Introduction to Finance

Prepared By:
Dr. H. M. Mosarof Hossain
Professor
Department of Finance
University of Dhaka
mosarof@du.ac.bd

1 6-1
Chapter 6: Time Value of Money

 Concept of time value of money

 Rationale for time value of money
 Present value and future value
 Discounting and compounding
 Installment and annuity
 Simple and compound interest rate
 Nominal and effective interest rate
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 Time Value of Money
 Definition: A rationale human being would not value the
opportunity to receive a specific amount of money today
equally with the opportunity to have the same amount at
some future date. Most human beings value the opportunity
to receive money now higher than receive one or two years
from now the same amount. The additional amount that is
required for receiving after a certain time period in future
than the amount received today is known as time value of
money. That is this additional amount is given as value of
time waiting. Actually the percentage change in value of a
certain amount of money for a certain time period gap is
known as time value of money

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 Rationale for Time Value of Money

 Time value of money is existed for the

following reasons:
 Future uncertainty
 Sacrifice present consumption or preference for
higher consumption in future period
 Alternative investment opportunities i.e.
opportunity cost.
 Sacrifice of cash holding preference
 Inflation
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 Terminologies

Present value: The value of today that is

obtained by discounting a future cash flow or
a series of cash flows by the opportunity cost
of fund as discount rate.
Future value: The amount or value will be
obtained at a certain time point in future of a
cash flow or a series of cash flows by
compounding at a given interest rate or
opportunity cost over a certain time period.
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 Terminologies

Discounting: The process of finding the

present value of a cash flow or a series of
cash flows by using a given discount rate.
Compounding: The arithmetic process of
determining the final value of a cash flow or a
series of cash flows by using a certain interest
rate

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 Terminologies

 Simple interest rate: The interest rate that

charged only on the principal amount for a
specific period is called simple interest rate.
 Compound interest rate: The interest rate
that is charged both on principal and interest
amount period to period is called compound
interest rate.

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 Terminologies

 Installment: Periodic payments or receipts related

to any transaction or contract are known as
installment.
 Annuity: The equal amount of cash flow incurred at
equal time interval is called annuity.
 Annuity due: The annuity under which the cash
flow is incurred at the beginning of each period is
called annuity due.
 Annuity immediate: The annuity under which the
cash flow is incurred at the end of each period is
called annuity immediate.
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 Terminologies

 Perpetuity: The annuity under which the cash flow

is incurred for a infinite period of time is called
Perpetuity..
 Nominal interest rate: Rate of interest stated in
an agreement for transferring fund from one party to
another party is known as nominal interest rate.
 Effective interest rate: Rate of interest ultimately
paid by the user of fund to the supplier of fund by
taking into consideration of timing frequencies and
other charges is known as effective interest rate.

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 Solving for PV:
The arithmetic method
Example # 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 = FVn / ( 1 + i )n
PV = FV3 / ( 1 + i )3
= Tk.100 / ( 1.10 )3
= Tk.75.13

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 Finding the interest rate
and time period
Example # 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%
Example # 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
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 Compounding more than once
in year
Example # 4: You like to set aside an amount of
money so that you get Tk.50000 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

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 Classifications of interest rates
 Effective (or equivalent) annual rate (EAR =
EFF%) – the annual rate of interest actually being
earned, taking into account compounding.
 EFF% for 10% semiannual investment
EFF% = ( 1 + iNOM / m )m - 1
= ( 1 + 0.10 / 2 )2 – 1 = 10.25%
 An investor would be indifferent between an
investment offering a 10.25% annual return
and one offering a 10% annual return,
compounded semiannually.
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 Effective Annual Rate
EFF% = ( 1 + iNOM / m )m – 1
Example # 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%

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 Why is it important to consider
effective rates of return?
 An investment with monthly payments is different
from one with quarterly payments. Must put each
return on an EFF% basis to compare rates of return.
Must use EFF% for comparisons. See following
values of EFF% rates at various compounding levels.

EARANNUAL 10.00%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%

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 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. For example, at 10%
interest rate, you can borrow Tk.173.55 in a 2
year annuity of Tk.100 installment. The amount of
Tk.173.55 is composed of (the PV of FV1 of
Tk.100 or) Tk.90.91 and (FV2 of Tk.100) or
Tk.82.64.
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Formulae for Present Value Interest Factor of Annuity

1
1-
(1+i)n
PVIFA=
i

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 Present Value of Annuity
Example # 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
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 Present Value of Annuity
Example # 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?

