RM - Topic 3 - Time Value of Money

Segment 2: Value of Money and Valuation of Bonds
and Shares
Topic 3 : Time Value of Money
Time Value of Money
Table of Contents:
3.1 Introduction
Objectives
Rationale
3.2 Time Preference for Money
Time preference rate and required rate of return
Compounding technique
Discounting technique
3.3 Future value
Doubling period
Increased frequency of compounding
Effective vs. nominal rate of interest
Future value of series of cash flows
Future value of annuity
Sinking fund
3.4 Present Value
Present value of a single flow
Present value of even series of cash flows
Present value of perpetuity
Present value of an uneven periodic sum
Capital recovery factor
3.5 Summary
3.6 Glossary
3.7 Solved problems
3.8 Terminal Questions
3.9 Answers
3.10 Case Study
©COPYRIGHT 2020, ALL RIGHTS RESERVED. MANIPAL ACADEMY OF HIGHER EDUCATION Page No. 62
Time Value of Money
3.1 Introduction
In the previous unit, you have learnt about the steps in financial planning,
factors affecting financial planning, estimation of financial requirements of a
firm, and the concept of capitalisation. In the earlier units, you have also
learnt that wealth maximisation is far more superior to profit maximisation.
Wealth maximisation considers time value of money which translates cash
flow occurring at different periods into a comparable value at zero period.
For example, a firm investing in fixed assets will reap the benefits of such
investment for a number of years. However, if such assets are procured
through bank borrowings or term loans from financial institutions, there is an
obligation to pay interest and return of principal.
Decisions, therefore, are made by comparing the cash inflows
(benefits/returns) and cash outflows (outlays). Since these two components
occur at different time periods, there should be a comparison between the
two.
In order to have a logical and a meaningful comparison between cash flow
occurring over different intervals of time, it is necessary to convert the
amounts to a common point of time. This unit is devoted to a discussion of
the time value of money.
Learning Objectives:
After studying this unit, you should be able to:
• explain the time value of money
• compute the future values of lump sums and annuity flows
• calculate the present values of lump sums and annuity flows.
3.1.1 Rationale
“Time value of money” is the value of a unit of money at different time
intervals. The value of the money received today is more than its value
received at a later date. In other words, the value of money changes over a
period of time. Since a rupee received today has always more value,
rational investors would prefer current receipts over future receipts. That is
why this phenomenon is referred to as “time preference of money”.
Time Value of Money
Consider this – we intuitively know that Rs.100 in hand now is more

valuable than Rs. 100 receivable after a year. In other words, we will not
part with Rs. 100 now in return for a firm assurance that the same sum will
be repaid after a year. But we might part with the same Rs. 100 now if we
are assured that something more than Rs. 100 will be paid at the end of first
year. This additional compensation required for parting with Rs. 100 now is
called the ‘interest’ or the time value of money.
Some important factors contributing to this nature are:
• Investment opportunities
• Preference for consumption
• Risk
These factors remind us of the famous English saying, “A bird in hand is
worth two in the bush”. The question now is: why should money have time
value?
Some of the reasons are:
• Productivity – Money can be employed productively to generate real
returns. For example, if we spend Rs. 500 on materials, Rs. 300 on
labour, and Rs. 200 on other expenses and the finished product is sold
for Rs. 1100, we can say that the investment of Rs. 1000 has fetched us
a return of 10%.
• Inflation – During periods of inflation, a rupee has higher purchasing
power than a rupee in the future.
• Risk and uncertainty – We all live under conditions of risk and
uncertainty. As the future is characterised by uncertainty, individuals
prefer current consumption over future consumption. Most people have
subjective preference for present consumption either because of their
current preferences or because of inflationary pressures.
3.2 Time Preference for Money

3.2.1 Time preference rate and required rate of return
The time preference for money is generally expressed by an interest rate
which remains positive even in the absence of any risk. It is called the risk-
free rate.
Time Value of Money
For example, if an individual’s time preference is 8%, it implies that he or

she is willing to forego Rs. 100 today to receive Rs. 108 after a period of
one year. Thus, he or she considers Rs. 100 and Rs. 108 as equivalent in
value. In reality though, this is not the only factor he or she considers. He or
she requires another rate for compensating him or her for the amount of risk
involved in such an investment. This rate is called the risk premium.
Required rate of return = Risk-free rate + Risk premium
There are two methods by which the time value of money can be calculated:
• Compounding technique
• Discounting technique
3.2.1.1 Compounding technique
In the compounding technique, the future values of all cash inflow at the end
of the time horizon at a particular rate of interest are calculated. The amount
earned on an initial deposit becomes part of the principal at the end of the
first compounding period.
The compounding of interest can be calculated by the following equation:
n
.
Where, A = Amount at the end of the period

P = Principal at the end of the year
i = Rate of interest
n = Number of years
Example
Mr. A invests Rs. 1,000 in a bank which offers him 5% interest
compounded annually. Table 3.1 depicts the values arrived at by
substituting the actual figures for the investment or Rs. 1000 in the
n
formula .
Table 3.1: Interest Compounded Annually
Year 1 2 3
Beginning amount Rs.1000 Rs.1050 Rs.1102.50
Interest rate 5% 5% 5%
Time Value of Money
Amount of interest 50 52.50 55.13

