Business Finance

(MGT 232)

Lecture 6

4-1
Time
Time Value
Value of
of Money
Money

4-2
 Overview of the Last Lecture
• Annuity
• Types of Annuity
• Future Value Annuity
• Ordinary Annuity
• Annuity Due
• Present Value Annuity
• Ordinary Annuity
• Annuity Due
• Steps to Solve Time Value of Money Problems

4-3
 Uneven Cash Flows
• When we have UNEQUAL Payments over
UNEQUAL number of periods
• We cant use Annuity…
• Uneven Cash flow Stream…

4-4
 Uneven Cash Flows
Ali will receive the set of cash flows below.
What is the Present Value at a discount rate of
10%?
10%
0 1 2 3 4 5

10%
Rs.600 Rs.600 Rs.400 Rs.400 Rs.100

PV0

4-5
 How to Solve?
1. Solve a “piece-at-a-time”
piece-at-a-time by discounting each piece back to
t=0.

0 1 2 3 4 5

i%
R R R R R

PV 4-6
 “Piece-At-A-Time”
PV of Uneven Cashflow Stream
0 1 2 3 4 5

10%
Rs.600 Rs.600 Rs.400 Rs.400 Rs.100
Rs.545.45
Rs.495.87
Rs.300.53
Rs.273.21
Rs. 62.09
Rs.1677.15 = PV of the Mixed Flow
4-7
 “Piece-At-A-Time”
FV of Uneven Cashflow Stream
0 1 2 3 4 5

10%
Rs.600 Rs.600 Rs.400 Rs.400 Rs.100

4-8
 Frequency of
Compounding
General Formula:
FVn = PV(1
PV + [i/m])mn
n: Number of Years
m: Compounding Periods per Year i:
Annual Interest Rate
FVn,m: FV at the end of Year n
PV0 : PV of the Cash Flow today

4-9
 Frequency of
Compounding

Compounding Interest Year (i/m) No of Periods (nxm)

Annually

Semi-Annually

Quarterly

Monthly

Daily

4-10
 Impact of Frequency
Ali has Rs.1,000 to invest for 2 years at an annual
interest rate of 12%.
Annual FV =

Semi FV =

4-11
 Impact of Frequency
Qrtly FV

Monthly FV =

Daily FV =
4-12
 Impact of Frequency
Ali has to make equal payments of Rs.1,000 to for
3 years at an annual interest rate of 12% in order
to have some amount in future.
Annual FV =

Semi FV =

4-13
 Impact of Frequency
For Present Value:

4-14
Effective Annual Interest Rate
The actual rate of interest earned (paid) after
adjusting the nominal rate for factors such
as the number of compounding periods per
year.
Formula:

4-15
 BW’s Effective
Annual Interest Rate
Basket Wonders (BW) has a Rs.1,000 CD at the
bank. The interest rate is 6% compounded
quarterly for 1 year. What is the Effective
Annual Interest Rate (EAR)?
EAR

EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1
= .0614 or 6.14%!
4-16
 Effective Annual Interest Rate

Suppose you borrow either through credit card which charges

12 % per month for a year or through bank loan with 12%
interest rate that is compounded quarterly. What should
you choose?

4-17
 Loan Amortization
• If a loan is to be repaid in equal periodic
payments, it is said to be amortized loan.

• It is an application of compounding interest

and annuity.

• Example: Car Loan, Mortgage Loan, Student

Loan
4-18
 Steps to Amortizing a Loan
1. Calculate the payment per period.
2. Determine the interest in Period t.
(interest x Beg. Amt)
3. Compute principal payment in Period t.
(Payment - interest from Step 2)
4. Determine ending balance in Period t.
(Balance - principal payment from Step 3)
5. Start again at Step 2 and repeat.

4-19
 Summary
• Uneven Cash flow Streams
• Frequency of Compounding
• FV and PV Compounding
• Effective Annual Rate
• Loan Amortization

4-20