 million in Year
1, Tsh 13 million in Year 2, Tsh 16 million in year 3, Tsh 19 million in Year 4
and Tsh 22 million in Year 5. Calculate the payback value of the project.

Solution
(cash flows inCumulative
millions) Cash Flow
Year Cash Flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30
Payback Period
= 3 + (Tsh 11M ÷ Tsh 19M)
≈ 3 + 0.58
≈ 3.58 years

Decision Rule

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Accept the project only if it’s payback period is LESS than the target payback
period.

Discussion Questions

Question 1

The initial investment in a pollution prevention project is Tsh 10,000. The

projected savings is Tsh 4,000 for the first year, Tsh 4,000 for the second year,
Tsh 2,500 for the third year, Tsh 2,000 in the fourth year, and Tsh 2,000 for
the fifth year.

Question 2

The Delta company is planning to purchase a machine known as machine X.

Machine X would cost Tsh 25,000 and would have a useful life of 10 years with
zero salvage value. The expected annual cash inflow of the machine is Tsh
10,000.

Required: Compute payback period of machine X and conclude whether or not

the machine would be purchased if the maximum desired payback period of
Delta company is 3 years.

Question 3

Due to increased demand, the management of Pepsi Beverage Company is

considering to purchase a new equipment to increase the production and
revenues. The useful life of the equipment is 10 years and the company’s
maximum desired payback period is 4 years. The inflow and outflow of cash
associated with the new equipment is given below:

Initial cost of equipment: Tsh 37,500

Annual cash inflows:

Sales: Tsh 75,000

Annual cash Outflows:

Cost of ingredients: Tsh 45,000

Salaries expenses: Tsh 13,500

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Maintenance expenses: Tsh 1,500

Non cash expenses:

Depreciation expense: Tsh 5,000

Required: Should Pepsi Beverage Company purchase the new equipment? Use
payback method for your answer.

Solution:

Step 1: In order to compute the payback period of the equipment, we need to

workout the net annual cash inflow by deducting the total of cash outflow from
the total of cash inflow associated with the equipment.

Computation of net annual cash inflow:

Tsh 75,000 – (Tsh 45,000 + Tsh 13,500 + Tsh 1,500)

= Tsh 15,000

Step 2: Now, the amount of investment required to purchase the equipment

would be divided by the amount of net annual cash inflow (computed in step 1)
to find the payback period of the equipment.

= Tsh 37,500/ Tsh 15,000

=2.5 years

Depreciation is a non-cash expense and has therefore been ignored while

calculating the payback period of the project.

According to payback method, the equipment should be purchased because the

payback period of the equipment is 2.5 years which is shorter than the
maximum desired payback period of 4 years.

Example 4:

The management of Health Supplement Inc. wants to reduce its labour cost by
installing a new machine. Two types of machines are available in the market –
machine X and machine Y. Machine X would cost Tsh 18,000 where as
machine Y would cost Tsh 15,000. Both the machines can reduce annual
labour cost by Tsh 3,000.

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Required: Which is the best machine to purchase according to payback

method?

Solution:

Payback period of machine X: Tsh 18,000/ Tsh 3,000 = 6 years

Payback period of machine y: Tsh 15,000/ Tsh 3,000 = 5 years

According to payback method, machine Y is more desirable than machine X

because it has a shorter payback period than machine X.

Unrecoverd cost at start of the year

Payback period = Years before full recovery +
Cash flow during the year

Example 5:

An investment of Tsh 200,000 is expected to generate the following cash

inflows in six years:

Year 1: Tsh 70,000

Year 2: Tsh 60,000
Year 3: Tsh 55,000
Year 4: Tsh 40,000
Year 5: Tsh 30,000
Year 6: Tsh 25,000

Required: Compute payback period of the investment. Should the investment

be made if management wants to recover the initial investment in 3 years or
less?

Solution:

(1). Because the cash inflow is uneven, the payback period formula cannot be
used to compute the payback period. We can compute the payback period by
computing the cumulative net cash flow as follows:

Initial Investment: Tsh 200,000

Year Cash Inflow Cumulative Cash
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(Tsh) Inflow(Tsh)
1 70,000 70,000
2 60,000 130,000
3 55,000 185,000
4 40,000 225,000
5 30,000 255,000
6 25,000 280,000

Payback period = 3 + (15,000*/40,000)

= 3 + 0.375

= 3.375 Years

*Unrecovered investment at start of 4th year:

= Initial cost – Cumulative cash inflow at the end of 3rd year

= Tsh 200,000 – Tsh 185,000 = Tsh 15,000

The payback period for this project is 3.375 years which is longer than the
maximum desired payback period of the management (3 years). The investment
in this project is therefore not desirable.

