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Introduction to Finance

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

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

1PVIFA=

1 (1+i)n 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 2 3 4

5000 3768.6 2524.9 1268.7

1281.4 50 1231.4 3768.6 1281.4 37.686 1243.7 2524.9 1281.4 25.249 1256.2 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 2*12] For example, 208820.4[(1+.15/12) =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. RICs 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?
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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?
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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?

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