Islamic Finance, Dr

Waheed, COMSATS,
Lahore
 Islamic Finance, Dr
Waheed, COMSATS,
Lahore
Business Finance, Dr
Waheed, COMSATS,
Lahore
Business Finance, Dr
Waheed, COMSATS,
Lahore
Chapter 5: Time Value of Money

Business Finance, Dr
Waheed, COMSATS,
Lahore
Learning Goals

● Understand the concepts of future value and present

value, their calculation for single amounts,
● Find the future value and the present value of both an
ordinary annuity and an annuity due, and find the
present value of a perpetuity.
● Understand the effect that compounding interest more
frequently than annually has on future value and on the
effective annual rate of interest.
● Describe the procedures involved in (1) loan
amortization (2) finding interest or growth rates, and (3)
finding an unknown number of periods. Business Finance, Dr
Waheed, COMSATS,
Lahore
 FUTURE VALUE VS PRESENT VALUE

● Is this a wise investment?

Business Finance, Dr
Waheed, COMSATS,
Lahore
 Concept of Time line

● 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 flows.

Business Finance, Dr
Waheed, COMSATS,
Lahore
Compounding and Discounting

Business Finance, Dr
Waheed, COMSATS,
Lahore
BASIC PATTERNS OF CASH FLOW

● Single amount: A lump-sum amount either

currently held or expected at some future date.
● Annuity: A level periodic stream of cash flow.
For our purposes, we’ll work primarily with
annual cash flows.
● Mixed stream: A stream of cash flow that is not
an annuity; a stream of unequal periodic cash
flows that reflect no particular pattern.
Business Finance, Dr
Waheed, COMSATS,
Lahore
FUTURE VALUE OF A SINGLE
AMOUNT

Business Finance, Dr
Waheed, COMSATS,
Lahore
Future Value Relationship

Business Finance, Dr
Waheed, COMSATS,
Lahore
PRESENT VALUE OF A SINGLE
AMOUNT

Business Finance, Dr
Waheed, COMSATS,
Lahore
Present Value Relationship

Business Finance, Dr
Waheed, COMSATS,
Lahore
 Annuities

● A stream of equal periodic cash flows over a

specified time period. These cash flows can be
inflows of returns or outflows of funds invested
to earn future returns.
● Ordinary annuity- An annuity for which the
cash flow occurs at the end of each period.
● Annuity due - An annuity for which the cash
flow occurs at the beginning of each period.
Business Finance, Dr
Waheed, COMSATS,
Lahore
FINDING THE FUTURE VALUE OF AN
ORDINARY ANNUITY

Business Finance, Dr
Waheed, COMSATS,
Lahore
FUTURE VALUE OF AN ORDINARY
ANNUITY

Business Finance, Dr
Waheed, COMSATS,
Lahore
FINDING THE PRESENT VALUE OF AN
ORDINARY ANNUITY

Business Finance, Dr
Waheed, COMSATS,
Lahore
PRESENT VALUE OF AN
ORDINARY ANNUITY

Business Finance, Dr
Waheed, COMSATS,
Lahore
FINDING THE FUTURE VALUE OF
AN ANNUITY DUE

Business Finance, Dr
Waheed, COMSATS,
Lahore
FINDING THE PRESENT VALUE OF
AN ANNUITY DUE

Business Finance, Dr
Waheed, COMSATS,
Lahore
 FINDING THE PRESENT VALUE OF A
PERPETUITY

● Perpetuity - An annuity with an infinite life,

providing continual annual cash flow.
● Ross Clark wishes to endow a chair in finance
at his almamater. The university indicated that
it requires $200,000 per year to support the
chair, and the endowment would earn 10% per
year. Determine the amount Ross must give
the university to fund the chair.
Business Finance, Dr
Waheed, COMSATS,
Lahore
PRESENT VALUE OF A
PERPETUITY

Business Finance, Dr
Waheed, COMSATS,
Lahore
 FUTURE VALUE OF A MIXED
STREAM
● Mixed stream - A stream of unequal periodic cash flows
that reflect no particular pattern.
● Shrell Industries, a cabinet manufacturer,
expects to receive a mixed stream of
cash flows over the next 5 years from one
of its small customers.
● If Shrell expects to earn 8% on its
investments, how much will it accumulate
by the end of year 5 if it immediately
invests these cash flows when they are
received? Business Finance, Dr
Waheed, COMSATS,
Lahore
FUTURE VALUE OF A MIXED
STREAM – contd.

