Financial Management I

6. Time Value of Money

suresh.suralkar@gmail.com, Phone: 40434399

 Course Content - Syllabus


Sr Title ICMR Ch. PC Ch. IMP Ch.




1 Introduction to Financial Management 1* 1 1



2 Overview of Financial Markets 2* 2 -



3 Sources of Long-Term Finance 10* 17 20, 21



4 Raising Long-term Finance - 18* 20, 21, 23



5 Introduction to Risk and Return 4* 8, 9 4, 5



6 Time Value of Money 3* 6 2



7 Valuation of Securities 5* 7 3


8 Cost of Capital 11* 14 9



9 Basics of Capital Expenditure Decisions 18* 11 8



10 Analysis of Project Cash Flows - 12* 10, 11



11 Risk Analysis and Optimal Capital - 13* 12



*Book preference
Expenditure Decision
2 / 53
  Time Value of Money


Reference Books


1. Financial Management, ICMR Book, Chapter 3

2. Financial Management, Prasanna Chandra, 7th Edition,

Chapter 6

3. Financial Management, I. M. Pandey, 9th Edition,

Chapter 2

3 / 57
  Syllabus – Time Value of Money


1. Introduction
2. Types of Cash Flows
3. Future Value of a Single Cash Flow
4. Multiple Flows and Annuity
5. Present Value of a Single Cash Flow
6. Multiple Flows and Annuity
7. Growing Annuity
8. Perpetuity and Growing Perpetuity
4 / 57
  1. Introduction


Companies take up new projects, where they invest money



for the benefits expected over a period of time in future.

•
•
 4 Cr 1 Cr 1 Cr 1 Cr 1 Cr 1 Cr
Investment

How to determine whether the project is financially viable

or not?
Answer to this question will be to sum up the benefits

accruing over the future period and compare the total

value of benefits with the initial investment.
If the total of benefits exceed the initial investment, then

the project is considered to be financially viable.

5 / 57
  1. Introduction


Concept of Time Value of Money

One rupee at present is worth more than one rupee next

year. Because one rupee at present can be invested to

earn an income. Value of money at present is more than
value of money in future time. Hence we can say money
has a value based on time. This concept is called as ‘time
value of money’ or an ‘interest’.


•
 4 Cr 1 Cr 1 Cr 1 Cr 1 Cr 1 Cr
Investment

 Present values 0.86Cr 0.74Cr 0.64Cr 0.55Cr
0.47Cr
 total 3.26 Cr


6 / 57
  1. Introduction


How to determine the time value of money and use it into

cash flows of a project?
 We are going to study these things in this chapter.
Nominal or market interest rate depends on real interest

rate, inflation and uncertainty about future.



 Nominal or market interest rate = Real interest rate +

expected inflation rate + risk premium for uncertainty


Due to inflation, a rupee today has higher purchasing

power than rupee in future.
Future is characterized by uncertainty, which require

some risk premium.

7 / 57
  Compounding


 0 1 2 3 4
 -1000 250 500 750 750
 +
 FV(750)
 +
 FV(500)
 +
 FV(250)


 compare with
FV(1000)


 Under the method of compounding, we find the future

values (FV) of all the cash flows at the end of the time
horizon, at a particular rate of interest.
8 / 57
  Discounting


 0 1 2 3 4
 -1000 250 500 750
750
 compare with the
 sums of PV(250)
 +
 PV(500)
 +
 PV(750)
 +
 PV(750)


 Under the method of discounting, we calculate the time

value of money at present. So we will be comparing the
initial outflow with the sum of the present values (PV) of
the future inflows at a given rate of interest. 9 / 57
  2. Types of Cash Flows


Types of Cash Flows: Cash flows from



 Operating Activities,

 Investing Activities and

 Financing Activities.

Cash flow is the difference between amount of cash



flowing in and out a company.

