Beruflich Dokumente
Kultur Dokumente
Prepared By: Dr. H. M. Mosarof Hossain Professor Department of Finance University of Dhaka mosarof@du.ac.bd
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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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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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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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Effective (or equivalent) annual rate (EAR = EFF%) the annual rate of interest actually being earned, taking into account compounding.
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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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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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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1PVIFA=
1 (1+i)n i
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Amortization Schedule
n Beginning Bal. Instalment paid Interest paid Principal paid Ending Bal.
1 2 3 4
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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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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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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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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