TIME VALUE OF MONEY

Which one do you prefer?

Eg.1 - A Rs.1000 receivable now or a year later.
Obviously, Rs.1000 today.
Eg.2 - Today you lent Rs.10,000 to Mr.X. After 5 years do
you want to receive same amount what you lent or
higher than that?
Obviously, higher than Rs.10,000.
You already recognize that there is TIME VALUE TO
MONEY!!
TIME allows you the opportunity to postpone
consumption and earn RETURN.
Why should money have time value?
A Rupee received today is worth more than a rupee received
tomorrow.
Three reasons may be attributed to the individuals time
preference for money:
preference for consumption
investment opportunities
Inflation
The time preference for money is generally expressed in
percentages per annual for e.g. 8% p.a.
Time value of money differs from time to time and person to
person
A lender/borrower has two options. Either he can go for simple
interest and compound interest.
'Simple' or 'flat rate' interest is the amount of interest
paid each year as a fixed percentage of the principal
amount. And is calculated by using the formula
SI = Pnr
If the investor does not withdraw the interest
periodically, the maturity value of investment would be
calculated by using the formula
FV = SI +P
Where,
o SI = Simple Interest
o P = Principal
o n = Maturity priod
o r = interest rate
o FV= Maturity value after n years
Compound Interest
Compound Interest is the interest that is received on the
original amount (principal) as well as on any interest earned
but not withdrawn during earlier periods. And is calculated by
using the formula
CI = P (1+r)
n
P
The maturity value of investment would be calculated by
using the formula
FV= P (1+r)
n
Where,
CI = Compound Interest
o P = Principal
o n = Maturity Period
o k = interest Rate
o F = Total Amount after n years

Simple Interest V/s Compound Interest
What is the difference between Simple interest
and Compound interest?
How does these affect on your investment?
Which one would you prefer? Why?
You deposited Rs. 1000 for 5 years at 10% interest
rate. Find out how much amount you get after 5
years for simple interest and compound interest?
Interpret the answer.


Time Value Adjustment
The time value of money is a way of calculating the value of
a sum of money, at any time in the present or future. It
allows us to calculate
oFuture Value: is the future worth of a present
amount. i.e. is the investments maturity value that an
investor would receive at the end of the specified
period. The process of calculating future values is
called as COMPOUNDING.
oPresent Value: is the present worth of an amount that
will be received in the future. i.e. is the amount that
needs to be invested now, at the specified rate , to get
the future cash flow. The process of calculating
present values is called as DISCOUNTING.
There are three types of cash flows
oSingle Flow
oMultiple Flow-Uneven Series
Cash flows occurring at the beginning of the period
Cash flows occurring at the end of the period
oMultiple Flow-Even Series (Annuities)
Cash flows occurring at the beginning of the period
[Annuity due]
Cash flows occurring at the end of the period
[Regular Annuity]
NOTE: A cash flow can be outflow or inflow.
An Annuity represents a series of equal payments (or receipts)
occurring over a specified number of equidistant periods. (say
monthly, quarterly, semi-annually etc.)
Types of Annuity
Regular Annuity: Payments or receipts occur at the
end of each period. examples bonds pay interest at
the end.
Annuity Due: Payments or receipts occur at the
beginning of each period. examples lease rentals or
mortgage. payments
Examples of Annuities:
Recurring deposits, PF deposits, Student Loan
Payments, Retirement Savings, Car Loan Payments,
Insurance Premiums, Mortgage Payments, etc.
Some points before we start problems.
Steps to Solve Time Value of Money Problems
1. Read Problem Thoroughly
2. Create a Time Line
3. Put Cash Flows and Arrows on Time Line
4. Determine whether it is a PV or FV Problem
5. Determine if Solution involves a Single CF, Annuity
Stream (s), or Mixed Flow
6. Apply appropriate formula
7. Solve the Problem


Calculation of Future Value of Single Flow
0 1 2 3 4 5
I 12% I 12% I 12% I 12% I 12%_____I
1000 FV
5
=?
The future Value of single cash flow can be calculated by using
following formula
FV
n
= PV(1+r)
n

