RE 232

FINANCIAL MATHEMATICS
PART A — Topic 1: Interest Rate Mathematics (Time Value of Money)

1.1 What Is Interest?

Interest is the reward (fee) paid by one party (the borrower) for the use of an asset — called capital —
belonging to another party (the lender).
● When you borrow money from a bank, you pay interest for the use of the bank's money — this is
Paying Interest.
● When you deposit money in a savings account, the bank pays you interest for letting them use your
money — this is Earning Interest.
Note: Chain of logic: you use somebody else's money → you owe a service charge → that charge is paid back
together with the original amount → the charge itself is called INTEREST.

1.2 Key Terminology

Term Meaning
Principal (P) The sum of money borrowed or invested
Interest (I) Compensation (cost) for borrowing the money
Accumulated Value (A) Money returned at the end of the period = Principal + Interest
Number of periods over which interest is payable (annual, semi-annual,
Time (t / n)
monthly...)
Frequency of compounding
Number of times interest is paid/added per period
(m)
Note: A loan may run for 5 years (5 annual periods) but be compounded semi-annually — meaning interest is
actually paid 10 times.

1.3 Types of Interest Rates

Type Definition
The stated/quoted annual rate on which interest payments are
Nominal Interest Rate
calculated; ignores compounding effects
Real Interest Rate Useful for showing the impact of inflation on the nominal rate
Takes compounding into account over the full term — used to compare
Effective Rate (EAR)
rates with different compounding frequencies

1.4 Impact of Interest Rates (Low vs High)

Rate level Effect on borrowers Effect on savers
Negative — less worthwhile to save
Low interest rates Positive — repayments are low
in banks
Positive — worthwhile to save in
High interest rates Negative — repayments are high
banks

1.5 Simple Interest

The essential feature of simple interest is that interest, once credited, does not itself earn further interest —
the interest earned is proportional to the length of the period.
I=P×i×n

P = Principal amount | i = interest rate (per period, usually annual) | n = number of periods
Q: A loan of Tsh 10,000 is issued for 6 years at 5% simple interest per annum. Find the amount to be repaid.
A: I = P × i × n = 10,000 × 0.05 × 6 = Tsh 3,000. Amount at end of year 6 (A = P + I) = 10,000 + 3,000 = Tsh
13,000.

1.6 Compound Interest

The essential feature of compound interest is that interest itself earns interest — the accumulated amount
at the end of one period becomes the principal for the next period.
A = P (1 + i)ⁿ

A = Compound (accumulated) amount | P = Principal | i = annual interest rate | n = number of years |

Compound Interest = A − P.
When compounding happens more or less frequently than once a year, the rate must be divided by the
compounding frequency and the exponent multiplied by it:
A = P (1 + i/t)^(n×t) [t = number of compounding periods per year]

Q: A bank issues a loan of Tsh 1,000 for 5 years at 5% compounded annually. Find (i) the compound amount
and (ii) the compound interest.
A: A = 1,000 (1.05)^5 = Tsh 1,276. Compound Interest = 1,276 − 1,000 = Tsh 276.

1.7 Simple vs Compound Interest — Comparing the Two Methods

Q: You deposit Tshs 5 million today at 12%. How much will you have after 6 years under (a) simple interest
and (b) compound interest?
A: Simple interest: AV = 5,000,000 + (5,000,000 × 0.12 × 6) = Tsh 8,600,000; Interest = Tsh 3,600,000.
Compound interest: AV = 5,000,000 (1.12)^6 = Tsh 9,869,113.5; Interest = Tsh 4,869,113.5. → Compounding
always produces a larger accumulated value than simple interest over the same term, because interest
earns interest.

Q: You win a Tshs 100 million jackpot. Option A: invest at 7% compounded annually. Option B: give it to your
brother-in-law at 9% simple interest for 10 years (principal returned at year 10). Which gives more money
after 10 years?
A: Option A (compound): AV = 100,000,000 (1.07)^10 = Tsh 196.72 million; Interest = Tsh 96.72 million.
Option B (simple): AV = 100,000,000 + (100,000,000 × 0.09 × 10) = Tsh 190 million; Interest = Tsh 90 million.
→ Option A (7% compounded) gives more money, even though 7% < 9%, because compounding beats
simple interest over a long enough period.

Exam Tip: A lower rate compounded can beat a higher rate charged simply, given enough time — never
assume the bigger quoted % automatically wins.

1.8 Effective Annual Rate (EAR)

Institutions must disclose interest on an annual, comparable basis. This rate goes by several names
depending on the market: Annual Percentage Rate (APR), Annual Equivalent Rate (AER), Effective Interest
Rate (EIR), Effective Annual Rate (EAR), Annual Percentage Yield (APY).
EAR = (1 + i/t)^t − 1

i = annual (nominal) interest rate | t = number of compounding periods per year.

Note: Key rule: the more frequent the compounding, the greater the effective return (though the extra gain
shrinks as frequency rises toward the continuous-compounding limit).

Compounding frequency EAR for a 10% nominal rate

Semi-annually 10.25%
Compounding frequency EAR for a 10% nominal rate
Quarterly 10.381%
Monthly 10.471%
Daily 10.516%
Hourly 10.517029%
Every minute 10.517091%

Q: Credit card companies quote 1.5% per month (18% per year). What EAR are they really charging?
A: EAR = (1 + 0.015)^12 − 1 = (1.015)^12 − 1 = 19.6%. → The true annual cost (19.6%) is noticeably higher
than the quoted 18% nominal rate.

Q: You need Tshs 1 million today. Mzee Biashara Faida lends it to you and asks for Tshs 1,100,000 back in 3
months. (a) What EAR is he charging? (b) A financial institution offers students 25% p.a. — which loan
should you take?
A: Interest for the 3-month period = 100,000 / 1,000,000 = 10%. EAR = (1 + 0.10)^4 − 1 = 46.41% (4 quarters
in a year). → 46.41% (Mzee Biashara Faida) is far higher than 25% (the financial institution) — take the loan
from the Financial Institution.

FN 200 Cross-Reference: FN 200 Chapter 2 confirms and simplifies this exact idea with its own worked
example: a bank advertising 18% nominal compounded monthly has periodic rate r = 0.18/12 = 1.5%, so EAR
= (1.015)^12 − 1 ≈ 19.56% — essentially identical to the RE 232 credit-card example above. Use FN 200's
compact rule whenever you only have a nominal rate and a compounding frequency: r(periodic) =
r(nominal)/m, then EAR = (1+r(periodic))^m − 1. This is the single most commonly mis-applied formula in
tests — always convert to EAR before comparing two loans/accounts quoted at different compounding
frequencies.

1.9 The Compounding Limit — Continuous Compounding

There is a ceiling to compounding: even if interest compounds an infinite number of times, the return
converges to a fixed limit. This limiting case is called continuous compounding.
EAR = e^APR − 1 [e ≈ 2.71828]

Q: A bank pays 10% per year compounded continuously. What does it effectively pay?
A: EAR = e^0.10 − 1 = 10.52%.

1.10 Present Value and Future Value — The Time Value of Money (TVM)
Present Value (PV) and Future Value (FV) are foundational finance concepts underlying stock pricing, bond
pricing, banking and insurance — they account for the Time Value of Money: cash today is worth more than
the same cash in the future, because of:
● Consumption preferences — people prefer to consume now rather than later.
● Inflation — money loses purchasing power over time.
● Uncertainty — a future sum is less certain than cash in hand today.
Concept Definition Process used
Present Value (PV) How much a future sum of money is worth today Discounting
How much a current sum of money is worth in the
Future Value (FV) Compounding
future

FN 200 Cross-Reference: FN 200 Chapter 2 lists the identical three drivers of TVM using slightly different
labels — inflation, preference for current consumption, and investment opportunities (the return money
could otherwise earn). Same idea, worth knowing both phrasings in case an exam question uses FN 200's
wording instead of RE 232's.
1.11 Future Value (FV)
Derivation: FV₁ = PV(1+i); FV₂ = FV₁(1+i) = PV(1+i)²; generalising for n periods:

FVₙ = PV (1 + i)ⁿ [(1+i)ⁿ is the 'Future Value of $1' interest factor]

Excel/spreadsheet function: FV(rate, nper, pmt, pv, type) — e.g. =FV(7%,18,0,-1000,0) = $3,379.93

Q: Jesca Mwita deposits Tshs 10 million today at a compound annual rate of 10% for 5 years. How large will
the deposit become?
A: FV = 10,000,000 (1.10)^5 = Tsh 16,105,100.

Q: Assume you invest Tsh 100 for 3 years at 10%. Find the future value using each method (algebraic,
financial tables, calculator, spreadsheet).
A: Algebraic: FV = 100 (1.10)^3 = Tsh 133.10. Financial tables: FV = 100 × FVIF(10%,3) = 100 × 1.3310 = Tsh
133.10. Financial calculator: N=3, I/Y=10, PV=-100, PMT=0 → FV = 133.10. Spreadsheet: =FV(0.10,3,0,-100,0)
= Tshs 133.10. → All four methods must agree — a useful cross-check technique in the exam.

1.12 Present Value (PV)

Calculating present value (discounting) is simply the inverse of calculating future value (compounding):

PV = FVₙ × [1 / (1+i)ⁿ] [this bracket is the 'Present Value of $1' interest factor]

Excel/spreadsheet function: PV(rate, nper, pmt, fv, type) — e.g. =PV(6%,5,0,1000,0) = −$747.26

Q: You plan to start graduate school in 5 years; MBA tuition is expected to be Tshs 9,000,000. Your
benefactor can deposit money now in an account paying 12%. How much should be deposited today?
A: PV = 9,000,000 × [1/(1.12)^5] = Tsh 5,106,841.7.

Q: You will receive Tsh 100 in 3 years at 10%. Find the present value using each method.
A: Algebraic: PV = 100 × [1/(1.10)^3] = Tsh 75.13. Financial tables: PV = 100 × PVIF(10%,3) = 100 × 0.7513 =
Tsh 75.13. Financial calculator: N=3, I/Y=10, PMT=0, FV=100 → PV = −75.13. Spreadsheet:
=PV(0.10,3,0,100,0) = Tshs −75.13.

Note: Besides algebra and spreadsheets, discounting/compounding problems can also be solved with
financial tables or a financial calculator — all four approaches should give the same answer.

FN 200 Cross-Reference: FN 200 Chapter 2's own worked examples use the identical formulas FV =
PV(1+r)^n and PV = FV/(1+r)^n, e.g. Tshs 500,000 deposited at 12% for 6 years grows to Tshs 986,911, and
Tshs 12,000,000 needed in 8 years at 9% requires a deposit today of about Tshs 6,022,800 using PVIF(9%,8)
= 0.5019. If you are ever given a table of PVIF/FVIF factors in an exam instead of being told to compute
(1+r)^n directly, this is exactly how you would use it — multiply the cash amount by the table factor.

1.13 Solving for the Interest Rate, the Duration, and the Rule of 72
(a) Solving for the interest rate — used when PV, FV and n are known but the rate is not:

r = (FVₙ / PV₀)^(1/n) − 1

Q: Peter John needs Tshs 5 million in 4 years and deposits Tshs 3 million today. What interest rate must he
earn per year?
A: r = (5,000,000 / 3,000,000)^(1/4) − 1 = 13.6%.

(b) Solving for the duration (number of periods) — used when PV, FV and the interest rate are known but
the time is not:

n = ln(FVₙ / PV₀) / ln(1 + r)

Q: Jestina Masha wants to know how long it will take to grow Tshs 4,000,000 into Tshs 10,000,000 at 9% per
year.
A: n = ln(10,000,000/4,000,000) / ln(1.09) = 10.63 years.

(c) Quick approximation — the Rule of 72

Approx. years to double = 72 / i%

Q: Roughly how long does it take to double Tshs 5 million at a compound rate of 12% per year?
A: Rule of 72: 72 / 12 = 6 years (approx.) Actual (exact) duration = 6.12 years — the rule of 72 is a fast
estimate, not exact.

Note: Other unknowns sometimes examined: solving for the interest rate, solving for the number of periods,
and dealing with uneven (non-constant) cash flows — these build directly on the PV/FV formulas above (see
Topic 2).

