FACULTY OF MANAGEMENT SCIENCES

Hamdard Institute of Management Sciences-HIMS

Spring-2020

Financial Management
Submitted by: Abdul Ahad Khan
Submitted to: Sir Muhammad Asim Rafiq
Subject: Financial Management
DATE: 10/APRIL/2020
TIME VALUE OF MONEY:
Time value of money is the concept that the value of a dollar to be received in
future is less than the value of a dollar on hand today. One reason is that money
received today can be invested thus generating more money. Another reason is
that when a person opts to receive a sum of money in future rather than today,
he is effectively lending the money and there are risks involved in lending such as
default risk and inflation. Default risk arises when the borrower does not pay the
money back to the lender. Inflation is the decrease in purchasing power of money
due to a general increase level of overall price level.

PRESENT VALUE:

When a future payment or series of payments are discounted at the given interest
rate to the present date to reflect the time value of money, the resulting value is
called present value.

For example, if you have to pay $1,000 in one year and the bank offers an annual
percentage rate of 10% on any money that you deposit, you must deposit at least
$909.1 (=$1,000/(1+10%)) today. This is the present value of $1,000 payment to
be made in one year. Present value of an annuity finds out the present value of a
series of equal cash flows that occur after equal period of time. The present value
of annuity further depends on whether it is an (ordinary) annuity or an annuity
due.

FUTURE VALUE:
Future value is amount that is obtained by enhancing the value of a present
payment or a series of payments at the given interest rate to reflect the time
value of money. Let us that you deposit $909.1 in a bank today which pays 10%
annual percentage rate. Your account would grow to $1,000 (=$909.1 × (1 + 10%))
by the end of first year. This is the future value.

Future value of an annuity equals the accumulated value at a future date of a

series of equal equidistant payments/receipts.

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INTEREST:
Interest is charge against use of money paid by the borrower to the lender
in addition to the actual money lent. The amount of interest depends on
whether there is simple interest or compound interest. In simple interest,
there is no interest on interest but in compound interest, interest is
calculated on both principal and interest already earned. It also depends on
whether we are working with an interest rate or a discount rate.

TIME VALUE OF MONEY RELATIONSHIPS:

 A value today called present value (PV),
 A value at some future date called future value (FV),
 Number of time periods between the PV and FV, referred to as n,
 Annual percentage interest rate labeled as r,
 Number of compounding periods per year, m,
 An annuity payment (only case of annuities), PMT.

If the interest rate is high, time duration is longer and compounding periods
are more frequent, the present value is lower and vice versa.

Similarly, future value of a single sum or an annuity is high when the

interest rate is high, time duration is longer, compounding is more frequent,
and vice versa.

APPLICATION OF TIME VALUE OF MONEY PRINICIPLE:

Time value of money is one of the most fundamental phenomenon in
finance. It is underlying theme embodies in financial concepts such as:

 Net present value,

 Internal rate of return,
 Compound annual growth rate, etc.

It is the basis used to work out the intrinsic value of a firm, a share of
common stock, a bond or any other financial instrument.

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SIMPLE INTEREST:
DEFINITION:

Simple interest is interest calculated on the principal portion of a loan or the

original contribution to a savings account. Simple interest does not
compound, meaning that an account holder will only gain interest on the
principal, and a borrower will never have to pay interest on interest already
accrued.

EXPLANATION:

The formula for calculating simple interest is: Principal, Interest Rate, Term
of the loan.

Loans rarely use the simple-interest calculation, but those that do are auto
loans and short-term personal loans. A handful of mortgages also use this
calculation, most notably the biweekly mortgage. One of the reasons that
the biweekly mortgage helps borrowers pay their homes off quicker is that
paying the interest more frequently accelerates the payoff date.

With simple-interest loans, the lender applies the payment to the month’s
interest first; the remainder of the payment reduces the principal. Each
month, the borrower pays the interest in full so that it never accrues. If she
pays her loan late, she’ll have to pay more money to cover the additional
interest and keep the loan’s specified payoff date. This contrasts with
compound interest, which adds a portion of the old interest to the loan. The
lender then calculates new interest on the old interest owed by the
borrower.

Simple interest is also rare with savings accounts; most savings accounts
use the compounding method to calculate interest.

EXAMPLE:

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Sara takes out a new short-term personal loan. The loan is a Rs.20,000
auto loan with 3 percent interest for five years, meaning that she’ll owe
Rs.3,000 over the life of the loan: Rs.20,000 x .03 x 5. Each month, Rs.50
of her payment goes toward interest on the loan.

COMPOUND INTEREST:
DEFINITION:

Compound interest is a method of calculating interest whereby interest

earned over time is added to the principal. As with interest generally,
compound interest is the key incentive for banks to issue loans and
for depositors to keep money at banks. It is applied regularly to savings
accounts or loans according to various compounding methods.

