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CHAPTER 4 and 5

The Time Value of Money and

Discounted Cash Flow Valuation

Future value

Present value

Annuities

Rates of return

Amortization

6-2

Time Value of Money

Definition: Value of money changes as time

changes. This is because of the positive rate of

interest in all the markets. If the market interest

rate is 10%, then Tk.100 today has the same

value as Tk.110 after 1 year from now and

Tk.121 after 2 years from now. So the present

value of Tk.110 of the next year is Tk.100, or the

future value of Tk.100 now is Tk.110 in the next

year. FV

n

=PV(1+i)

n

PV=FV

n

/(1+i)

n

6-3

Solving for PV:

The arithmetic method

Problem 1: How much should you set

aside now to get Tk.100 after 3 years

from now?

Solve the general FV equation for PV:

PV = FV

n

/ ( 1 + i )

n

PV = FV

3

/ ( 1 + i )

3

= Tk.100 / ( 1.10 )

3

= Tk.75.13

6-4

Finding the interest rate

and time period

Problem 2. What is the rate of interest by

what Tk.100 becomes Tk.200 in 4 years?

200=100(1+i)

4

(1+i)

4

=2, 1+i=2

1/4

=2

.25

=1.1892, i=18.92%

Problem 3. How long time it takes to double

an amount if the interest rate is 15% per

annum?

200=100(1+.15)

n

(1.15)

n

=2, n log(1.15)=log(2)

n=log(2)/log(1.15)=4.96 years

6-5

Compounding more

than once in year

Problem 4: You like to set aside an amount of

money so that you get Tk.50,000 after 5

years from now. Bank One offers you 10%

annual interest rate and Bank Two offers you

9.5% interest rate compounded monthly.

Where should you put the money?

Bank One: PV=50,000/(1.1)

5

=Tk.31046.07

Bank Two:

PV=50,000/(1+.095/12))

60

=Tk.31152.46

Bank One is a better choice

6-6

Effective Annual Rate

EAR% = ( 1 + i

NOM

/ m )

m

- 1

Problem 5: A Credit card charges 2%

interest rate per month. What is the

effective interest rate?

EAR=(1+.24/12)

12

-1

=(1.02)

12

-1

=26.82%

6-7

Annuity

Definition: A series of equal payments is

made against what an accumulated

sum can be received either at the

beginning or at the end of the period of

annuity. If the accumulated sum takes

place at the beginning then it is a

Present Value Annuity, and if the

accumulated sum takes place at the

end then it is a Future Value Annuity.

6-8

Annuity

100 100 100

0 1 2 3

i%

3 year $100 ordinary annuity.

PV?

6-9

Present Value Annuity

All kinds of consumers’ credit schemes follow

present value annuity. A lump sum amount is

borrowed now against what payments would be

made in equal installments at a regular interval

for a definite period of time.

6-10

PVIFA=

1-

1

(1+i)

n

i

Formulae for Present Value

Interest Factor of Annuity (PVIFA)

6-11

Present Value Annuity

Problem 6: At 10% interest rate, How much

can you borrow now against the repayment 3

equal annual installments of Tk.1000?

PV Annuity=C*(PVIFA)

=C{[1-(1/(1+i)

n

)]/i}

=1000{[1-(1/(1.1)

3

]/.1}

=1000*2.4869

=2486.90

6-12

Present Value Annuity

Problem 7: You have a plan to deposit

Tk.1,000 per month in a bank for next 20

years. If the interest rate is 8.5% per annum

then how much can you borrow from the

bank against that?

6-13

Solution of Problem 7

PVIFA={1-1/(1+.085/12)

12*20

]}/(.085/12)

=115.2308

PV Annuity= C*PVIFA

=1000*115.2308=1,15,230.80

6-14

Present Value Annuity

Problem 8: Find the amount of

installment of a loan of Tk.5,000 to be

repaid in 4 equal monthly installment at

12% interest. Make an amortization

schedule.

5000=C(PVIFA, i=.12, m=12, n=4)

=C(3.901966)

C=5000/3.901966=1281.405

6-15

Amortization Schedule

n OPENG BALANCEINSTALLMENT INTEREST PAIDPRINCIPAL PAID CLOSING BALANCE

1 5000 1281.4 50 1231.4 3768.6

2 3768.6 1281.4 37.686 1243.7 2524.9

3 2524.9 1281.4 25.249 1256.2 1268.7

4 1268.7 1281.4 12.687 1268.7 0.0

6-16

Present Value Annuity

Problem 9: You need Tk.12 lakh now to

buy a car, under the terms and

condition of monthly installments for 10

year. Interest rate is 15% per annum.

