Financial Market

Present Value of Money

Mr. Raman receives the following series of money at the end of each year. What is the present value?
End of year Amount in ₹
1 1000
2 2000 Interest Rate 10% p.a.
3 3000
4 4000
5 5000

Interest Rate or Discount Rate or Hurdle Rate or Opportunity Cost of Funds!!!

1000 2000 3000 4000 5000

0 1 4
2 3 5
P𝑽 = 𝟏𝟎𝟎𝟎 ∗ 𝟎. 𝟗𝟎𝟗 + 𝟐𝟎𝟎𝟎 ∗ 𝟎. 𝟖𝟐𝟔 + 𝟑𝟎𝟎𝟎 ∗ 𝟎. 𝟕𝟓𝟏 + 𝟒𝟎𝟎𝟎 ∗ 𝟎. 𝟔𝟖𝟑 + 𝟓𝟎𝟎𝟎 ∗ 𝟎. 𝟔𝟐𝟏 = 𝟏𝟎, 𝟔𝟓𝟏

A case of Different Cash Flows in different Periods!

Present Value of Money
What if Mr. Raman receives the following series of money at the end of each year. Present value?
Hurdle rate 10% pa.

End of year Amount in ₹

1 1000
2 1000 ANNUITY
3 1000
4 1000
5 1000

P𝑽 = 𝟏𝟎𝟎𝟎 ∗ 𝟎. 𝟗𝟎𝟗 + 𝟏𝟎𝟎𝟎 ∗ 𝟎. 𝟖𝟐𝟔 + 𝟏𝟎𝟎𝟎 ∗ 𝟎. 𝟕𝟓𝟏 + 𝟏𝟎𝟎𝟎 ∗ 𝟎. 𝟔𝟖𝟑 + 𝟏𝟎𝟎𝟎 ∗ 𝟎. 𝟔𝟐𝟏 = 𝟑, 𝟕𝟗𝟎

𝑷𝑽 = 𝟏𝟎𝟎𝟎 ∗ 𝟑. 𝟕𝟗𝟏 = 𝟑, 𝟕𝟗𝟏

Present Value of Money - Discounting Formulae for Annuity

1. End of the period (Ordinary Annuity)

𝟏 𝟏
𝑷𝑽𝒐𝒂 = 𝑨 ∗
𝒓
−
𝒓(𝟏+𝒓)𝒏
or 𝑷𝑽𝒐𝒂 = 𝑨 ∗ 𝑷𝑽𝑰𝑭𝑨𝒏, 𝒓

2. Annuity Due (Beginning of the period)

𝟏 𝟏
𝑷𝑽𝒂𝒅 = 𝑨 ∗ − ∗ (𝟏 + 𝒓) or 𝑷𝑽𝒂𝒅 = 𝑨 ∗ 𝑷𝑽𝑰𝑭𝑨𝒏, 𝒓 ∗ (𝟏 + 𝒓)
𝒓 𝒓 𝟏+𝒓 𝒏

An Annuity Due is worth (1+r) times an Ordinary Annuity!!!!

Present Value of Money

Ex. What is the present value of the cash flow that Frontier Company expects to generate as per
the following table. Assume the opportunity cost of fund to be 9%.

End of Year Amount in ₹

1 1 lac
2 2 lac
3-10 1.5 lac

Mixed stream of cash flows!

 Solution:
100000 200000 150000 150000 150000

Amount at 0 1 2 3 4 to 10
Year 0 ??
Different Cash Flows

Annuity - Ordinary

𝑷𝑽 = 𝟏𝑳𝒂𝒄 ∗ 𝑷𝑽𝑰𝑭1,9% + 𝟐𝑳𝒂𝒄 ∗ 𝑷𝑽𝑰𝑭2,9% + 𝟏. 𝟓𝑳𝒂𝒄 ∗ 𝑷𝑽𝑰𝑭𝑨8,9% ∗ 𝑷𝑽𝑰𝑭2,9%

𝑷𝑽 = 𝟏𝟎𝟎𝟎𝟎𝟎𝟎 ∗ 𝟎. 𝟗𝟏𝟕 + 𝟐𝟎𝟎𝟎𝟎𝟎 ∗ 𝟎. 𝟖𝟒𝟐 + 𝟏𝟓𝟎𝟎𝟎𝟎 ∗ 𝟓. 𝟓𝟑𝟓 ∗ 𝟎. 𝟖𝟒𝟐 = 𝟗, 𝟓𝟗, 𝟏𝟕𝟎

Present Value of Money

Ex. Ms. Dogra, an entrepreneur, meets with an accident while driving to her office and is advised

bed rest for the next five years. While adjudicating her case, the judge mandates the defendant to

pay a lump sum amount to Ms. Dogra in lieu of the loss of earnings that she has to suffer

because of the accident. Besides, another ₹ 1 lac is to be paid towards legal expenses borne by

her. If Ms. Dogra is expected to earn ₹ 5 lacs by the end of the year, and the earnings are

expected to grow at 6% p.a., what is the amount that the judge has asked the defendant to pay,

given that the five-year return on government bonds is 8% p.a.?

