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    financial Literacy 2

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    Financial Lit (Unit1) ch3,4 27-Feb-2024 10-02-47

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    Stuti Paliwal
    financial Literacy 2

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    Financial Goals and Planning eke ccd ‘the learning from this chapter will enable students > get familiarized with the financial goals popular among the public > understand how to prioritize and set financial goals > learn the concept of financial planning and its need/importance > become aware of the steps to follow in financial planning INTRODUCTION We can all agree that the ultimate goal of financial literacy is to attain the re- quired skills to prepare a sound financial plan. We all have various goals which we want to achieve in life like funds for higher education, owning house property, owning a vehicle, children’s marriage, retirement, etc. Without proper financial skills and knowledge, it is next to impossible to achieve all these goals. So, in this, we will look at the different types of financial goals and the steps needs to attain these goals. FINANCIAL GOALS Financial goals are the targets one intends to achieve through money manage- ment. Setting financial goals can help in attaining financial discipline. They assist in encouraging savings and making conscious investment decisions. Some of the popular financial goals are given below: Make a budget and live by it: A certified financial planner and renowned author Ric Edelman once said “Budgets are focused on debts and expenses and nobody got rich by focusing on their debts,” and “You get wealthy by focusing on your assets and your income.” However, many experts agree that when it comes to financial planning budgeting has a lot to offer. They clearly define Si RODUCTS. FINANCIAL PLANNING ANP FINANCIAL P! UNIT 1: @ ynses of a household which helps in pel 3 the amount of income and ex] , a wi and investments. Petering off credit oa ie ee ax credit card debt: Being S HRaaeal prrovation but ft (sai mee Pay Credit cards are a great Int ne default leads to anoth mene very crucial. Wear ir not managed proper another and after some time you “Once you pay them o! ssi ao arc as much, The whole system en p / know what's happ Once you get caught up in that culture, you don’t even until you add it all up”, ly. You never k realize are under a debt trap. In the ii rt A ’ worth of expenses is a must. The snort @ Save an emergency fund: 6 aa Do oe eaical bisa Soe market is very fragile and you nevel ae tial. | emergency funds are essen! ; : as ¢ Save for retirement: Lusardi emphasised Sec aed co saving ae i a tirement saving a Onsur erg need to make a saving, particularly re t ie aa ider i e capacity to reach g tion. And it is exciting when you consider it ee a igi pacity ach a long-term dreams. People just need to see it tha’ iy”. f aaa ¢ Live below your means: This does not involve rocket science to understang) right It is simple logic. If you spend more than you earn, you will incur debt ang your spending is within your earnings, you can save for your future. to pel ¢ Develop skills to improve your income: Spending on oneself is very impon| (2) ' ant and if those spendings are directed towards skill development is benefitjg) The. exponential. Thus, do keep targets on up skilling yourself and you will realig| has | the world has a lot of opportunities to offer. be g * Save for your children's education: The importance of college education) °°?" can be realized from the fact that college graduates earn 66 per cent more thag| 1°27 Ist high school graduates. The rising college tuition has mandated peoples 2° ¢ Plan for their children’s education well in advance. ee mid livel int of investment free overnight Thus, one should start planning at a ae can le down payment, th sy pesca € more freedom and flexibilit ol it : eauerove your credit score: The credit score of a - anaes timate of his/her creditworthiness, A te Hal le ‘or loans at lower interest rates whi He go f e to maintain high creditworthiness. Th 8 Ti i : ightly said by, Annamaria Lusardi, a George w; m sardi, A : ae : Pease fone of ie bond S foremost eee is Oma a boxe neendge n debt mana; “tT mers ftir Be ae and everyone shoul igement. at id do more to plan t plan.” Plan, the; n follow thai (il, FINANCIAL GOALS AND PLANNING 33 Rip hy wo ACHIEVE YOUR FINANCIAL GOALS * b Hl n by prioritizing your goals is the most efficient Way to reach ie ana” analyse YOUr goals, you will discover that some might take you cote Sop when Y" ‘ah, while others do not so much. Thus, based on the time span, th ame 1 als are classified into 3 categories: ae nig | rail 8° ing w short-term Goals rm goals are financial goals with a narrow scope and limited time hore: ir includes purchasing household electronics, furniture, house renowatiey ty ath om spending etc. Moreover, the more important short-term goalie gay serjpon your spending, starting to practice budgeting, avoiding short-term dete Ve | 3s, setting a minimum limit of regular savings and starting building your p seergency fund as soon as possible, ir portterm goals require you to question your spending and ask yourself “is t really that necessary?" If you are able to answer them honestly you are on the 1, right path towards financial peace and freedom, Ths all might sound daunting | to perform on your: own but can always go to financial advisors for assistance ob | short fe (B) Mid-term Goals ‘ The tendency to weight financial plans around the near and long-term goals has been called the “barbell” approach. However, due considerations need to be given to mid-term goals which take between 3 to 10 years to fulfil. Some examples of mid-term goals are a down payment on a house, paying off a study loan, international vacation, starting a business, etc. As the time horizon increases, so does the money needed. Thus, an important mid-term goal is to generate multiple streams of income. In today's time where livelihood is getting expensive day by day, one cannot survive just with active income, you need to develop a passive income stream as well through part-time freelancing work or income-generating investments. Your financial counsellor can guide you towards your midterm strategy. (C) Long-term Goals Your long-term goals are directed towards being done with your responsibili- ties and lining.a comfortable and stress-free life. Thus, some popular long-term | als are children’s education, children's marriage and comfortable retirement, These goals are realised between 20 to 40 years. These goals require disciplined investing because they cannot be compromised. | The goal-setting process includes decisions regarding what goals you want to attain; determining the quantum of funds you need; and estimating the time period required to reach those goals. ou wan: The goals should be ys Meve? One should start by answering this quag clearly stated, This ).u°a"W” Outlined and how they con be seklewed et track, Ambiguity abe ISO helps in keeping oneself motivated to stay on thea in achieving ee ut one’s goals can lead to confusion and chaos and de, For example, if Swer the followi You aim to Save for hii " ‘ing questions, ©w much do I need for this goal? igher education of children you muse H low long do I have to collect the funds for this goal? How am I going to collect funds for this goal? M stands for Measurable The essence of this attribute can be phrased as “if you can see it, you can it By measurable, we mean that one should be able to gauge his/her prog during the courses of fulfilment. This will help in keeping track of the eu efforts and if any revisions are required in the efforts in the future. One do so by putting small yearly milestones in the overall long-term goal to oneself in check. ‘ For example, one can use a retirement calculator available online to gauge process and see how much more is required to attain the goal. A stands for Achievable Wishful thinking can result in disappointment and mental distress. Fina goals are indeed challenging, but they should not be impossible to attain should be realistic about one’s goals and should perform thorough res regarding their attainability. For example, currently, you are 28 with an annual income of ¢ 7,50,000" have to ask yourself in light of current finances will you be able to # or is it just wishful thinking? R stands for Relevant By relevance, we mean that your goals should not be arbitrary. They *! : and must hold some significance to you. The path an be very tough and daunting and if you set a ance to you, the journey will feel like 2 ; FINANCIAL GOALS AND PLANNING cH. on planning your retirement as yourself, mpl i future affect m: por eran ty expenses in the fu y goal? will mY ci activities or hobbies of mine which can deter me from attaining a there I? nis to do I need nt promis ot ag Timely/Time-Bound “a pstands for Tl achieve it in the requited time period? Can it be 7 C com- area few popular phrases like “You have all the time in the world” or Ther to long to fret about things": They sound pretty nice and carsfnes Right? 