(a) What would be the amount of

installments? (b) How much would be

the accumulated liability of interest?

6-17

Solution: Problem 9

(a) Installment =PV Annuity/PVIFA

=12,00,000/61.98285=Tk.19,360.19

(b) Accumulated Interest=Total payments

– Present value of annuity

=(19,360.19*120)-12,00,000

=23,23,223-12,00,000=11,23,223

6-18

Future Value Annuity

Definition: FV Annuity is different from PV

Annuity in that the accumulated sum takes

place at the end of the period of the annuity.

In a savings scheme if you deposit equal

installment regularly and at the maturity of

the annuity receive the accumulated sum

then it is an example of future value annuity.

It is composed of the principal amounts and

the interest thereof.

FVIFA=[(1+i)

n

-1]/i

FV of Annuity=C*FVIFA

6-19

Composition of Future Value

of Annuity

Suppose, there is a 2 year annuity of

$100 installments at 10% interest. The

future value is

FV Annuity= C*FVIFA=

=100*[(1.1)

2

-1]/0.1=$210

This is composed of $110 and $100.

6-20

Future Value Annuity (Contd.)

Problem 10: You like to deposit Tk.1000

per month for a period of 15 years.

Assuming an interest of 10% how much

would you get at the end?

FV Annuity=C*(FVIFA)

=1000*{[(1+.1/12)

15*12

]-1}/(.1/12)

=1000*414.4703

=Tk.4,14,470.30

6-21

Future Value Annuity (Contd.)

Problem 11: You need to have Tk.1 million after

20 years from now. Assuming the market interest

rate of 13% per annum if you like to deposit

equal quarterly installments during the period in a

bank then how much would be the amount of

each installment? What is the interest

accumulation in the annuity?

Given, FV=Tk.1,000,000, i=.13/4, n=20*4, C=?

6-22

Solution: Problem 11

C=FV/FVIFA.

C=1,000,000/366.7164=Tk.2,726.90

Interest accumulation=FV Annuity-Total

payments

=1,000,000-(C*n)=1,000,000-

(2726.90*80)

=Tk.781,847.80 (This is 78.18% of face

value)

6-23

Ordinary Annuity and Annuity

Due

The installments of an annuity can be paid

either at the beginning or at the end of the

period. If it is paid at the end of the period

then it is called ordinary annuity. If it is paid

at the beginning of the period then it is called

annuity due. Both present value annuity and

future value annuity can be an ordinary

annuity or annuity due. To convert ordinary

annuity into annuity due multiply the value by

(1+i).

6-24

What is the difference between an

ordinary annuity and an annuity due?

Ordinary Annuity

PMT PMT PMT

0 1 2 3

i%

PMT PMT

0 1 2 3

i%

PMT

Annuity Due

6-25

Annuity Due

Problem 12: You need to receive Tk.10,000

monthly for a period of 2 years to pursue

your MBA program. You make an

arrangement with a Bank that says the

interest rate is 15%.

(a) How much will you have to return back

to the bank at the end?

(b) How much should you deposit to the

bank now to get the same monthly

installments throughout the MBA program?

6-26

Solution: Problem 12(a)

(a) FV Annuity=C*FVIFA

=10000*[(1+.15/12)

24

-1]/(.15/12)

=10000*27.78808=Tk.2,77,880.80

Since you need the money at the beginning of

the month so it is an annuity due.

In that case,

FV Annuity

Due=2,77,880.80*(1+.15/12)=Tk.2,81,354.40

6-27

Solution: Problem 12(b)

(b) This is the present value annuity due.

PV Annuity due=C*PVIFA*(1+i)

=10,000*20.62423*(1+.15/12)

=2,08,820.4

Also notice: you can get answer to (b) by dividing

answer to (a) by (1+i)

n

or [(1+.15/12)

2*12

]

Or, you can get (a) through multiplying (b) by

(1+i)

n

factor

For example, 208820.4[(1+.15/12)

2*12

]

=208820.4*[(1.0125)

24

]=281354.40

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