Beginning principal Rs.1000 Rs.1050 Rs.1102.50
Ending principal Rs.1050 Rs.1102.50 Rs.1157.63
As seen from table 3.1, Mr. A has Rs. 1050 in his account at the end of
the first year. The total of the interest and principal amount
Rs. 1050 constitutes the principal for the next year. He thus earns
Rs. 1102.50 for the second year. This becomes the principal for the third
year. This compounding procedure will continue for an indefinite number
of years.
Let us now see how the values in table 3.1 are arrived at.
Amount at the end of year 1 = Rs. 1000 (1+0.05) = Rs. 1050
Amount at the end of year 2 = Rs. 1050 (1+0.05) = Rs. 1102.50
Amount at the end of year 3 = Rs. 1102.50 (1+0.05) = Rs. 1157.63
The amount at the end of the second year can be ascertained by
substituting Rs.1000 (1+0.05) for Rs.1050, that is,
Rs.1000 (1+0.05) (1+0.05) = Rs.1102.50
Similarly, the amount at the end of the third year can be ascertained by
substituting Rs.1000 (1+0.05) for Rs.1102.50, that is,
Rs.1000 (1+0.05) (1+0.05) (1+0.05) = Rs.1157.63
3.2.1.2 Discounting technique

In the discounting technique, the present value of the future amount is
determined. Time value of money at time zero on the time line is calculated.
This technique is in contrast to the compounding approach where we
convert the present amounts into future amounts.
Solved Problem – 1
Mr. A requires Rs. 1050 at the end of the first year. Given the rate of
interest as 5%, find out how much Mr. A would invest today to earn this
amount.
Solution:
If P is the unknown amount, then
P (1+0.05) = 1050
P = 1050/(1+0.05)
Time Value of Money
= Rs.1000
Thus, Rs. 1000 would be the required principal investment to have
Rs. 1050 at the end of the first year at 5% interest rate. The present
value of the money is the reciprocal of the compounding value.
Mathematically, we have
 1 
P=A  n 
 (1 + i) 
Where P is the present value for the future sum to be received,

A is the sum to be received in future,
i is the interest rate, and
n is the number of years.
3.3 Future value

The process of calculating future value will become very cumbersome if it
has to be calculated over long maturity periods of 10 or 20 years. A
generalised procedure of calculating the future value of a single cash flow
compounded annually is as follows:
FVn = PV(1+i)n
Where, FVn = future value of the initial flow in n years hence,

PV = initial cash flow
i = annual rate of interest
n = life of investment
The expression ( 1 + i)n represents the future value of the initial investment
of Re. 1 at the end of n number of years at a rate of interest ‘i’ referred to as
the Future Value Interest Factor (FVIF). To help ease the calculations, this
expression has been evaluated for various combinations of “i” and “n” and
these values are presented in table 3.1. To calculate the future value of any
investment, the corresponding value of (1 + i)n from table 3.1 is multiplied
with the initial investment.
Time Value of Money
Table 3.2 depicts the interest rates offered by the fixed deposit scheme
of a bank.
Table 3.2: Fixed Deposit Scheme of a Bank
Period of deposit Rate per annum
<45 days 9%
46 days to 179 days 10%
180 days to 365 days 10.5%
365 days and above 11%
What will be the status of Rs. 10,000 after three years if it is invested at
this point of time?
Solution:
FVn = PV(1+i)n or PV*FVIF (11%, 3y)
= 10000*1.368 (from the tables)
= Rs.13, 680
The status of Rs. 10,000 after three years, if it is invested at this point of
time, would be Rs.13,680.
3.3.1 Doubling period

A very common question arising in the minds of an investor is “how long will
it take for the amount invested to double for a given rate of interest”. There
are 2 ways of answering this question:
1. One way is to answer it by a rule known as ‘rule of 72’. This rule states
that the period within which the amount doubles is obtained by dividing
72 by the rate of interest. Though it is a crude way of calculating, this
rule is followed by most.
For instance, if the given rate of interest is 10%, the doubling period is
72/10, that is, 7.2 years.
2. A much accurate way of calculating doubling period is by using the rule
known as ‘rule of 69’. By this method,
Doubling Period = 0.35+69/Interest rate
Going by the same example given above, we get the number of years as
7.25 years {(0.35 + 69/10) or (0.35 +6.9)}.
Time Value of Money
Growth rate:
The compound rate of growth for a given series for a period of time can be
calculated by employing the FVIF. Consider the following example.
Years 1 2 3 4 5 6
Profits (in Lakh) 75 90 105 140 160 180
How is the compound rate of growth for the above series determined? This
can be done in two steps:
1. The ratio of profits for year 6 to year 1 is to be determined, i.e., 180/75 =
2.4.
2. The FVIF table is to be looked at. Look at the value that is close to 2.4
for the row of 5 years.
The value close to 2.4 is 2.386, and the interest rate corresponding to this is
19%. Therefore, the compound rate of growth is 19%.
3.3.2 Increased frequency of compounding