5 tain carefree can cost you your future. The timeliness of the fina maisensures that you are serious about your goals and can set priorities ‘Thee parting a time stamp on your goals is important. It also Sives you a realistic {eadline which can help is guiding the quantum of your efforts to achieve thane You can a This can be done by giving oneself regular timely deadlines, ny ProRr LANNING the cust) FINANCIAL P ©. One ¢, Financial planning means developing a personal roadmap for your financial al to eg well-being. The outcome of the whole planning process is a path which needs to be followed to attain all the financial goals in the light of external hindrances gauge the _ lke inflation, taxes, etc. It means systematically planning your finances in order * to achieve your financial goals within the defined timeline. Financial planning process i The financial planning process involves several steps that an individual can “Inancid follow to achieve their financial goals, Step 1: Define your financial goals The first step in the financial planning process is to define your financial goals. This involves understanding your current financial situation and determining 10. You What you want to achieve in the short-term, medium-term, and long:term. Some 0. No common financial goals include saving for retirement, purchasing a home, paying ofl 1 ievel) off debt, and saving for a child’s education. | Step 2: Assess your current financial situation ‘ituati is it s review- The next step is to assess your current financial situation. Ts a ee ing your income, expenses, assets, and liabilities. By underaey ees Id financial situation, you can identify areas where you may vil! in order to reach your financial goals. IAL PLANNING AND FINANCIAL PRODUCTS iT1 ; FINANCI 3.6 unr : Create a budget Aran mee have a clear understanding of your financial situation, you can Once you ; how you will allocate your jp is a plan that outlines Pas nerd to meet your financial goals. It is imeporas to track a sing ahe stick to your budget to achieve your financial goals. spendi p a financial plan and assessed your current fing, Step 4: Develo ti ; fined your financial goals and asses ; Se a REC ‘financial plan. A financial plan is a roadma achieve your financial goals. It sh out ae to take to outlines the steps you need fdude a timeline for achieving each goal, as well as a strategy for how will achieve them. Step 5: Implement your financial plan Once you have developed a financial plan, it is important to implement it. Th, may involve making changes to your spending habits, investing your savings 9) making other financial decisions to help you reach your goals. Step 6: Monitor and review your progress It is important to regularly review and monitor your financial plan to ensys| that you are on the right track to attain your financial goals. This may involv reviewing your budget, adjusting your financial plan as needed, and making necessary changes to your financial strategy. a By following these steps, you can create a soli 5 solid financial plan that will on ae all your crucial financial goals. It is important to be praca isciplined in managing your finances, as this wi i agit , as this will hel i stability and security in the long term. Prey aie ae Practical benefits to financial planning Financial planning helps you to: nour your obligations 0 ‘PeNses and sti ji still enjoy a Comfortable and stl ress- ut a bout. — and — rac- | sing ch 3: FINANCIAL GOALS AND PLANNING 37 red for emergencies: The creation of an emergency /conti . It is the first step towards a stress and anxiet ele ected financial distress can affect your mental health Wher RF life. ¢ performance, which ultimately results in a loss of ccs it is advised to maintain a fund equivalent to 6 pf incre of your expens vrrain peace of mind: A person practising financial planning is abl anage his/er finances properly and have a peaceful mind Sotatites ey might hit a rock bottom, but you should not be discouraged hecaue ‘icimately you will reach your goal if you stay disciplined in the shai ot your goals. It might take you some time, but you will reach the aaa a financial peace. Attain Need for financial planning ‘the financial plan serves as a guide as you go through life’s journey. It helps you to manage your income, expenses, and investments in such a way that you can manage your finances and achieve your goals. You need to have enough money to achieve your goals and desires. Personal finances can help us increase our cash flow. Keeping track of our ex- penses and usage patterns enables us to increase our revenue. Careful planning, careful spending, and careful saving ensure that we do not lose the money we have worked hard for. A well-defined plan ensures that you do not deviate from them. It reduces the mental stress and anxiety related to financial well-being, If the goals are well defined in the planning process, one can customize the strategies in order to attain them. appreciated for one achievement. As ive you a sense of achievement which als. We all agree that everyone thrives when you attain your goals in your life, it will gi will further act as a motivator to stay motivated for future go: Personal finances include concepts related to money management, savings and investment, insurance, retire- investment, It includes banking, budgeting, debt, ment planning, and tax planning. aay QUESTIONS 1, What do you mean by financial goals? List 0 identified financial goals. 