1.14 Topic 1 — Quick-Reference Formula Sheet

Concept Formula
Simple interest I=P×i×n
Compound amount (annual) A = P(1 + i)ⁿ
Compound amount (m times/year) A = P(1 + i/t)^(n×t)
Effective Annual Rate EAR = (1 + i/t)^t − 1
EAR with continuous compounding EAR = e^APR − 1
Future value FVₙ = PV(1 + i)ⁿ
Present value PV = FVₙ × [1/(1+i)ⁿ]
Solving for rate r = (FVₙ/PV₀)^(1/n) − 1
Solving for time n = ln(FVₙ/PV₀) / ln(1+r)
Rule of 72 (time to double) n ≈ 72 / i%
PART B — Topic 2: Annuities & Special Cash Flows

2.1 What Is an Annuity?

An annuity represents a series of equal payments (or receipts) occurring over a specified number of
equidistant periods.
Type Definition
Ordinary Annuity Payments or receipts occur at the end of each period.
Annuity Due Payments or receipts occur at the beginning of each period.
An ordinary annuity whose payment stream does not begin until after a
Deferred Annuity
certain designated time has passed.
Everyday examples: house rental payments, student loan payments, car loan payments, insurance
premiums, mortgage payments, retirement savings.

2.2 Future Value of Annuities

The future value of an ordinary annuity is viewed as occurring at the end of the last cash-flow period,
whereas the future value of an annuity due is viewed as occurring at the beginning of the last cash-flow
period (i.e. one extra period of compounding).
Ordinary annuity: FV₀ = PMT × [(1+r)ⁿ − 1] / r

Annuity due: FV₀ = PMT × [(1+r)ⁿ − 1] / r × (1+r)

Spreadsheet: FV(rate, nper, pmt, pv, type) — type = 0 for end-of-period, type = 1 for beginning-of-period.
Example: =FV(14%,12,-1000,0,0) = $27,270.75.

Q: Suppose you plan to buy a house in five years' time. You decide to deposit Tshs 30 million at the end of
each of the next 5 years in an account paying 15% p.a. How much will you have accumulated at the end of
the 5th year?
A: FV₀ = 30,000,000 × [(1.15)^5 − 1]/0.15 = Tshs 202,271,437.50.

Q: How much would you have in your account if the money is deposited at the beginning of each of the next
five years instead (same data)?
A: This becomes an annuity due: FV₀(due) = 202,271,437.50 × (1.15) = Tshs 232,612,153.13 — one extra
year of compounding on every deposit.

2.3 Present Value of Annuities

The present value of an ordinary annuity is viewed as occurring one period before the first cash flow (at t=0,
with the first payment at the end of period 1); the present value of an annuity due is viewed as occurring at
the same time as the first cash flow (t=0, first payment immediately).
Ordinary annuity: PV₀ = PMT × [1 − 1/(1+r)ⁿ] / r

Annuity due: PV₀ = PMT × [1 − 1/(1+r)ⁿ] / r × (1+r)

Q: Suppose you plan to start a PhD programme and enter an agreement to deposit a sum today; the
institution will pay you Tshs 10 million at the end of each of 3 years while you are at school. At 15% p.a.,
how much should you deposit?
A: PV₀ = 10,000,000 × [1 − 1/(1.15)^3]/0.15 = Tshs 22,832,251 (per-year factor); always re-derive PVIFA(r,n)
= [1−(1+r)^-n]/r for the actual r and n given in the question.

Q: How much should you deposit if the fixed payment is instead made at the beginning of each of the years
you will be at school?
A: Use the annuity-due version: PV₀(due) = PV₀(ordinary) × (1+r) — simply multiply the ordinary-annuity
answer by (1+r) once.

Note: Besides algebra and spreadsheets, annuity problems can also be tackled using Financial Tables (PVIFA
/ FVIFA factor tables) or a Financial Calculator.

Note: Across Future Value of a Single Amount, Present Value of a Single Amount, Future Value of an Annuity,
and Present Value of an Annuity, there are always four variables — interest rate, number of periods, and two
cash-flow amounts (present and future). Given any three, you can always solve algebraically for the fourth.

FN 200 Cross-Reference: FN 200 Chapter 2 gives a clean set of matching worked drills you can use for extra
self-testing: FV of an ordinary annuity of Tshs 300,000/year for 8 years at 8% ≈ Tshs 3,190,980 (using
FVIFA(8%,8)=10.6366); PV of Tshs 1,000,000/year for 5 years at 10% ≈ Tshs 3,790,800
(PVIFA(10%,5)=3.7908); and a perpetuity of Tshs 2,000,000/year at 8% is worth Tshs 25,000,000 today (PV =
A/r). These reinforce exactly the same PVIFA/FVIFA mechanics as the RE 232 examples above — good extra
practice numbers if you want a second data point for each formula.

2.4 Growing Annuities

A growing annuity is a series of payments or receipts over a specified number of periods that increases each
period at a constant percentage. Because of inflation, rising costs, and/or increasing benefits, many real
annuities are not zero-growth.
PV of a growing annuity: PVA₀ = PMT₀(1+g) × [1 − ((1+g)/(1+r))ⁿ] / (r−g)

FV of a growing annuity: FVA₀ = PMT₀(1+g) × [(1+r)ⁿ − (1+g)ⁿ] / (r−g)

Note: Alternative shortcut for the PV: adjust the rate to r* = (1+r)/(1+g) − 1, then compute an ordinary-
annuity PV using PMT₀ as the payment amount.

Q: Ms. Investor receives a 3-year ordinary annuity that begins at Tsh 1,000 but increases at a 10% annual
rate. She deposits the money at the end of each year in an account earning 6% compounded annually. How
much will her account be worth at the end of the 3-year period?
A: Using the growing-annuity FV formula with PMT₀=1,000, g=10%, r=6%, n=3: FVA₀ = Tsh 3,499.6.

Q: Annual end-of-year lease payments on a building increase 10% annually for the next 5 years. At an 8%
interest rate, if the first year's lease payment is Tsh 10,000, what is the most an investor would pay for these
lease payments?
A: Using the growing-annuity PV formula with PMT₀=10,000, g=10%, r=8%, n=5: PVA₀ = Tsh 48,043.

2.5 Perpetuities (Perpetual Annuities)

A perpetuity is an annuity that never ends — a stream of cash payments that continues forever. Perpetuities
are one of the time-value-of-money methods used to value financial assets (e.g. some bonds, preference
shares).
PV₀ = CF₁ / r

Q: The British government has a consol bond outstanding paying £100 per year forever. Assume the current
interest rate is 4% per year. What is it worth?
A: PV₀ = 100 / 0.04 = £2,500.

Q: You want to sponsor an annual graduation party at ARU forever, budgeting TSh 30,000 per year. If the
university earns 8% per year on its investments and the first party is in one year's time, how much must you
donate?
A: PV₀ = 30,000 / 0.08 = TSh 375,000.
2.6 Growing Perpetuities
A growing perpetuity is a series of future cash flows expected to grow indefinitely at a constant growth rate.
PV₀ = CF₀(1+g) / (r−g) = CF₁ / (r−g)

Q: Continuing the ARU party example (TSh 30,000 next year, r = 8%): the ARU student body now asks that
the donation grow by 4% per year forever to keep pace with rising costs. How much must you donate now?
A: PV₀ = CF₁ / (r−g) = 30,000 / (0.08 − 0.04) = TSh 750,000 (exactly double the non-growing perpetuity value,
since growth halves the effective discount margin).

2.7 Deferred Annuities

In every annuity problem discussed so far, the cash flows commenced in the 1st period. A deferred annuity
is a financial transaction where the annuity payments are delayed until a certain period of time has elapsed.
PV of a Deferred Ordinary Annuity: PV₀ = PMT (1+r)^(−k) × [1 − 1/(1+r)ⁿ] / r

PV of a Deferred Annuity Due: PV₀ = PMT (1+r)^(−k) × [1 − 1/(1+r)ⁿ] / r × (1+r) [k = length of the
deferral period]

Q: What is the present value of a non-deferred ordinary annuity of Tshs 100,000 per year for 3 years at r =
10%? What if the payments instead don't start until the end of the third year (i.e. first payment at t = 3,
running to t = 5)?
A: Non-deferred: PV₀ = 100,000 × [1−1/(1.10)^3]/0.10 = Tshs 248,690. Deferred: the value Tshs 248,690
represents the annuity's worth exactly one period before the cash flows begin — i.e. at t = 2 (PV₂). To bring
it back to today (t = 0), discount two more periods: PV₀ = 248,690 × (PVIF 10%,2) = 248,690 × 0.826 ≈ Tshs
205,502.

Q: When you turn 35 in 4 years, you will begin receiving an annuity of Tshs 10 million per year for 4 years
from your late grandfather's estate. If interest rates are 7% per year, how much is this annuity worth today?
A: This is a deferred ordinary annuity with PMT=10,000,000, r=7%, n=4, k=4 (deferral): PV₀ = 10,000,000 ×
(1.07)^(−4) × [1−1/(1.07)^4]/0.07 ≈ TSh 27.649713 million.

Note: Future Value of a Deferred Annuity: the FV formula for a deferred annuity is identical to the FV formula
for an immediate (non-deferred) annuity of the same n. This is because whether the annuity starts at period
0 or after a deferral of d periods, we are always finding the future value of the same n total payments as of
the date the last payment is made.

2.8 Uneven (Non-Constant) Cash Flows

Some cash-flow streams are not equal from period to period — e.g. the savings pattern of a self-employed
person whose savings vary with income. Two equivalent solution techniques exist:
● Piece-at-a-time: discount each individual cash flow back to t = 0 separately, then sum.
● Group-at-a-time: split the stream into sub-groups that are each an annuity (or single amount),
discount each group back to t = 0, then sum.

Q: Jestina Masha will receive the following cash flows (Tshs millions) at a 10% discount rate — Year 1: 6,
Year 2: 6, Year 3: 4, Year 4: 4, Year 5: 1. What is the present value of the total receipt?
A: Piece-at-a-time: PV = 6/1.10 + 6/1.10² + 4/1.10³ + 4/1.10⁴ + 1/1.10⁵ = 5.4545 + 4.9587 + 3.0053 + 2.7321 +
0.6209 = Tshs 16.7715 million. Group-at-a-time (splitting into a 2-year annuity of 6, a 2-year annuity of 4
deferred 2 years, and a single Tshs 1 in year 5): 6×PVIFA(10%,2) + 4×PVIFA(10%,2)×PVIF(10%,2) +
1×PVIF(10%,5) = 6(1.736) + 4(1.736)(0.826) + 1(0.621) ≈ Tshs 16.77 million. Both methods agree (small
differences are only due to table-factor rounding).
Note: We generally assume the cash-flow period coincides with the interest-conversion period. When it
doesn't, apply the formulas using i = the effective rate of interest for the payment period (not the nominal
interest-conversion-period rate).

2.9 A Method for Digesting Complex TVM Problems

● Read the problem thoroughly.
● Create a timeline.
● Put the cash flows and arrows on the timeline.
● Determine whether it is a PV or an FV problem.
● Determine whether the cash flow is single / annuity / perpetual, immediate / deferred, growing /
constant, or a mixed pattern, and what interest rate(s) apply.
● Solve the problem.
● Check with a financial calculator if available (optional).

Q: Your company's earnings are predicted to grow at 30% per year for the next 5 years, then slow to 2% per
year forever. The company has just announced earnings of TShs 1,000,000. What is the present value of all
future earnings at an 8% interest rate (assume cash flows occur at year-end)?
A: Stage 1 (years 1–5, growing annuity at 30% growth, discounted at 8%): PV₁ ≈ TSh 9.02 million. Stage 2
(years 6 onward, growing perpetuity at 2% growth starting from year-6 earnings, discounted back to today):
PV₂ ≈ TSh 42.96 million. Total PV = PV₁ + PV₂ ≈ TSh 51.98 million.

Q: You currently earn Tshs 30 million/year. You are considering a 2-year MBA costing Tshs 8 million/year in
tuition (and you forgo your salary while studying). After graduating, your expected salary is Tshs 40
million/year for 30 years. At 8%, should you pursue the programme?
A: PV of Master's Degree Costs (2 years of forgone salary + tuition) ≈ TSh 68.905 million. PV of Master's
Degree Benefits (30-year salary increment) ≈ TSh 96.517 million. → Since PV(Benefits) > PV(Costs), the MBA
programme is worthwhile — pursue it.