So far, we have seen the calculation of the time value of money. It has been
assumed that the compounding is done annually.
Let us now see the effect on interest earned when compounding is done
more frequently - half-yearly or quarterly.
Example
Table 3.3 depicts the interest earned if we have deposited Rs.10,000 in a bank
which offers 10% interest per annum compounded semi-annually.
Table 3.3: Interest Earned
Amount invested Rs.10,000
Interest earned for first 6 months
10000*10%*1/2 (for 6 months) Rs.500
Amount at the end of 6 months Rs.10,500
Interest earned for second 6 months
105000*10%*1/2 Rs.525
Amount at the end of the year Rs.11,025
If in the above case, compounding is done only once in a year the interest
earned will be 10000*10% which is equal to Rs. 1000, and we will have
Rs. 11000 at the end of first year.
Time Value of Money
Going by the calculations, we see that one gets more interest if

compounding is done on a more frequent basis. The generalised formula for
shorter compounding periods is:
mXn
 i 
FVn = PV 1 + 
 m
Where, FVn = future value after n years

PV = cash flow today
i = nominal interest rate per annum
m = number of times compounding is done during a year
n = number of years for which compounding is done
Under the ABC Bank’s Cash Multiplier Scheme, deposits can be made
for periods ranging from 3 months to 5 years and for every quarter,
interest is added to the principal. The applicable rate of interest is 9%
for deposits less than 23 months and 10% for periods more than 24
months. What will be the amount of Rs. 1000 after 2 years?
Solution:
mXn
 i 
FV n = PV 1 + m 
m = 12/3 = 4 (quarterly compounding)
1000 (1+0.10/4)4*2
1000 (1+0.10/4)8
Rs. 1218
The amount of Rs. 1000 after 2 years would be Rs. 1218.
3.3.3 Effective vs. nominal rate of interest

We have just learnt that interest accumulation under half-yearly/quarterly
compounding is much more than in the case of annual compounding. This
means that the rate of interest given to us in the example, i.e., 10% is the
nominal rate of interest per annum.
If the compounding is done more frequently, say semi-annually, the principal
amount grows at 10.25% per annum. This 10.25% is known as the
“effective rate of interest” which is the rate of interest per annum under
Time Value of Money
the annual compounding that produces the same effect as that produced by
an interest rate of 10% under semi-annual compounding.
The general relationship between the effective and nominal rates of interest
is as follows:
 i m
r = (1 + ( ) ) −1
 m 
Where,
r = Effective rate of interest
i = Nominal rate of interest
m = Frequency of compounding per year
Calculate the effective rate of interest if the nominal rate of interest is
12% and interest is compounded quarterly.
Solution:
 i 
r = (1 + ( )m ) − 1
 m 
M = 12/3 = 4 (quarterly compounding)
r = {(1+0.12/4)4}-1
r = 0.126 or 12.6% p.a. effective rate of interest is 12.6% p.a.
3.3.4 Future value of series of cash flows

An investor may be interested in investing money in instalments and wish to
know the value of his or her savings after n years.
Let us understand the calculation of the same with the help of a solved
problem.
Time Value of Money
Mr. Madan invests Rs. 500, Rs. 1000, Rs. 1500, Rs.2000, and Rs. 2500
at the end of each year for 5 years. Calculate the value at the end of 5
years compounded annually if the rate of interest is 5% p.a.
Solution:
Table 3.4 depicts the value at the end of 5 years, compounded annually
at a rate of interest of 5% per annum
Table 3.4: Future Value of Series of Cash Flow
Amount Number of Compounded
End of invested years interest factors FV in Rs.
year
(Rs.) compounded from tables
1 500 4 1.216 608
2 1000 3 1.158 1158
3 1500 2 1.103 1654
4 2000 1 1.050 2100
5 2500 0 1.000 2500
Amount at the end of the fifth year Rs.8020
The value at the end of the fifth year is Rs. 8020
Thus, to ascertain the accumulation of a series of unequal flows as at the

end of a specified time horizon, we have to find out the accumulations of
each of these flows using the appropriate FVIF and sum up these
accumulations.
This process tends to get tedious if we have to determine the accumulation
of a series of flows over a long period of time, for example, the accumulation
of a recurring bank deposit of Rs. 100 per month for 60 months at a rate of
1 percent per month. In such cases, an easier method can be employed
provided the flows are of equal amounts. This method is discussed in the
following sub-section.
Time Value of Money
3.3.5 Future value of an annuity

Annuity refers to the periodic flows of equal amounts. These flows can be
either receipts or payments.
Example
If you have subscribed to the recurring deposit scheme of a bank
requiring you to pay Rs. 5000 annually for 10 years, this stream of
payouts can be called “annuities”. Annuities require calculations based
on regular periodic contribution of a fixed sum of money.
The future value of a regular annuity for a period of n years at “i” rate of
interest can be summed up as follows:
 (1 + i ) n − 1
FVAn = A  
 i 
Where, FVAn = Accumulation at the end of n years
i = Rate of interest
n = Time horizon or number of years
A = Amount invested at the end of every year for n years
The expression [(1 + i ) n − 1] / i ) is called the Future Value Interest Factor

for Annuity (FVIFA). This represents the accumulation of Re.1 invested at
the end of every year for n number of years at “i” rate of interest.
As in the case of FVIFA, this expression has also been evaluated for
different combinations of ‘i’ and ‘n’. Table 3.4 and table 3.5 depict these
tabulations respectively. We just have to multiply the relevant value from
the table with ‘A’ (i.e., Amount invested at the end of every year for n years)
and get the accumulation in the formula given above.
Time Value of Money
Mr. Ram Kumar deposits Rs. 3000 at the end of every year for five years
into his account. Interest is being compounded annually at a rate of 5%.
Determine the amount of money he will have at the end of the fifth year.
Solution:
Table 3.5 depicts the amount of money Mr. Ram Kumar will have at the
end of the fifth year.
Table 3.5: Computation of Future Value of Annuity