Where,
oFV
n
= Future Value of Initial Cash Flow n years
oPV = Initial Cash Flow
or = Annual rate of return
on = Life of Investment

Calculation of Future Value of Single Flow
In the above formula, the term (1 + r)
n
is the Future Value
Interest Factor (FVIF) of a lump sum of Rs. 1,
For example, FVIF
(12%,5)
=1.7623. What does it indicate?
FVIF is always has a value greater than 1 for positive r. Why?
What is the relationship between FV and Interest rate?
Direct relationship i.e. as rate of interest increases FV also
increases.
FV increases as r and n increase. i.e. FV increases as r
and n increase

CALCULATION OF FUTURE VALUE OF MULTIPLE FLOW-UNEVEN SERIES
The cash flow can occur either at the end of the year or beginning of
the year.
o Multiple Flow-Uneven Series occurring at the end of the period
0 1 2 3 4 5
I 12% I 12% I 12% I 12% I 12% I
0 1000 1500 750 2000 3000 FV
5
=?

o Multiple Flow-Uneven Series occurring at the beginning of the
period
0 1 2 3 4 5
I 12% I 12% I 12% I 12% I 12% I
1000 1500 750 2000 3000 0 FV
5
=?
Make out the difference between two time lines.
Which cash flow generate the highest FV? Why?
CALCULATION OF FUTURE VALUE OF MULTIPLE FLOW-UNEVEN SERIES
Find out future value of all cash flows individually and sum up
When cash flows occur at the end of the year


o When cash flows occur at the beginning of the year


Where,
o FV
n
= Future Value of all cash flow n years
o CF
n
= Cash flow during year n
o r = Annual rate of return
o n = Life of Investment
0
n
3 - n
3
2 - n
2
1 - n
1 n
r) (1 CF .......... r) (1 CF r) (1 CF r) (1 CF FV + + + + + + + =
1
n
2 - n
3
1 - n
2
n
1 n
r) (1 CF . .......... r) (1 CF r) (1 CF r) (1 CF FV + + + + + + + =
The cash flow can occur either at the end of the year or
beginning of the year.
oRegular Annuity
0 1 2 3 4 5
I 12% I 12% I 12% I 12% I 12% I
0 1000 1000 1000 1000 1000 FV
5
=?
oAnnuity Due
0 1 2 3 4 5
I 12% I 12% I 12% I 12% I 12% I
1000 1000 1000 1000 1000 0 FV
5
=?

Calculation of Future Value of Multiple Flow-Even series
(Annuity)
The Future Value of Annuity can be calculated by using following
Formulae
o Future Value of Regular Annuity


o Future Value of Annuity Due


NOTE: Where CF
1
=CF
2
=CF
3
==CF
n
=A

(

+
=
r
1 r) (1
A FVA
n
n
r) (1
r
1 r) (1
A FVA
n
n
+
(

+
=
Calculation of Future Value of Multiple Flow-Even series
(Annuity)
In the above formula



oFVA
n
= Future Value of Annuity at the end of the n years
oA = Amount invested at the end (regular
annuity)/beginning (annuity due) of the every year for n
years
or = Annual rate of return
on = Life of Investment
In the above formula, the term is the Future Value Interest
Factor of Annuity (FVIFA) of Rs.1.

(

+
r
1 r) (1
n
For example, FVAIF
(12%,5)
=6.3528. What does it
indicate?
FVAIF is always has a value greater than n for
positive r.
NOTE: In reality, most of the cases we use regular
annuity than annuity due. If information regarding
the point of deposit/receipt of cash flow is missing
in the problem, it is assumed that the cash flow
occurred at the end of the month i.e. regular
annuity.