2.10 Topic 2 — Quick-Reference Formula Sheet

Cash-flow pattern Present Value Future Value
Ordinary annuity PMT × [1−(1+r)⁻ⁿ]/r PMT × [(1+r)ⁿ−1]/r
Annuity due PV(ordinary) × (1+r) FV(ordinary) × (1+r)
Growing annuity PMT₀(1+g)×[1−((1+g)/(1+r))ⁿ]/(r−g) PMT₀(1+g)×[(1+r)ⁿ−(1+g)ⁿ]/(r−g)
Perpetuity CF₁ / r n/a (never ends)
Growing perpetuity CF₁ / (r−g) n/a
Deferred annuity (k same as an immediate annuity of n
PMT(1+r)⁻ᵏ×[1−(1+r)⁻ⁿ]/r
periods) payments
Σ [CFₜ / (1+r)ᵗ] — piece- or group-at-a- compound each CF forward to the
Uneven cash flows
time target date and sum
PART B+ — Bond Valuation (Extension of Topic 2)
Bond valuation is not a separate technique — it is a direct application of the Present-Value-of-an-Annuity
and Present-Value-of-a-Single-Sum formulas from Topic 2, applied together. A bond promises two distinct
cash-flow streams: a series of equal coupon (interest) payments (an ordinary annuity) and a single lump-
sum repayment of the face/par value at maturity (a single sum). This section is added because both Test 1
and Test 2 examine bond pricing directly, even though it is not a standalone topic heading in the original
slides.

B+.1 Key Terms

Term Meaning
The amount the bondholder is repaid at maturity (commonly
Face value / Par value (F)
Tshs/TZS 1,000 or 100 in textbook problems)
The stated annual interest rate printed on the bond, used to
Coupon rate compute the coupon payment (not the same as the
market/required rate)
Coupon rate × Face value, divided by the number of coupon
Coupon payment (PMT)
payments per year if paid more than annually
The market's current required return for a bond of this risk level —
Required rate of return (r) / Yield
the discount rate used to price the bond
Number of years (or number of coupon periods) until the face value
Maturity (n)
is repaid

B+.2 The Bond Pricing Formula

A bond's price is the present value of its coupon annuity plus the present value of its face value repaid at
maturity:
Bond Price = PMT × [1 − (1+r)⁻ⁿ] / r + F × (1+r)⁻ⁿ

Where, if coupons are paid semi-annually: PMT = (annual coupon rate / 2) × F, r = (annual required rate)/2,
and n = number of years × 2 — exactly the same non-annual-compounding adjustment used throughout
Topic 1 and Topic 2.

B+.3 Discount, Premium, and Par Bonds

Situation Relationship Price vs Face Value
Discount bond Coupon rate < Required rate (yield) Price < Face value
Premium bond Coupon rate > Required rate (yield) Price > Face value
Par bond Coupon rate = Required rate (yield) Price = Face value

Note: Intuition: if the coupon rate is below what the market currently requires, investors will only buy the
bond at a discounted price (so their effective yield rises to match the market); if the coupon rate is above
what the market requires, investors will pay a premium (bidding the price up until the effective yield falls to
the market rate).

Q: A TZS 1,000 bond has a 10% annual coupon paid semiannually, with 5 years to maturity. The required
rate of return is 12% per annum. Calculate the bond's current price using semiannual compounding.
A: Semiannual coupon PMT = 1,000 × 0.10/2 = TZS 50. n = 5×2 = 10 periods. Semiannual required rate r =
12%/2 = 6%. PVIFA(6%,10) = [1−(1.06)⁻¹⁰]/0.06 = 7.3601. PV factor (1.06)⁻¹⁰ = 0.5584. Price = 50 × 7.3601 +
1,000 × 0.5584 = 368.00 + 558.40 = TZS 926.40. Since the price (926.40) is below the TZS 1,000 face value,
this is a DISCOUNT bond — consistent with the 10% coupon being below the 12% required return.
Q: Bond A: 20-year maturity, 12% coupon (paid semiannually), TZS 1,000 par. Bond B: 30-year maturity, 8%
coupon (paid semiannually), TZS 1,000 par. If both bonds have a required rate of return of 10%, what would
the bonds' prices be?
A: Bond A: PMT = 1,000×0.12/2 = TZS 60; n = 40; r = 10%/2 = 5%. PVIFA(5%,40) = 17.1591; (1.05)⁻⁴⁰ = 0.1420.
Price A = 60×17.1591 + 1,000×0.1420 = 1,029.55 + 142.05 = TZS 1,171.60. Bond B: PMT = 1,000×0.08/2 = TZS
40; n = 60; r = 5%. PVIFA(5%,60) = 18.9293; (1.05)⁻⁶⁰ = 0.0535. Price B = 40×18.9293 + 1,000×0.0535 =
757.17 + 53.54 = TZS 810.71.

B+.4 Worked Example — Re-pricing at a New Required Return

Using the same two bonds as above (Bond A: 12% coupon / 20 yrs; Bond B: 8% coupon / 30 yrs; both TZS
1,000 par, semiannual coupons), if the required rate of return falls to 9% per annum:
A: Semiannual required rate falls to r = 9%/2 = 4.5%.
Bond A (PMT=60, n=40): PVIFA(4.5%,40) = 18.4017; (1.045)⁻⁴⁰ = 0.1719. Price A = 60×18.4017 +
1,000×0.1719 = 1,104.10 + 171.92 = TZS 1,276.03.
Bond B (PMT=40, n=60): PVIFA(4.5%,60) = 20.6380; (1.045)⁻⁶⁰ = 0.0713. Price B = 40×20.6380 +
1,000×0.0713 = 825.52 + 71.29 = TZS 896.81.
→ Both bond prices rose when the required return fell from 10% to 9% — bond prices and required yields
always move in opposite directions. Bond A remains at a premium (coupon 12% > required 9%); Bond B is
still at a discount (coupon 8% < required 9%) but the discount is now smaller than it was at a 10% required
return.

Exam Tip: Bond price and market yield move inversely: when the required return (market yield) rises, bond
prices fall; when it falls, prices rise. A bond always converges to exactly its face value as it approaches
maturity, regardless of whether it started at a discount or a premium.

B+.5 Topic B+ — Quick-Reference Formula Sheet

Concept Formula / Rule
Bond price (general) PMT × [1−(1+r)⁻ⁿ]/r + F×(1+r)⁻ⁿ
Semiannual coupon payment PMT = (Annual coupon rate / 2) × Face value
Semiannual required rate r = Annual required rate / 2
Number of periods (semiannual) n = Years to maturity × 2
Discount bond Coupon rate < required rate → Price < Par
Premium bond Coupon rate > required rate → Price > Par
Par bond Coupon rate = required rate → Price = Par
PART C — Topic 3: Relevant Cash Flows for Investment Analysis

3.1 Context: Investment Analysis and Estimating Cash Flows

This topic covers forecasting the annual cash flows of a project. Once all cash flows are forecast, the NPV or
IRR (Topic 5) can be calculated and the project recommended for acceptance or rejection.
● If a firm evaluates a project's cash flows improperly, it risks being off-course at every later stage of
capital budgeting.
● Properly evaluating a project's cash flows is crucial for its viability and profitability — later steps
cannot proceed without it.
● The relevant cash flows considered are always AFTER-TAX cash flows.

3.2 What Is Capital Budgeting?

Capital budgeting is the process of identifying, analysing, and selecting investment projects whose returns
(cash flows) are expected to extend beyond one year.
FN 200 Cross-Reference: FN 200 Chapter 7 defines capital budgeting identically — 'evaluating and selecting
long-term investments whose returns are expected to extend beyond one year' — and adds that it is also
called investment decision-making. FN 200 further highlights four defining characteristics worth memorising
for definition-style exam questions: (1) a large initial outlay with long-term implications, (2) largely
irreversible — reversing a wrong decision is very costly, (3) complex, often affecting more than one
department, and (4) strategic and risky, with consequences for firm value well beyond the immediate
future.

3.3 The Investment Analysis (Capital Budgeting) Process

● Generate investment project proposals consistent with the firm's strategic objectives.
● Estimate the project's after-tax incremental cash flows.
● Select projects based on a value-maximising acceptance criterion.
● Re-evaluate implemented projects continually and perform post-audits on completed projects.
FN 200 Cross-Reference: FN 200 Chapter 7 also introduces a classification of project types that RE 232 does
not spell out explicitly but that examiners sometimes test: Independent projects (accepting one does not
affect the other), Mutually exclusive projects (accepting one automatically rejects the other(s) — e.g.
choosing between two different machines for the same job), and Contingent/dependent projects
(acceptance of one depends on another being accepted first, e.g. a new product line that requires a
warehouse expansion first).

3.4 Issues Associated with Capital Budgeting Cash Flows

The key to analysing a new project is always to think incrementally — how will the corporation's total after-
tax cash flows change if the project is accepted?
Rule Explanation
Don't forget future inflation Inflation must be built into future cash-flow estimates
Include all side effects A project may cannibalise or enhance the firm's existing operations
Money already spent in the past is irrelevant — only current and future
Exclude sunk costs
cash flows matter
An asset used for the project might have a higher value in an alternative
Include opportunity costs
use
Overhead usually occurs regardless of whether the project is accepted —
Exclude overhead costs
not incremental
Rule Explanation
Include working-capital A change in net working capital (NWC) caused by the project must be
changes counted
Ignore interest & financing Financing costs are captured in the discount rate; including them again
costs double-counts

FN 200 Cross-Reference: FN 200 Chapter 7 states the financing-cost rule from the opposite direction, which
is a useful double-check: 'interest expense is excluded from project cash flows because it is captured
through the discount rate/cost of capital instead, since investment decisions are evaluated independently of
financing decisions.' If an exam question ever gives you an interest expense figure inside a capital-budgeting
cash-flow table, treat it as a distractor — do not subtract it from operating cash flow a second time.

3.5 Calculating the Incremental Cash Flows — Three Components

● Initial cash outflow — the initial net cash investment (time 0).
● Interim (operating) incremental net cash flows — the net cash flows occurring after the initial
investment but before the final period.
● Terminal-year incremental net cash flows — the final period's net cash flow, including project wind-
up items.
Note: Picture a timeline: a negative outflow at t=0, positive operating cash flows in each year of the project's
life, and an extra terminal cash flow layered on top of the final year's operating flow.

Initial Cash Outflow

● (a) Cost of "new" assets
● (b) + Capitalised expenditures
● (c) +/− Increased (decreased) Net Working Capital (NWC)
● (d) − Net proceeds from sale of "old" asset(s), if replacement
● (e) +/− Taxes (savings) on sale of "old" asset(s), if replacement
● (f) = Initial cash outflow
Components explained:
● Cost of "new" assets: the relevant cash outflow to obtain fixed assets at the start of the project (t₀).
● Capitalised expenditures: costs providing future benefit (e.g. shipping and installation) — added to
the asset's depreciable base rather than expensed immediately.
● Increased/decreased NWC: NWC = current assets − current liabilities. A rise in current assets
(receivables, inventory) is a cash outflow; a rise in current liabilities (payables) is a cash inflow, since
the firm is effectively financed by its creditors.
● Sunk costs: money already spent before the investment decision (e.g. prior-year market research) —
irrelevant, must be ignored.
● Opportunity costs: the value of the best alternative use of an asset — must be included even though
no cash physically changes hands.