2. Explain different types of financial 3. What are the attributes of a sound ut some of the commonly goals. financial goal? UCTS 1. PROD INANCIA\ UNIT 1: FINANCIAL PLANNING AND F 3.8 Se ? Mention the s in financial planning. ial planning? Ment step: lan ‘ ial planning? 5. What is the need and benefits of financial p PRACTICAL EXERCISE aa ncial p! 1. After learning in detail about financial goals and fina ee your knowledge with your elder brothe ae it they never thought about developi taking with you they disclosed tha’ our hel 2 formal financial plan for their life goals. They asked you for y p You are required to help them to financial goals and develop a well the whole Process. analyze (using SMART) and set their “structured financial plan. Document LEARNING QUTCOMES. | The learning from this chapter will enable students » gain an understanding of the concept of the time value of money > learn how to choose between present cash inflow or cash inflow in the future : - » understand the power of compounding * get familiarized with the application of the time value of money in real life L INTRODUCTION We all have gone grocery shopping with our mother in the local markets. Right? So, we recall the same grocery like potatoes which we used to buy for ¢ 5/kg 15 years back is now sold for % 30/kg. Have you thought of the reason why is it so? What happened in these 15 years? The answer is the time value of money. In any financial decision, the time value of money holds immense importance. In this chapter, we will understand this concept, how to calculate it and why? TIME VALUE OF MONEY Simply stating, the time value of money means that the value of a rupee today will not be equal to the value of a rupee tomorrow. The purchases you make with the specific amount of money will not be sufficient to make the same quantum of purchases in the future. If you want to derive the same utility in the future you have to spend more. Thus, with time the money loses its worth. —_— 42 UNIT 1 aia INANCIAL PLANNING AND FINANCIAL PRODUCTS ; © Of Time Value of Money As already Stated, mon - inflation. They, one . try to delay thei mn mee its value with time. One of the key reasons is ee Prefer to receive money as soon as possible and aes y ‘aS much as possible, Other reasons are given below: Ttainty in the future: to receive money today ane with a 10 per cent apprec If you are presented with two options. One js d the other is to receive money after 2 years - iation. What will be your choice? Along wie emis whether this 10% appreciation will (i able to cover the vated will ere ood will also depend on how certain you are that you is amount after 2 years. Preference for current consumption: Anyone who is more concerne about current or immediate consumptions will mostly go for immediate cash inflows. Therefore, your decision between current or future infloyjs will be based on how much your consumptions can be delayed and hoy well they fit with your inflow’s timeline. ® Opportunity for reinvestment: Another reason for preferring current income is the opportunities available for their investment. Here, you have to compare if there is any investment opportunity available which can provide better returns that the return which is offered to accept future payment. For example, you have two options. One is to receive = 1,000 today and the other is to receive % 1,050 after one year. There is an im vestment opportunity which offers an annual return of 10%. Now in light | of the existing opportunity, what will be your choice? The answer will be option 1. If you accept after 1 year you only receive % 50 appreciation. However, if you go for the current receipt and invest it you will receive = 100 appreciation. It is safe to say that knowledge about the time value of money is relevant make an informed decision. It helps you understand the worth of your mote! thereby guiding you to derive the most out of it. TVM GLOSSARY Annuity An annuity refers to the regular cash flow of a fixed amount at equal ite™ for a specific time period. A lease requiring payment of 20,000 per mort a a period of 50 years is an example of an annuity. It is a “600 months P® i % 20,000 annuity”. The identical nature of cash flows in terms of amoutt j time gap in frequency of payment is a Necessary condition to call ita? a