TIME VALUE OF MONEY

Books:

1. Engineering Economy by Leland T. Blank and Anthony J Tarquine

2. Engineering Economy by E. Paul DeGarmo, John R. Canada and William G. Sullivan

Humor without Malice

1. A government office issued an urgent document to be distributed among its subsidiaries. To ensure
that it would be delivered in time, the messenger was provided with a horse.
Running behind the horse, the messenger whipped the horse until it was galloping at full speed.
Someone asked him in amazement: ―If it’s such an urgent mission why don’t you ride the horse?‖
The messenger answered: ―Running on six legs is certainly quicker than on four, isn’t it?‖

2. During a Q&A session, a scholar was asked, ―Will we get cigarettes in Jannah?‖ to which he replied,
―May be, but you’d have to go to Jahannam to light it‖.

I LOVE YOU ALL FOR THE SAKE OF ALLAH SBWT.

ISLAM is a COMPLETE SYSTEM of LIFE for the TOTAL WELFARE of Mankind. SYSTEM means
putting together all elements for a complete whole.

ISLAM = FULL SURRENDER and SUBMISSION and OBEDIENCE WITH SINCERITY (input and
processing) = PEACE, PROGRESS, PROSPERITY and PARADISE (outcomes).

TIME VALUE OF MONEY

Interest is the price of capital. Interest is not an old word as a financial term. Relatively new. Original
word was usury. It was used to take ―additional or extra‖ amount of money paid out of certain
amount of loan for certain period. According to the Qur’anic word, interest or usury is termed as
riba.
According to some ahadith, the Prophet Muhammad (SAW) said there are either 70, 72, or 73 varieties
(depending on the ahadith) of riba. ... Ribaan-jahiliya: usury was practiced in pre-Islamic Arabia
referred to in The Quran 3:130.

Usury (riba) was prohibited in Bible (Exodus 22: 21-27). In 1536, Protestant theory of usury was
established by John Calvin, and it refuted the notion that interest was unlawful.

Is Riba an interest?

Riba is a concept in Islamic banking that refers to charged interest. It has also been referred to as usury,
or the charging of unreasonably high interest rates. There is also another form of riba, according to
most Islamic jurists, which refers to the simultaneous exchange of goods of unequal quantities or
qualities.

What is Riba in Quran?

Riba defined in this way is called in fiqh riba al-duyun (debt usury). (Abdel-Rahman Yousri Ahmad)
An increase in a particular item. The word is derived from a root meaning increase or growth. ...
(Some translations of verses of the Quran substitute the word "interest" for riba or "usury".)

What is Riba Al Nasiah?

Riba al-nasiah. Interest-based lending that results from the exchange not being immediate. A previously
acceptable practice similar to conventional lending today where the borrower pays the lender more
than the original amount lent to reflect the delay in repayment.

What is Islamic banking system?

Islamic banking or Islamic finance (Arabic: ‫ ) مية م صرف ية‬or sharia-compliant finance is banking or
financing activity that complies with sharia (Islamic law) and its practical application through the
development of Islamic economics.

What is Murabaha in Islamic banking?

The purpose of murabaha is to finance a purchase without involving interest payments, which most
Muslims (particularly most scholars) consider riba (usury) and thus haram
(forbidden). Murabaha has come to be "the most prevalent" or "default" type of Islamic finance.

What Islamic financial instruments?

Islamic finance products, services and contracts. From Wikipedia, the free
encyclopedia. Banking or banking activity that complies with sharia (Islamic law)—known
as Islamic banking and finance, or shariah-compliant finance—has its own products, services and
contracts that differ from conventional banking.

Is interest allowed in Islam?

Most Muslims and most "non-Muslim observers of the Islamic world" believe that interest on loans
(also on bonds, bank deposits etc.) is forbidden by Islam. (Such loans — or banks that make them —
are sometimes referred to as ribawi, i.e. carrying riba.)

What is Ijarah in Islamic banking?

In Islamic finance, al Ijarah does lead to purchase (Ijara wa Iqtina, or "rent and acquisition") and
usually refers to a leasing contract of property (such as land, plant, office automation, a motor
vehicle), which is leased to a client for stream of rental and purchase payments, ending with a
transfer of ownership to ...
 What is revenue farming?

Farming or tax-farming is a technique of financial management, namely the process of commuting

(changing), by its assignment by legal contract to a third party, a future uncertain revenue stream
into fixed and certain periodic rents, in consideration for which commutation a discount in value
received is suffered.

What is an Islamic loan?

Islamic banking or Islamic finance (Arabic: ‫ ) مية م صرف ية‬or sharia-compliant finance is banking or
financing activity that complies with sharia (Islamic law) and its practical application through the
development of Islamic economics.

What is Gharar in Islam?

Gharar (Arabic: ‫ ) ر‬literally means uncertainty, hazard, chance or risk. It is a negative element in
mu'amalat fiqh (transactional Islamic jurisprudence), like riba (usury) and maysir (gambling).

CHAPTER 4 PROHIBITION OF RIBA IN THE QUR'AN AND AHADITH

Riba was not prohibited abruptly, rather its prohibition was established in a gradual manner. In the
Qur’an, 4 (four) verses that were revealed in order to prohibit riba gradually are stated in the
following lines as per the sequence of their revelation.

1. First Revelation (Surah al-Rum, verse 39) "Whatever Riba (increased amount) you give, so that it may
increase in the wealth of the people, it does not increase with Allah; and whatever zakah/charity you
give, seeking Allah's pleasure with it, (it is multiplied by Allah, and) it is such people who multiply (their
wealth in real terms)." (Al-Run 30: 39)
– This Surah was revealed in Makkah. - Although this verse does not prohibit riba directly, as explained by
some commentators of the Holy Quran, but it simply says that riba does not increase with Allah and it does
not carry any reward in the life hereafter. On the other hand, giving out charity is a greater gesture that
Allah appreciates.