Incremental Operating Cash Flows

ΔCFᵢ = [Δrevenue − Δcosts − Δdepreciation] × (1 − tax rate) + Δdepreciation ± ΔNWC ± Salvage/Terminal
items

● Operating cash flow (CF) is the net after-tax cash flow expected at any stage of the project's life as a
result of running the project. It is usually positive, though some years may show outflows greater
than inflows.
 ● Non-cash items such as depreciation are excluded directly from cash flow — only the tax saving
("tax shield") that depreciation creates is counted.
● Cost savings from a project are treated as a cash inflow.
● Interest and financing costs are excluded from operating cash flow — captured instead through the
project's discount rate (cost of capital), which blends the cost of debt and equity financing.
FN 200 Cross-Reference: FN 200 Chapter 7 gives an alternative, quicker way to arrive at exactly the same
operating cash-flow number, useful as a cross-check: CF = Net Income + (1 − Tax Rate) × Interest +
Depreciation, equivalently CF = EBIT × (1 − Tax Rate) + Depreciation. Since RE 232's incremental-cash-flow
formula already excludes interest, the (1−Tax Rate)×Interest term is normally zero for RE 232-style project
analysis — but the EBIT×(1−Tax)+Depreciation form is exactly the RE 232 formula rearranged, and is the
version most commonly seen on FN 200-style exam tables (EBIT → Tax → Net income → +Depreciation → =
Operating Cash Flow), as used in the worked Basket Wonders and TW examples below.

Depreciation in Cash-Flow Analysis

● Business investment requires both long-term assets (plant, property, equipment — depreciated
over time) and short-term assets (cash, receivables, inventory).
● Any increase in short-term assets financed by investor capital is Net Working Capital and must be
included in the project's NPV.
● Depreciation is the systematic allocation of a capital asset's cost over time for financial-reporting
and/or tax purposes. It is a non-cash expense.
● All else equal, higher depreciation charges → lower taxable income → lower taxes paid. Profitable
firms generally prefer an accelerated depreciation method for tax purposes.
Depreciable Basis = Cost of Asset + Capitalised Expenditures (e.g. shipping and installation)

When an asset is sold, the difference between the sale price and its remaining (net) book value creates a
capital gain or loss, which is taxed (or provides a tax saving):
Tax on sale = Tax rate × (Sale price − Remaining book value)

Terminal-Year Incremental Cash Flows

● (a) Incremental net cash flow for the terminal period
● (b) +/− Salvage value (or disposal/reclamation costs) of sold/disposed assets
● (c) −/+ Taxes (tax savings) due to asset sale/disposal
● (d) +/− Decreased (increased) level of net working capital
● (e) = Terminal-year incremental net cash flow
The terminal cash flow (CFₙ) is the net cash flow tied to ending the project — e.g. selling the asset(s) and
recovering working capital originally tied up. It can be positive or negative.

3.6 Fully Worked Example — Five-Year Project ("Project X")

Project features: new machine TZS 100,000,000 + shipping/installation TZS 50,000,000; sold after 5 years for
an estimated TZS 10,000,000 salvage value; revenues rise by TZS 80,000,000/yr and operating expenses
(before depreciation) rise by TZS 30,000,000/yr for years 1–5; NWC rises by TZS 5,000,000 today, fully
recovered in year 5; an old, fully depreciated machine is removed and sold today for TZS 5,000,000; straight-
line depreciation; cost of capital r = 11%; corporate tax rate = 40%.

Step (i): Initial Investment Cost

Item Amount (TZS)
Purchase of machine 100,000,000
+ Installation and shipping 50,000,000
Item Amount (TZS)
= Installed cost 150,000,000
+ Initial increase in NWC 5,000,000
− Proceeds from sale of old asset (5,000,000)
Net investment before taxes 150,000,000
+ Tax on sale of old asset (40% × (5,000,000 − 0 book value)) 2,000,000
= Total Initial Net Investment (outflow) 152,000,000

Step (ii): Annual Incremental Operating Cash Flows (Years 1–5)

Note: Straight-line depreciation = 150,000,000 / 5 = TZS 30,000,000/year — always recompute the exact
depreciable-base ÷ life figure for your own exam answer.

Year Incremental Cash Flow (TZS)

0 −152,000,000
1 43,200,000
2 43,200,000
3 43,200,000
4 43,200,000
53,200,000 (operating CF + recovery of TZS 5,000,000 NWC + salvage TZS
10,000,000
5 − tax on sale of new machine — always re-derive the terminal-year figure directly
from the sale price, tax on sale, and NWC recovery for the numbers given in your
own exam question)
Note: The project's cost of capital, r = 11%, is then used to discount these cash flows to compute the project's
NPV — the standard next step, covered in Topic 5 (Discounted Cash Flow Techniques).

3.7 Practice Question 1 — The "TW" Product (Fully Solved)

Data: R&D already spent TZS 100,000,000 (sunk cost, 3 years ago). New machine cost TZS 200,000,000, life
15 years, salvage TZS 5,000,000 at year 15, depreciated straight-line to TZS 0 over only the first 10 years.
Painting done on an existing machine with excess capacity that already costs TZS 3,000,000 regardless of
usage (not incremental). Operating cost TZS 4,000,000/yr. Sales TZS 40,000,000/yr, but cannibalises TZS
2,000,000/yr of existing product sales. Working capital: TZS 25,000,000 required over the project's life. Tax
rate 34%. Opportunity cost of capital 10%.
● The TZS 100,000,000 R&D cost is a sunk cost — EXCLUDE from the analysis.
● The TZS 3,000,000 painting-machine cost does not change regardless of usage — not incremental —
EXCLUDE.
● Net incremental revenue = 40,000,000 − 2,000,000 (cannibalisation) = TZS 38,000,000/yr.
● Depreciation = 200,000,000 / 10 = TZS 20,000,000/yr for years 1–10; TZS 0 for years 11–15 (fully
depreciated, but the machine is still used).
Initial outlay (t=0): −(200,000,000 machine + 25,000,000 NWC) = −TZS 225,000,000.
Period EBIT (Rev−Cost−Dep) Tax (34%) Net income + Dep = OCF
38m−4m−20m = 9,240,000 +
Years 1–10 4,760,000 29,240,000
14,000,000 20,000,000
Years 11–15 38m−4m−0 = 34,000,000 11,560,000 22,440,000 + 0 22,440,000
Terminal cash flow (year 15): recovery of NWC +25,000,000; book value of machine at year 15 = TZS 0 (fully
depreciated after year 10); sale (salvage) value = TZS 5,000,000 → taxable gain = 5,000,000; tax (34%) = TZS
1,700,000; after-tax salvage proceeds = 5,000,000 − 1,700,000 = TZS 3,300,000. Total terminal addition at
year 15 = 25,000,000 + 3,300,000 = TZS 28,300,000, on top of the year-15 operating cash flow of TZS
22,440,000 (total year-15 cash flow = TZS 50,740,000).

NPV Decision (discounted at 10%)

Component Present Value (TZS)
Initial outlay (t=0) (225,000,000)
PV of OCF, years 1–10 (annuity, 29,240,000/yr) 179,667,000
PV of extra OCF, years 11–15 (annuity, 22,440,000/yr, deferred 10 yrs) 32,796,000
PV of terminal addition at year 15 (28,300,000) 6,775,000
≈ NPV (5,762,000)

Q: Should the company go ahead with production of the TW?

A: NPV ≈ −TZS 5.76 million (negative) at a 10% opportunity cost of capital → Decision: REJECT the project as
currently specified — the NPV is negative, so it destroys value.

Note: The NPV is only marginally negative here, so this project sits close to the break-even point — a small
improvement in revenue, cost, or the discount rate could flip the decision. Always show full workings, since
markers award partial credit for correct method even if the final NPV sign is borderline.

3.8 Practice Question 2 — Basket Wonders (BW) (Fully Solved)

Data: machine cost TZS 50,000,000 + TZS 20,000,000 shipping/installation = TZS 70,000,000 installed cost; 4-
year economic life; straight-line depreciation down to a salvage value of TZS 10,000,000; NWC rises by TZS
5,000,000 at the start (recovered at year 4); revenues rise by TZS 110,000,000/yr for 4 years; machine
actually sold (scrapped) for TZS 20,000,000 at end of year 4; operating costs rise by TZS 70,000,000/yr; tax
rate 40%.
● Step 1 — Depreciation: (70,000,000 − 10,000,000) / 4 = TZS 15,000,000/year.
● Step 2 — Initial outlay (t=0): −(70,000,000 installed cost + 5,000,000 NWC) = −TZS 75,000,000.

Step 3: Annual Operating Cash Flow (Years 1–4)

Item Amount (TZS)
Revenue 110,000,000
− Operating costs (70,000,000)
− Depreciation (15,000,000)
= EBIT 25,000,000
− Tax (40%) (10,000,000)
= Net income 15,000,000
+ Depreciation (added back) 15,000,000
= Operating cash flow (years 1–4) 30,000,000
Step 4 — Terminal cash flow (year 4): book value at year 4 = TZS 10,000,000 (salvage-for-depreciation
value); actual sale price TZS 20,000,000 → taxable gain = 10,000,000; tax (40%) = TZS 4,000,000; after-tax
sale proceeds = 20,000,000 − 4,000,000 = TZS 16,000,000; recovery of NWC = +TZS 5,000,000. Total terminal
addition at year 4 = 16,000,000 + 5,000,000 = TZS 21,000,000, added to the year-4 operating cash flow of
TZS 30,000,000.

Q: Calculate the relevant cash flows for the Basket Wonders project.
A: Year 0: −TZS 75,000,000. Year 1: TZS 30,000,000. Year 2: TZS 30,000,000. Year 3: TZS 30,000,000. Year 4:
30,000,000 + 21,000,000 = TZS 51,000,000.

3.9 Topic 3 — Quick-Reference Formula Sheet

Concept Formula / Rule
Cost of new assets + capitalised expenditures ± ΔNWC − proceeds
Initial cash outflow
from sale of old asset ± tax on that sale
[Δrevenue − Δcosts − Δdepreciation](1 − tax rate) + Δdepreciation ±
Operating cash flow
ΔNWC ± terminal items
Operating cash flow (FN 200 cross- Net Income + (1−Tax)×Interest + Depreciation, i.e. EBIT×(1−Tax) +
check form) Depreciation
Tax on sale of an asset Tax rate × (Sale price − Remaining book value)
Terminal-year cash flow Operating CF for final year + salvage (after tax) + recovery of NWC
Straight-line depreciation (Cost − Salvage value) / Useful life
Note: Rules to remember: Ignore sunk costs · Ignore financing/interest costs · Include opportunity costs ·
Include side effects (cannibalisation) · Exclude non-incremental overhead.
PART D — Topic 4: Asset Depreciation Methods

4.1 What Is Depreciation?

Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.
Depreciable amount = Cost of asset (CA) − Residual Value (RV)

4.2 Key Terms

Term Meaning
The initial acquisition price of the asset — the starting point for
Original Cost of the Asset (CA) depreciation. Includes all costs necessary to acquire the asset and
prepare it for its intended use.
The estimated residual value of the asset at the end of its useful life
Salvage / Residual Value (RV)
— the amount expected to be recovered on disposal.
The estimated number of years the asset is expected to be
Useful Life productive. Affected by wear and tear, obsolescence, and
legal/contractual limits.
Original cost minus accumulated depreciation to date — the asset's
Current (Net) Book Value
remaining recorded value.
The percentage at which the asset is depreciated each year; for
Depreciation Rate
straight-line, = 1 / Useful life.
The number of years left for the asset to be useful; starts at the
Remaining Lifespan
useful life and falls each year.

Cost Elements Included in the Original Cost (CA)

● Purchase price, less trade discount but not a cash discount.
● Import duty and other non-refundable taxes.
● Directly attributable costs of bringing the asset to the location/condition intended for use (e.g.
delivery, installation, testing, professional costs).
● Initial estimate (present value) of dismantling the asset and restoring its site.
● For constructed assets: material costs, labour costs, and direct overheads.

Costs Excluded from the Original Cost

● Administrative costs / general overheads / indirect costs.
● Abnormal costs (e.g. material wastage, labour cost during idle time).
● Training cost on how to use the asset.
● Relocation cost of staff.
● Cost of the opening/launch ceremony.
● Loss incurred during the initial period of operation.
Note: Subsequent costs (servicing/repair, replacement, upgrading, repainting) are added to the asset's
original cost only if (a) it is probable that future economic benefits will flow to the entity, and (b) the cost can
be measured reliably — i.e. only if the cost improves/enhances the asset's efficiency or extends its useful life.
Otherwise the cost is a normal (period) expense.