End Amount Number of years Compounded FV in Rs.
of invested compounded interest factors
year (Rs) from tables
1 2000 4 1.216 2432
2 2000 3 1.158 2316
3 2000 2 1.103 2206
4 2000 1 1.050 2100
5 2000 0 1.000 2000
Amount at the end of the fifth year 11054
Or Refer FVIFA table to compute the value at the end of 5th year:
= 2000 * FVIFA (5%, 5y)
= 2000*5.526
= Rs. 11052
We notice that we can get the accumulations at the end of n period using
the tables. Calculations for a long time horizon are easily done with the help
of reference tables. Annuity tables are widely used in the field of investment
banking as ready beckoners.
Time Value of Money
Calculate the value of an annuity flow of Rs. 5000 done on a yearly
basis of five years, yielding at an interest of 8% p.a.
Solution:
= 5000 FVIFA (8%, 5y)
= 5000* 5.867
= Rs. 29335
The value of annuity flow is Rs. 29,335.
If the payments/investments are made at the beginning of every year, then

the value of such an annuity, called ‘annuity due’, is ascertained by
modifying the formula for annuity (regular):
FVAn(due) = A ( 1+ i ) FVIFAi,n
Activity 1
If you are investing in State Bank of India Recurring deposit scheme that
requires you to pay Rs 1000 annually for 10 years how would you
calculate the contribution?
Hint: Future value of an Annuity
3.3.6 Sinking fund

Sinking fund is a fund which is created out of fixed payments each period to
accumulate for a future sum after a specified period.
It can be said that it is a fund created for a specified purpose by way of
sequence of periodic payments over a time period at a specified interest
rate.
The sinking fund factor is useful in determining the annual amount to be put
in a fund, to repay bonds or debentures, or to purchase a fixed asset or a
property at the end of a specified period.
 i 
A = FV  
 (1 + i)n − 1
i /[(1 + i ) n −1] is called the sinking fund factor.
Example: Manas Ltd. has an obligation to redeem Rs. 50,00,000 debentures
for 6 years. How much should the company deposit annually in the sinking
Time Value of Money
fund account yielding 14 percent interest to cumulate Rs. 50,00,000 six

years from now?
Solution: n=6 years, r= 14%, Accumulated sum = 50,00,000
Annual sinking fund deposit should be:
A= 50,00,000
FVIFA (14%, 6yrs)
Referring FVIFA table the factor is 8.536
50,00,000
= = Rs. 5,85,754
8.536
3.4 Present Value

Given the interest rate, compounding technique can be used to compare the
cash flows separated by more than one time period. With this technique, the
amount of present cash can be converted into an amount of cash of
equivalent value in future.
Likewise, we may be interested in converting the future cash flow into their
present values. ‘Present value’ can be simply defined as ‘the current value
of a future sum’. It can also be defined as the amount to be invested today
(present value) at a given rate of interest over a specified period to equal the
‘future’ sum.
If we reverse the flow by saying that we expect a fixed amount after ‘n’
number of years and we also know the present prevailing interest rate, then
by discounting the future amount at the given interest rate, we will get the
present value of investment to be made.
The present value of a sum to be received at a future date is determined by
discounting the future value at the interest rate that the money could earn
over the period. This process is known as discounting.
3.4.1 Present value of a single flow
Ascertaining Present Value (PV) is simply the reverse of finding Future
Value (FV). Hence, the formula for FV can be simply transformed into the
PV formula. Thus, we can determine the PV of a future cash flow or a
stream of future cash flows using the formula:
Time Value of Money
Where, PV = Present Value

FVn = Amount (Future value after ‘n’ years)
i = Interest rate
n = Number of years for which discounting is done
If Ms. Sapna expects to have an amount of Rs. 1000 after one year what
should be the amount she has to invest today if the bank is offering 10%
interest rate?
FVn
Solution: PV =
(1 + i ) n
= 1000/(1+0.10)1
= Rs. 909.09
The same can be calculated with the help of tables.
= 1000*PVIF (10%, 1y)
= 1000*0.909
= Rs. 909
The amount to be invested today to have an amount of Rs, 1000 after
one year is Rs. 909.
An investor wants to find out the value of an amount of Rs.10,000 to be
received after 15 years. The interest offered by bank is 9%. Calculate the
PV of this amount.
Solution:
FVn
PV = or 10000 PVIF (9%, 15y)
(1 + i ) n
= 10000*0.275
= Rs. 2750
The PV of Rs. 10, 000 is Rs. 2750.
Activity-2
If you are an investor and are interested in finding out the value of an
amount 2020,
©COPYRIGHT of Rs 1000RESERVED.
ALL RIGHTS to be MANIPAL
received afterOF15
ACADEMY years,
HIGHER how would
EDUCATION Pageyou
No. 77
calculate?
Hint: calculate Present value
Time Value of Money
3.4.2 Present value of even series of cash flows