There are two types of annuities based on the time of payment: CH. 4: TIME VALUE OF MONEY 43 Regular/Ordinary Annuity - The first payment Tae Payment is made at the end of @ Annuity Due ~ The first payment is made in the beginning only (at period Y i ment is i innii Compound Interest Compound interest is a situation where the interest is calculated not only on the principal amount but also on the interest earned throughout the years. This is a concept of exponential growth of money. Compounding Frequency Compounding frequency means how frequently the interest is calculated and credited to the account. As the interest is credited it becomes principal in the immediate next period. The compounding frequency plays a crucial role in determining the exponential growth of money. The higher the frequency, the higher the growth of money. For example, the future value of @ 10,000 invested at the rate of 10% per annum for a period of 3 years compounded annually is ¢ 13,310, compounded bi-annually is % 13,400, compounded quarterly is % 13,449 and compounded monthly is % 13,481. Discount Rate A discount rate is a rate which is used to derive present value from future value. The process is known as discounting because the present value is less than the future value in absolute terms. Future Value Future value refers to the value of money which is expected to occur at some future date. For example, the future value of € 1,000 invested today for a period of 2 years at the rate of 15% per annum compounded annually is ¢ 1,322. This means that after 2 years this % 1,000 is equal to ¥ 1,322. So, in literal transla- tion, future value means “what will it be worth at some future point in time?” Number of Periods It is the time period for which’ the compounding and discounting are done to arrive at future value or present value respectively. For example, if compounding rs then the number of periods is 5. If compounding is done annually for 5 yea ds is S then the number of periods is 20 (5 years * 4 is done quarterly for 5 years, quarters). Co ee 44 UNIT 1; P, FINANCIAL PLANNING AND FINANCIAL PRODUCTS erpetuity Perpetuity is like an annui Perpetual an i. Annuity for an infinite time period. It is also known af 4 if lil nui Present Value et : today's values of the cash flows which will be received in thy witches amount that an individual is willing to pay at present in Orde meals “Wier tain cash flows in the future. Literally translated, present Value ceived afters cuit Worth right now?" The present value of 10,000 to be re see ner 2 Years having a rate of interest of 10% is ® 8,264. This means tha | oa You are willing to pay today % 8,264 in order to receive ® 10,000 after 2 yean | COMPOUNDING gir! Compounding is a strategy where the return on an asset or investment is rei vested in order to generate more income. In simple words, it means “generating returns from returns in the future’. The value derived through the compound | process is known as future value. Present val future, It Power of Compounding Let us understand the power of compounding with an example. | Pee Mr Sahil decided to invest % 1,00,000 every year for a period of 5 years. rate of return is 10% per annum. He has two options. Option 1: Withdraw interest earned as and when they are earned. Option 2: Reinvest the interest earned in the same investment option. Re Now, in option 1 Mr Sahil will be earning a return of & 50,000 (1,00,000* * 5) during the 5 years. Under Option the calculation is as follows: ‘ ea Interest | 1 1,00,000 Eorant 10000 P| A 1,10,000 1,00,000" 21,000 23M : oa ato 100,000 33,100 ant Uiaedea\iaa.64400, 1,00,000 46,410 si 5.10510 | 1,00,000 61,051 ane 500,000 | 4,71,561 0,01 in principle he invested only ® 5.0! a erS years offering a total return 0 The 0% CH. 4: TIME VALUE OF MONEY 45 which is significantly higher than & 50,0 power of compounding, 1000 (option 1). This is what ye call the (A) Present Value of Single Cash flow for Annual Compounding Future value = Present value * (1 + K)" Where, K = compounding rate n= number of years for which compounding is done Alternatively, Future value = Present value * (FVF,,) Where FVF = Future Value Factor for the given rate and time period. (FVF Table) Illustration: If Seema deposited & 5,000 at the rate of 12% compounded annu- ally for 4 years, what will be the value at the time of maturity? Solution: For this, we will calculate the future value Future value = Present value * (1 + K)" Future value = 5,000 (1 + 0.12)* Future value = 5,000 * 1.57 Future value = % 7,850 (B) Present value of Single Cash flow for Non-Annual Com- pounding Future value = Present value * (1 + K/m)"™ Where, K = compounding rate n= number of years for which compounding is done m = number of