4.3 The Five Common Depreciation Methods

Straight line · Reducing (Diminishing) Balance · Machine Hour Rate · Sum-of-the-Years'-Digits (SYD) · Units of
Production.
(1) Straight-Line Method
The depreciable amount is allocated equally to each year of the asset's useful life.
Annual depreciation = (Cost of asset (C) − Residual Value (R)) / Useful life (U)

Q: A company purchases a machine for TZS 25,000,000 with a useful life of 5 years and a salvage value of
TZS 5,000,000. Using straight-line depreciation, what is the annual depreciation expense?
A: Depreciation/year = (25,000,000 − 5,000,000) / 5 = TZS 4,000,000 per year, every year for 5 years.

(2) Reducing (Diminishing) Balance Method

Depreciation is calculated by applying a constant rate to the carrying (book) value of the asset at the start of
each year.
Depreciation per annum = Constant rate (r) × carrying value at start of year

Constant rate r = 1 − (R/C)^(1/n) [n = useful life, C = cost, R = residual value]

Q: A company purchased a machine for TZS 25,000,000 and decided to depreciate it using the declining-
balance method, with a useful life of 5 years and a salvage value of TZS 2,500,000. Compute the annual
depreciation expense.
A: r = 1 − (2,500,000 / 25,000,000)^(1/5) = 1 − (0.1)^0.2 = 36.90%.

Year Opening CV (TZS) Depreciation (36.90%) Closing CV (TZS)

1 25,000,000 9,226,066 15,773,934
2 15,773,934 5,821,254 9,952,679
3 9,952,679 3,672,963 6,279,716
4 6,279,716 2,317,483 3,962,233
2,500,000 (= salvage value, as
5 3,962,233 1,462,233
designed)

(3) Machine Hour Rate Method

Depreciation per annum is based on the depreciation rate per hour and the total number of hours the
machine actually runs during the year.
Rate per hour = Depreciable Amount / Budgeted total hours; Annual depreciation = Rate per hour × hours
consumed that year

Q: A company purchased a machine for TZS 250,000,000 expected to run for a total of 10,000 hours over its
life (assume nil residual value unless stated otherwise). In the first year the machine ran for 1,000 hours.
Compute year-1 depreciation.
A: Rate/hour = 250,000,000 / 10,000 = TZS 25,000 per hour. Year-1 depreciation = 25,000 × 1,000 hours =
TZS 25,000,000.

(4) Sum-of-the-Years'-Digits (SYD) Method

An accelerated method giving higher depreciation in the earlier years.
Sum of the years' digits = n(n+1)/2; Year's depreciation = [Years remaining at start of year / SYD] ×
Depreciable amount

Q: A company purchased a delivery truck for TZS 125,000,000, useful life 5 years, no salvage value. Using
SYD, compute the depreciation expense for each year.
A: SYD = 5(5+1)/2 = 15. Year 1 (5/15): TZS 41,666,667. Year 2 (4/15): TZS 33,333,333. Year 3 (3/15): TZS
25,000,000. Year 4 (2/15): TZS 16,666,667. Year 5 (1/15): TZS 8,333,333. (Sum of all years = TZS 125,000,000
✓)
(5) Units of Production Method
Depreciation per annum is based on the depreciation rate per unit and the actual number of units produced
during the year.
Rate per unit = Depreciable Amount / Budgeted total units; Annual depreciation = Rate per unit × units
produced that year

Q: A company purchased a machine for TZS 250,000,000 with a total expected production capacity of
500,000 units. In the first year, the machine produced 50,000 units. Compute the first-year depreciation.
A: Rate/unit = 250,000,000 / 500,000 = TZS 500 per unit. Year-1 depreciation = 500 × 50,000 units = TZS
25,000,000.

4.4 Self-Test: The Journey of NDABA Ltd.'s New Machine (Fully Solved, All Five Methods)
NDABA Ltd, a Tanzanian manufacturer, imports a machine from Germany listed at TZS 200,000,000,
negotiating a 10% trade discount. Import duty is 25% of the (discounted) purchase price = TZS 45,000,000. A
refundable VAT of 18% (TZS 32,400,000) is also paid. Delivery costs TZS 5,000,000; installation TZS
8,000,000; testing TZS 2,500,000; professional fees TZS 4,000,000. The company also incurs:
administrative/overhead costs TZS 6,000,000, staff training TZS 3,500,000, staff relocation TZS 2,000,000, an
opening ceremony TZS 1,000,000, and an initial-period operating loss of TZS 500,000.
Additional data for depreciation: expected lifespan 5 years, residual value TZS 10,000,000, total operational
lifespan 432,000 hours (spread equally over 5 years = 86,400 hrs/yr), total production output 400,000 units
(spread equally over 5 years = 80,000 units/yr).

Step 1 — Determine the depreciable Cost of the Asset (CA)

Note: Applying the cost-recognition rules from §4.2: the VAT is refundable and therefore excluded;
administrative/overhead costs, training, relocation, the opening ceremony, and the initial-period loss are all
excluded (they match exactly the excluded-cost list). Only directly attributable acquisition costs are
capitalised.

Cost element Amount (TZS)

List price 200,000,000 less 10% trade discount 180,000,000
+ Import duty (25% of 180,000,000) 45,000,000
+ Delivery cost 5,000,000
+ Installation cost 8,000,000
+ Testing cost 2,500,000
+ Professional (consulting) costs 4,000,000
= Cost of Asset (CA) 244,500,000
Depreciable amount = CA − RV = 244,500,000 − 10,000,000 = TZS 234,500,000.

Step 2 — Apply Each of the Five Methods

(a) Straight-line: 234,500,000 / 5 = TZS 46,900,000 per year, every year.
(b) Reducing balance: r = 1 − (10,000,000/244,500,000)^(1/5) = 47.235%.
Year Opening CV (TZS) Depreciation (TZS) Closing CV (TZS)
1 244,500,000 115,490,085 129,009,915
2 129,009,915 60,938,102 68,071,813
3 68,071,813 32,153,863 35,917,950
4 35,917,950 16,965,919 18,952,032
5 18,952,032 8,952,032 10,000,000
(c) Machine hour rate: rate/hour = 234,500,000 / 432,000 = TZS 542.82/hour. Since hours are spread equally
(86,400/yr), each year's depreciation = 542.82 × 86,400 = TZS 46,900,000/year — identical to straight-line
because usage is even across years.
(d) Sum-of-the-years'-digits: SYD = 5×6/2 = 15.
Year Fraction Depreciation (TZS)
1 5/15 78,166,667
2 4/15 62,533,333
3 3/15 46,900,000
4 2/15 31,266,667
5 1/15 15,633,333
(e) Units of production: rate/unit = 234,500,000 / 400,000 = TZS 586.25/unit. Since production is spread
equally (80,000 units/yr), each year's depreciation = 586.25 × 80,000 = TZS 46,900,000/year — again
identical to straight-line, because output is even across years.
Note: This self-test is designed to test two things at once: (1) correctly separating capitalisable costs from
excluded/expensed costs when building CA, and (2) recognising that straight-line, machine-hour-rate, and
units-of-production methods converge to the same annual figure whenever usage (hours or units) happens
to be spread evenly over the asset's life — only the reducing-balance and SYD methods are genuinely
accelerated (front-loaded).

4.5 Depreciation of Separate Components / Complex Assets

Certain large assets combine a collection of smaller assets, each with a different cost and useful life — e.g.
an aircraft consists of an airframe that may last many years plus an engine, radar, seats, etc. with a much
shorter life. Rather than depreciating the aircraft as a single whole, each component should be depreciated
separately to give more reliable information.

4.6 Non-Depreciable Assets

● Land — a fixed asset with unlimited useful life, so it is never depreciated (buildings and some land
improvements on it may still qualify for depreciation).
● Accounts Receivable / Inventory — not depreciable, since they are expected to convert to cash
within about a year.
● Minimal-useful-life / low-cost assets — treated as expenses rather than depreciated.

4.7 Topic 4 — Quick-Reference Formula Sheet

Method Formula
Straight-line (Cost − Residual value) / Useful life
Reducing balance rate r = 1 − (Residual value / Cost)^(1/n)
Reducing balance depreciation r × opening (carrying) book value each year
Machine hour rate (Depreciable amount / Budgeted total hours) × hours used that year
SYD = n(n+1)/2; year's dep. = (years remaining / SYD) × depreciable
Sum-of-the-years'-digits (SYD)
amount
(Depreciable amount / Budgeted total units) × units produced that
Units of production
year
PART E — Topic 5: Discounted Cash Flow / Investment Evaluation
Techniques

5.1 The Investment Decision — Overview

A capital-budgeting decision has four components: (1) the Time Value of Money (Topics 1–2), (2)
determination of the Relevant Cash Flows (Topic 3), (3) the Investment Evaluation Methods (this topic), and
(4) Risk Analysis.
The main investment-evaluation methods are: Net Present Value (NPV); Internal Rate of Return (IRR) /
Modified IRR (MIRR); Benefit-Cost Ratio (Profitability Index); Payback Period (PBP) / Discounted PBP;
Accounting Rate of Return (ARR); Economic Value Added (EVA).
FN 200 Cross-Reference: FN 200 Chapter 7 organises the same evaluation methods into two clean families
worth memorising as a pair: Non-discounting techniques, which ignore the time value of money (Payback
Period and Accounting Rate of Return), versus Discounting techniques, which account for it (Discounted
Payback, NPV, IRR, PI, and MIRR). If an exam asks you to classify a method as discounted or non-discounted,
this is the fastest way to answer correctly.

5.2 Net Present Value (NPV)

The NPV method compares the present value of a project's cash inflows with the present value of its cash
outflows. The difference between these two streams is the net present value.

NPV = −C₀ + Σ [Cₜ / (1+k)ᵗ] for t = 1 to n (C₀ = initial outlay, Cₜ = net cash flow at time t, n = project life, k =
required rate of return)

To determine NPV: calculate the present value of the cash inflows, calculate the present value of the cash
outflows, then subtract the outflows' PV from the inflows' PV.
If the Net Present Value is… Then the Project is…
Acceptable — promises a return greater than the required rate of
Positive
return.
Acceptable — promises a return equal to the required rate of
Zero
return.
Not acceptable — promises a return less than the required rate of
Negative
return.
Note: Two simplifying assumptions in NPV analysis: (1) all cash flows other than the initial investment occur
at the end of the period; (2) all cash flows generated are immediately reinvested at a rate of return equal to
the discount rate. Choosing a discount rate: the firm's cost of capital is usually the minimum required rate of
return.

Q: MK Company Ltd is offered a 5-year contract to supply component parts for a mining firm (Tshs million):
special equipment 160; working capital required 100; relining the equipment in year 3, 30; salvage value of
equipment in year 5, 5; annual sales revenue 750; cost of parts sold 400; salaries/shipping etc. 270. MK uses
a 10% discount rate, and the working capital is released and reusable at the end of year 5. Should the
contract be accepted?
A: Annual net cash inflow from operations = 750 − 400 − 270 = Tshs 80 million/year. Investment in
equipment (now): (160). Working capital needed (now): (100). Annual net cash inflows (years 1–5): 80 ×
PVIFA(10%,5)=3.791 = 303.28. Relining of equipment (year 3): (30) × PVIF(10%,3)=0.751 = (22.53). Salvage
value of equipment (year 5): 5 × PVIF(10%,5)=0.621 = 3.105. Working capital released (year 5): 100 ×
PVIF(10%,5)=0.621 = 62.1. NET PRESENT VALUE = −160 −100 + 303.28 − 22.53 + 3.105 + 62.1 = Tshs 85.955
million. Decision: ACCEPT the contract — the project has a positive NPV.
Is NPV a good decision rule? Yes — it is consistent with the primary goal of financial managers: it considers
the time value of money, evaluates cash flows, and considers risk and return.
FN 200 Cross-Reference: FN 200 Chapter 7 gives a compact drill-question version of exactly this logic: a
project costing TZS 20,000,000 generating TZS 8,000,000/year for 4 years at a 12% cost of capital has PV of
inflows = 8,000,000 × PVIFA(12%,4) = 8,000,000 × 3.0373 = TZS 24,298,400, giving NPV = TZS 4,298,400 —
positive, so ACCEPT. Same mechanics as the MK Company example above, just a single lump-sum ordinary
annuity instead of several separate cash-flow components — useful as a simpler warm-up before tackling a
multi-component NPV question like MK Company's.