NET PRESENT VALUE

The net present value (NPV) method is the classic economic method of
evaluating the investment proposals. It is a DCF (Discounted Cash Flow)
technique that explicitly recognizes the time value of money. It correctly
postulates that cash flows arising at different time periods differ in value and
are comparable only when their equivalents – present values – found out. The
following steps are involved in the calculation of NPV:

Cash flows of investment project should be forecasted based on realistic

assumptions.

Appropriate discount rate should be identified to discount the forecasted cash

flows.

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Present value of cash flows should be calculated

Net present value should be found out by subtracting present value of cash
outflows from present value of cash inflows.

Decision Rule

Accept the project only if NPV is positive ( i.e., NPV>0)

Reject the project only if NPV is negative ( i.e., NPV<0)
May accept or reject the project when NPV is zero

In NPV, there are two cases to be considered:-

The formula for the net present value can be written as follows when there is
an Even Cash Inflows:

1 - (1 + k )− n 
NPV = R   - Initial Investment
 k 

In the above formula,

R is the net cash inflow expected to be received in each period;
k is the required rate of return per period;
n are the number of periods during which the project is expected to operate
and generate cash inflows.

Example 1: Even Cash Inflows:

Calculate the net present value of a project which requires an initial investment
of Tsh 243,000 and it is expected to generate a cash inflow of Tsh 50,000 each
month for 12 months. Assume that the salvage value of the project is zero. The
target rate of return is 12% per annum.

Solution

We have,
Initial Investment = Tsh 243,000
Net Cash Inflow per Period = Tsh 50,000
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Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%

1 - (1 + 1%) −12
NPV = Tsh 50,000  - Tsh 243,000
 1% 
1 - (1.01)−12 
NPV = Tsh 50,000  - Tsh 243,000
 0.01 
1 − 0.887449
NPV = Tsh 50,000  - Tsh 243,000
 0.01 
 0.112551
NPV = Tsh 50,000  - Tsh 243,000
 0.01 

 0.112551
NPV = Tsh 50,000  - Tsh 243,000
 0.01 

NPV = Tsh 50,000(11.2551) - Tsh 243,000

NPV = Tsh 562,754 - Tsh 243,000

NPV = Tsh 319,754

The formula for the net present value can be written as follows when Uneven
Cash Inflows:

 C1 C2 C3 Cn  n
Cn
NPV =  + + + ..... + −C = − C0
 (1 + k )
1
(1 + k ) (1 + k )
2 3
(1 + k )n  0 t =1 (1 + k )t
Where;
k is the target rate of return per period;
C1 is the net cash inflow during the first period;
C2 is the net cash inflow during the second period;
C3 is the net cash inflow during the third period, and so on ...

Example 1: When cash inflows are uneven:

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Assume the project X costs Tsh 2,500 now and I expected to generate year-end
cash inflows of Tsh 900, Tsh 800, Tsh 700, Tsh 600 and Tsh 500 in year 1
through 5. The opportunity cost of the capital may be assumed to be 10 per
cent. Determine the NPV of the project X.
Solution:
 Tsh 900 Tsh 800 Tsh 700 Tsh 600 Tsh 500 
NPV =  + + + + − Tsh 2,500
 (1 + 0.01)
1
(1 + 0.01) (1 + 0.01) (1 + 0.01) (1 + 0.01)5 
2 3 4

= Tsh 900(NPF1,0.01 ) + Tsh 800(NPF2,0.01 ) + Tsh 700(NPF3,0.01 ) + Tsh 600(NPF4,0.01 ) + Tsh 500(NPF5,0.01 ) − Tsh 2,500

= Tsh 900(0.909) + Tsh 800(0.826) + Tsh 700(0.751) + Tsh 600(0.683) + Tsh 500(0.620) − Tsh 2, 500

= Tsh 2,725 − Tsh 2, 500 = +Tsh 225

Project X’s present value of cash inflows (Tsh 2,725) is greater than that of
cash outflows (Tsh 2,500). Thus, it generates a positive net present value (NPV
= + Tsh 225). Project X adds the wealth to the owners; therefore, it should be
accepted.

Example 2: Uneven Cash Inflows:

An initial investment of Tsh 8,320 thousand on plant and machinery is
expected to generate cash inflows of Tsh 3,411 thousand, Tsh 4,070 thousand,
Tsh 5,824 thousand and Tsh 2,065 thousand at the end of first, second, third
and fourth year respectively. At the end of the fourth year, the machinery will
be sold for Tsh 900 thousand. Calculate the net present value of the
investment if the discount rate is 18%. Round your answer to nearest
thousand Tanzanian Shillings.