- In this verse, the word Riba does not mean interest or usury. But the word riba here means a gift/bribe offered
by someone to a person with the intention that the latter will give a greater gift or greater benefit to the
former.

- If the word riba is taken to mean usury than there is no specific prohibition against it in this verse. However,
there is subtle indication to the fact that Allah does not favor this practice.

2. Second Revelation (Surah al-Nisa', verse 161) "And for their charging Riba (usury or interest) while they
were forbidden from it, and for their consuming of the properties of the people by false means. We have
prepared, for the disbelievers among them, a painful punishment.‖ (An-Nissa 4: 161)"

- The ayah was revealed before the 4th year of Hijra. It was revealed in answer to the argumentation of the Jews
who came to the Holy Prophet and asked him to bring down a book from heavens like the one given to them
by Prophet Musa.

- Riba in this verse, undoubtedly, refers to usury or interest.

- It lists the evil deeds of the Jews and mentions that they used to take Riba, which was prohibited for them,
however from this verse, we cannot ascertain that it was also prohibitive for Muslims.
- But we can infer though that it would be a sinful act for the Muslims as well otherwise, they had no reason to
blame the Jews for this practice. So, the prohibition of riba for Muslims is still not explicitly mentioned in
the verse. (Source: Meezan Bank’s Guide to Islamic Banking).

3. Third Revelation (Surah Al 'Imran, verses 130-132) "O you believe, do not eat up the amounts acquired
through Riba (interest), doubled and multiplied. Fear Allah, so that you may be successful, [130] and fear
the fire that has been prepared for the disbelievers. [131] Obey Allah and the Messenger, so that you may
be blessed.‖ [132]

- This verse was revealed sometime in the 2nd year after Hijra. As it was revealed somewhere around the
time of the battle of Uhud which took place in the 2nd year after Hijra. - This verse clearly prohibits
the practice of Riba for the Muslims.

- The reason behind this verse's revelation was that the invaders of Makkah had financed their army by taking
usurious loans to arrange arms against Muslims and it was feared that the Muslims might follow the same
practice, so in order to prevent the Muslims from this approach, this verse was revealed.

4. Fourth Revelation (Surah al-Baqarah, verses 275-281) Prohibition of Riba in Qur'an and Hadith "Those who
take riba (usury or interest) will not stand but as stands the one whom the demon has driven crazy by his
touch. That is because they have said: “Sale is but like riba", while Allah has permitted sale, and prohibited
riba. So, whoever receives an advice from the Lord and desists (from indulging in riba), then what has
passed is allowed for him, and his matter is up to Allah. As for the ones who revert back, those are the
people of Fire. There they will remain forever. [275] Allah destroys riba and nourishes charities, and Allah
does not like any sinful disbeliever. [276] Surely those who believe and do good deeds, and establish
Salah(prayer) and pay Zakah will have their reward with their Lord, and there is no fear for them, nor
shall they grieve. [277] O you, who believe, fear Allah and give up what still remains of riba, if you are
believers. [278] But if you do not (give it up), then listen to the declaration of war from Allah and His
Messenger. However, if you repent, yours is your principal. Neither wrong, nor be wronged. [279] If there
is one in misery, then (the creditor should allow) deferment till (his) ease, and that you forgo it as alms is
much better for you, if you really know. [280] Be fearful of a day when you shall be returned to Allah, then
every person shall be paid, in full, what he has earned, and they shall not be wronged.‖ [281]

- Now these verses elaborate the severity of the prohibition of Riba. (Meezan Bank’s Guide to Islamic Banking)

- After the victory of Makkah, the Holy Prophet (pbuh) declared as void all the amounts of Riba that were due at
that time.

- Tribe of Thaqif who were the inhabitants of Taaif came to Holy Prophet (pbuh) and embraced Islam and also
entered into a treaty with him in which they signified that all the riba payable by the tribe of Thaqif will be
void but the amount of Riba that is to be received by the people of Thaqif will not be void.

- The Holy Prophet (pbuh) instead of signing the treaty simply wrote a sentence that Banu-Thaqif will have the
same rights as the Muslims have - Banu Ibn-al-Mughirah declined to pay interest on the ground that Riba
was prohibited in Islam. The matter was placed before the Holy Prophet on which, this holy verse was
revealed and Banu-Thaqif surrendered and said we have no power to wage war against Allah. Prohibition
of Riba in Hadith

A. General

1. Narrated by Jabir‖: The Prophet cursed the receiver and the payer of interest, the one who
records it and the two witnesses to the transaction and said: "They are all alike [in guilt]."

2. Prohibition of Riba in Qur'an and Hadith

Jabir ibn 'Abdallah‖, giving a report on the Prophet's (pbuh) Farewell Pilgrimage, said: The Prophet,
addressed the people and said "All of the riba of Jahiliyyah is annulled. The first riba that I annul
 is our riba, that accruing to 'Abbas ibn 'Abd alMuttalib [the Prophet's uncle]; it is being cancelled
completely."

3. Narrated by 'Abdallah ibn Hanzalah‖,‖: The Prophet (pbuh), said: "A dirham of riba which a man receives
knowingly is worse than committing adultery thirty-six times" (narrated in Musnad-e-Ahmed and Ad-
Daruqutni). Bayhaqi has also reported the above hadith in Shu'ab al-iman with the addition that "Hell befits
him whose flesh has been nourished by the unlawful."

4. Narrated by Abu Hurayrah, The Prophet (pbuh) said: "On the night of Ascension, I came upon people whose
stomachs were like houses with snakes visible from the outside. I asked Gabriel who they were. He replied
that they were people who had received riba/interest."

5. Narrated by Abu Hurayrah, The Prophet (pbuh) said: "Riba has seventy segments, the least serious being
equivalent to a man committing adultery with his own mother." (Meezan Bank’s Guide to Islamic Banking)

6. Narrated by Abu Hurayrah The Prophet (pbuh) said: "There will certainly come a time for mankind when
everyone will take riba and if he does not do so, its dust will reach him."

