SM Nahidul Islam

Dept. of Finance & Banking (2nd batch)

1. Define Time value of money & State the role / importance / significance of time value of
money
Answer: Time value of money is the premise that an investor prefers to receive a payment of a fixed
amount of money today, rather than an equal amount in the future, all else being equal. The significance
of the concept of time value of money could be stated as below:
a. Investment Decision: Investment decision is concerned with the allocation of capital into longterm investment projects. The cash flow from long-term investment occurs at different point in time
in the future. They are not comparable to each other and against the cost of the project spent at
present. To make them comparable, the future cash flows are discounted back to present value.
The concept of time value of money is useful to securities investors. They use valuation models
while making investment in securities such as stock and bonds. These security valuation models
consider time value of cash flows from securities.
b. Financing Decision: Financing decision is concerned with designing optimum capital structure and
raising funds from least cost sources. The concept of time value of money is equally useful in
financing decision, especially when we deal with comparing the cost of different sources of
financing. The effective rate of interest of each source of financing is calculated based on time value
of money concept. Similarly, in leasing versus buying decision, we calculate the present value of
cost of leasing and cost of buying. The present value of costs of two alternatives is compared
against each other to decide on appropriate source of financing.
Besides, the concept of time value of money is also used in evaluating proposed credit policies and
the firm's efficiency in managing cash collection under current assets management.

2. Why money has time value?

Answer: The time value of money is the value of money figuring in a given amount of interest earned over a
given amount of time. Money has time value for the following reasons:

1. Present consumption preference: people prefer present consumption to future consumption. They
can be induced to delay consumption but only by offering them more in the future.
2. Uncertainty: Uncertainty is the state of mind of an individual who is unable to make any estimate
of future events. Does not give any odds and all outcomes, expected or not, are possible.
3. Interest rate: The existence of interest rate s in the economy provides money with its time value
quite apart from the attitudes of any one person or the investment opportunities available to a
particular firm.
4. Inflation: Inflation occurs when general price level goes up, the supply of money goes up and
demand for money goes down.
5. Deflation: Deflation occurs when general price level goes down, the supply of
money goes down and the Supply of Goods goes up.

3. Describe Time line

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
Answer: Time line is a horizontal line on which time zero appears at the leftmost end
and future periods are marked from left to right; can be used to depict investment
cash flow. To illustrate how to construct a timeline, assume that a friend owes you
money. He has agreed to repay the loan by making two payments of $10,000 at the
end of each of the next two years. We represent this information on a timeline as
follows:

Date

Cash flow

Year 1

Year 2

TK. 0

10,000

10,000

In a word, Time line is a graphical representation used to show the timing of cash
flows.

4. What is the difference between future value and present value? Which approach is generally
preferred by financial managers? Why?
Answer: The differences between Present value and future value are given below:
Present value
Present value is the value today of a
stream of payments to be received in the
future at a given cost of capital.
It represents the original investment that
we have in hand today
Present value techniques measure cash
flow at the start of a project`s life (zero
time).
Present value of an annuity helps to
calculate how much money needs to be
paid.
Formula:
PV=

FV
n
(1+i) Where, FV is future

value, PV is present value, i is annual

interest rate, n is number of years.

Future value
Future value is the value of a present amount at a
future date, is calculated by applying compound
interest over a specific time period.
It represents what that investment will
grow to when interest is earned on a
sequential renewal of investment.
Future value techniques measure cash
flow at the end of a project`s life
Future value of an annuity helps to
calculate how much money needs to
be invested today, in order to receive a
certain payment in the future.
Formula:
n
FV = PV (1+i) Where, FV is future
value, PV is present value, i is annual
interest rate, n is number of years.

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
Financial managers prefer present value to future value because they typically make decisions
at time zero, before the start of a project.

5. How are present value and future value calculations related?

Answer: Present value calculations are the exact inverse of compound interest calculations. Using
compound interest, one attempts to find the future value of a present amount; using present value, one
attempts to find the present value of an amount to be received in the future.

6. Define and differentiate among the three basic patterns of cash flow: (1) a single amount, (2)
an annuity, and (3) a mixed stream.
Answer: A single amount cash flow refers to an individual, stand alone, value occurring at one point in
time.
An annuity consists of an unbroken series of cash flows of equal dollar amount occurring over more
than one period.
A mixed stream is a pattern of cash flows over more than one time period and the amount of cash
associated with each period will vary.

