Time Value of Money

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Time Value of Money

Prof. (Dr.) Paresh Shah

FCMA., Ph.D. (Finance),
F.D.P. (IIM-Ahd.)

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Introduction to Financial
Mathematics

Financial mathematics deals with the problem of

investing money, or capital. If a company (or an
individual investor) puts some capital into an
investment, it (or he/she) will want a financial return
for it.

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Time lines show timing of cash flows.

CF1

CF2

CF3

i%

CF0

Tick marks at ends of periods, so Time 0

is today; Time 1 is the end of Period 1;
or the beginning of Period 2.
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Time line for a Rs.100 lump sum

due at the end of Year 2.
0

i%

2 Year
100

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Notation Subscripts

In both compounding and discounting, subscripts

are used to show the period of time to which a
sum of money relates.

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Interest

Interest is the amount of money, which a capital

investment earns when it is invested for a certain
length of time.

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Simple Interest

Simple interest is the amount of interest, which is earned in

an equal amount every year (or month), and which is a given
proportion of the (original investment or principal).

If a sum of money is invested for a period of time than the

amount of simple interest, which accrues is equal to the
number of accounting periods x the interest rate X the
amount invested, i.e.

S n = P + nr P

Where P = Original sum invested;

r = Interest rate (Expressed as a proportion, e.g.

10% = 0.1)

n = Number of periods (Normally years);

S = Sum after n periods, consisting of the original

capital plus interest earned

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Compound Interest

Interest is normally calculated by means of

compounding. If a sum of money, the principal, is
invested at a fixed rate of interest and the interest is
added to the principal and no withdrawals are made,
then the amount invested grows at an increasing rate
as time progresses, because interest earned in earlier
periods itself also earns interest later on.

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Whats the FV of an initial Rs.100

after 3 years if i = 10%?
0

10%

100

FV = ?

Finding FVs (moving to the right

on a time line) is called compounding.
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After 1 year: FV1 = PV + INT1 = PV + PV (i)

= PV(1 + i)
= Rs.100(1.10)
= Rs.110.00.
After 2 years:

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FV2 = PV(1 + i)2

= Rs.100(1.10)2
= Rs.121.00.

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After 3 years:

FV3 = PV(1 + i)3

= Rs.100(1.10)3
= Rs.133.10.

In general,

FVn = PV(1 + i)n.

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Will the FV of a lump sum be larger or

smaller if we compound more often, holding
the stated I% constant? Why?
LARGER! If compounding is more
frequent than once a year--for
example, semiannually, quarterly,
or daily--interest is earned on interest
more often.

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10%
100

133.10

Annually: FV3 = Rs.100(1.10)3 = Rs.133.10.

0
0

1
2

2
4

3
6

5%
100

134.01

Semiannually: FV6 = Rs.100(1.05)6 = Rs.134.01

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We will deal with 3 different

rates:
iNom = nominal, or stated, or
quoted, rate per year.
iPer = periodic rate.
effective annual
rate
EIR =
.

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 iNom

is stated in contracts. Periods per year

(m) must also be given.
Examples:
8%; Quarterly
8%, Daily interest (365 days)

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Periodic rate = iPer = iNom/m, where m is number

of compounding periods per year. m = 4 for
quarterly, 12 for monthly, and 360 or 365 for
daily compounding.
Examples:

8% quarterly: iPer = 8%/4 = 2%.

8% daily (365): iPer = 8%/365 = 0.021918%.

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Effective Annual Rate (EAR =

EFF%):
The annual rate which causes PV to grow to
the same FV as under multi-period
compounding.
Example: EFF% for 10%, semiannual:
FV = (1 + iNom/m)m
= (1.05)2 = 1.1025.
EFF% = 10.25% because
(1.1025)1 = 1.1025.
Any PV would grow to same FV at 10.25%
annually or 10% semiannually.
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An investment with monthly payments

is different from one with quarterly
payments. Must put on EIR% basis to
compare rates of return. Use EIR% only
for comparisons.
Banks say interest paid daily. Same
as compounded daily.

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How do we find EFF% for a nominal rate of 10%,

compounded semiannually?

iNom m
1+ m -1

(
)
= (1 + 0.10) - 1.0
2

EIR% =

= (1.05)2 - 1.0
= 0.1025 = 10.25%.

Or use a financial calculator.

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EAR = EFF% of 10%

EARAnnual

= 10%.

EARQ

= (1 + 0.10/4)4 - 1

= 10.38%.

EARM

= (1 + 0.10/12)12 - 1

= 10.47%.

EARD(360) = (1 + 0.10/360)360 - 1 = 10.52%.

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FV of Rs.100 after 3 years under 10%

semiannual compounding? Quarterly?

iNom

FVn = PV 1 +

m
FV3S

mn

0.10

= Rs.100
1 +

2
= Rs.100(1.05)6

2x3

= Rs.134.01.

FV3Q = Rs.100(1.025)12 = Rs.134.49.

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Can the effective rate ever be equal

to the nominal rate?
Yes, but only if annual compounding is
used, i.e., if m = 1.
If m > 1, EFF% will always be greater than
the nominal rate.

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When is each rate used?

iNom: Written into contracts, quoted

by banks and brokers. Not
used in calculations or shown
on time lines.

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Changes in the Rate of Interest

If the rate of interest changes during the period of an

investment, the compounding formula would be amended
slightly as follows

Sn = P(1+ r1)x (1+r2)(n-x)

Where r1 = Initial rate of interest

x = Number of years in which the interest rate r1

applies

r2 = Next rate of interest

n x =Balancing number of years in which the

interest rate r2 applies

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Increasing the Sum Invested

Each Year

There is an alternative formula for calculating the

value of an investment at the end of n years, which
you may prefer to use, or which you may be
required to use in an examination.

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Discounting

The discounting is the reverse of compounding.

Its major application in business is in the evaluation of

the capital expenditure projects, to decide whether they
offer a satisfactory return to the investor.

This technique of discounting is known as Discounted

Cash Flow, (DCF), and this will be described later.

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Whats the PV of Rs.100 due in 3 years

if i = 10%?

Finding PVs is discounting, and its

the reverse of compounding.

10%

PV = ?

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100

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Solve FVn = PV(1 + i )n for PV:

PV =

FVn
1

n = FVn
1+ i
1+ i

PV = 100
1.10
= 100 0.7513 = Rs.75.13.
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Present Values

The term present value is often used in

discounting cash flow. It simply means the amount
of money, which must be invested now for n years
at an interest rate of r %, to earn a future sum of
money at the end of year n.

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What is the PV of this uneven cash

flow stream?

100

300

300

-50

10%

90.91
247.93
225.39
-34.15
530.08 = PV
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Annuities

An annuity is a stream of equal annual cashflows.

A more general definition of an annuity would be a

constant sum of money each year for a given number
of years.

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Whats the difference between an

ordinary annuity and an annuity due?
Ordinary Annuity
0

i%

PMT

PMT

PMT

PMT

PMT

Annuity Due
0
i%
PMT
PV
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FV
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Whats the FV of a 3-year ordinary annuity of

Rs.100 at 10%?
0

100

100

10%

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100
110
121
FV = 331
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Whats the PV of this ordinary annuity?

100

100

100

10%

90.91
82.64
75.13
248.69 = PV
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Cash Flows of Perpetuity

The present value of an annuity for every year in

perpetuity is PV = a / r where r is the cost of
capital as proportion.

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