Solution
PV Factors:
Year 1 = 1 ÷ (1 + 18%)^1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)^2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)^3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)^4 ≈ 0.5158
The rest of the calculation is summarized below:
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Year 1 2 3 4
Net Cash Inflow Tsh 3,411 Tsh 4,070 Tsh 5,824 Tsh 2,065
Salvage Value Tsh 900
Total Cash Inflow Tsh 3,411 Tsh 4,070 Tsh 5,824 Tsh 2,965
× Present Value Factor 0.8475 0.7182 0.6086 0.5158
Present Value of Cash Tsh Tsh Tsh Tsh
Flows 2,890.68 2,923.01 3,544.67 1,529.31
Total PV of Cash Inflows Tsh 10,888
− Initial Investment − Tsh 8,320
Net Present Value Tsh +2,568 thousand

Discussion Questions.

Question 1.

The management of Fine Electronics Company is considering to purchase an

equipment to be attached with the main manufacturing machine. The
equipment will cost Tsh 6,000 and will increase annual cash inflow by Tsh
2,200. The useful life of the equipment is 6 years. After 6 years it will have no
salvage value. The management wants a 20% return on all investments.

Required:

1. Compute net present value (NPV) of this investment project.

2. Should the equipment be purchased according to NPV analysis?

Question 2.

Smart Manufacturing Company is planning to reduce its labour costs by

automating a critical task that is currently performed manually. The
automation requires the installation of a new machine. The cost to purchase
and install a new machine is Tsh 15,000. The installation of machine can
reduce annual labour cost by Tsh 4,200. The life of the machine is 15 years.
The salvage value of the machine after fifteen years will be zero. The required
rate of return of Smart Manufacturing Company is 25%. Should Smart
Manufacturing Company purchase the machine?

Question 3.

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A project requires an initial investment of Tsh 225,000 and is expected to

generate the following net cash inflows:

Year 1: Tsh 95,000

Year 2: Tsh 80,000

Year 3: Tsh 60,000

Year 4: Tsh 55,000

Required: Compute net present value of the project if the minimum desired
rate of return is 12%.

Profitability Index ( or Benefit - cost ratio)

Profitability Index (PI) is the ratio of the present value of cash inflows, at the
required rate of return, to the initial cash outflow of the investment. The
formula for calculating benefit – cost ratio or profitability index is as follows:

n
Ct
PV of cash inflows PV(C t )
 (1 + k )
t =1
t
PI = = =
Initial cash outlay C0 C0

Or

NPV of cash inflows NPV(C t )

PI = 1 + = 1+
Initial cash outlay C0

Decision rule
Accept the project when PI is greater than one PI >1
Reject the project when PI is greater than one PI <1
May accept the project when PI is equal to one PI = 1

Example 1

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The initial cash outlay of a project is Tsh 100,000 and it can generate cash
inflow of Tsh 40,000, Tsh 30,000, Tsh 50,000 and Tsh 20,000 in year 1
through 4. Assume a 10 per cent rate of discount.

Solution

The PV of cash inflows at 10 per cent discount rate is:

 Tsh 40,000 Tsh 30,000 Tsh 50,000 Tsh 20,000

PV =  + + +
 (1 + 0.01)1
(1 + 0.01)2
(1 + 0.01)3
(1 + 0.01)4 
= Tsh 40,000(NPF1,0.01 ) + Tsh30,000(NPF2,0.01 ) + Tsh 50,000(NPF3,0.01 ) + Tsh 20,000(NPF4,0.01 )

= Tsh 40,000(0.909) + Tsh 30,000(0.826) + Tsh 50,000(0.751) + Tsh 20,000(0.683)

NPV = Tsh 112,350− Tsh 100,000 = +Tsh 12,350

Tsh 112,350 Tsh 12,350

Therefore, PI = = 1.1235 or PI = 1 + = 1 + 0.1235 = 1.1235
Tsh 100,000 Tsh 100,000

Discussion Questions

Question 1

Company C is undertaking a project at a cost of Tsh 50 million which is

expected to generate future net cash flows with a present value of Tsh 65
million. Calculate the profitability index.

Question 2

Company C is considering two mutually exclusive projects with the same initial
cost of Tsh 20,000 and cost of capital of 11%. Detailed information about the
projects’ future cash flows is presented in the table below.

Tsh in Initial Cash flows at the end of the year,

thousands Cost(C0) Ct

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0 1 2 3 4 5

Project Y -20,000 9,000 8,000 7,000 5,000 4,000

Project Z -20,000 4,000 5,000 7,000 9,000 10,000

Use PI to decide which project should be accepted.

Internal Rate of Return (IRR)

Internal rate of return (IRR) is the discount rate at which the net present
value of an investment becomes zero. In other words, IRR is the discount rate
which equates the present value of the future cash flows of an investment with
the initial investment. It is one of the several measures used for investment
appraisal.

