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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
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).
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
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?
(𝟏+𝟏𝟎%)𝟑 − 𝟏
FV of an Annuity (FVA) = 100,000 *
10%
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.
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%
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
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
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
Page 6 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
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.
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
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
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
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.
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
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
(112,000− 100,000)
Rate of return = * 100 = 12%
100,000
(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
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.
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;
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;
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.
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