5.3 Internal Rate of Return (IRR)

The IRR is the rate of return promised by a project over its useful life (also called the project's yield). It is the
discount rate that makes a project's NPV equal to zero. It works cleanly when a project's cash flows are
identical every year (an annuity); otherwise a trial-and-error / interpolation process is needed.

IRR solves: 0 = −C₀ + Σ [Cₜ / (1+IRR)ᵗ] for t = 1 to n

If the IRR is… Then the Project is…

Equal to or greater than the
Acceptable.
minimum required rate of return
Less than the minimum required
Rejected.
rate of return

Q: DC Company can purchase a new machine costing Tshs 104,320,000 that will save Tshs 20,000,000/year
in cash operating costs over a 10-year life. What is the IRR?
A: Since the annual cash flows are equal (an annuity), the required PV-of-annuity factor = Investment /
Annual cash flow = 104,320,000 / 20,000,000 = 5.216. Looking along the 10-period row of the PV-of-annuity-
of-$1 table, a factor of 5.216 corresponds to a rate of 14%. Since IRR (14%) > the 10% opportunity cost of
capital → ACCEPT the project.

Problems with the IRR Decision Rule

● Multiple IRRs: for projects with non-standard (non-conventional) cash-flow patterns — more than
one change of sign in the cash-flow stream — there can be more than one discount rate that sets
NPV = 0. Example — Project P: t0 = (Tshs 8m), t1 = +Tshs 50m, t2 = (Tshs 50m): two rates set NPV = 0
— 25% and 400%.
● A further NPV-profile example shows two IRRs of 10.11% and 42.66% — the project should only be
accepted if the required return lies between the two.
● Reinvestment assumption: the IRR rule assumes all intermediate cash flows can be reinvested at the
IRR itself, which may be unrealistic — giving rise to the Modified Internal Rate of Return (MIRR).
● Not suitable for mutually exclusive projects: a small project with a high IRR but small NPV might
wrongly be preferred over a large project with a lower IRR but a larger NPV.

Q: At a 2% discount rate, Project A: −10, −16, +30 and Project B: −10, +2, +11. NPV(A)=3.149, NPV(B)=2.534,
IRR(A)=10.79%, IRR(B)=15.36%. Which should be chosen if the projects are mutually exclusive?
A: Choose Project A — even though IRR(B) is higher, NPV(A) is larger, and for mutually exclusive projects
NPV should be the deciding criterion, not IRR.

Modified Internal Rate of Return (MIRR)

● Step 1: Find the future value of all cash inflows at the end of the project's life, using the required
return (not the IRR) as the reinvestment rate.
● Step 2: Find the rate that sets the present value of that future value equal to the initial investment
amount — this rate is the MIRR.
Q: A project has cash flows (Tshs million): t0 = −100, t1 = +10, t2 = +60, t3 = +80. The opportunity cost of
capital is 10%; the computed IRR is 18.1%. Because the company only expects to reinvest intermediate cash
flows at 10% (not 18.1%), compute the MIRR.
A: Step 1: FV of all inflows at year 3, at 10%: FV₃ = 10×(FV factor,10%,2) + 60×(FV factor,10%,1) + 80 = Tshs
158.10 million. Step 2: Find the rate that equates 100 to 158.10 three years later: 100 = 158.10 × (PV factor,
MIRR, 3) → MIRR = 16.4959%. Decision: the project is still acceptable, since MIRR (16.50%) > the required
return of 10%.

FN 200 Cross-Reference: FN 200 Chapter 7 lists MIRR as one of five core discounting evaluation techniques
(alongside Discounted Payback, NPV, IRR and PI), and states its purpose in one line worth quoting from
memory in a definition question: 'MIRR corrects IRR's assumption that cash flows are reinvested at the IRR
itself, instead assuming reinvestment at the firm's cost of capital' — exactly the two-step process shown
above.

5.4 Comparing NPV and IRR

NPV offers two advantages over IRR: (1) it is often simpler to use; and (2) IRR makes the questionable
assumption that cash inflows can be reinvested at the IRR itself — if the IRR is high, this assumption may be
unrealistic. It is more realistic to assume cash flows are reinvested at the discount rate, which is exactly the
assumption built into NPV. The NPV of one project also cannot be directly compared to the NPV of another
unless the two require equal initial investments.
FN 200 Cross-Reference: FN 200 Chapter 7 pinpoints exactly three circumstances that create NPV vs IRR
conflicts for mutually exclusive projects: (i) differences in the scale/size of the initial investment, (ii)
differences in the timing or pattern of cash flows (including non-conventional cash flows that can produce
multiple IRRs — matching RE 232 §5.3 above), and (iii) differences in project life. In every one of these
conflict cases, both guides agree: NPV should be preferred, because it measures the absolute increase in
shareholder wealth in monetary terms and assumes the more realistic cost-of-capital reinvestment rate.

5.5 Ranking Investment Projects

Screening vs Preference Decisions

Screening decisions come first and ask whether a proposed investment is acceptable at all. Preference
decisions come after screening and rank acceptable alternatives from most to least appealing — necessary
because the number of acceptable projects usually exceeds available funds.
Ranking rule for IRR: the higher the IRR, the more desirable the project is considered (subject to the caveats
above about mutually exclusive projects).

Profitability Index (PI) / Benefit-Cost Ratio

PI = PV of future net cash flows / Initial cash outlay

Decision rule: Accept if PI > 1; Reject if PI < 1 (equivalently, PI ≥ 1.00 is acceptable).

Capital rationing occurs when a firm has limited investment funds — soft rationing (temporary, often self-
imposed) or hard rationing (capital genuinely unavailable). The Profitability Index is the natural ranking tool
under soft rationing, since the goal is to get the biggest 'bang' (NPV) per unit of scarce capital invested.
FN 200 Cross-Reference: FN 200 Chapter 7 reinforces the PI decision rule with its own simple drill: for the
TZS 20,000,000 / TZS 8,000,000-per-year / 4-year / 12% project used above (PV of inflows = TZS 24,298,400),
PI = 24,298,400/20,000,000 = 1.215 — for every TZS 1 invested the project generates about TZS 1.215 in
present-value terms, a net gain of roughly 21.5 cents per shilling invested. FN 200 also states the capital-
rationing ranking rule identically to RE 232: 'when funds are limited, the firm should rank divisible projects
by their Profitability Index and select the combination that maximizes total NPV within the available budget.'
Q: Eight candidate projects are available (Tshs million); capital available is limited to Tshs 500 million.
Determine which projects should be undertaken (i) if projects are divisible, (ii) if they are not.
A: Computed results: Project A NPV 98.897 IRR 13.5% PI 1.25 (rank 3); B NPV 87.953 IRR 17.7% PI 1.35 (rank
1); C NPV 28.038 IRR 17.3% PI 1.28 (rank 2); D NPV 16.273 IRR 13.7% PI 1.22 (rank 4); E NPV 3.395 IRR 11.5%
PI 1.05 (rank 6); F NPV 3.071 IRR 12.4% PI 1.06 (rank 5); G NPV 1.929 IRR 10.2% PI 1.01 (rank 7); H NPV
−3.797 IRR 9.1% PI 0.98 (rejected, PI<1). If divisible: undertake B, C, and 37.5% of A (150/400) — total NPV ≈
Tshs 153.08 million, capital utilisation 100%. If not divisible: undertake B, C, D, and F — total NPV ≈ Tshs
135.34 million, capital utilisation 95%.

5.6 The Payback Period (PBP)

The payback period is the length of time it takes a project to recover its initial cost out of the cash receipts it
generates.
Payback period = Investment required / Annual net cash inflow (only valid when annual cash inflows are
equal)

Q: DG Hotels wants to install an espresso bar costing Tshs 14 million (10-year life) generating annual net
cash inflows of Tshs 3.5 million. Management requires a payback of 5 years or less. Should the project be
undertaken?
A: Payback period = 14,000,000 / 3,500,000 = 4.0 years. Since 4.0 years < the 5-year criterion, the project
should be undertaken.

Payback with uneven cash flows: when annual cash flows differ from year to year, the simple division
formula cannot be used — instead, track the unrecovered investment balance year by year until it reaches
zero.

Q: A project requires an initial investment of Tshs 40 and provides uneven net cash inflows over years 1–5 of
10, 3, 20, 12, 5. In which year is the investment fully recovered?
A: Cumulative recovery: after yr1 = 10 (30 remaining); after yr2 = 13 (27 remaining); after yr3 = 33 (7
remaining); after yr4 = 45 (fully recovered partway through year 4, since only 7 of the year-4 inflow of 12
was still needed) — the investment is fully recovered in Year 4.

FN 200 Cross-Reference: FN 200 Chapter 7 gives the general-purpose payback formula for uneven cash
flows in one line, useful whenever recovery happens partway through a year: Payback = Years fully
recovered + (Remaining amount to recover / Cash flow in the recovery year). Applied to its own worked
example — TZS 12,000,000 outlay, cash flows of TZS 4m, 5m, 4m, 3m in years 1–4 — cumulative recovery is
4m (yr1), 9m (yr2), 13m (yr3), so full recovery falls in year 3: Payback = 2 +
(12,000,000−9,000,000)/4,000,000 = 2.75 years. This is exactly the same cumulative-tracking approach as
the RE 232 example above, just expressed as a single formula rather than a running balance.

Advantages of Payback: easy to understand; naturally adjusts for the uncertainty of later, less-certain cash
flows; biased toward liquidity (favours projects that return cash sooner).
Disadvantages of Payback: ignores the time value of money; requires an arbitrary cut-off point; ignores cash
flows beyond the cut-off date; biased against long-term projects such as R&D and new-product
development.
Is PBP a good decision rule? Time value of money — No. Evaluating cash flows — Yes. Considering risk and
return — Not explicitly.

5.7 Discounted Payback Period (DPBP)

The number of periods until the sum of the present values of the cash flows equals the initial investment. It
does incorporate the time value of money and risk/return within the discounted payback window, but still
ignores cash flows and risk/return outside that window.
Q: A project has cash flows (Tshs million): t0 = −100, t1 = +10, t2 = +60, t3 = +80, at an opportunity cost of
capital of 10%. Compute the discounted payback period; the firm's policy requires DPBP ≤ 3 years.
A: Year 1: discounted CF = 9.09; cumulative = (90.91). Year 2: discounted CF = 49.59; cumulative = (41.32).
Year 3: discounted CF = 60.11; cumulative = +18.79. The balance turns positive during year 3, giving a
discounted payback period of 2.69 years. Since DPBP (2.69 yrs) < 3 years, the project is ACCEPTABLE.

Advantages of DPBP: includes the time value of money; easy to understand; will not accept a negative-NPV
investment when all future cash flows are positive; biased toward liquidity.
Disadvantages of DPBP: may still reject positive-NPV investments; requires an arbitrary cut-off point; ignores
cash flows beyond the cut-off; biased against long-term projects; does not measure overall profitability, only
speed of recovery.

5.8 Accounting Rate of Return (ARR)

Also called the Simple Rate of Return or Average Rate of Return. Unlike the methods above, it does not
focus on cash flows — it focuses on accounting net operating income.
ARR = Annual incremental net operating income / Initial investment* (*reduced by any salvage
recovered from an old asset sold)

Q: DG Hotels wants to install an espresso bar costing Tshs 14 million (10-year life), generating incremental
revenues of Tshs 10 million and incremental expenses (including depreciation) of Tshs 6.5 million. If the
firm's cost of capital is 10%, should the project be accepted?
A: Annual incremental net income = 10,000,000 − 6,500,000 = Tshs 3.5 million. ARR = 3.5m / 14m = 25%.
Since ARR (25%) > the 10% cost-of-capital benchmark, the project should be ACCEPTED.

Advantages of ARR: easy to calculate; the needed information is usually already available in the accounts.
Disadvantages of ARR: not a true rate of return, since it ignores the time value of money; uses an arbitrary
benchmark cut-off rate; based on accounting net income and book values rather than cash flows and market
values.

5.9 Economic Value Added (EVA)

EVA is an alternative to the discounted-cash-flow, accounting-rate-of-return, and payback methods, with
the required rate of return as its key input. EVA is the difference between a project's accounting profit and
the required return on the capital invested in the project.