In a business scenario, the businessman will receive periodic amounts
(annuity) for a certain number of years. An investment done today will fetch
him returns spread over a period of time. He would like to know if it is
worthwhile to invest a certain sum now in anticipation of returns he expects
after a certain number of years. He should, therefore, equate the anticipated
future returns to the present sum he is willing to forego. The PV of a series
of cash flows can be represented by the following formula:
A A A A
PVAn = + + + ... +
(1 + i) 1
(1 + i) 2
(1 + i) 3
(1 + i) n
The above formula or the equation reduces to:
 (1 + i ) n − 1
PVAn= A  n 
 i (1 + i ) 
The expression {(1+ i)n −1/ i (1 + i)n } is known as Present Value Interest
Factor Annuity (PVIFA). It represents the present value of a regular annuity
of Re. 1 for the given values of i and n. Table 3.6 depicts the values of
PVIFA (i, n) for different combinations of ‘I’ and ‘n’. It should be noted that
these values are true only if the cash flows are equal and the flows occur at
the end of every year.
It must also be noted that PVIFA (i,n) is NOT the inverse of FVIFA (i,n),
although PVIF (i,n) is the inverse of FVIF (i,n).
Calculate the PV of an annuity of Rs. 500 received annually for four years
when discounting factor is 10%.
Solution:
Table 3.6 depicts the calculated present value of annuity:
Table 3.6: Computation of PV of Annuity
End of year Cash inflows PV factor PV in Rs.
1 Rs.500 0.909 454.5
2 Rs.500 0.827 413.5
3 Rs.500 0.751 375.5
4 Rs.500 0.683 341.5
Time Value of Money
3.170 1585.0
Present value of an annuity is Rs. 1585.

or
By directly looking at the table we can calculate:
= 500*PVIFA (10%, 4y)
= 500*3.170
= Rs. 1585
The present value of annuity is Rs. 1585.
Find out the present value of an annuity of Rs. 10000 over 3 years when
discounted at 5%.
Solution:
Present value of annuity
= 10000*PVIFA(5%, 3y)
= 10000*2.7232
= Rs. 27232
Hence, the present value of annuity is Rs. 27232.
3.4.3 Present value of perpetuity

An annuity for an infinite time period is perpetuity. It occurs indefinitely. A
person may like to find out the present value of his investment assuming he
will receive a constant return year after year.
The present values of perpetuity can be expressed as follows:
Where, = Present value of perpetuity

A = constant annual payment
= Present value interest factor for a perpetuity
Therefore, the value of is

It can be said that PVIF of perpetuity is simply one divided by interest rate
expressed in decimal form. Hence, PV of perpetuity is simply equal to the
Time Value of Money
constant annual payment divided by the interest rate. This can be expressed
as follows:
The principal of a college wants to institute a scholarship of Rs. 5000 for
a meritorious student every year. Find out the PV of investment which
would yield Rs. 5000 in perpetuity, discounted at 10%.
Solution:
= 5000/0.10
= Rs. 50000
This means he should invest Rs. 50000 to get an annual return of
Rs. 5000.
3.4.4 Present value of an uneven periodic sum

In some investment decisions of a firm, the returns may not be constant. In
such cases, the PV is calculated as follows:
A1 A2 A3 An
P= + + + ... +
(1 + i ) 1
(1 + i ) 2
(1 + i ) 3
(1 + i ) n
or
PV= A1 PVIF (i, 1) + A2 PVIF (i, 2) + A3 PVIF (i, 3) + A4 PVIF (i, 4)
+……………..…. + An PVIF (i, n)
Time Value of Money
An investor will receive Rs. 10000, Rs. 15000, Rs. 8000, Rs. 11000, and
Rs. 4000 respectively at the end of every five years. Find out the
present value of this stream of uneven cash flows, if the investors
interest rate is 8%.
Solution:
PV=10000/ (1+0.08) +15000/ (1+0.08)2+8000/ (1+0.08)3+11000/
(1+0.08)4+4000/ (1+0.08)5
=Rs.39276
Or by referring table we can compute
PV=10000 PVIF(8%,1yr)+15000 PVIF(8%,2yrs)+ 8000 PVIF(8%,3yrs)+
11000 PVIF(8%,4yrs)+4000 PVIF(8%,5yrs)
= 10000*0.926+15000*0.857+8000*0.794+11000*0.735+4000*0.681
=9260+ 12855 + 6352 +8085 + 2724 =Rs.39,276
The present value of this stream of uneven cash flows is Rs. 39,276
3.4.5 Capital recovery factor