IRR Calculation
The calculation of IRR is a bit complex than other capital
budgeting techniques. We know that at IRR, Net Present Value (NPV) is zero,
thus:
NPV = 0; or
PV of future cash flows − Initial Investment = 0; or

 C1 C2 C3 
 1
+ 2
+ 3
+ ....  − Initial Investment (C 0 ) = 0
 ( 1 + r ) ( 1 + r ) ( 1 + r ) 

Where,
r is the internal rate of return;
C1 is the period one net cash inflow;
C2 is the period two net cash inflow,
C3 is the period three net cash inflow, and so on ...

Decision Rule

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A project should only be accepted if its IRR is NOT less than the target internal
rate of return. When comparing two or more mutually exclusive projects, the
project having highest value of IRR should be accepted.

But the problem is, we cannot isolate the variable r (=internal rate of return) on
one side of the above equation. However, there are alternative procedures
which can be followed to find IRR. The simplest of them is described below:
1. Guess the value of r and calculate the NPV of the project at that value.
2. If NPV is close to zero then IRR is equal to r.
3. If NPV is greater than 0 then increase r and jump to step 5.
4. If NPV is smaller than 0 then decrease r and jump to step 5.
5. Recalculate NPV using the new value of r and go back to step 2.
Example
A project costs Tsh 16,000 and is expected to generate cash inflows of Tsh
8,000, Tsh 7,000 and Tsh 6,000 at the end of each year for next 3 years. Find
the rate of return of the project.

Solution
We know that IRR is the rate at which project will have a zero NPV. As first
step, we try (arbitrarily) a 20 per cent discount rate. The project’s NPV at 20
per cent is:

NPV = Tsh 8,000(PVF1,0.20 ) + Tsh 7,000(PVF2,0.20 ) + Tsh 6,000(PVF3,0.20 ) − Tsh 16,000

= Tsh 8,000 0.833 + Tsh 7,000 0.694 + Tsh 6,000 0.579 − Tsh 16,000

= Tsh 14,996 − Tsh 16,000 = -Tsh 1.004

A negative NPV of Tsh 1.004 at 20 per cent indicates that the project’s true rate
of return is lower than 20 per cent.

Let us try 16 per cent as the discount rate. At 16 per cent, the project’s NPV is:

NPV = Tsh 8,000(PVF1,0.16 ) + Tsh 7,000(PVF2,0.16 ) + Tsh 6,000(PVF3,0.16 ) − Tsh 16,000

= Tsh 8,000 0.862 + Tsh 7,000 0.743 + Tsh 6,000 0.641 − Tsh 16,000

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= Tsh 15,943 − Tsh 16,000 = -Tsh 57

Since the project’s NPV is still negative at16 per cent, a rate lower than 16 per
cent should be tried.

Let us try 15 per cent as the discount rate. At 15 per cent, the project’s NPV is:

NPV = Tsh 8,000(PVF1,0.15 ) + Tsh 7,000(PVF2,0.15 ) + Tsh 6,000(PVF3,0.15 ) − Tsh 16,000

= Tsh 8,000 0.870 + Tsh 7,000 0.756 + Tsh 6,000 0.658 − Tsh 16,000

= Tsh 16,200 − Tsh 16,000 = +Tsh 200

The true rate should be lie between 15 – 16 per cent. We can find out a close
approximation of the rate of return by the method of linear interpolation as
follows:

PV required Tsh 16,000

200

PV at lower rate, 15% Tsh 16,200

257

PV at higher rate, 16% Tsh 15,943

r = 15% + (16% - 15%)*200/257

= 15% + 0.80%

= 15.8%

Discussion Questions

Question 1

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 Tanzania Institute of Accountancy

Find the IRR of an investment having initial cash outflow of Tsh 213,000. The
cash inflows during the first, second, third and fourth years are expected to be
Tsh 65,200, Tsh 96,000, Tsh 73,100 and Tsh 55,400 respectively.

Question 2
Assume Company XYZ must decide whether to purchase a piece of factory
equipment for Tsh 300,000. The equipment would only last three years, but it
is expected to generate Tsh 150,000 of additional annual profit during those
years. Company XYZ also thinks it can sell the equipment for scrap afterward
for about Tsh 10,000. Using IRR, Company XYZ can determine whether the
equipment purchase is a better use of its cashthan its other investment
options, which should return about 10%.

Solution

Here is how the IRR equation looks in this scenario:

Tsh 150,000 Tsh 150,000 Tsh 150,000 Tsh 10,000

0 = - Tsh 300,000+ + + +
(1 + .2431)1 (1 + .2431)2 (1 + .2431)3 (1 + .2431)4

The investment’s IRR is 24.31%, which is the rate that makes the present
value of the investment's cash flows equal to zero. From a purely financial
standpoint, Company XYZ should purchase the equipment since this generates
a 24.31% return for the Company --much higher than the 10% return available
from other investments.

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