Solution:
5 lac 5*1.06 lac 5*(1.06)^2 lac 5*(1.06)^3 lac 5*(1.06)^4 lac

Amount at 0 1 2 3 4 5
Year 0 ??
X lac
Growing Annuity - Ordinary

𝟏+𝒈 𝒏
𝟏−( )
𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒂 𝑮𝒓𝒐𝒘𝒊𝒏𝒈 𝑨𝒏𝒏𝒖𝒊𝒕𝒚 = 𝑷𝑽𝒈 = 𝑨𝒈 𝟏+𝒓
𝒓−𝒈

𝑨𝒈 = 𝟓 𝒍𝒂𝒄 𝒈 = 𝟔% 𝒐𝒓 𝟎. 𝟎𝟔 𝒓 = 𝟖% 𝒐𝒓 𝟎. 𝟎𝟖 𝒏=𝟓

𝑷𝑽 = 𝟐𝟐, 𝟑𝟎, 𝟔𝟓𝟑. 𝟗𝟓 𝑳𝒆𝒈𝒂𝒍 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔 = 𝟏 𝒍𝒂𝒄

𝑻𝒐𝒕𝒂𝒍 𝑷𝒂𝒚𝒐𝒖𝒕 = 𝟐𝟑, 𝟑𝟎, 𝟔𝟓𝟑. 𝟗𝟓

Ex. Azim Premji wants to initiate a donation of ₹3,00,000 per year in perpetuity to a
foundation helping with disabilities. If the opportunity cost of funds is 9%, what will be the
amount that he has to keep aside today for the payments to go uninterrupted.

3 Lac 3 Lac 3 Lac 3 Lac 3 Lac

Perpetual
Amount at 0 1 2 3 4
Year 0 ?? X lac
PV of Perpetual Cashflows

Perpetuity – Ordinary - infinite series of constant cash flows.

𝑨
𝑷𝑽 = A = Periodic payment value r = Relevant interest rate
𝒓

Ans: 33,33,333
Ex. Mark Weinstein has been working on an advance technology in a laser eye surgery. His
technology will be available in the near term. He anticipates his first annual cashflow from
technology to be $215,000, received two years from today. Subsequent annual cashflows will
grow at 3.8% in perpetuity. What is the present value of the technology is the discount rate is
10%.
215,000 215,000*1.038 215,000*(1.038)^2

Perpetual
Amount at 0 1 2 3 4
Year 0 ??
X mn
PV of Perpetual Cashflows
PV of the (PV of Perpetual Cashflow)

Growing Perpetuity - Ordinary

 Solution:
215,000 215,000*1.038 215,000*(1.038)^2

Perpetual
Amount at 0 1 2 3 4
Year 0 ??
X mn
PV of Perpetual Cashflows
PV of the (PV of Perpetual Cashflow)

𝑨
𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒂 𝑮𝒓𝒐𝒘𝒊𝒏𝒈 𝑷𝒆𝒓𝒑𝒆𝒕𝒖𝒊𝒕𝒚 = 𝑷𝑽 =
𝒓−𝒈

𝑨𝒈 = 𝟐𝟏𝟓, 𝟎𝟎𝟎 𝒈 = 𝟑. 𝟖% 𝒐𝒓 𝟎. 𝟎𝟑𝟖 𝒓 = 𝟏𝟎% 𝒐𝒓 𝟎. 𝟏

𝟐𝟏𝟓𝟎𝟎𝟎
𝑷𝑽𝒐𝒇 𝑷𝒆𝒓𝒑𝒆𝒕𝒖𝒊𝒕𝒚 = = 𝟑, 𝟒𝟔𝟕, 𝟕𝟒𝟏. 𝟗𝟒
𝟎. 𝟏 − 𝟎. 𝟎𝟑𝟖

𝟑, 𝟒𝟔𝟕, 𝟕𝟒𝟏. 𝟗𝟒
𝑷𝑽 𝒂𝒕 𝒁𝒆𝒓𝒐 𝑻𝒊𝒎𝒆 = = 𝟑, 𝟏𝟓𝟐, 𝟒𝟗𝟐. 𝟔𝟕
𝟏. 𝟏
Growing Annuity
𝟏+𝒈 𝒏
𝟏−( )
𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒂 𝑮𝒓𝒐𝒘𝒊𝒏𝒈 𝑨𝒏𝒏𝒖𝒊𝒕𝒚 = 𝑷𝑽 = 𝑨𝒈 𝟏+𝒓
𝒓−𝒈

Perpetuity
𝑨
𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒂 𝑷𝒆𝒓𝒑𝒆𝒕𝒖𝒊𝒕𝒚 = 𝑷𝑽 =
𝒓
Growing Perpetuity
𝑨
𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒂 𝑮𝒓𝒐𝒘𝒊𝒏𝒈 𝑷𝒆𝒓𝒑𝒆𝒕𝒖𝒊𝒕𝒚 = 𝑷𝑽 =
𝒓−𝒈

Unless specifically stated, it is Assumed that the Cashflows Start at the End of the Year!!

Quoted Interest Rate is also calle Annual Percentage Rate or APR!!