Capital recovery factor is the annuity of an investment for a specified time at
a given rate of interest.
The reciprocal of the present value annuity factor is called capital recovery
factor.
 i (1 + i ) n 
A = PVAn  n −1 
 (1 + i ) 
 i (1 + i ) n 
 n −1 
is known as the Capital Recovery Factor.
 (1 + i ) 
Time Value of Money
A loan of Rs. 100000 is to be repaid in 5 equal annual instalments. If the
loan carries a rate of 14% p.a, what is the amount of each instalment?
Solution:
Instalment*PVIFA(14%, 5) = 100000
Instalment=100000/3.433 = Rs. 29128.
The amount of each instalment has been calculated.
Time Value of Money
3.5 Summary
Let us recapitulate the important concepts discussed in this unit:
• Money has time preference.
• A rupee in hand today is more valuable than a rupee a year later.
Individuals prefer possession of cash now rather than at a future point of
time. Therefore, cash flow occurring at different points in time cannot be
compared.
• Interest rate gives money its value and facilitates comparison of cash
flow occurring at different periods of time.
• Compounding and discounting are two methods used to calculate the
time value of money.
3.6 Glossary
Annuity: Refers to the periodic flows of equal amounts.
Capital recovery factor: Annuity of an investment for a specified time at a
given rate of interest.
Perpetuity: An annuity for an infinite time period.
Required rate of return: Risk free rate + Risk premium.
Rule of 72: The period within which the amount doubles is obtained by
dividing 72 by the rate of interest.
Sinking fund: Fund which is created out of fixed payments each period to
accumulate for a future sum after a specified period.
Time value of money: Value of a unit of money at different time intervals.
3.7 Solved Problems

15. What is the future value of a regular annuity of Re. 1.00 earning a rate
of 12% interest p.a. for 5 years?
Solution: FVAn = A * FVIFA (12%,5yrs)

= 1*FVIFA (12%, 5y) = 1*6.353 = Rs. 6.353
Time Value of Money
16. If a borrower promises to pay Rs. 20,000 eight years from now in return
for a loan of Rs. 12,550 today, what is the annual interest being
offered?
Solution: PV = A * PVIF(r%,8 yrs)

12550 = 20000*PVIF (r%, 8yrs)
12550/20000 = PVIF (r%, 8yrs)
0.627 = PVIF (r%, 8yrs)
Refer PVIF table and search for 0.627 in the 8th year row. You can
identify this number under the 6% column.
Hence the annual interest (r) = 6%
17. A loan of Rs. 500000 is to be repaid in 10 equal instalments. If the loan

carries 12% interest p.a., what is the value of one instalment?
Solution:
PV = A*PVIFA (12%, 10y)
500000 = A *5.650
500000/5.650= A
Rs. 88492 = A (instalment amount)
18. A person deposits Rs. 25,000 in a bank that pays 6% interest half-
yearly. Calculate the amount at the end of 3 years
Solution:
mXn
 i 
FVn = PV 1 + 
 m
I/m = 6%; m = 2; n = 3 yrs
25000*(1+0.06)3*2 = 25000*1.14185 = Rs. 35462
19. Find the present value of Rs. 100000 receivable after 10 years if 10%
is the time preference for money.
Time Value of Money
Solution:
FVn
PV =
(1 + i )n
Refer PVIF table (10%,10yrs)
PV =100000*(0.386)
= Rs. 38600
3.8 Terminal Questions

1. If you deposit Rs. 10000 today in a bank that offers 8% interest, how
many years will the amount take to double?
2. An employee of a bank deposits Rs. 30000 into his PF A/c at the end of
each year for 20 years. What is the amount he or she will accumulate in
his or her PF at the end of 20 years if the rate of interest given by PF
authorities is 9%?
3. A person can save _____________ annually to accumulate Rs. 400000
by the end of 10 years if the saving earns 12%.
4. Mr. Vinod has to receive Rs. 20000 per year for 5 years. Calculate the
present value of the annuity assuming he or she can earn interest on his
or her investment at 10% per annum.
5. Aparna invests Rs. 5000 at the end of each year at 10% interest p.a.
What is the amount she will receive after 4 years?
3.9 Answers
1. 9 years (using rule of 72); 8.975 years (using rule of 69)
2. 30000*FVIFA(9%, 20Y) = 30000*51.160 = Rs. 1534800
3. A*FVIFA(12%, 10y) = 400000 which is 400000/17.549 = Rs.22795
4. 20000*PVIFA(105, 5y)=20000*3.791 = Rs. 75820
5. 5000*FVIFA(10%, 4y) = 5000*6.105 = Rs. 23205
Time Value of Money
3.10 Case Study: Multiple Investment Avenues