EXPLANATION:

There are two ways of thinking about interest: it is the price borrowers pay
lenders for credit, or the fee depositors demand for leaving their money in
a bank. In addition, there are two methods for calculating interest.
With the simple-interest approach, interest is only calculated against the
principal.

Compound interest is more subtle: interest is earned on the principle and

previous interest payments that is, interest accumulating on interest.
Compound interest accrues over a compounding period specified in the
terms and conditions of the account or loan. The compounding period is
usually a year: at that point, regular interest is added to the principal, and
interest begins accumulating against the combined amount.

For a savings account, that means earnings on an investment are retained

so that the value of the investment increases every time the bank pays
interest; for a loan, that means a percentage of interest that accrues during
the compounding period is based on interest already owed and will end up
costing the borrower more money, albeit not too much more. The process a

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bank uses to determine how interest compounds is called the compounding
method.

Get the best returns on your investment by comparing interest rates on

savings accounts with Bank rate’s comparison tool.

EXAMPLE:

Rashid invests Rs.100 at an interest rate of 5 percent. After the first year,
his account is worth Rs.105. After that period ends, the interest
compounds, and the next year he earns 5 percent of Rs.105, or Rs.5.25,
which brings his account to Rs.110.25. As time goes on, the value of his
investment increases. However, the third year, when his account is worth
Rs.115.76, Rashid decides to withdraw the interest bringing his account
down to Rs.100. The following year, he only earns $5 again.

WHAT IS ANNUITIES?
An annuity is a series of equal payments made at equal intervals during a
period of time. In other words, it’s a system of making or receiving
payments where the payment amount and time period between payments
is equal.

An annuity is the payment or receipt of equal cash flows per period for a
specified amount of time. An ordinary annuity is one in which the payments
or receipts occur at the end of each period, as shown. An annuity due is
one in which payments or receipts occur at the beginning of each period,
as shown. Most lease payments, such as apartment rentals, and life
insurance premiums are annuities due. In a 4-year ordinary annuity, the
last payment is made at the end of the fourth year. In a 4-year annuity due,
the last payment is made at the end of the third year (the beginning of the
fourth year).

FUTUTE VALUE OF AN ORDINARY ANNUITY:

Future value (FV) is a measure of how much a series of regular payments
will be worth at some point in the future, given a specified interest rate. So,
for example, if you plan to invest a certain amount each month or year, it
will tell you how much you'll have accumulated as of a future date. If you

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are making regular payments on a loan, the future value is useful in
determining the total cost of the loan.

 C = cash flow per period

 I = interest rate

 n = number of payments

PRESENT VALUE OF AN ORDINARY ANNUITY:

In contrast to the future value calculation, a present value (PV) calculation
tells you how much money would be required now to produce a series of
payments in the future, again assuming a set interest rate.

FUTURE VALUE OF AN ANNUITY DUE:

An annuity due, you may recall, differs from an ordinary annuity in that the
annuity due's payments are made at the beginning, rather than the end, of
each time period. To account for payments occurring at the beginning of
each period requires a slight modification to formula used to calculate the
future value of an ordinary annuity and results in higher values The reason
the values are higher is that payments made at the beginning of the period
have more time to earn interest.

PRESENT VALUE OF AN ANNUITY DUE:

Similarly, the formula for calculating the present value of an annuity due
takes into account the fact that payments are made at the beginning rather
than the end of each period.

EXAMPLE OF ANNUITY:
Many people play the lottery in hopes to cash in on the big jackpot.
Unfortunately, most people don’t win it big, but an extremely small
percentage of people do. After they win, they often have to make the
choice whether to be paid in a lump sum or in an annuity. For example, a
million dollar jackpot could be paid out immediately in one lump sum of
$600,000 or in $5,000 monthly installments for 15 years.

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This option takes the time value of money into consideration. Notice that
neither option actually pays out a full $1,000,000. This is because over time
money should earn interest. Thus, $600,000 today will equal $1,000,000 in
the future after interest is added up over the years. The same is true for the
annuity payments.

The bank determines the interest rate and the time value of money needed
to recoup their principle and generate the adequate return on the loan.

Accounting for annuities can be simple or complicated depending on the

agreement, payment terms, and compounding interest arrangement. The
key thing to remember is that prevent value and future value tables are
often needed to calculate terms without a financial calculator.

TYPE OF ANNUITIES:
An annuity is a contractual arrangement with an insurer to exchange an
upfront premium for future (usually retirement) payments. Retirees then
have a guaranteed income that isn’t subject to stock market swings. There
are four main types of annuities:

1. Deferred income annuities.

2. Fixed annuities.
3. Variable annuities.
4. Immediate annuities.

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