7. Narrated by Abu Hurayrah The Prophet (pbuh) said: "Allah would be justified in not allowing four persons to
enter paradise or to taste its blessings: he who drinks habitually, he who takes riba, he who usurps an
orphan's property without right, and he who is undutiful to his parents."

B. Riba an Nasiyah

1. Narrated by Usamah ibn Zayd The Prophet (pbuh) said: "There is no riba except in Nasiyah [Deferment]." In
another narration: "There is no riba in hand-to-hand [spot] transactions."

2. Narrated by Abdullah Ibn Mas'ud The Prophet (pbuh) said: "Even when interest is much, it is bound to end up
into paltriness."

3. Narrated by Anas ibn Malik The Prophet (pbuh) said: "When one of you grants a loan and the borrower offers
him a dish, he should not accept it; and if the borrower offers a ride on an animal, he should not ride, unless
the two of them have been previously accustomed to exchanging such favours mutually."

4. Narrated by Anas ibn Malik The Prophet (pbuh) said: "If a man extends a loan to someone, he should not
accept a gift."

5. From Abu Burdah ibn Abi Musa came to Madinah and met 'Abdallah ibn Salam who said, "You live in a
country where riba is rampant; hence if anyone owes you something and presents you with a load of hay, or
a load of barley, or a rope of straw, do not accept it for it is riba."

6. Fadalah ibn 'Ubayd said that "The benefit derived from any loan is one of the different aspects of riba." This
hadith is mawquf implying that it is not necessarily from the Holy Prophet; it could be an explanation
provided by Fadalah himself, a companion of the Prophet.

C. Riba al-FadI

1. The Prophet (pbuh) said, "Sell gold in exchange of equivalent gold, sell silver in exchange of equivalent
silver, sell dates in exchange of equivalent dates, sell wheat in exchange of equivalent wheat, sell salt in
exchange of equivalent salt, sell barley in exchange of equivalent barley, but if a person transacts in excess,
it will be usury (riba). However, sell gold for silver anyway you please on the condition it is hand-to-hand
(spot) and sell barley for date anyway you please on the condition it is hand-to-hand (spot)."

2. From 'Ubada ibn al-Samit The Prophet (pbuh) said: "Gold for gold, silver for silver, wheat for wheat, barley
for barley, dates for dates, and salt for salt - like for like, equal for equal, and hand-to-hand; if the
commodities differ, then you may sell as you wish, provided that the exchange is hand-to-hand."
3. Narrated by Abu Sa'id al-Khudri, The Prophet (pbuh) said: "Gold for gold, silver for silver, wheat for wheat,
barley for barley, dates for dates, and salt for salt - like for like, and hand-to-hand. Whoever pays more or
takes more has indulged in riba. The taker and the giver are alike [in guilt]."

4. Narrated by Abu Sa'id and Abu Hurayrah, A man employed by the Prophet (pbuh) in Khayber brought for
him ―Janeeb‖ [dates of very fine quality]. The Prophet asked him, "Are all the dates of Khayber like that?"
The man replied, "No, I swear Allah, O Prophet of Allah, we exchange one sa' [a unit of measurement] of
this kind of dates for two or three [of the other kind of dates]". The Prophet replied, "Do not do so. Sell all
the dates (no matter they are of fine quality or not) for darahim and then use the darahim to buy janeeb.‖ The
Prophet (pbuh) then said that ―the ruling of the things that are exchanged by weight is same as that.‖

5. Narrated by Abu Sa'id ‖: Bilal brought to the Prophet (pbuh) some ―Barni‖ [good quality] dates whereupon
the Prophet (pbuh) asked him where these were from. Bilal replied, "I had some inferior dates which I
exchanged for these - two sa's for a sa'." The Prophet (pbuh) said, "Oh no, this is exactly riba. Do not do so,
but when you wish to buy, sell the inferior dates against something [cash] and then buy the better dates with
the price you receive."

6. Narrated by Fadalah ibn 'Ubayd al-Ansari ‖: On the day of Khayber I bought a necklace of gold and pearls for
twelve dinars. On separating the two, I found that the gold itself was equal to more than twelve dinars. So I
mentioned this to the Prophet (pbuh) who replied, "It [jewellery] must not be sold until the contents have
been valued separately."

7. Narrated by Abu Umamah : The Prophet (pbuh) said: "Whoever makes a recommendation for his brother and
accepts a gift offered by him has entered in one of the largest gates of riba."

8. Narrated by Anas ibn Malik : The Prophet (pbuh) said: "Deceiving a mustarsal [an unknowing entrant into
the market] is riba."

9. Narrated by 'Abdallah ibn Abi Awfa : The Prophet (pbuh) said: "A najish [one who serves as an agent to bid
up the price in an auction] is a taker of riba, a treacherous."

Currency notes were introduced by the USA sometime in 1930s. Before that, people used coins – such as
Dinner and Dirham. Still earlier, people used goods or commodities to exchange. For example, grain
for grain. It was done through an agreement between the parties.

Lending or investment was done between the parties through direct interactions. There was no bank or
intermediaries and no credit instruments in the money market. Government was not a party.

Today, there are many credit instruments, many banks, etc. Business and government are biggest
borrowers. Individuals are also borrowers and lenders. So time values of money come in force.

Interest rate and Time value of money

You like it or not, today, everyone is directly or indirectly exposed to or affected by interest transactions
regularly. Interest represents the earning/sucking power of money. A borrower pays interest charges
for the opportunity to do something now that otherwise would have to be delayed or never done.

Interest rate (also called discount rate) is the extra money charges per unit period (usually one year). It is
expressed in percentage.