CALCULATION OF FUTURE VALUE OF MULTIPLE
FLOW-EVEN SERIES (ANNUITY)
Application:
o Knowing what lies in store for you
o How much should you save annually
o Annual deposit in a sinking fund
o Finding the interest rate
o How long should you wait

Calculation of Present Value of Single Flow

0 1 2 3 4 5
I 12% I 12% I 12% I 12% I 12%_____I
PV
0
=? 10000
The present value of single cash flow can be calculated by using
following formula


Where,
oPV=Present Value
oFVn = Future Value
or = Annual rate of return
on = Life of Investment

(

+
=
n
n
r) (1
1
FV PV
Calculation of Present Value of Single Flow


In the above formula, the term is the Present

Value Interest Factor (PVIF) of a lump sum of Rs.1.
For example, PVIF
(12%,5)
=0.5674. What does it indicate?
PVIF is always has a value lower than 1 for positive r. Why?
What is the relationship between PV and r?
Inverse relationship i.e. as rate of interest increases FV also
increases.
PV increases as r and n decrease. i.e. PV decreases as r and
n increase

(

+
n
r) (1
1
Calculation of Present Value of Multiple Flow-Uneven Series
The cash flow can occur either at the end of the year or beginning
of the year.
oMultiple Flow-Uneven Series occurring at the end
of the period
0 1 2 3 4 5
I 12% I 12% I 12% I 12% I 12% I
PV
0
=? 0 1000 1500 750 2000 3000
oMultiple Flow-Uneven Series occurring at the
beginning of the period
0 1 2 3 4 5
I 12% I 12% I 12% I 12% I 12% I
PV
0
=?1000 1500 750 2000 3000 0
CALCULATION OF PRESENT VALUE OF MULTIPLE FLOW-UNEVEN
SERIES
Find out Present value of all cash flows & sum up
o When cash flow receivable at the end of the year




o When cash flow receivable at the beginning of the year


Where
oPV
0
= Present Value of all cash flow n years
oCF
n
= Cash flow during year n
or = Annual rate of return
on = Life of Investment
n
n
3
3
2
2
1
1
0
r) (1
CF
... ..........
r) (1
CF
r) (1
CF
r) (1
CF
PV
+
+ +
+
+
+
+
+
=
1 - n
n
2
3
1
2
0
1
0
r) (1
CF
... ..........
r) (1
CF
r) (1
CF
r) (1
CF
PV
+
+ +
+
+
+
+
+
=
Calculation of Present Value of Multiple Flow-Even
Series (Annuities)
The cash flow can occur either at the end of the year or
beginning of the year.
oRegular Annuity
0 1 2 3 4 5
I 12% I 12% I 12% I 12% I 12% I
PV
0
=? 0 1000 1000 1000 1000 1000

oAnnuity Due
0 1 2 3 4 5
I 12% I 12% I 12% I 12% I 12% I
PV
0
=?1000 1000 1000 1000 1000 0

Calculation of Present Value of Multiple Flow-Even Series
(Annuity)
The Present Value of Annuity can be calculated by using
following Formulae
o Present value of regular annuity



o Present value of annuity due




NOTE: Where CF
1
=CF
2
=CF
3
==CF
n
=A

(

+
+
=
n
n
0
r) r(1
1 ) r 1 (
A PVA
r) (1
r) r(1
1 ) r 1 (
A PVA
n
n
0
+
(

+
+
=
Calculation of Present Value of Multiple Flow-Even Series
(Annuity)
In the above Formula,



oPVA = Present Value of Annuity
oA = Amount deposited/invested at the end of the every
year for n years
ok = Annual rate of return
on = Life of Investment
In the above Formula, the term
Present Value Interest Factor of Annuity

(

+
+
n
n
r) r(1
1 r) (1
Calculation of Present Value of Multiple Flow-
Even series (Annuity)
Application:
oDetermining repayment instalment
oDetermining the periodic withdrawal
oDetermining the Loan Amortization schedule
oFinding the interest rate

Look at the following problems
1. Kapoor Ltd owns a factory , the factory is
expected to produce annual fixed cash flow
of 78720 forever and has a cost of capital
of 16.4%. What is the worth of the factory?