In India, multiple investment avenues are available to meet the varied
interests and backgrounds of the public. These include savings bank
accounts, money market or liquid funds, and fixed deposits with banks.
These are mostly short-term investments avenues. There are also some
financial instruments which offer a long-term horizon for investment. These
include post office savings, public provident fund (PPF), company fixed
deposits, bonds, and mutual funds.
Small savings schemes in India are framed and enacted by the central
government under the Government Savings Bank Act, 1873, and
Government Savings Certificate Act, 1959. Small savings schemes came
into existence after independence with the objective of providing safe and
simple investment opportunities to the lower and middle income groups.
These schemes were channelised and administered by government
institutions, such as post offices and nationalised banks. With the same
objective, the PPF was established in 1968 for individuals to save for their
investments.
There are various schemes offered by the Government of India (GoI)
through post offices across the country. These schemes include the post-
office Savings Account, the post-office Recurring Deposit Account, the post-
office Time Deposit Account, the post-office Monthly Income Account, the
post-office Public Provident Fund Account, the Kisan Vikas Patra, the
National Savings Certificate, and the Senior Citizens Savings Scheme. The
maturity period of these schemes varies from very short as in the case of a
savings deposit to over 15 years as in the case of PPF. However, all these
investment options come under the same risk class as all of them have fixed
returns and are guaranteed by the GoI. The returns vary between the
schemes based on their features and maturity period.
The responsibility of promoting and mobilising small savings schemes rests
with the National Savings Institute (NSI), a division of the ministry of finance.
The NSI markets the small savings schemes on a nationwide basis and
provides the government with feedback from customers.
The small savings scheme programme aims at promoting the savings habit
and providing safe investment avenues to people with limited income and
savings potential. These schemes are operated through about 1,60,000 post
Time Value of Money
offices across the country. The PPF scheme is also operated through more
than 8000 branches of public sector banks.
Post Office Savings Schemes in India
The main financial services offered by the Department of Posts are the Post
Office Savings Bank. It is the largest and oldest banking service institution in
the country. The Department of Posts operates the Post Office Savings
Scheme function on behalf of the Ministry of Finance, Government of India.
Under this scheme, more than 20.50 crores savings accounts are operated.
These accounts are operated through more than 1,54,000 post offices
across the country.
The Post offices provide a number of savings schemes like the Savings
Account Schemes, Recurring Deposit Schemes, Time Deposit Schemes,
Public Provident Fund Schemes, Monthly Income Schemes, National
Savings Certificates, Kisan Vikas Patras, and Senior Citizens
Savings Scheme. A brief of the various schemes is as follows:
Investment
Interest Denominati
Scheme Tenure Salient Features Tax rebate
Rates ons and
limits
Post 3.5% p.a. On No Min: Rs. 50 • Cheque facility Interest is
Office individual specific Max: Rs. 1 available tax-free u/s
Savings and joint or fix lakh for 80L
Account account tenure individual
and 2 lakhs
for joint
account
5-Year 7.5% 5 years. Min: Rs. 10 • One withdrawal up to No tax rebate
Post compounded Can be per month 50% of
Office quarterly renewed or multiples the balance is
Recurring for of Rs. 5 allowed after one
Deposit another Max: No year.
Account 5 years limit • Full maturity value
allowed on R.D.
• 6 and 12 months
advance deposits
earn rebate.
Post 6.25% 1 year Min: Rs. 200 • Long-term accounts Investment
Office and its could be closed after qualifies for
6.50% 2 years
Time multiple 1 year for discounted deduction u/s
Deposit 7.25% 3 years thereof Max: interest. 80C. Interest
Account No limit • Accounts could be is tax-free u/s
7.50% 5 years 80L
Time Value of Money
closed after 6
months but before a
year for no interest.
• Interest is calculated
quarterly but payable
yearly.
Post 8% p.a. 6 years Min: Rs. • Account if closed Interest is
Office 1500 per after 1 year but tax-free u/s
Monthly month or before 3 years will 80L
Income multiples of suffer a deduction of
Account it. Max: Rs. 2% of the deposit.
4.5 lakhs for • Account if closed
individual after 3 years will
account and suffer a deduction of
Rs. 9 lakhs 1% of the deposit.
for joint • On maturity, bonus
account of 5% on principal
amount is admissible
15-year 8% p.a. 15 years Min: Rs. 500 • Withdrawal can be Investment
Public compounded tenure in 1 year made every year qualifies for
Provident yearly Max: Rs. after the 7th financial deduction u/s
Fund 70000 in 1 year. 80C. Interest
Account year • From the 3rd is tax-free u/s
Deposits financial year, loan 80L
can be can be availed
made in against PPF.
lump-sum or • No attachment under
12 court decree order.
instalments
Kinas 8.4% --- No limits. • A single holder No tax
Vikas compounded Investment certificate can be benefits
Patra yearly. denominatio purchased by an
Money ns available adult.
doubles in 8 are of • A certificate can also
years and 7 Rs. 100, be purchased jointly
months Rs. 500, by two adults.
Rs. 1000,
Rs. 5000,
Rs. 10,000,
in all Post
Offices and
Rs. 50,000
in all Head
Post
Offices.
National 8% p.a. 6 years Min: • A single holder Investment
Savings compounded Rs. 100. certificate can be as well as the
Certificate half-yearly Also purchased by an interest
(VIII issue) but payable available in adult. deemed to
after maturity denominatio be re-
Time Value of Money
ns of Rs. invested
100/-, 500/-, qualifies for
1000/-, 5000 deduction u/s
and Rs. 80C.
10,000/-.
Max: no limit
Senior 9% p.a. 5 years Only 1 • Age should be above Investment
Citizens deposit 60 years or 55 years qualifies for
Savings allowed in above if retired under deduction u/s
Scheme multiple of superannuation. 80C.
Rs. 1000. • Account if closed
Max is after 1 year will
Rs. 15 lakhs suffer a deduction of
1.5% interest and
after 2 years will
suffer a deduction of
1% interest.
• TDS is made on
interest if it exceeds
Rs. 10000 p.a.
Mr. Sreedhar is looking for some simple investment options. Mr. Sreedhar
works in a local textile factory. His annual income is Rs. 5,30,000. His
monthly net pay is approx. Rs. 37,000. The break-up of his salary income is
as below:
Salary Components Monthly Annual
Basic 15,900 1,90,800
Allowances /FBP 21,179 2,54,146
Sub-total(A) 37,079 4,44,946
PF 1,908 22,896
Gratuity 763 9,158
Retirals Total(B) 2,671 32,054

