TIME VALUE OF MONEY

Objectives
On completing this session we will be able to
o explain the meaning & usefulness of "time value of
money."
o explain the relationship between present and future
value.
o describe how the interest rate can be used to adjust
the value of cash flows both forward and backward
to a single point in time.
o compute both the future and present value of: (a) an
amount invested today; (b) a stream of mixed cash
flows. (c) a stream of equal cash flows (an annuity);
o compute the present value of perpetuity and growing
perpetuity
o describe the impact of frequency of
compounding/discounting
o explain and compute the effective rate of return
o compute the doubling period
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 INTEREST.
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 by
an interest rate.
A investor has two options. Either he can go for simple
interest and compound interest.
Simple 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 period
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but not withdrawn during earlier periods.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,
o 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.


Simple Interest V/s Compound Interest
Here, P=1000, n=5 years, k=10% p.a.







By this example, it is clear that investor always prefer
compound interest.
CI
1000+(1000 X 0.10) = 1100
1100+(1100 X 0.10) = 1210
1210+(1210 X 0.10) = 1331
1331+(1331 X 0.10) = 1464
1464+(1464 X 0.10) = 1610
SI
1000+(1000 X 0.10) = 1100
1100+(1000 X 0.10) = 1200
1200+(1000 X 0.10) = 1300
1300+(1000 X 0.10) = 1400
1400+(1000 X 0.10) = 1500
Year
1
2
3
4
5
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
o Future 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.
o Present 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.
Some points before we start problems.
There are three types of cash flows
o Single Flow
o Multiple Flow-Uneven Series
Cash flows occurring at the beginning of the
period
Cash flows occurring at the end of the period
o Multiple Flow-Even Series (Annuities)
Cash flows occurring at the beginning of the
period
Cash flows occurring at the end of the period
NOTE: A cash flow can be outflow (deposit) or inflow
(receipt).
Some points before we start problems.
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.
Annuity Due: Payments or receipts occur at the beginning of
each period.
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,
o FV
n
= Future Value of Initial Cash Flow n years
o PV
0
= Initial Cash Flow
o r = Annual rate of return
o n = 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, IFVIF
(12%,5)
=1.7623. What does it indicate?
FVIF is always has a value greater than 1 for positive r.
Why?
FVIF increases as r and n increase. i.e. FV increases as
r and n increase
What is the relationship between FV and Interest rate?
Direct relationship i.e. as rate of interest increases FV
also increases
The solution can be find out by using Future Value
Interest Factor (FVIF) table.
FV
n
= PV X FVIF
(r,n)

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
o 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 + + + + + + + =
Calculation of Future Value of Multiple Flow-Even
series (Annuity)
The cash flow can occur either at the end of the year or
beginning of the year.
o Regular 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
=?
o Annuity 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
=?
Make out the difference between two time lines.
Which cash flow generate the highest FV? Why?

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 FV of Multiple Flow-Even series
(Annuity)
In the above formula
o FVA
n
= Future Value of Annuity at the end of the n
years
o A = Amount invested at the end (regular
annuity)/beginning (annuity due) of the every year
for n years
o k = Annual rate of return
o n = 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
Calculation of Future Value of Multiple Flow-Even
series (Annuity)
The solution can be found out by using Future Value
Interest Factor Annuity (FVIFA) table.
o Future Value of Regular Annuity is
FVA
n
= A X FVIFA
(r,n)
o Future Value of Annuity due is
FVA
n
= A (1+r) X FVIFA
(r,n)

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.
Why Regular annuity? Why not annuity due?
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,
o PV=Present Value
o FVn = Future Value
o r = Annual rate of return
o n = 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?
PVIF increases as r and n decrease. i.e. PV decreases
as r and n increase
The solution can be find out by using Present Value
Interest Factor (PVIF) table.
PV
0
= FV
n
X PVIF
(r,n)
(

+
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.
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
PV
0
=? 0 1000 1500 750 2000 3000
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
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
o PV
0
= Present 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
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.
o Regular 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
o Annuity 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,
o PVA
0
= Present Value of Annuity
o A = Amount deposited/invested at the end of the
every year for n years
o k = Annual rate of return
o n = Life of Investment
In the above Formula, the term

Present Value Interest Factor of Annuity (PVIFA) of Rs 1.


(

+
+
n
r) r(1
1 ) r 1 (
n
Calculation of Present Value of Multiple Flow-Even
Series (Annuity)
The solution can be find out by using Present
Value Interest Factor Annuity (PVIFA) table.
o Present Value of Regular Annuity is
PVA
0
= A X PVIFA
(r,n)
o Present Value of Annuity due is
PVA
0
= A X PVIFA
(r,n)
(1+r)


Calculation of Present Value of Multiple Flow-Even
series (Annuity)
Application:
o Period of Loan amortization
o Determining the Loan Amortization schedule
o Determining the periodic withdrawal
o Finding the interest rate

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
0
r
A
PV =

PV
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
0
g - r
A
PV =

PV
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?
We can find out the future value and present value by
modifying the formula as below.
o r should be divided by number of frequency per annum
o n should be multiplied number of frequency per annum

Intra-Year Compounding/Discounting
In bank most of the time we use intra year
compounding/discounting
For Example,
o Fixed deposits are quarterly compounded
o Recurring deposits are quarterly compounded
o All retail loans (Personal loans, Home loans, Educational
Loans, Vehicle Loans etc.) monthly installments are
monthly discounted
[Refer next chapter]
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 and why?
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 k = normal rate of return
o m = frequency of compounding
1
m
r
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 37
Quarterly
10%
10.38%
Semi-annually
10%
10.25%
Annually
10%
10%
Particulars
Normal rate of Interest
Effective rate of interest
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 .

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+ =