times the compounding is done in a year Alternatively, Future value = Present value * (FVFyjm.n0y) Where FVF = Future Value Factor for the given rate and time period. (FVF Table) Illustration: If Rohit deposited % 12,000 at the rate of 15% compounded quar- terly for 7 years what will be the value at the time of maturity? Solution: For this, we will calculate the future value Future value = Present value *(1+K/m)"" Future value = 12,000 (1 + 0.15/4)”* Future value = 12,000 * 2.80 Future value = & 33,600 46 UNIT 1: FINANCIAL PLANNING AND FINANCIAL PRODUCTS (C) Effective Rate of Interest us effective rate of interest is the annual interest rate received or © compounding is not done annually. Effective Interest rate = (1 + K/m)" - 1 Where, K = compounding rate ald jp, m = number of times the compounding is done in a year Mlustration: Find the effective interest rate if the amount is invested at yy of 20% for 10 years compounded monthly. Solution: Effective Interest rate = (1 + K/m)" - 1 Effective Interest rate = (1 + 0.20/12)" - 1 Effective Interest rate = 1.2194 - 1 Effective Interest rate = 0.2194 = 21.94% (D) Future value of Multiple and Cash flows Illustration: Following are the cash inflows of Yash at the end of each year 5 years. Calculate the future value at the end of Sthe year if the compou rate is 5% annually. ae SE 1,000 2,500 1,500 750 1,200 alolrle 5 ig iy the J ear fy 1ndiy ed || lal CH. 4: TIME VALUE OF MONEY 47 (E) Future Value of Regular/Ordinary Annuity Future value = ACL#K)™ + ACL#K)"™ + ACK = 4 compounding rate where, K n= number of years for which compounding is done a= Annuity amount ively, Alterna Future value = Annuity * (FVFA,.) Where, K = compounding rate n = number of years for which compounding is done FVFA,, = Future value factor for Annuity (future value annuity table) Illustration: A person deposited & 1,000 at the end of each year for 10 years. Find the total amount accumulated at the end of the 10" year if the compound- ing rate is 9% annually. Solution: Future value = Annuity * (FVFA,,) Future value = 1,000 (FVFA,,.,.) Future value = 1,000 * 15.193 Future value = % 15,193 (F) Future Value of Annuity Due Future value = Annuity * (FVFA,,) * (1+K) Where, K = compounding rate n= number of years for which compounding is done FVFA,, = Future Value factor for Annuity (future value annuity table) Illustration: If a person deposits € 30,000 at the beginning of each year, find out what will be the value at the end of 10 years if compounded annually at the rate of 11%. Solution: Future value = Annuity * (FVFA,,) * (1+K) Future value = 30,000 (FVFA,,4.:9) * (1 + 0.11) Future value = 30,000 * 16.722 mad Future value = & 5,56,823 ' (7 1: FINAL INANCIAL PRODUCTS CIAL PLANNING AND FINA cl ce UNIT 1: DISCOUNTING of determining the present vajye Discounting can be defined as the pric fie future, 1-is a technique of rye iv the stream of cash flows to be rece! compounding future cash flows. (A) Present Value of Single Cash Flow i Present value = Future value ae Where, K = discounting rate n = number of years for which discounting is done Alternatively, Present value = Future value / (PVF,,,) Where, PVF = Present Value Factor for the given rate and time period. (PVF Tabi Illustration: Calculate the present value of deposits if deposited today at rate of 10% per annum will yield % 10,000 after 5 years. Solution: Present value = Future value / (1+ K)" Present value = 10,000 / (1+0.10)° Present value = 10,000 / 1.61 Present value = % 6,211.18 (B) Present Value of Multiple Cash Flow Illustration: Find the present value of the following future cash flows if dis counting rate is 10% . i Cash Flow 2,500 3,400 1,800 1,500 2,700 Solution: CH. 4: TIME VALUE OF MONEY 1,676.7 9,132.4 10 * 0.75 * 75 + 1,500 * 0.683 Present value present value = 2,500 * 0.909 + 3,400 * 0.826 + 1,00 + 2,700 * 0.621 Present value = 2,272.5 + 2,808.4 + 1,350 + 1,0245 + 1,676.7 | Present value = & 9,132.1 | (c) Present Value of Regular/Ordinary Annuity Present value = Annuity * (PVFA, ) Ko VF Tabjy where, K = discounting rate °Y at yj, n= number of years for which discounting is done PVFA,.,, = Present Value factor for Annuity (present value annuity table) illustration: A person deposited % 1,000 at the end of each year for the next 10 years. What is the present value if the rate of interest is 11%? Solution: Present value = Annuity * (PVFA,,) Present value = 1,000 * 5.889 Present value = % 5,889 cm (D) Present Value of Annuity Due tt a Present value = Annuity * (PVFA,..) * (1+K) a Where, K = discounting rate n= number of years for which discounting is done | PVFA,.,= Present Value factor for Annuity (present value annuity table) | Illustration: A person deposited € 1,000 at the beginning of each year