Performance Based
53,000
Pay
Variable Pay(C)
Total(A+B) 39,750 5,30,000

FBP - Flexible Benefit Plan (Consists of various options in the
menu from which one can choose what he wants to take. These
are basically allowances/reimbursements which attracts Fringe
Time Value of Money
Benefit Tax). The unclaimed amount is paid as Special Allowance

and taxed fully as per the tax bracket.
Mr. Sreedhar has decided to invest Rs.1,00,000 per annum in a balanced

proportion of short (<5 years ) and long term (7–15 yrs) instruments of
investments. He is looking at the same as an avenue to avail tax benefits.
He would appreciate a portion of returns to come to him in a series of even
flows through the tenure of the investment to meet some of his monthly
commitments.
He is rather conservative and wants to invest in the Post Office savings
schemes, as he believes they are simple and safe.
Discussion Questions:
1. Help Mr. Sreedhar choose a good mix of instruments and thus plan his
investments.
(Hint: Do keep in mind to take care of his requirements of proportions,
returns, and tenure of investments. Justify your suggestion with details of
returns and how the selected scheme is most profitable.)
2. Mr. Sreedhar is further considering two finance schemes to purchase a
motorbike. His income details are as available above. The price of the
motorbike of his choice is Rs.24,000. Prime Finance Ltd. is offering
100% finance on the bike for a period up to 2 years. For a two-year
finance scheme, Mr. Sreedhar has to pay monthly instalments of
Rs.1,200. Another finance scheme under consideration is offered by a
mercantile bank. But the bank wants Mr. Sreedhar to bring in a margin of
Rs.5,000 and pay equated monthly instalment of Rs.940 for two years.
Mr. Sreedhar is confident that he can raise the amount of margin
payment from a friend and repay it in semi-annual instalments of
Rs1,500 each in two years. He would like to find the effective rate of
interest under both the alternatives and opt for the alternative which has
lower interest rate. Help him in choosing the more profitable alternative.
(Hint: Find the effective rate of interest under both the alternatives and
opt for the alternative which has lower interest rate.)
(Source: www.finmin.nic.in retrieved on 10/12/2011)
Time Value of Money
References:
• Keown, Arthur J. (2005). Financial Management. Principles and
Applications, 10th Edition.
• "Time Value of Money", (2008) Finance for Engineers,
E-References:
• www.ideaindia.org retrieved on 10/12/2011
• www.finmin.nic.in retrieved on 10/12/2011

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Segment 2: Value of Money and Valuation of Bonds

Consider this – we intuitively know that Rs.100 in hand now is more

3.2 Time Preference for Money

For example, if an individual’s time preference is 8%, it implies that he or

Required rate of return = Risk-free rate + Risk premium

Where, A = Amount at the end of the period

Amount of interest 50 52.50 55.13

3.2.1.2 Discounting technique

Where P is the present value for the future sum to be received,

3.3 Future value

Where, FVn = future value of the initial flow in n years hence,

3.3.1 Doubling period

3.3.2 Increased frequency of compounding

Going by the calculations, we see that one gets more interest if

Where, FVn = future value after n years

3.3.3 Effective vs. nominal rate of interest

3.3.4 Future value of series of cash flows

2 1000 3 1.158 1158

3 1500 2 1.103 1654

4 2000 1 1.050 2100

5 2500 0 1.000 2500

Amount at the end of the fifth year Rs.8020

The value at the end of the fifth year is Rs. 8020

Thus, to ascertain the accumulation of a series of unequal flows as at the

3.3.5 Future value of an annuity

The expression [(1 + i ) n − 1] / i ) is called the Future Value Interest Factor

Table 3.5: Computation of Future Value of Annuity

If the payments/investments are made at the beginning of every year, then

3.3.6 Sinking fund

fund account yielding 14 percent interest to cumulate Rs. 50,00,000 six

3.4 Present Value

Where, PV = Present Value

3.4.2 Present value of even series of cash flows

Present value of an annuity is Rs. 1585.

3.4.3 Present value of perpetuity

Where, = Present value of perpetuity

Therefore, the value of is

3.4.4 Present value of an uneven periodic sum

3.4.5 Capital recovery factor

3.7 Solved Problems

Solution: FVAn = A * FVIFA (12%,5yrs)

Solution: PV = A * PVIF(r%,8 yrs)

17. A loan of Rs. 500000 is to be repaid in 10 equal instalments. If the loan

3.8 Terminal Questions

3.10 Case Study: Multiple Investment Avenues

Salary Components Monthly Annual

Basic 15,900 1,90,800

Allowances /FBP 21,179 2,54,146

Sub-total(A) 37,079 4,44,946

Gratuity 763 9,158

Retirals Total(B) 2,671 32,054

Total(A+B) 39,750 5,30,000

Benefit Tax). The unclaimed amount is paid as Special Allowance

Mr. Sreedhar has decided to invest Rs.1,00,000 per annum in a balanced

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