Ex. 10% interest rate, means 10/100 = 0.10 per annum. Rates payable monthly could be 0.00833,
payable quarterly 0.025, or semiannually 0.05.
 Ex. A tk100,000 loan at 8.5% interest for 4 repayment periods

Repayment Monthly payment, tk Total interest, tk

periods
15 984.51 77,210
20 867.57 108,217
25 804.96 141,485
30 768.63 176,707

A tk100,000 loan for 30 years at 4 interest rates

Interest rate, % Monthly payment, Total interest, tk

tk
7.5 699.21 151,722
8.5 768.63 176,707
9.5 841.15 202,806
10.0 877.28 215,812

Equivalence and repayment plan: Value of certain amount of money at different points of time. It
depends on interest rate. It could be future or past amount/worth of certain present worth/money.

Ex. Tk. 113 at present is equivalent of Tk100 of the last year at the rate of 13% interest; or Tk. 87 one
year before.

According to Shariah compliance it is purchasing ability of certain good in different times.

Ex. Suppose purchasing ability of Tk100 last year is equivalent to Tk110 this year.

Illustration by a Figure.

Types of interest and relevant calculations

Gross and net interests.

Net Interest is the earnings of capital simply or the reward of waiting simply.
Thus, Net Interest = Gross Interest – (payment for risk + payment for inconvenience + cost of administering
credit)

i.e., Net Interest = Net Payment for the use of capital.

Can interest be
negative? No. Either no interest or interest.
Ex. Dishari company invested tk500,000 on July 1 and on June 30th of the next year withdrew tk.
560,000. Compute

i. The interest/profit gain, and

ii. The interest/profit rate on the investment.
iii. If Dishari borrowed tk100,000 now and paid back tk95,000 after one year. Calculate both of
them. Comment.

Ex. Dishari plans to borrow tk100,000 from a scheduled bank for 1 year at the rate 13% interest for
buying some equipment. Compute the interest and the total amount due after 1 year. Construct a
graph which shows the numbers that would be used to compute the loan interest rate at 13% per
annum.

Other way, two types of interest:

1. Simple interest
2. Compound interest

Simple interest calculation: it is simple. The amount of interest charges (I) is directly proportional to
the original/principal/capital (P) amount loaned at a certain rate, i, for certain periods, n.

So (total) interest charges is:

Future sum of money at the end of period n is

There is ordinary simple interest where the year is divided into 12 30-day periods or 360 days and exact
simple interest, a year has precisely the calendar number of days, and n is the fraction of the number of
days the loan is in effect that year.

Ex. Tk50,000 was borrowed from a lending organization for 6 months at the interest rate of 10%. How
much must be paid at the end of the period if the ordinary simple interest concept is applied? If we exact
simple interest for Jan and Feb in a nonleap year, what would be the future sum?

Illustration by a Figure.

Compound interest includes charges for the accumulated interest as well as the amount of unpaid
principal.

A nominal interest rate r of 8% compounded quarterly, e.g., indicates an interest charge of 2% per
quarter compounded 4 times per year, Suppose, m is the number of compounding periods per year,
we will see that the equivalent effective interest rate, or actual annual interest earned or paid, ieff (per
year) from a nominal rate is

( )

Continuous interest rate, when m approaches to infinity. Its equivalent effective rate is
 , where e = 2.71828

Present worth and future equivalence

Compound amount at the end of 2nd period is:

Compound amount at the end of n periods is:

Ex. Future value of tk1,000 loan when interest is due on both the principal and unpaid interest
(compound interest case) at the rate of 10%.

Year Amount owned at Interest on amount Amount owned at

the beginning of year owned the end of year
(1) (2) (3) = (2)i (4) = (2) + (3)
1 Tk1,000 Tk100 Tk1,100
2 Tk1,100 ? ?
3
Figure: simple versus compound interest for 3 periods

Nominal (compound) interest rates

If interest rate is compounded several times per year: monthly, quarterly, etc.

Ex. 2% per quarter is quoted as 8% compounded quarterly. This 8% is called nominal annual interest
rate. For tk1,000, future values compounded quarterly are as follows:

F3 month = P + Pi = 1,000 + 1000 (0.02) = 1020

F6 month = 1020 + 1020 (0.02)

F9 month =

F12 month =

F12 month at 8% = 1000 + 1000 (0.08) = 1080

Effective annual interest rate examples

Ex. A Shsriah compliant bank

Equivalence

Ex. Three plans for repayment of tk1,000 in four years with interest at 10% per year.

Yr Amount owed at Interest Total owed Principal Total end-of-

 (1) the beginning of accrued for at the end payment (5) yr payment
yr (2) yr (3) = of yr (4) = (cash flow) (6)
(2)x10% (2) + (3) = (3)+(5)
Plan 1: At end of each year pay tk250 principal plus interest due
1 1,000 100 1,100 250 350
2 750 75 825 250 325
3 500 50 550 250 300
4 250 25 275 250 275
Total 2,500 -yr Total 250 Total 1,000 Total amount
repaid 1,250
Plan 2: Pay interest due at end of each year and principal at the end of four years
1 1,000 100 1,100 0 100
2 1,000 100 1,100 0 100
3 1,000 100 1,100 0 100
4 1,000 100 1,100 1,000 1,100
Total 4,000 -yr Total 250 Total 1,000 Total amount
repaid 1,400
Plan 3: Pay principal and interest in one payment at end of four years
1 1,000 100 1,100 0 0
2 1,100 110 1,210 0 0
3 1,210 121 1,331 0 0
4 1,331

Other symbols:

T/t = time stated in periods – years, months, days.

i = an interest or an effective interest rate per interest period

n = number of compounding/interest periods

P = present sum of money; equivalent value of one or more cash flows at a reference point of time at
present.

F = future sum of money; equivalent value of one or more cash flows at a reference point of time in
future

A = annual worth or equivalent value per period (say Tk per year or per month). A uniform amount for a
given interest rate.

G = arithmetic gradient in a cash flow series.

Rate of return and Minimum Attractive Rate of Return (MARR)

MARR by a Figure.
Opportunity cost is the opportunity to make an additional return that must be forgone.

Capital investment.

