Prof. Dr. Zulfiqar Hasan
An important concept in finance is time value of money which means that cash received at different times has different values. A dollar today is worth more than the same dollar tomorrow.
Time value of money refers to the fact that the same money return has a higher present value if it is to be received early that it is to be received later.
Time value of money means that the value of a sum of money received today is more than its value received after some time. Conversely, the sum of money received in future is less valuable in the future.
Application of Time Value of Money
- TVM helps to analyze the future investments decisions
- It helps to calculate the future values
- It helps to determine the periodic payments
- Most financial decisions involve costs and benefits that are spread out over time.
- Time value of money allows comparison of cash flows from different periods.
- Banks can use TVM to determine the payments of DPS
- Banks can also use it to determine the rate of interest.
- Borrower can make decisions to identify the sources of financing.
Future value (FV) is the amount an investment is worth after one or more periods.
Present value (PV) is the current value of future cash flows of an investment.
Simple interest refers to interest earned only on the original capital investment amount.
Compound interest refers to interest earned on both the initial capital investment and on the interest reinvested from prior periods.
Compounding is the process of finding FV
Discounting is the process of finding PV
The nominal interest rate (NIR) is the interest rate expressed in terms of the interest payment made each period.
The effective annual interest rate (EAR) is the interest rate expressed as if it was compounded once per year. The effective annual interest rate is the interest rate that is actually earned or paid on an investment, loan or other financial product due to the result of compounding over a given time period. It is also called the effective interest rate, the effective rate or the annual equivalent rate.
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 is called time line.
Profit vs Interest
Profit: Profit is the positive gain from an investment or business operation after subtracting for all expenses. It is opposite of loss. There are some differences between interest and profit. Islam always supports profit form doing business and trade. Interest is strictly prohibited in Islam.
Profit is related to buying or selling of goods. That is, it is related to the business (Trading). But Interest is related to debt and time.
Profit is the integrated investment of capital, labor and time of the Investors or producers. On the other hand, in case of interest, the lender doesn’t need to invest his labor.
Profit is undefined and uncertain. In contrast, Interest is predefined and certain.
Profit is earned in once only. But Interest may be taken several times.
In case of Profit, there is a risk of loss. But, in case of interest, there is no uncertainty of loss.
Interest is a psychological pressure to the investment. But profit is the tonic of satisfaction and freedom for the investor.