for 10 | Years. What is the present value if the rate of interest is 9%? | Solution: — Present value = Annuity * (PVFA,.,) * (1+K) Present value = 1,000 * 6.418 * 1.10 Present value = @ 7,059.8 (E) Present Value of Perpetuity Present value = Annual cash flow/discounting rate 4.10 UNIT 1 7 FINANCIAL PLANNING AND FINANCIAL PRODUCTS Mlustratio n: A com, Years and the no™PaYY Promises to ‘ate of int Solution: r Pay ® 10,000 for an indefinite numis “rest is 15%. Calculate the present value, Present value = Annual cash flow/discounting rate Present value = 10,000 / 0.15 Present value = & 66,666.67 APPLICATIONS OF TIME VALUE OF MONEY (A) Sinking Fund Problem At the time the fin; of money regular} which is to be use mine this regular ancial managers of a company have to set aside a certain su 'y for a while in order to create a corpus of a specific amouny d to replace an asset or pay off.a financial obligation. To deter amount to be set aside compounding technique is appropriate For example, if the company wants to accumulate % 20,00,000 in a period of years and the rate of interest is 10% compounded annually, what will be th annual cash outflow for such corpus? Future value = Annuity * (FVFA,,) Annuity = Future value / (FVFA,,) Annuity = 20,00,000 / (FVFA,,,.., Annuity = 20,00,000 / 6.105 = & 3,27,600 (B) Capital Recovery Problem/ Loan Repayment Corporations regularly indulge in taking loans for their operation. Whe! indulging in debt, the financial manager must be thorough about the fiat ition of the company and its repayment ability. In order to determine Par ero equal instalments to be paid in order to honour the debt obligat maith the given time period and the interest rate charges; the concept of present value technique is applied. ‘he int le, ABC company takes a loan of 25,00,000 from a bank. T! a For ee is at the rate of 10% per annum and the repayment period ae What should be the annual instalment? resent value = Annuity * (PVFA,..) CH. 4 : TIME VALUE OF MONEY (C) Compounded Growth Rate Problem Sometimes the financial managers have to calculate at what rate the sales or profits ofa corporation are growing, For this purpose, compounding factors can be used. Future value = Present value (1+ Growth rate)" Growth rate = (Future value/present value)!/n - 1 For example, in 5 years the sales of the company increased from & 2,00,000 to Z 10,00,000. What is the growth rate of sales? Future value = Present value (1+ Growth rate)" 10,00,000 = 2,00,000 (1 + G)° The value of G can be determined from the future value factor table. The value 5 ina 5-year row lies under 38% row. Thus, the growth rate is 38%. (D) Interest Rate Problem At times financial institutions provide information about investments in terms of present value, future value and time period. Thus, in order to determine the rate of interest offered in such investments the compounding and discount techniques are applied depending on the case. Forexample, in an investment option, an investor is required to invest? 50,000 today and receive 12,000 every year for 5 years. What is the rate of interest offered? Present value = Annuity * (PVFA,.,) 50,000 = 10,000 * (PVFA,.) PVFA,,= 4.17 ‘The rate of interest can be seen from the present value factor for the annuity table. The value nearest to 4.17 in a 5-year row is 7%. Therefore, the rate of interest offered is 7%. (E) Deferred Payment Problem At the time when the loan is given, its repayment starts after a certain period of time. This is known as deferred payment like education loans. This means that for the deferred period, the interest gets accumulated. Thus, itis necessary to cal- culate the repayment instalment taking into consideration the principal amount as well as the accumulated interest. For this, the techniques of compounding and discounting are applied. For example, if a loat 4.12 UNIT 1: FINANCIAL PLANNING AND FINANCIAL PRODUCTS Future value = Present value (1+K)" Future value = 2,00,000 (1+0.10)* Future value = % 24,20,000 Present value = Annuity * (PVFA,.,) Annuity = Present value / (PVFA,,) Annuity = 24,20,000 / (PVFA, 4.) Annuity = 24,20,000 / 5.335 = % 4,53,608 SOLVED PROBLEMS Problem 1: A deposited % 15,000 at the rate of 12% compounded annually for 2 years. What would be the amount at the time of maturity? What ‘Would be: the answer if the rate is 7%? Solution: Future value = Present value * (FVF,.,) Case - 1 Future value = 15,000 * 1,254 Future value = = 18,810 Case - 2 Futur Future value = 5,000 * 1.145 Future value = % 17,175 Problem 2: If Kiran deposited % 25,000 at the rate of 15% compounded annually for 10 years, what will be the value at the time of maturity? Solution: For this, we will calculate the future value Future value = Present value * (FVF,.,) Future value = 25,000 * 4.046 Future value = & 1,01,150 Problem 3: If harsh deposited 18,000 at the rate of 8% compounded bia" nually for 5 years what will be the value at the time of maturity? Solution: For this, we will calculate the future value Future value = Present value * (FVF, Future value = 18,000 * 1,480 w/matn) oe CH. 4: TIME VALUE OF MONEY 413 solution: Effective Interest rate = (1+ K/mym — 4 Effective Interest rate = (1+ 0,25/4)' - 4 2744 = 1 Effective Interest rate = 0.2744 = 27,449% | : Ifa person deposits % problem 5: If a p' posits % 50,000 at the begi Pie what will be the value at the end of § years if compadheat conan el Effective Interest rate = rate of 6%: solution: Future value = ‘ity * i Dually fe = Annuity * (FVFA,,) * (14K) would ‘i Future value = 50,000 (FVFA,,,.) * (1 + 0.06) q Future value = 50,000* 5.637 * 1.06 Future value = % 2,98,761 problem 6: A person deposited % 40,000 at the end of each year for one 8 years. Find the total amount accumulated at the end of the 8" year if the compounding rate is 12% annually. Solution: Future value = Annuity * (FVFA,,) Future value = 40,000 (FVFA,,.,4) Future value = 40,000 * 12.3 nnually Future value = 4,92,000 Problem 6: A company promises to pay % 15,000 for an indefinite number of years and the rate of interest is 12%. Calculate the present value. Solution: Present value = Annual cash flow/discounting rate | Present value = 15,000 / 0.12 dian | Present value = % 1,25,000 Problem 7: A person deposited % 35,000 at the beginning of each year for 12 | years. What is the present Solution: t value if the rate of interest is 5%? t value = Annuity * (PVFA,.,) * (1+K) Present 35,000 * 8.863 * 1.05 Present value = Present value = € 3,25,715.25 0 at the end of each year for the next e rate of interest is 9%? 2 rate Problem 8; A person deposited & 12,00 20 years, What is the present value if th suopnyos. ‘ Z parayo jaqut JO APA OU ST EYM “Sakad g 40J teak AxaA9 QDO'SZ 2 2AloIe1 pure AEpOr 0'00'T 2 ISU 0} pounbas st soysaaur ue undo quawysaauy ue Ul :ZP We{qold O88'2S'bT 2 = b€7'S / sue‘vo'9u = Anuuy “ CO ana) / scé's0'92 = &amuuy C"vana) / onqes quasaig = 4nuuy C'vana) « Aamuuy = onjea quasaig jeg Pare |n2[e9 anyen ayy Sulsn junowe Aynuue ayy ayeyno[ed 07 aAey NOA ‘MON SLE'V0'9Z 2 = anjea anny (ST0+T) 000‘00's = anqea aunang «Q1+T) enjea quasarg = onyea aungng Palla 9tp Jo pus aya ze onqea aunyny ayeinozes on aaey nod Kpsaty “uORNIOS ‘anyea quawyeysu! ayy areqnsqes vay eat parya ay Jo pus 3 ueis [IMM Yoryar Swuowersut jenba QT uF apeut aq or s} uoUIAedas ou, Mmuue sad 96ST Jo ayes amp ae parayo si QOO'OO'DS 2 Jo UeO| e J] :ET walqoig 000'0S'T 2 = anjea quasarg 210 / 00°81 = anqea quasaig a1e1 BuUNods!p/moy yseo fenuuy = onfea quasorg suonnjog 5 id ay are[Nd]eD “%ZT st sasaqUI Jo aye. ‘ ‘anyea quasaid ay: 1 JO ayes ayy pue suvak oat quinu ayuyapur ue 405 900'8T 2 Sed 0 sasiword Auedwios y :97 waqorg Ae LOZLOZL 2 = Anyea Wasorg 0ZE°0 / 00022 = anyea quasarg (aaa) / anqea aanyng = anqea quasaag ik i suonnios ‘sueaf 9 Joye 000'LZ 2 PIAA [WM wnuUe tad * fepoy paysodap 41 susodep Jo anjea quasaid ayp ayemnoye5 el oe BhS'60'T 2 = Onyea quasorg 6216 + 000'ZT = Anika quasorg Cand) « Aynuuy = ane quasoag tuonnjos SLONdOwd ‘IVIONYNEd ONV DNINNV'd TWIONVNI Taine, = Te CH. 4: TIME VALUE OF MONEY 415 Bre vale we can be seen from the present value factor for the annuity wh learest to 4 in a 5-year row is 8%. Therefore, the rate of in- 2d terest offered is 8%, . toda, problem 13: In 7 years th 3 ‘ars the sales of the co ei ‘0 ‘" Pe NtDO. Wii Le La Vee are increased from @ 5,00,000 to Solution: Future value = Present value (1+ Growth rate)" 30,00,000 = 5,00,000 (1 + Gy’ (1+G)"=6 ite num The value eH G can be determined from the future value factor table. The value ‘ er, _ nearest to 6 in a 7-year row lays under 29% row. Thus, the growth rate is 29%. Problem 14: Mila Itd took a loan of & 50,00,000 from a bank. The interest rate charged is at the rate of 12% per annum and the repayment period is 15 years. e What should be the annual instalment? Solution: Present value = Annuity * (PVFA,.,) b per ana Annuity = Present value / (PVFA,,) | start at Annuity = 50,00,000 / (PVFA,,,...) Annuity = 50,00,000 / 6.811 = & 7,34,107 .¢ third eq Problem 15: If the company wants to accumulate € 25,00,000 in a period of 10 years and the rate of interest is 8% compounded annually, what will be the | annual cash outflow for such corpus? Solution: | Future value = Annuity * (FVFA,.,) Annuity = Future value / (FVFA,,) | Annuity = 25,00,000 / (FVFA,s, 0) 5,00,000 / 14.487 % 1,72,569 ated befor Annuity | REVIEW QUESTIONS mean by the time value of money? What t is the relevance 00,00! 1. What do you

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