Cash Flows: Estimation and diagram

Cash inflows or receipts: samples

 Revenues
 Operating cost reduction
 Asset salvage value
 Receipt of loan principal
 Income-tax savings
 Receipts from stock and bond sales
 Construction and facility cost savings
 Savings or return of corporate capital funds

Cash outflows or disbursements: examples

 First cost of asset + installation and delivery

 Operating cost
 Periodic maintenance and rebuild costs
 Loan interest and principal payments
 Major, expected upgrade costs
 Income taxes
 Bond dividends and bond payment
 Expenditure of corporate capital funds.

End-of-period convention = at the end of interest period convention.

Cash flow diagrams (single sums):

= single-payment compound amount factor

= single-payment present-worth factor.

Ex. Before evaluating the economic merits of a proposed investment, the XYZ corporation insists
that its engineers develop a cash flow diagram of the proposal. An investment of Tk10,000 can
be made that will produce uniform annual revenue of 5,310 for five years and then have a market
(recovery) value of tk2,000 at the end of year five. Annual expenses will be tk3,000 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/investor’s viewpoint.

Ex. Tabular form. Two alternatives. (either) One of them must be implemented. Eight years lifetime.

Items Alternative A Alternative B

Equipment, labor and materials to upgrade Tk18,000 Tk60,000
Annual cost of electricity Tk32,000 9,000
Annual maintenance expenses 2,400 16,000
Replacement of a major component 4 years - 9,400
hence
Estimated market value at the end of 8 years 2,000 8,000
i. Use a cash flow table and end-of-year convention to tabulate the net cash flows for both
alternatives.
ii. Determine the annual net cash flow difference between alternatives (B - A).
iii. Compute the sum of differences, B – A, from years zero through eight.

End-of-yr Alternative A net Alternative B net Difference Cumulative

cash flow cash flow B–A difference
0
1
2
3
4
5
6
7
8
Total

Interest Formulas Relating present and future values of single cash flows

If need to find unknown interest rate or RoR:

Ex. A present investment of tk50,000 is expected to become tk77,000 after 5 years. Find its RoR.
 Rule of 72: Estimating doubling time and interest rate

It is for a single cash flow to double in size for compound interest system. Empirical formula:

Rate of return, % per Doubling time, years

year Rule of 72 estimate Actual years
1 72 70
2 36 35.3
5 14.4 14.3
10 7.2 7.5
20 3.6 3.9
40 1.8 2.0

 Finding F when P is given

 Finding P when F is given

Borrowing terminology – a firm borrows tk500,000 for 8 yrs at 10% interest. What is to be
found?

Lending terminology – a firm wishes to have 1 million …. What is to be found?

Interest formulas relating a uniform series (annuity) to its present and future equivalent values

 Finding F when A is known

Say A is invested at-the-end of each year for n years.
1st yr money will become . 2nd yr money . So on.
So,
∑
And ∑ . By subtraction .
* +. So is termed as the uniform series compound amount
factor.
In geo seq, sum of first n terms * +
 Finding P when A is known – uniform series … factor
 Finding A when F is known – sinking fund factor
 Finding A when P is known – capital recovery factor

Ex. Suppose you make 15 equal deposits of $1,000 each into a bank account paying 5% interest per year.
The first deposit will be made one year from today. How much money can be withdrawn from this
bank account immediately after the 15th deposit? Draw a cash flow diagram.

Example: Calculating the Amount of an Ordinary Annuity

If at the end of each month, a saver deposited $100 into a savings account that paid 6%
compounded monthly, how much would he have at the end of 10 years?

A = $100
r = 6% per year compounded monthly, which = .5% interest per month = .005
n = the number of compounding time periods = 120 in 10 years.
Substituting these values into the equation for the future value of an ordinary annuity:
100 * ((1+.005)1 2 0 -1)/.005 = $16,387.93

Example: Calculating the Amount of an Annuity Due

If the saver deposited the money at the beginning of the month instead of the end, then there will
be an additional amount of money = A(1 + r)n - A = 100(1.005)1 2 0 -100 = $81.94, which is the
difference in this example between an annuity due and an ordinary annuity.

Example: Calculating the Annuity Payment, or the Periodic Rent

A 20 year old wants to retire as a millionaire by the time she turns 70. (With life spans increasing,
and the social security fund being depleted by baby boomers, the retirement age will have
invariably risen by the time she reaches 65 years of age, probably to something even higher than
70, actually.) How much will she have to save at the end of each month if she can earn 5%
compounded annually, tax-free, to have $1,000,000 by the time she is 70?

Solution: Note that the equation for the future value of an annuity consists of 3 independent
variables, and 1 dependent variable. In other words, if we know the value of 3 of the variables,
then we can determine the remaining variable.

Since r = 5% = .05, and n = 50, the interest factor (1 + r)n - 1)/r = (1.055 0 -
1)/.05 = 209.35, rounded to 2 decimal places. To find A, we divide both sides of the equation for
the future value of an annuity by this interest factor, which
yields 1,000,000/209.35 = $4,776.69. So she would have to save $4,776.69 dollars per year,
or $398.06 per month, to have $1,000,000 in 50 years — assuming, of course, that she could
save it tax-free!

Of course, using the formula for the present value of a dollar, we find that in 50 years,
assuming 3% inflation, $1,000,000 will be worth about 1,000,000/1.035 0 = $228,107.08!
Ouch!

Since the current limit for IRA contributions is $2,000 per year for a young person, how much
will this earn after 50 years, assuming that the $2,000 is deposited at the end of the
year? FVOA = 2,000 * (1.055 0 - 1)/.05 = $418,695.99.

What's that in today's dollars, assuming 3% inflation? 418,695.99/1.035 0 = $95,507.52!

Clearly, the IRA contribution limits must be raised substantially. Of course, you can save all the
money at the beginning of each year instead of at the end, and this annuity due will yield an
extra (using the Annuity Difference Formula above) 2,000 * 1.055 0 -
2,000 = $20,934.80 which, in today's dollars, again assuming a 3% inflation rate,
= $20,934.80/1.035 0 = $4,775.38 more money in today's dollars over the ordinary annuity, but
clearly, you'll still be eating dog food when you retire with this amount of cash, unless you are
planning to die early! With the limitations on IRAs, stocks are the only viable choice for
investments that could possibly yield anything decent to retire on!