EVAₜ = Cₜ + (Iₜ − Iₜ₋₁) − k×Iₜ₋₁ (Cₜ = net cash flow at t; Iₜ = investment value, end of year t; k = required rate of
return)

Note: The discounted sum of a project's EVAs across its life equals the project's NPV — EVA is simply a
period-by-period re-statement of the same underlying value creation.

Postaudit of investment projects: a postaudit is a follow-up review after a project is completed, checking
whether the expected results were actually realised — an important discipline that closes the loop on the
capital-budgeting process.

5.10 Comparing the Investment-Evaluation Methods

Accounting Rate of Internal Rate of
Payback Period Net Present Value
Return Return
Basis of Cash flows / Cash flows /
Cash flows Accrual income
measurement profitability profitability
Measure
Number of years Percent Currency amount Percent
expressed as
 Accounting Rate of Internal Rate of
Payback Period Net Present Value
Return Return
Considers TVM;
Easy to understand; Easy to understand; Considers TVM;
accommodates
Strengths allows comparison allows comparison allows comparison of
different risk levels
across projects across projects dissimilar projects
over life
Ignores TVM; ignores Ignores TVM; doesn't Difficult to compare Doesn't reflect
Limitations cash flows after give annual rates dissimilar projects varying risk levels
payback over life directly over life

5.11 Topic 5 — Quick-Reference Formula Sheet

Method Formula / Decision Rule
Net Present Value (NPV) −C₀ + Σ Cₜ/(1+k)ᵗ; Accept if NPV > 0
Internal Rate of Return (IRR) Rate that sets NPV = 0; Accept if IRR ≥ required return
FV all inflows at required return, then find rate equating that FV to
Modified IRR (MIRR)
the initial outlay
Profitability Index (PI) PV of future cash flows / Initial outlay; Accept if PI > 1
Investment required / Annual net cash inflow (equal CFs); track
Payback Period
cumulative balance if uneven
Discounted Payback Period Same as payback, but using discounted (PV) cash flows
Accounting Rate of Return (ARR) Annual incremental net operating income / Initial investment
Economic Value Added (EVA) Cₜ + (Iₜ−Iₜ₋₁) − k·Iₜ₋₁; discounted sum of EVAs = NPV
PART F — Fully Solved Official Review Questions (Topics I & II)
The questions below are the complete official 'RE 232 — Review Questions, Topic I & Topic II (2024/2025)'
set. Every question is solved in full below, using the formulas from Parts A and B. Work through each one
yourself first, then check the workings.

Q1 — Simple vs Compound Interest

Q: The rate of interest is 8 percent. What will Tshs 100 million be worth in three years' time using (a) simple
interest? (b) annual compound interest?
A: (a) Simple: A = P + P×i×n = 100,000,000 + (100,000,000×0.08×3) = Tshs 124,000,000 (interest =
24,000,000). (b) Compound: A = 100,000,000 × (1.08)^3 = Tshs 125,971,200 (interest = 25,971,200).

Q2 — Growth at Different Rates

Q: You plan to invest Tshs 1 million in TBL shares. (a) If the value increases by 5% a year, what will the shares
be worth in 20 years? (b) If the value increases by 15% a year, what will they be worth in 20 years?
A: (a) FV = 1,000,000 × (1.05)^20 = Tshs 2,653,297.71. (b) FV = 1,000,000 × (1.15)^20 = Tshs 16,366,537.39.
→ Note how dramatically the growth rate changes the 20-year outcome — this is the power of
compounding over long horizons.

Q3 — Time to Double Your Money

Q: How long will it take to double your money if you invest at (a) 5 percent? (b) 15 percent?
A: (a) Exact: n = ln(2)/ln(1.05) = 14.21 years. (Rule of 72 approximation: 72/5 = 14.4 years.) (b) Exact: n =
ln(2)/ln(1.15) = 4.96 years. (Rule of 72 approximation: 72/15 = 4.8 years.)

Q4 — Comparing Four Prize Options

Q: A Jackpot Bingo winner may choose: (a) Tshs 1 million now; (b) Tshs 1,700,000 at the end of 5 years; (c)
Tshs 135,000 a year forever, starting at year end; (d) Tshs 200,000 for each of the next 10 years, starting in 1
year. At an interest (discount) rate of 9%, which is the most valuable prize?
A: (a) PV = Tshs 1,000,000 (already at t=0). (b) PV = 1,700,000 / (1.09)^5 = Tshs 1,104,883.36. (c) PV
(perpetuity) = 135,000 / 0.09 = Tshs 1,500,000.00. (d) PV (10-yr ordinary annuity) = 200,000 × [1 − (1.09)^-
10]/0.09 = Tshs 1,283,531.54. → Option (c), the Tshs 135,000 perpetuity, is the most valuable at Tshs
1,500,000.

Q5 — Solving for the Interest Rate

Q: A bank lends a customer Tshs 5 million. At the end of 10 years he repays Tshs 8,950,000 (principal plus
interest). What is the interest rate charged?
A: r = (8,950,000 / 5,000,000)^(1/10) − 1 = 5.995% ≈ 6% per annum, compounded annually.

Q6 — Immediate Payment Plus a Perpetuity

Q: Lala Salama Enterprises (LSE) will repair and maintain your parents' house for a payment of Tshs 500,000
now, followed by annual payments in perpetuity of Tshs 50,000. How much would you need in an account
earning 8% to fund these payments?
A: The Tshs 500,000 is paid immediately, so it needs no discounting. PV of the Tshs 50,000/year perpetuity =
50,000 / 0.08 = Tshs 625,000. Total amount needed today = 500,000 + 625,000 = Tshs 1,125,000.

Q7 — Annual vs Semi-Annual Discounting

Q: What is the present value of Tshs 10 million to be received in 10 years' time at a nominal annual rate of
12% if (a) annual discounting is used? (b) semi-annual discounting is used?
A: (a) Annual: PV = 10,000,000 / (1.12)^10 = Tshs 3,219,732.37. (b) Semi-annual: rate 6% per half-year, 20
periods: PV = 10,000,000 / (1.06)^20 = Tshs 3,118,047.27. → More frequent compounding of the same
nominal rate raises the effective rate, so the same future sum is worth less today (a smaller PV) under semi-
annual discounting.

Q8 — Two-Stage Interest Rates

Q: What sum must be invested now to provide Tshs 18 million at the end of 15 years, if interest accumulates
at 8% for the first 10 years and 12% thereafter?
A: PV = 18,000,000 / [(1.08)^10 × (1.12)^5] = Tshs 4,730,911.64.

Q9 — Quarterly Compounding and EAR

Q: How much must be invested now to provide Tshs 10 million in 6 years' time, assuming interest
compounds quarterly at a nominal annual rate of 8%? What is the effective annual rate?
A: Quarterly rate = 2%, periods = 24: PV = 10,000,000 / (1.02)^24 = Tshs 6,217,214.88. EAR = (1.02)^4 − 1 =
8.243%.

Q10 — Should You Buy the Annuity?

Q: A salesman offers an annuity of Tshs 800,000 per annum for 10 years, priced at Tshs 4,800,000. If you
could earn 11% elsewhere, would you buy it?
A: PV of the annuity = 800,000 × [1 − (1.11)^-10]/0.11 = Tshs 4,711,385.61. Since the fair PV (Tshs 4,711,386)
is less than the asking price (Tshs 4,800,000), the annuity is overpriced — DO NOT BUY.

Q11 — Hire-Purchase (Annuity Due)

Q: Kingo buys a music system on hire purchase: 5 annual instalments of Tshs 150,000, with the first being an
immediate cash deposit. At 8%, what is the current cash price of the music system?
A: Because the first payment is immediate, this is an annuity due with n=5. PV (ordinary annuity) = 150,000
× [1 − (1.08)^-5]/0.08 = Tshs 598,906.51. PV (annuity due) = 598,906.51 × 1.08 = Tshs 646,819.03 — the cash
price of the system.

Q12 — Multi-Stage Retirement Planning

Q: You retire 33 years from now and expect to live 27 years after retiring. At retirement you want to
withdraw Tshs 180,000 at the beginning of each year you expect to live, and still have Tshs 2,500,000 left at
your expected death (year 60). You will make equal deposits at the end of each of the next 33 years, earning
12% during the accumulation phase and 6% during retirement. What equal annual deposit must you make?
A: Step 1 — Amount needed AT retirement (t=33): PV (at 6%) of 27 beginning-of-year withdrawals of Tshs
180,000 (annuity due) PLUS the PV of the Tshs 2,500,000 remaining after the 27th withdrawal. PV of
withdrawals (annuity due, n=27, r=6%) = 180,000 × [1 − (1.06)^-27]/0.06 × 1.06 = Tshs 2,464,738. PV of the
Tshs 2,500,000 remaining balance, discounted 27 years at 6% = Tshs 549,977. Total amount needed at
retirement (X) = Tshs 3,038,989.79. Step 2 — Solve for the level annual deposit (ordinary annuity, n=33,
r=12%) that accumulates to X by year 33: FVIFA(12%,33) = [(1.12)^33 − 1]/0.12 = 342.4294. Required annual
deposit = 3,038,989.79 / 342.4294 = Tshs 8,874.79 per year.

Q13 — Pension Obligation (Context Question)

Q: Nerwin, Inc. (50 employees) starts a pension plan on 1 January 2003. Average time to retirement is 15
years; expected life duration after retirement is 10 years. The controller must report the pension obligation
(liability).
A: As extracted, this question sets out the pension-plan timeline (15 years to retirement, 10 years of post-
retirement life) but does not carry a specific annual pension-payment amount or discount rate. To answer it
fully, apply the two-stage deferred-annuity method used in Q12 above: find the PV, at the assumed discount
rate, of the (unknown) annual pension payment as an annuity covering the 10 post-retirement years,
deferred 15 years — this PV is the reported pension obligation as of today. If your lecturer supplied a
specific pension amount and discount rate in class, substitute PMT, r and the two periods (15 and 10 years)
into the deferred-annuity PV formula from §2.7.

Q14 — Prize Paid in Instalments, Monthly-Compounded Alternative

Q: You win the CPA-T Best Graduate prize of Tshs 11,000,000, paid in 26 equal annual instalments with the
first payment made immediately. If invested instead in an account with a quoted annual rate of 9% with
monthly compounding, what is the present value of the stream of payments?
A: Each instalment = 11,000,000 / 26 = Tshs 423,076.92. Convert the quoted 9% monthly-compounded
nominal rate to an effective annual rate: EAR = (1 + 0.09/12)^12 − 1 = 9.3807%. Since the first payment is
immediate, this is an annuity due of 26 payments at the EAR: PV = 423,076.92 × [1 − (1.093807)^-
26]/0.093807 × 1.093807 = Tshs 4,453,793.24.

Q15 — Saving Toward a Retirement Target

Q: Your sister, age 20 today, wants to accumulate Tshs 9,000,000 by her 55th birthday by making annual
deposits on her 20th through 54th birthdays, in an account earning 8% compounded annually. What annual
deposit is required?
A: Deposits are made on 35 birthdays (age 20 through 54), and the target value is needed at age 55 — one
year after the last (age-54) deposit — so this is an annuity due with n = 35 accumulating for one extra
period. FV factor = [(1.08)^35 − 1]/0.08 × 1.08 = 186.1021. Required annual deposit = 9,000,000 / 186.1021
= Tshs 48,360.54. (If instead modelled as a plain end-of-year ordinary annuity of 35 payments with the
target measured exactly at the 35th deposit, the required deposit would be Tshs 52,229.38 — state clearly
which timeline assumption you are using in an exam answer.)

Q16 — Mixed Deposits and Withdrawals (Uneven Cash Flows, Future Value)
Q: You deposit $1,000 today, $2,000 in 2 years, and $8,000 in 5 years; you withdraw $3,000 in 3 years and
$5,000 in 7 years. At 9%, how much will you have after 8 years?
A: Compound every cash flow forward to year 8 individually (piece-at-a-time) and sum, treating withdrawals
as negative: +1,000×(1.09)^8 = 1,992.56; +2,000×(1.09)^6 = 3,353.98; +8,000×(1.09)^3 = 10,362.62;
−3,000×(1.09)^5 = −4,616.68; −5,000×(1.09)^1 = −5,450.00. Sum = Tshs (or $) 5,641.12 after 8 years.