Business Finance, Dr
Waheed, COMSATS,
Lahore
 PRESENT VALUE OF A MIXED
STREAM

● Frey Company, a shoe

manufacturer, has been offered an
opportunity to receive a mixed
stream of cash flows over the next 5
years:
● If the firm must earn at least 9% on
its investments, what is the most it
should pay for this opportunity?

Business Finance, Dr
Waheed, COMSATS,
Lahore
PRESENT VALUE OF A MIXED
STREAM

Business Finance, Dr
Waheed, COMSATS,
Lahore
 Compounding Interest More
Frequently Than Annually

● Semiannual compounding - Compounding of interest

over two periods within the year.
● Quarterly compounding - Compounding of interest
over four periods within the year.

● Where m equals the number of times per year

interest is compounded
Business Finance, Dr
Waheed, COMSATS,
Lahore
 Future values under compounding
Interest More Frequently Than Annually

● Calculate the amount that Fred would have at the end

of 2 years if he deposited $100 at 8% interest
compounded semiannually and compounded quarterly.

Business Finance, Dr
Waheed, COMSATS,
Lahore
 CONTINUOUS COMPOUNDING

● Compounding of interest an infinite number of times

per year at intervals of microseconds.
●

● To find the value at the end of 2 years ( ) of Fred

Moreno’s $100 deposit in an account paying 8%
annual interest compounded continuously

Business Finance, Dr
Waheed, COMSATS,
Lahore
 NOMINAL AND EFFECTIVE
ANNUAL RATES OF INTEREST

● Nominal annual rate – Contractual (stated)

annual rate of interest charged by a lender or
promised by a borrower
Effective annual rate (EAR) - The (true)
annual rate of interest actually paid or earned.
●

Business Finance, Dr
Waheed, COMSATS,
Lahore
Calculating Effective annual rate
(EAR)

Business Finance, Dr
Waheed, COMSATS,
Lahore
Special Applications of Time Value

● Determining deposits needed to accumulate a

future sum,
● Loan amortization,
● Finding interest or growth rates,
● Finding an unknown number of periods

Business Finance, Dr
Waheed, COMSATS,
Lahore
 Determining deposits needed to
accumulate a future sum

● Suppose you want to buy a house 5 years from now,

and you estimate that an initial down payment of
$30,000 will be required at that time. To accumulate
the $30,000, you will wish to make equal annual
end-of-year deposits into an account paying annual
interest of 6 percent.

Business Finance, Dr
Waheed, COMSATS,
Lahore
 Loan amortization

● Loan amortization - The determination of the

equal periodic loan payments necessary to
provide a lender with a specified interest return
and to repay the loan principal over a specified
period.
Loan amortization schedule - A schedule of
equal payments to repay a loan. It shows the
allocation of each loan payment to interest and
principal.
Business Finance, Dr
Waheed, COMSATS,
Lahore
 Loan amortization (contd.)

● You borrow $6,000 at 10 percent and agree to make

equal annual end-of-year payments over 4 years. To
find the size of the payments, the lender determines
the amount of a 4-year annuity discounted at 10
percent that has a present value of $6,000.

Business Finance, Dr
Waheed, COMSATS,
Lahore
Business Finance, Dr
Waheed, COMSATS,
Lahore
 FINDING INTEREST OR GROWTH
RATES

● Ray Noble purchased an investment four years ago for

$1,250. Now it is worth $1,520. What compound
annual rate of return has Ray earned on this
investment?

Business Finance, Dr
Waheed, COMSATS,
Lahore
 FINDING AN UNKNOWN NUMBER
OF PERIODS

● Ann Bates wishes to determine the number of years it

will take for her initial $1,000 deposit, earning 8%
annual interest, to grow to equal $2,500. Simply stated,
at an 8% annual rate of interest, how many years, n,
will it take for Ann’s $1,000, PV, to grow to $2,500,
FVn?

Business Finance, Dr
Waheed, COMSATS,
Lahore
EXERCISE QUESTIONS

Business Finance, Dr
Waheed, COMSATS,
Lahore
EXERCISE QUESTIONS (CONTD.)

Business Finance, Dr
Waheed, COMSATS,
Lahore
SELF TEST PROBLEMS

Business Finance, Dr
Waheed, COMSATS,
Lahore
SELF TEST PROBLEMS (contd.)

Business Finance, Dr
Waheed, COMSATS,
Lahore
SELF TEST PROBLEMS (contd.)

exercise

Business Finance, Dr
Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore
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Waheed, COMSATS,
Lahore