2. Longhorn corporation issues a security that
promises to pay to pay its holders Rs 200
indefinitely. Money markets are such that
investors can earn about 8 .p.a .How much
can longhorn sell this special security for?

Present Value of Perpetuity
An annuity of infinite duration is known as Perpetuity.
Present value of perpetuity


OR

Where,
o = Present value of perpetuity
o A = Annual Cash flow
o r = Required rate of return

+
+ +
+
+
+
+
+
=
r) (1
A
... ..........
r) (1
A
r) (1
A
r) (1
A
PVA
3 2 1
r
A
PVA =

PVA
Look at the following problem
Seema owns a fashion clothing store that is
expected to produce cash flows forever, the
next cash is expected to be 50,000 and
subsequent cash flows are expected to
increase by 3% each year forever, the cost of
capital for the shop is 9%. What is the fashion
worth?

Present value of growing perpetuity
In case of growing perpetuity the annual cash flow
grows at a constant rate of g.

Present value of growing perpetuity




OR



Where,
o = Present Value of Perpetuity
o A = Amount receivable at the end of the every year for n years
o r = Required rate of return
o g = Growth Rate

+
+
+ +
+
+
+
+
+
+
+
=
r) (1
) g 1 ( A
... ..........
r) (1
g) 1 ( A
r) (1
g) 1 ( A
r) (1
A
PVA
3
2
2 1
g - r
A
PVA =

PVA
DOUBLING PERIOD
If you know the compound rate of return of your investment is going to earn,
can you tell in how many years the investment will get doubled?
It can be calculated by using below formulae.
Doubling Period


o .


Out of above two, Rule of 69 gives the precise answer where as Rule of 72
gives the approximate answer.
Rate Interest
72
72 of Rule =
Rate Interest
69
35 . 0 69 of Rule+ =
Intra-Year Compounding/Discounting
Can we go for multiple compounding/ discounting in a year?
If yes, How frequently we can go for compounding /
discounting in a year?
What is the use of that?
How to calculate the future value and present value?
In two way we can find out the future value and present
value
By modifying the formula as below.
r should be divided by number of frequency per annum
n should be multiplied number of frequency per annum
By taking r as effective rate of return



Intra-Year Compounding/Discounting
In bank most of the time we use intra year
compounding/discounting
For Example,
oFixed deposits are quarterly compounded
oRecurring deposits are quarterly compounded
oAll retail loans (Personal loans, Home loans,
Educational Loans, Vehicle Loans etc.) monthly
installments are monthly discounted

Impact of frequency
You deposited Rs.10000 for 1 year which earns at
an interest rate of 10%. You got three options for
compounding viz. yearly, semiannually, quarterly.
Which will you prefer
Impact of frequency
Example: Consider, P=10,000, n=1year, r=10% p.a., m =
1 (annually)/2 (Semi-annually)/4 (Quarterly)
Quarterly
10000.00
250.00
10250
256.25
10506.25
262.65
10768.90
269.25
11038.15
Semi-annually
10000
-
-
500
10500
-
-
525
11025
Annually
10000
-
-
-
-
-
-
1000
11000
Particulars
Amount at beginning
Interest for the first Quarter
Amount at the end of 3 months
Interest for the Second Quarter
Amount at the end of 6 months
Interest for the third Quarter
Amount at the end of 9 months
Interest for the fourth Quarter
Amount at the end of the year
Effective Rate of Return
The rate of interest under annual compounding
which produces the same result as that produced
by an interest rate under multiple compounding. It
can be calculated by using below formula


Where
o r = effective rate of return
o i= normal rate of return
o m = frequency of compounding
1
m
i
1 r
m

+ =
Effective Rate of Return
Find out the effective rate of return for the previous
problem in case of annual, semi-annual and quarterly
compounding.
Effective rate of return for the example which is in slide
35





Particulars

Annually

Semi-annually

Quarterly

Normal rate of
Interest
10% 10%

10%

Effective rate of
interest
10% 10.25%

10.38%

Future Value 10000(1.1)
=11000
10000(1.1025)
=11025
10000(1.1038)
=11038