The present value of an annuity (PVA) is the sum of the present value of each
annuity payment. Since the present value of a lump sum payment is simply the
future value of that payment divided by the interest factor (1 + r)n , the present value
of an annuity is the sum of the present value of each of those payments:

Present Value of an Annuity (PVA-∑ notation)

 n
A
PVA =
∑ (1 + i)k
k=1
PVA = Present Value of Annuity Amount
A = annuity payment
i = interest rate per time period
n = number of time periods

The sum of this geometric progression can be simplified to:

Present Value of an
Annuity (PVA) Formula

1
1-

PVA = A × (1 + r)n

Example: Calculating the Present Value of an Annuity

You win a $1,000,000 lottery, which is paid in annual installments of $50,000 over 20 years.
How much did you really win, assuming that you could earn 5% interest, compounded
annually?

Solution: Since you are not receiving the full $1,000,000 payment right away, but in the form of
an annuity, its actual worth is much less.
Present Value of Annuity = 50,000 * (1 - (1 + .05)- 2 0 )/.05 = $623,110.52

Example: How Much of a Loan Can you afford?

You want to get a mortgage, but can only afford to pay $1,000 per month. How much can you
borrow, if the interest rate is 5% annually for a 30 year mortgage?

Solution: The monthly payments constitute an annuity, whose present value is the amount of the
loan.
Loan Amount = 1,000 * (1 - (1 + .004166667)- 3 6 0 )/.004166667 = $186,281.62

r = the monthly interest rate = .05/12 = .004166667.

n = the number of months in 30 years = 12 × 30 = 360.

Math Reminder: y- x = 1/yx .

Example: Calculating Monthly Mortgage payments

You want to borrow $200,000 to buy a house. What are the monthly mortgage payments if the
interest rate is 6% for 30 years?
Solution: In the above example, we asked how much one would have to save per month or per
year to have $1,000,000 in 50 years. In other words, what periodic payments would we have to
make to have a future value of $1,000,000? Here, we take out a loan, and thus, we already have
the money, whose present value, or discounted value, is equal to the amount of the loan. The
monthly payment would be the annuity payment, A. Thus, we use the equation for the present
value, because the present value is already known, and what we need to know is how much the
payments will be if the length of the loan is 30 years, and the interest rate is 6% annually.

Because we know 3 of the 4 variables, but not A, the monthly payment, we solve for A by
dividing both sides of the present value of annuity equation by the factor (1 - (1 + r)- n )/r, but note
that to divide by a fraction is the same as multiplying the numerator by the inverse of the
fraction, and so, we can simplify further:

Present Value Annuity Payment Formula

PV
r
A = 1 - (1 + r) -n = PV ×
1 - (1 + r)- n
r

Formula for the monthly payment of a loan.

A = monthly payment, or annuity payment.
PV = present value, or the amount of the loan.
r = interest rate per time period.
n = number of time periods.

Present Value Annuity Payment Example

.005
$1,199.10
A = 200,000 × =
per month
1 - (1 + .005)- 3 6 0

The interest rate for each month = .06/12 =.005

The number of months in 30 years = 12 × 30 = 360.

Calculating the Interest rate

We end our discussion on annuities by noting that r cannot be solved algebraically in

the formula for the present value of annuities, so, even if we know the annuity
payment, the number of time periods, and the present value, we can only estimate r.
It is possible to estimate r either by plugging in values with guesses, by looking it up
in special tables that plot r against the annuity payment A, or by using a graphing
calculator, and graphing the value of the annuity payment as a function of interest
for a given present value. In the latter case, the interest rate is where the line
representing the rate of interest intersects the line for the annuity payment.
Summary of interest factor relationships
 ∑

Interest formulas for discrete compounding and discrete cash flows

Table: Discrete compound interest factors and symbols

To find Given Factor by which Factor name Factor functional

to multiply the symbol
―Given‖
For single cash flows
F P Single-payment
compound
amount factor.
Single payment
present-worth.
P F
For uniform series (annuities)
F A Uniform series
compound
amount.

Uniform series
P A present worth.
Sinking fund.

Capital recovery.
A F

A P

Deferred Annuities (uniform series)

Ordinary annuities – for uniform series first cash is made at the end of first period.

Deferred annuity – if the cash flow does NOT begin until some later date. First payment is made at the
end of (j = 1) period (all periods are equal in length).

Ex. A company plans to withdraw tk50,000 on each of 18th, 19th, 20th, and 21st periods. Calculate P17 and
P0. Interest rate is 7%. What about F21, and F24?
Equivalence calculations involving multiple interest formulas

Ex. See the table below: expected maintenance costs for a certain generator.

Period 0 1 2 3 4 5 6 7 8
Yr-end cash 100 200 500 400 400 400 400 400
outflow
Find (i) present equivalent expenditure, (ii) future equivalent expenditure, (iii) annual equivalent
expenditure. Take annual interest rate 7%. Draw the cash flow diagram in each case and use the
interest table and abbreviated relationships.

Ex. Two friends are going to make some investment. They wish to know the number of periods until
their future equivalent values of both savings plans are equal. The following table shows the relevant
data. Interest rate is 7%.

Pd 21 22 23 … 35 36 37 38 … 64 65
Savings 500 500 500 500
nd
2 friend

Pd 21 22 23 … 32 33 34 35 36 … 64 65
Savings 2000 2000 2000 2000 2000 2000 2000
Determine n.

Interest formulas relating a uniform gradient of cash flows to its annual and present equivalents.
Ex. Equipment maintenance problem.

