Section A: Time Value of Money (TVM) - 50 Marks

1. Conceptual Understanding ( 10 marks)
   a) Define the time value of money (TVM) and explain its importance in financial decision-making. ( 5 marks)
   b) Differentiate between present value (PV), future value (FV), annuities, and perpetuities. ( 5 marks)

a) Definition and Importance of Time Value of Money (TVM)

1. Definition:
   The time value of money (TVM) is the financial principle stating that a sum of money is worth more today than the same sum in the future due to its potential earning capacity. This concept recognizes that money can earn interest, making it more valuable over time.
2. Importance in Financial Decision-Making:
   • Investment Decisions: TVM is fundamental when evaluating investments. It allows for the comparison of cash flows received at different times, enabling investors to determine the present and future values of investments.
   • Interest and Return Calculations: With TVM, one can calculate how much current funds will grow over a period at a given interest rate, or conversely, what future sums are worth today, using formulas such as: where is the present value, is the interest rate, and is the number of periods.
   • Risk and Opportunity Cost Assessment: It helps in understanding opportunity costs, as funds utilized now might have generated additional value if invested.
   • Loan and Mortgage Structuring: TVM is critical in determining the optimal payment structures for loans and mortgages by balancing principal and interest over time.

b) Differentiation Between Present Value (PV), Future Value (FV), Annuities, and Perpetuities

1. Present Value (PV):
   • PV refers to the current worth of a future sum of money or a stream of cash flows, given a specified rate of return.
   • The formula for calculating the present value of a future amount is: where is the future value, is the interest rate per period, and is the number of periods.
2. Future Value (FV):
   • FV is the value of a current asset at a future date based on an assumed rate of growth over time.
   • The relationship between present value and future value is given by:
3. Annuities:
   • An annuity is a series of equal payments made at regular intervals for a fixed period.
   • There are two types:
     • Ordinary Annuity: Payments are made at the end of each period.
     • Annuity Due: Payments are made at the beginning of each period.
   • The present value of an annuity is calculated as: where is the payment per period, is the interest rate, and is the number of periods.
4. Perpetuities:
   • A perpetuity is a type of annuity that pays a fixed amount indefinitely.
   • Since the payments continue forever, the present value of a perpetuity is determined by: where is the periodic payment and is the interest rate.