PVIFA={1-1/(1+.085/12)12*20]}/(.085/12)
=115.2308
PV Annuity= C*PVIFA
=1000*115.2308=1,15,230.80

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 Present Value of Annuity
Example # 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

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 Amortization Schedule

n Beginning Bal. Instalment paid Interest paid Principal paid Ending Bal.

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

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 Present Value of Annuity
Example # 9: You need Tk.12 lakh now to
buy a car, under the terms and condition of
monthly installments for 10 years. Interest
rate is 15% per annum. (a) What would be
the amount of installments? (b) How much
would be the accumulated liability of
interest?

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 Solution:
(a) Installment =PV Annuity/PVIFA
=1200000/61.98285=Tk.19360.19
(b) Accumulated Interest=Total payments –
Present value of annuity
=(19360.19*120)-1200000
=2323223-1200000=1123223

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Example 10: In 1992, a 60 year old nurse
bought a $12 dollar lottery ticket and won
the biggest jackpot to that date of $9.3
million. Later it turned up that she would be
paid in 20 annual installments of $465,000
each. If the interest rate was 8%, then what
was the amount she was deprived of in
present value?

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 Answer to previous problem
PV = $465000*PVIFA [where, i=.085, n=20]
= $ 465,000 * $ 9.818147
= $4565417
So, she was paid less than $9.3 million by an
amount of $4734583.

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 Future Value of Annuity
 FVIFA=[(1+i)n-1]/i
 FV of Annuity=C*FVIFA
 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.
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 Future Value of Annuity
Example #11: 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.414470.30
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 Future Value of Annuity
Example # 12: 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.1000000, i=.13/4, n=20*4, C=?

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 Solution:

 C=FV/FVIFA.
C=1000000/366.7164=Tk.2726.90
 Interest accumulation=FV Annuity-Total
payments
=1000000-(C*n)=1000000-(2726.90*80)
=Tk.781847.80 (This is 78.18% of face
value)

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 Annuity Due
Example # 13: You need to receive Tk.10000
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?

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 Solution:
 (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=277880.80*(1+.15/12)=Tk.281354.40

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 Solution:
(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 X [(1.0125)24]=281354.40
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 Problems

1. What will be present value of Tk.500000 will be received

8 years from now at 15% discount rate?
2. Find the present value of Tk.20000, Tk.25000, Tk15000
and Tk.30000 will be received in years 0, 1, 2 & 3
respectively by considering discount/compound rate is 10%.

3. Find the present value of Tk.50000, Tk.28000, Tk.52000

and Tk.40000 will be received in years 1, 2, 3 & 4
respectively by considering discount/compound rate is 10%.

4. You have a choice of receiving 10 payments of Tk.85000

a year, with the first payment to be received one year from
now, or Tk.500000 in cash today. If your opportunity cost is
12%, which would you prefer?
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 Problems
5. You have a choice of receiving 15 payments of Tk.50000 a
year, with the first payment to be received just now, or
Tk.600000 at a time today. If your opportunity cost is 15%
which would you prefer?

6. RIC Inc. manufactures and sells tobacco products in the

market. The company receives about Tk.200000 cash flow
each year from the product after all expenses, including
taxes. Samson Ltd has recently offered to buy the product for
Tk.1500000. RIC’s opportunity cost is 11%. Should it sell the
product if it thinks its life expectancy is indefinitely long?

7. What will be future value of Tk.300000 deposited in a bank

after 5 years from now at 9% interest rate?
34 6-34
 Problems

8. Find the future value of Tk.10000, Tk.30000, Tk.45000 and

Tk.60000 will be received in years 0, 1, 2 & 3 respectively by
considering compound rate of 11%.

9. Find the future value of Tk.30000, Tk.20000, Tk.25000 and

Tk.30000 will be received in years 1, 2, 3 & 4 respectively by
considering compound rate of 10.5%.

10. ou have a choice of receiving 5 payments of Tk.150000 a

year, with the first payment to be received one year from now
or Tk.500000 at a time at the end of the total period. If your
opportunity cost is 12% which would you prefer?

35 6-35
 Problems

11. You have a choice of receiving 10 payments of Tk.50000

a year, with the first payment to be received just now, or
Tk.750000 at a time at the end of the total period. If your
opportunity cost is 13%, which would you prefer?

12. Contractual interest rate in a loan agreement is 16% and

loan processing fee is 2%. What is the effective interest rate
of the loan if interest is compounded monthly?

36 6-36