End of period Cash flows

1 0
2 G
3 2G
. .
. .
. .
n–1 (n – 2)G
n (n – 1)G

Cash flow diagram (in the class)

 Finding F when given G

 Finding A when given G
  Finding P when given G
 Computations using G
[ ]

Interest formulas relating to geometric sequence of cash flows to its present and annual equivalents

[ ] [ ]

= gradient to uniform series conversion factor.

Finding P when given G

( ) [ ][ ]

= , * +-= ( )

[( ) ( )]

( ) gradient to present equivalent conversion factor

Ex. Suppose i = 10% per period.

n 0 1 2 3 4 5 6 7 8
Amount 0 100 106 112 118 124 130 136 142

Can be

n 0 1 2 3 4 5 6 7 8
Constant 0 100 100 100 100 100 100 100 100
amount
Gradient 0 0 6 12 18 24 30 36 42
amount
[ ]

Ex.

End of yr 1 2 3 4
Cash flows -5,000k -6,000k -7,000k -8,000k
Find P0worth at i = 7%. Use arithmetic gradient interest formulas.

(three cash flow diagrams)

Then find annual equivalent of the original cash flows.

BUT ALLAH IS YOUR PROTECTOR, AND HE IS THE
BEST OF HELPERS (Ale-Imran 3:150)
Interest rates that vary with time
Ex. Suppose you decided to borrow $1,000 now and another
$1,000 two years hence. You have to repay all money at the
end of 4 years. Projected interest rates in years 1, 2, 3, and 4
are 7%, 10%, 12 % and 14%, respectively. How much as a
lump-sum amount you must pay at the end of four years?
Future value by using the basic formula. For present
equivalent

Interest problems with compounding more often than once per year
 Single amounts – say nominal interest rate is quoted and no.
compounding periods per year and no. of years are known, any problem
involving future, annual, or present equivalent values – easy calculation.
Ex. 100,000 amount is invested for 10 years at a nominal interest are of 6%
compounding quarterly. What is F10?
Total compounding periods = 4 x 10 = 40
Interest rate per interest period is = 6%/4 = 1.5%
Then find F10 = 100,000(1.015)40= 181,400
Alternatively: find effective interest rate. Then F10

( ) ( )
 ( )

 Uniform series and gradient series

Ex. One has a bank loan for $10,000, which is to be repaid in equal end-of-
month installments for 5 years with a nominal interest rate of 12%
compounding monthly. What is the amount of each payment?
Solution:
( )

Interest problems with cash flows less often than compounding periods
Suppose effective interest rate per interest period is i and there is a uniform
cash flow, X, at the end of each kth interest period (k > 1). Its equivalent A
at the end of each interest period is

( )

Suppose effective interest rate per interest period is i and there is a uniform
cash flow, X, at the beginning of each kth interest period (k > 1). Its
equivalent A at the end of each interest period is

( )

Ex. Say $X is deposited at the beginning of three consecutive periods from

now. Express the formula into their annual equivalent value over three end-
of-year (EoY) periods.
Interest formulas for continuous compounding and continuous cash flows
Infinite number of short periods and series of cash flows – continuous. A,
shop, a bank, etc. Interest is compounded daily. Say, nominal interest rate
per year is r and there are p payments per year (that amount a total of one
unit per year). Then apply

[ ]

[ ] [ ]
{ } { }
[ ] [ ]

Now, if p tends to infinity, [ ] becomes

So, continuous compounding present equivalent factor

(continuous, uniform cash flow over one period), becomes
̄ , where ̄ is the amount uniformly and
continuously over one period/year.
For flowing each year over n years (continuous compounding
present equivalent factor),

In terms of future amount

̄ [ ] [ ]

Continuous compounding compound amount factor

(continuous, uniform cash flow over one year) is

̄ [ ]

For n years
 ̄ [ ]
To find Given Factor by which to Factor name Factor
multiply the ―Given‖ functional
symbol
F ̄ Continuous compounding ̄
compound amount
(continuous, uniform cash
flows).

P ̄ Continuous compounding ̄
present equivalent
(continuous, uniform cash
flows).

̄ F Continuous compounding ̄
sinking-fund (continuous,
uniform cash flows).

̄ P Continuous compounding ̄
capital recovery
(continuous, uniform cash
flows).

Ex.

Ex.

Exercise: Problems to be solved

1. Suppose that you are working in a manufacturing firm that produces several different electronic
consumer products. State five nonmonetary factors (attributes) that may be important when a significant
change is considered in the design of the current best-selling product.
2. Describe the outcomes that could be expected from a feasible alternative. What are the differences
between potential alternatives and feasible alternatives?
3. Assume that you are a newly married student. What are some alternatives that you might consider for the
provision of family housing while you are a student of IUT? Discuss the problem of choice among these
alternatives with reference to the concepts learnt through this course.
4. Do some brain exercise! A friend of yours bought an apartment building for $100,000 in a town. He
paid $10,000 of his own money for it and obtained a mortgage from a local bank for the remaining
$90,000. The annual mortgage payment to the bank is $10,500. Your friend also expects that annual
maintenance on the building and grounds will be $15,000. There are four apartments (each of equal size)
in the building that each can be rented for $360 per month.
5. Suppose you have planned to start a small business in your area of interest. You have borrowed
tk100,000 (principal amount) for initial investment from a bank for 10 years at the rate 9% interest. This
course has opened your eyes to consider several plans to make the repayment. These are:
A. No partial payment of principal; only interest is paid each year, and the principal is paid in a lump
sum at the end of the period.
B. It involves systematic reduction of the principal of the loan by uniform repayment of principal with
diminishing interest.
C. This plan involves systematic reduction of the principal of the loan by a scheme that makes the
sum of interest payments and the principal payment.
D. This plan involves no payment of either principal or interest until the single payment of both at the
end of the tenth year.

Show the cash-flow diagram for each plan. Complete the following table for each plan.

