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Chapter 4 - Time Value of Money PDF
Chapter 4 - Time Value of Money PDF
(BPK 30905)
CHAPTER 4:
• Introduction
• Simple interest
• Compound interest
• The concept Equivalence
• Cash flow-diagram table
• Applications of Future and Present values
INTRODUCTION
• Capital refers to wealth in the form of money or
property that can be used to produce more wealth.
When money is borrowed the interest paid When money is lent or invested, the
is the charge to the borrower for the interest earned is the lender’s
use of the lender’s property gain from providing a good to
another use
Example 4.2:
You borrow RM10,000 for 60 days at 5% simple interest per year (assume a 365 day year).
What is the total amount borrowed by end of 60 days?
Interest = (P )(N)(i)
= (10,000)(0 .05)(60/365)
= RM82.19
Total borrowed = RM10,000 + RM82.19
= RM10,082.19
COMPOUND INTEREST
Therefore,
Compound interest reflects both the remaining principal and
any accumulated interest. For RM1,000 at 10%…
Example:
OR
100 (1 + 0.08)8
= RM 185.09
NOMINAL AND EFFECTIVE INTEREST RATES
Nominal rates:
1. Often states as the annual interest rate for credit cards, loans, and
house mortgages.
2. Also known as Annual Percentage Rate (APR).
3. E.g. an APR of 15% is the same as nominal 15% per year or a
nominal 1.25% per month.
NOMINAL AND EFFECTIVE INTEREST RATES
(CONT.)
Effective rates:
1. Commonly stated as annual rate of return for investments, certificates of
deposit, and savings account.
2. Also known as Annual Percentage Yield (APY).
3. It is used to compare the annual interest between loans with different
compounding terms (daily, monthly, annually, or other).
The nominal rates will never exceeds the effective rate, and similarly APR < APY
NOMINAL AND EFFECTIVE INTEREST RATES
(CONT.)
Example 4.4:
1. r = 6% per semiannual; M = 6
i = (1 + 0.06/6)6 – 1
= 0.0615 (6.15%)
Example 4.4:
1. M = 2; r = 7%
i = (1 + 0.07/2)2 – 1
= 0.0712 (7.12%)
2. M = 4; r = 14%
i = (1 + 0.14/4)4 – 1
= 0.1475 (14.75%)
THE CONCEPT OF EQUIVALENCE
• Using these elements we can “move” cash flows so that we can compare
them at particular points in time.
THE CONCEPT OF EQUIVALENCE
THE CONCEPT OF EQUIVALENCE (CONT.)
Different sums of money at different times may be equal in economic
value
RM110 one
year from now
RM90 last year
RM100 now
Interpretation: RM90 last year, RM100 now, and RM110 one year
from now are equivalent only at an interest rate of 10% per year
THE CONCEPT OF EQUIVALENCE (CONT.)
Example 4.5:
Company X makes auto batteries available to General Motors dealers. In general
the batteries are stored throughout the year, and a 5% cost increase is added each
year to cover the inventory carrying charge for the distributorship owner. Make
calculations to show which of the following statements are true and which are false
about battery costs.
1. The amount RM98 now is equivalent to a cost of RM105.60 one year from now.
2. A truck battery cost of RM200 one year ago is equivalent to RM205 now.
3. A RM38 cost now is equivalent to RM39.90 one year from now.
4. A RM3,000 cost now is equivalent to RM2,887.14 one year ago.
5. The carrying charge accumulated one year on an investment of RM2,000
worth of batteries is RM100.
THE CONCEPT OF EQUIVALENCE (CONT.)
Solution:
1. The amount RM98 now is equivalent to a cost of RM105.60 one year
from now.
RM98 (1.05) = RM102.9 ≠ RM105.60 FALSE
OR
RM105.60/1.05 = RM100.57 ≠ RM98
• The time line is a horizontal line divided into equal periods such
as days, months, or years.
CONSTRUCTING A CASH FLOW DIAGRAM
(CONT.)
• Each cash flow, such as a payment or receipt, is plotted along this
line at the beginning or end of the period in which it occurs.
• Funds that you pay out such as savings deposits or lease payments
are negative cash flows that are represented by arrows which extend
downward from the time line with their bases at the appropriate
positions along the line.
+ Cash flow
- Cash flow
CONSTRUCTING A CASH FLOW DIAGRAM
: LENDER VIEWPOINT
CONSTRUCTING A CASH FLOW DIAGRAM
(CONT.)
Example 4.6:
Construct a cash flow diagram for the following cash flows: RM10,000
outflow at time zero, RM3,000 per year inflow in years 1 through 5 at an
interest rate of 10% per year, and an unknown future amount in year 5.
CONSTRUCTING A CASH FLOW DIAGRAM
(CONT.)
CONSTRUCTING A CASH FLOW DIAGRAM
Example 4.7
The XYZ Corporation insists that its engineers develop a cash-flow diagram
of the proposal.
An investment of $10,000 can be made that will produce uniform annual
revenue of $5,310 for five years and then have a market (recovery) value of
$2,000 at the end of year (EOY) five.
Annual expenses will be $3,000 at the end of each year for operating and
maintaining the project.
Draw a cash-flow diagram for the five-year life of the project. Use the
corporation’s viewpoint.
CONSTRUCTING A CASH FLOW DIAGRAM Example 4.7 (Solution)
CONSTRUCTING A CASH FLOW TABLE
Example 4.8
Two feasible alternatives for upgrading the heating, ventilation, and air
conditioning (HVAC) system have been identified. Either Alternative A or
Alternative B must be implemented.
At the end of eight years, the estimated market value for Alternative A is $2,000
and for Alternative B it is $8,000.
Assume that both alternatives will provide comparable service (comfort) over an
eight-year period, and assume that the major component replaced in Alternative
B will have no market value at EOY eight.
(1) Use a cash-flow table and end-of-year convention to tabulate the net cash
flows for both alternatives.
(2) Determine the annual net cash-flow difference between the alternatives (B −
A).
CONSTRUCTING A CASH FLOW TABLE Example 4.8
Functional
symbol
Description: Formula:
P = RM100, i = 8%, N = 8, F = ?
F = P (1 + i)N
= 100 (1 + 0.08)8
= 100 (1.08)8
= 100 (1.8509)
= RM185.09
F = P (F/P, i%, N)
= 100 (F/P, 8%, 8)
= 100 (1.8509)
= RM185.09
SINGLE-PAYMENT FACTORS (CONT.)
Example 4.10:
F = RM30,000, N = 8, i = 10%, P = ?
P = F (1 + i)-N
= 30,000 (1 + 0.10)-8
= 30,000 (1.10)-8
= 30,000 (0.4665)
= RM13,995
P = F (P/F, i%, N)
= 30,000 (P/F, 8%, 10)
= 30, 000 (0.4665)
= RM13,995
SINGLE-PAYMENT FACTORS (CONT.)
Example 4.11:
F = P (F/P, i%, N)
= 15,000 (F/P, 6%, 25)
= 15,000 (4.2919)
= RM64,378.50
Example 4.12:
F/P
N
i = - 1
12
= √ (2.31/1.07) - 1
= 0.0662 or 6.62% per year
Example 4.12 (cont.):
= log (5.00/2.31)
log (1 + 0.0662)