7. What is the difference between an ordinary annuity and an annuity due? Which is more
valuable? Why?
Answer: An ordinary annuity is an annuity whose payments are made at the end of each period (e.g. a
month, a year). On the other hand, an annuity due is an annuity whose payments are made at the beginning
of each period (e.g. a month, a year).
The ordinary annuity is the more common. For otherwise identical annuities and interest rates, the
annuity due results in a higher future value because cash flows occur earlier and have more time to
compound.

8. Why is interest charged?

Answer: There are several reasons for interest to be justifiably charged that
are given below:
1. Risk of default: It is possible that the borrower may not repay the money. The
risk of default is different for each borrower; more credit-worthy borrowers have
a lower risk of default. Nevertheless, there is always a risk and the lender ought
to be compensated for this risk.
2. Opportunity cost: The lender could gainfully employ the capital elsewhere
instead of lending to the borrower. This is called opportunity cost. By lending
the money to a specific borrower, the lender closes all other avenues to use it
for gain.

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
3. Inflation: The value of money decreases with time because of inflation. If $100
is lent today and will be repaid 3 years from now, the same $100 will be worth
equivalent to only $98 today.

9. Explain the differences between simple interest and compound interest

Simple interest: Simple interest is interest paid on the original principal only. For
example, 4000 dollars is deposited into a bank account and the annual interest rate
is 8%. How much is the interest after 4 years?
Use the following simple interest formula:
I = p r n
Where
P = the principal or money deposited
i = the rate of interest
n = number of years
We get:
I
I
I
I

=
=
=
=

p r t
4000 8% 4
4000 0.08 4
1280 dollars.

Compound interest: compound interest is the interest earned not only on the
original principal, but also on all interests earned previously. If we use compound
interest for the situation above, the interest will be computed as follow:
Interest at the end of the first year:
I = 4000 0.08 1
I = 320 dollars
New principal is now 4000 + 320 = 4320
Interest at the end of the second year:
I = 4320 0.08 1
I = 345.6 dollars
New principal is now 4320 + 345.6 = 4665.6
Interest at the end of the third year:
I = 4665.6 0.08 1
I = 373.248 dollars
New principal is now 4665.6 + 373.248 = 5038.848
Interest at the end of the fourth year:
I = 5038.848 0.08 1
I = 403.10784 dollar
New principal is now 5038.848 + 403.10784 = 5441.95584
Total interest earned = 5441.95584 4000 = 1441.95584.
The difference in money between compound interest and simple interest is

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
1441.96 - 1280 = 161.96
As you can see, compound interest yields better result, so you make more
money. Therefore, before investing your money, you should double check with your
local bank if compound interest will be used.

10. Define Compounding & Discounting

Compounding: Compounding is the fact that the money you make off an investment
can be reinvested to make even more money than your initial investment. In a word,
Compounding refers to generating earnings from previous earnings.
Discounting: Discounting is a financial mechanism in which a debtor obtains the
right to delay payments to a creditor, for a defined period of time, in exchange for a
charge or fee. In a word, Discounting is multiplying an amount by a discount rate to
compute its present value .

Definition
PV = Present value
FV = Future value
PV A =Present valueof annuity
FV A

= Future value of annuity

n = Number of years
I = Annual interest rate
m = Number of times per year interest is compounded
A = Amount invested / received at the end/beginning of each year/month.

Formula
n
FV = PV (1+i)

PV = FV

1
n
(1+i)

Ordinary annuity:

FV A

= A

( 1+i )n1
i

]
5

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)

PV A

= A

1(1+i)n
i

Annuity due:

FV due

PV due

= A
= A

[
[

( 1+i)n1
i

1(1+i)
i

( 1+i )

(1+i )

Annuity (A)
A=

FV A

i
n
( 1+i ) 1

PV A

i
n
1(1+i)

Perpetuity / continuing forever:

PV =

A
i

Effective interest rate:

EIR=(1+

i m
) -1
m

Continuous compounding:

FV = PV e i. n

PV = FV ei. n

= 2.7183

Interest rate:
i=

FV
PV

-1
6

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
In case of mixed cash flow:
PV =

FV 1
(1+i)1

FV 2

FV 3
+
+
+
(1+i)2 (1+ i)3

FV n
(1+i)n

n1
n2
n3
nn
FV = PV 1 (1+i)
+ PV 2(1+i ) + PV 3 (1+i) + + PV 1 (1+i)

Compounding interest more frequently more than annually:

It is denoted by m (Number of periods interest is compounded) & it will be divided
with annual interest rate (i) and multiplied with number of year (n). For example:
n m
FV = PV (1+i/m)

Value of m may be
Particulars
Semi-annually
Quarterly
Bi-monthly
Monthly
Weekly
Daily

m
2
4
6
12
52
365