End Interest Total money owned Year-end Money owned

o due before year-end paymen after year-
f payment t end
payment
y
e
a
r
0
1
2
3
4
5
6
7
8
9
10
6. In case of the following exercises, use the formulas as well of compound interest factors’ Tables. a) If
tk100,000 is invested at 7% compound interest on Jan 1, 2016, how much will be accumulated by Jan 1,
2020? Show the cash-flow diagram?
b) How much would you have to invest at the same interest on Jan 1, 2016, in order to accumulate the
same amount as found 6a) on Jan 1, 2020? Show the cash-flow diagram?
c) What is the present worth on Jan 1, 2015 of tk120,000 on Jan 1, 2022 , if interest is at 6%.? Show the
cash-flow diagram.
d) If tk120,000 is invested at 6% on Jan, 2015, what equal year-end withdrawals can be made each year
for 10 years to have nothing in the fund after the 10th withdrawal? Show the cash-flow diagram.
e) How much will be accumulated in a fund, earning 5% interest, at the end of 10 years if tk7,500 is
deposited at the end of each year for 10 years, say beginning 2015? Show the cash-flow diagram.
f) How much must be deposited at 5% each year for 7 years beginning on Jan 1, 2016 in order to
accumulate tk120,000 on the date of the last deposit? Show the cash-flow diagram.
g) How much would you need to deposit at 5.5% on Jan 1, 2016, in order to draw out tk 7,500 at the end
of each year for 7 years, leaving nothing in the fund at the end? Show the cash-flow diagram.
7. In case of the following exercises, use the compound interest factors’ Tables.
a) If tk500,000 is invested now, tk300,000 2 years hence, and tk 200,000 y years hence, all at 8%,
what will the total amount be 10 years hence? Show the cash-flow diagram.
b) What is the compound amount of tk200,000 for 10 years plus tk150,000 for 8 years plus
tk100,000 for 6 years with interest at 8%?
 c) What must be the prospective saving 10 years hence in order to justify spending tk 200,000 now,
tk150,000 in 2 years, and tk100,000 in 4 years, if money is worth 8%?
d) What is the compound amount of tk100,000 for 64 years with interest at 6%? (Hint: if 64 years
compound amount factor is not available in a table, it would be the product of respective factors
for 60 years and 4 years. F  P( F / P,6%,60)(F / P,6%,4)
8. a) How much invested now at 5% would be just sufficient to provide tk100,000 5 years hence, tk
100,000 10 years hence, tk100,000 15 years hence and tk 100,000 20 years hence?
b) What payment is acceptable in place of prospective payments of tk100,000 at the end of 5, 10, 15, and
20 years, if interest is at 5%? Or, how much is justifiable to spend now in order to save prospective
expenditures of tk100,000 at the end of 5, 10, 15, and 20 years if money is worth 5%?

9. In how many years will an investment of tk100,000 now increase to double with interest rate of 7%?
Or, within how many years must a prospective expenditure of tk200,000 be required in order to
justify spending tk100,000 now to prevent it, if money is worth 7%?

10. A savings certificate costing tk8,000 now will pay tk10,000 in 5 years. What is the interest rate? Or,
at what interest rate will tk8,000 accumulate to tk10,000 in 5 years? Or, spending tk8,000 now to
avoid spending tk10,000 5 years hence is, in effect, securing what interest rate?

11. A present investment of tk500,000 is expected to yield receipts of tk70,000 a year for 15 years. What
is the appropriate rate of return that will be obtained on this investment? (Hint: apply linear
interpolation if necessary).

12. How much can one afford to spend each year for 15 years to avoid spending tk100,000 at zero date,
at 150,000 after 5 years, and tk200,000 after 10 years, if money is worth 8%? Or, what is the
equivalent annual cost for 15 years of disbursements of tk100,000 at once, tk150,000 5 years hence,
and tk200,000 10 years hence if interest is at 8%?

13. What amount must be deposited at the beginning of each year for the next 20 years in a savings fund
that earns 6% interest in order to accumulate tk200,000 at the end of 20 years?

14. A piece of electrical equipment will cost tk60,000 new and will have an expected life of 6 years, with
no salvage value at the end of its life. The disbursements for taxes, insurance, maintenance, fuels,
and lubricants are estimated to be tk15,000 for the first year, tk17,000 the second, tk19,000 the third,
and to continue to increase by tk2,000 each year thereafter. What is the lifetime equivalent uniform
annual cost of this piece of equipment if the rate of interest is 8%? What is the present worth at 8%
of the disbursements described above?

15. Tk100,000 compounded monthly at the rate 1% per month. The same amount is compounded
annually at 12% per annum. Calculate the amounts owed at the end of the year under both plans.
Then find the nominal interest rate and effective interest rate? Which one is greater and why? If the
nominal rate is 24% compounded monthly, what would be effective rate? How it is different from
the nominal rate 12% compounded monthly?

Solution: F  P1  imonth n  100,000(1.01)12  100,000( F / P,1%,12)

F  P1  i   100,000(1.12)1  100,000( F / P,11%,1)

n

16. Tk100,000 invested today is expected to be tk150,000 in 3 years. What is the annual growth rate?

17. In some cases interest is compounded continuously. Then the compound amount F of a present value
mn
 r
P is expressed as F  P1   , where r is the nominal interest rate with m compounding periods a
 m
 rn
m  1  1  k 
rkn

year. Now if r  k or m  rk , then F  P 1  

 P 1    . Now, as the number of
 k  k  
compounding periods per year, m, increases infinitely (too many) (so is the k). then limiting value of
F is Pe , i.e., F  Pe  p( factor). So, with continuous compounding, the single payment
rn rn

compound factor is e rn . So, the single payment present worth factor is e  rn . e  2.71828.

From the basic formula, e rn  (1  i) n , where i is the effective annual rate. So, nominal rate r  ln(1  i ) .

For tk100,000 to be realized in 5 years under continuous compounding at the nominal interest rate of
10%, what should be the present investment? Find the effective interest rate.

Solution: r  ln(1  i ) or 0.10  ln(1  i ) , Then find i.

F  Pe rn  P( factor).

1.