Q17 — Three-Stage Uneven Annuity, Monthly-Compounded Alternative

Q: An investment pays Tshs 26,000/year for the first 9 years, Tshs 34,000/year for the next 11 years, and
Tshs 47,000/year for the following 14 years (end-of-year payments). An alternative account offers a quoted
9% annual rate with monthly compounding. What is the present value, in today's terms, of the investment's
cash flows?
A: Convert to an effective annual rate: EAR = (1+0.09/12)^12 − 1 = 9.3807% — this is the correct discount
rate to use. Segment 1 (years 1–9): PV₁ = 26,000 × [1−(1.093807)^-9]/0.093807 = Tshs 153,492.76. Segment
2 (years 10–20): value at year 9 = 34,000 × [1−(1.093807)^-11]/0.093807, then discount back 9 more years
→ PV₂ = Tshs 101,409.61. Segment 3 (years 21–34): value at year 20 = 47,000 × [1−(1.093807)^-
14]/0.093807, then discount back 20 more years → PV₃ = Tshs 59,615.83. TOTAL present value = 153,492.76
+ 101,409.61 + 59,615.83 = Tshs 314,518.20.

Q18 — Saving Then Drawing Down at the Same Rate

Q: Deryl deposits a fixed amount at the end of each year for 30 years, then, starting one year after his final
deposit, withdraws Tshs 100,000 annually for 25 years (25 withdrawals). The fund earns 12% throughout.
What annual deposit is required?
A: Balance needed exactly at the end of year 30 = PV (at 12%) of the 25 end-of-year withdrawals of Tshs
100,000 = 100,000 × [1−(1.12)^-25]/0.12 = Tshs 784,313.91. This balance must itself equal the future value,
at year 30, of the 30 annual deposits: FVIFA(12%,30) = [(1.12)^30 − 1]/0.12. Required annual deposit =
784,313.91 / FVIFA(12%,30) = Tshs 3,249.93.

Q19 — Multi-Stage Monthly Retirement Plan

Q: You retire 15 years from now and expect to live 25 years after retiring. You want Tshs 800,000 per month
for those 25 years. Deposits are made monthly into a special account earning 4.8% p.a. for the first 15 years
and 6% p.a. thereafter (compounding monthly throughout). What monthly deposit is required?
A: Post-retirement monthly rate = 6%/12 = 0.5%; number of monthly withdrawals = 25×12 = 300. Amount
needed AT retirement (end of month 180) = PV of 300 monthly withdrawals of 800,000 at 0.5%/month =
800,000 × [1−(1.005)^-300]/0.005 = Tshs 124,165,491.21. Pre-retirement monthly rate = 4.8%/12 = 0.4%;
number of monthly deposits = 15×12 = 180. FVIFA(0.4%, 180) = [(1.004)^180 − 1]/0.004. Required monthly
deposit = 124,165,491.21 / FVIFA(0.4%,180) = Tshs 472,343.45 per month.

Q20 — Comparing Accounts with Different Compounding Frequencies

Q: A bank offers three otherwise-identical accounts: CLASSICS at 7.9% compounded annually; ROYAL at 7.8%
compounded semi-annually; PRINCESS at 7.5% compounded monthly. (a) Which would you recommend to a
friend, and why? (b) Would your answer change for a 20-year investment horizon?
A: Convert each to an Effective Annual Rate (EAR) for a fair comparison: CLASSICS EAR = 7.9000% (already
annual); ROYAL EAR = (1+0.078/2)^2 − 1 = 7.9521%; PRINCESS EAR = (1+0.075/12)^12 − 1 = 7.7633%. (a)
Recommend ROYAL — it has the highest effective annual rate (7.9521%) despite having neither the highest
quoted nominal rate nor the most frequent compounding, illustrating why nominal rates should never be
compared directly. (b) No, the recommendation does not change with a longer (20-year) horizon: since EAR
is itself an annual, compounding-adjusted rate, the same account that offers the best EAR for one year will
also compound to the largest balance over any number of years — the ranking by EAR is horizon-
independent.
PART G — Master Formula Sheet & Final Exam Tips (Extended Edition)
A single consolidated list of every formula in the course — plus the Bond Valuation extension and the FN
200 cross-checks — use this section for last-minute revision the night before the exam.

G.1 Master Formula Sheet (All Topics)

Topic 1 — Interest Rate Mathematics

Concept Formula
Simple interest I=P×i×n
Compound amount (annual) A = P(1+i)ⁿ
Compound amount (m times/yr) A = P(1+i/t)^(n×t)
Effective Annual Rate (EAR) EAR = (1+i/t)^t − 1
EAR, continuous compounding EAR = e^APR − 1
Future value FVₙ = PV(1+i)ⁿ
Present value PV = FVₙ × [1/(1+i)ⁿ]
Solve for rate r = (FVₙ/PV₀)^(1/n) − 1
Solve for time n = ln(FVₙ/PV₀) / ln(1+r)
Rule of 72 n ≈ 72 / i%

Topic 2 — Annuities & Special Cash Flows

Concept Formula
PV, ordinary annuity PMT × [1−(1+r)⁻ⁿ]/r
FV, ordinary annuity PMT × [(1+r)ⁿ−1]/r
Annuity due (either) Ordinary-annuity value × (1+r)
PV, growing annuity PMT₀(1+g)[1−((1+g)/(1+r))ⁿ]/(r−g)
FV, growing annuity PMT₀(1+g)[(1+r)ⁿ−(1+g)ⁿ]/(r−g)
PV, perpetuity CF₁ / r
PV, growing perpetuity CF₁ / (r−g)
PV, deferred ordinary annuity (k periods) PMT(1+r)⁻ᵏ × [1−(1+r)⁻ⁿ]/r
Σ CFₜ/(1+r)ᵗ, or split into annuity + single-sum
Uneven cash flows
groups

Bond Valuation (Extension)

Concept Formula
Bond price (general) PMT × [1−(1+r)⁻ⁿ]/r + F×(1+r)⁻ⁿ
Semiannual coupon PMT (Annual coupon rate / 2) × Face value
Semiannual required rate Annual required rate / 2
Discount / Premium / Par Coupon < / > / = Required rate ⇒ Price < / > / = Par

Topic 3 — Relevant Cash Flows for Investment Analysis

Concept Formula
New assets + capitalised costs ± ΔNWC − proceeds
Initial cash outflow
of old asset sale ± tax on sale
[Δrevenue−Δcosts−Δdepreciation](1−tax) +
Operating cash flow
Δdepreciation ± ΔNWC ± terminal items
Concept Formula
Net Income + (1−Tax)×Interest + Depreciation =
Operating cash flow (alt. form)
EBIT(1−Tax) + Depreciation
Tax on sale of asset Tax rate × (Sale price − Book value)
Final-year operating CF + after-tax salvage + NWC
Terminal-year cash flow
recovery

Topic 4 — Asset Depreciation

Method Formula
Straight-line (Cost−Residual)/Useful life
Reducing balance rate r = 1−(Residual/Cost)^(1/n)
(Depreciable amount/Total budgeted hours) ×
Machine hour rate
hours used
SYD=n(n+1)/2; year's dep = (years remaining/SYD) ×
SYD
depreciable amount
(Depreciable amount/Total budgeted units) × units
Units of production
produced

Topic 5 — Discounted Cash Flow / Investment Evaluation

Method Formula / Rule
NPV −C₀+ΣCₜ/(1+k)ᵗ; Accept if NPV>0
IRR Rate that sets NPV=0; Accept if IRR≥required return
FV inflows at required return, then find rate vs.
MIRR
initial outlay
Profitability Index PV of future CFs / Initial outlay; Accept if PI>1
Investment/Annual CF (or cumulative tracking if
Payback period
uneven)
Same as payback but with discounted (PV) cash
Discounted payback
flows
Annual incremental net operating income / Initial
ARR
investment
EVA Cₜ+(Iₜ−Iₜ₋₁)−k·Iₜ₋₁

G.2 FN 200 Companion Chapters — Quick Cross-Reference Map

This map shows exactly where the FN 200 Financial Management guide sharpens each RE 232 topic, so you
know which chapter to revisit if a concept still feels shaky.

RE 232 Topic Matching FN 200 Chapter What FN 200 adds

Compact EAR drills; the three TVM drivers
Topic 1 — Interest Rate Chapter 2 — Time Value of (inflation, current-consumption preference,
Mathematics Money investment opportunities) stated slightly
differently
Extra FV/PV-of-annuity and perpetuity drill
Topic 2 — Annuities & Chapter 2 — Time Value of
numbers for self-testing with the same
Special Cash Flows Money
PVIFA/FVIFA mechanics
Topic 3 — Relevant Cash Project-type classification (independent /
Chapter 7 — Capital
Flows for Investment mutually exclusive / contingent); alternate CF
Budgeting
Analysis = EBIT(1−Tax)+Depreciation formula
RE 232 Topic Matching FN 200 Chapter What FN 200 adds
Topic 4 — Asset Only touches depreciation indirectly, inside
— (no direct chapter)
Depreciation the Chapter 7 cash-flow formula above
Discounting vs non-discounting classification;
Topic 5 — DCF / Investment Chapter 7 — Capital
the three specific causes of NPV-vs-IRR
Evaluation Budgeting
conflict; a worked PI drill
— (not covered in either Added here because both Test 1 and Test 2
(New) Bond Valuation guide as a standalone examine it directly — built from the same PV-
chapter) of-annuity + PV-of-lump-sum logic as Topic 2

G.3 Final Exam Tips (Consolidated Across All Topics)

● Always identify whether a question is asking for simple or compound interest before writing any
formula.
● When compounding is not annual, remember to both divide the rate and multiply the exponent by
the compounding frequency: A = P(1+i/t)^(n×t).
● Use the EAR formula whenever you must compare two rates that compound at different
frequencies — never compare nominal (quoted) rates directly.
● Identify whether an annuity is ordinary (end of period) or due (beginning of period) before applying
a formula — an annuity-due value is always the ordinary-annuity value × (1+r).
● For deferred annuities, always find the value one period before the payments start first, then
discount that value back to today using the deferral period k.
● For bond questions, remember a bond price is simply PV of the coupon annuity PLUS PV of the face
value — do not forget either half. If coupons are semiannual, halve the rate and double the number
of periods before doing anything else.
● For cash-flow (capital budgeting) questions, always work in three blocks: Initial outflow (t=0) →
Operating cash flows (each year) → Terminal cash flow (final year), and total the final year as
operating CF + terminal items.
● Depreciation is never a cash flow itself — it only matters because it creates a tax shield (reduces
taxable income) and, at disposal, determines the taxable gain or loss on sale.
● Always exclude sunk costs and financing/interest costs from project cash flows; always include
opportunity costs and side effects such as cannibalisation.
● When building an asset's depreciable cost, separate capitalisable costs (purchase price net of trade
discount, non-refundable duties/taxes, and directly attributable costs like
delivery/installation/testing/professional fees) from excluded items (refundable taxes, overheads,
training, relocation, opening ceremonies, and initial-period losses).
● For NPV, a positive value means Accept; for IRR, compare against the hurdle/required rate; for PI,
compare against 1.0 — know all three decision rules cold, and know that NPV should govern when
methods disagree for mutually exclusive projects.
● Watch for non-conventional cash-flow patterns (more than one sign change) — these can produce
multiple IRRs, in which case NPV is the safer decision tool.
● For loan/mortgage amortisation questions, remember that the payment amount is constant but its
split between interest and principal is not — interest is always calculated on the opening balance for
that period, and the principal portion grows every payment as the balance shrinks.
● Show full workings step by step in every calculation-based question — partial credit is routinely
awarded for correct method and structure even if the final figure is slightly off due to rounding.
Exam Tip: Whenever a question gives you ready-made discount factors (e.g. 'Y1=0.9091, Y2=0.8264...'), use
them directly rather than recomputing (1+r)⁻ⁿ from scratch — this is both faster and exactly what the
examiner expects, since it tests your ability to apply a PV factor to a cash flow, not your arithmetic.