•
10 / 57
  3. Future Value of a Single Cash Flow


•
• FVn = PV (1 + k) n

Where FVn = future value in n years



 PV = present value or initial value of cash

flow
 k = annual rate of interest
 n = duration or the life of investment
 (1+k)n = future value of unit investment, say Rs. 1
 = FVIF(k, n)
 = future value interest factor
 Use Table 1 to get FVIF value for k & n
 Multiply PV and FVIF to get the future value
11 / 57
  3. Future Value of a Single Cash Flow


Example
If the bank offers a compounded rate of interest of 10%

per annum on the deposit. An amount of Rs. 10,000

deposited today, will become how much after 3 years?
•
Solution

 Formula
FVn = PV (1 + k) n
 ∴ FVn = PV x FVIF(k,n)
 = PV x FVIF(10,3)
 = 10,000 x 1.331
 = Rs. 13,310
12 / 57
  3. Future Value of a Single Cash Flow


Doubling Period
Frequent question asked by the investors is ‘How many

years required to double an investment with a given rate

of interest?’
Solution

Above question can be answered by a rule known as ‘Rule

of 72.” It is an approximate method of calculating. As

per the rule, the period within which the amount will be
doubled is obtained by dividing 72 by the rate of interest.


13 / 57
  3. Future Value of a Single Cash Flow


For example, if the given rate of interest is 10%, then

doubling period is 72 / 10 = 7.2 years.
•
However, more accurate way of calculating doubling

period is the ‘Rule of 69’, according to which the

doubling period is 69
0.35 +
 Interest Rate

 = 0.35 + 69/10
 = 0.35 + 6.9
 = 7.25 years
14 / 57
  3. Future Value of a Single Cash Flow


By calculator
Doubling Period Calculation

 Formula FV n = PV (1 + k) n


 ∴ FVn =(1 +k) n

PV
 By taking log on both sides
 log (FVn/PV) = n log(1+k)
 ∴ n = log(FVn/PV)

log(1 + k)
 = log 2 years
= 7.27
log 1.1 15 / 57
  3. Future Value of a Single Cash Flow


Growth Rate
Compounded Annual Growth Rate (CAGR) can be

calculated for a series of incomes by using Future Value

Interest Factor (FVIF) Table, (Table 1)


 Example:



Years 1 2 3 4 5 6

 Profits in lakh 95 105 140 160 165 170

 Calculate the compound rate of growth.

16 / 57
  3. Future Value of a Single Cash Flow


Calculate the compound rate of growth.



 Years 1 2 3 4 5 6

Profits in lakh 95 105 140 160 165 170


Solution:
Ratio of profits for last year to first year = 170 / 95 = 1.79

Refer FVIF
(k,n-1) table (Table 1)
Look for the value close to 1.79 for 5 years
The value close to 1.79 is 1.762 and corresponding interest

rate is 12 %.
Therefore compound rate of growth (CAGR) is 12%.

 17 / 57
  3. Future Value of a Single Cash Flow


By calculator


 FV = PV (1+k)n
 ∴ 170 = 95 (1+k)5
 ∴ 1+k = (170/95)1/5
 = 5
1.79
 = 1.1235
 ∴ k = 0.1235 or 12.35%

18 / 57
  3. Future Value of a Single Cash Flow


Increased Frequency of Compounding

For example, half yearly compounding, quarterly

compounding etc.
Example

You have deposited Rs. 10, 000 in a bank, which offers

10% interest p.a. compounded semi-annually. Calculate

the amount at end of the year.
 Formula

k mn
 FV n = PV (1 + )
m
 Where, FVn= future value after n years
19 / 57
  3. Future Value of a Single Cash Flow


Example
An amount of Rs. 1000 is invested in a bank for 2 years.

Rate of interest is 12 % compounded quarterly.

Calculate the amount at the end.
Solution

k mn

FV n = PV (1 + )
m
 where m = 4, frequency of compounded in a year.
 ∴ FVn = 1000 (1+0.12/4)8
 = 1000 (1.03)8
 = 1000 x 1.267
 = Rs. 1267
 20 / 57
  3. Future Value of a Single Cash Flow


Effective vs. Nominal Rate of Interest



Rs. 100 with 10 % interest amounts to Rs. 110 at the end



of year.
However semi-annually 100(1.05)2 = 100 x 1.1025 = 110.25


 ∴ The principal amount grows 10.25% p.a.

This 10.25% is called effective rate of interest.


Hence the accumulation under semi-annual compounding



exceeds the accumulation under annual compounding.

21 / 57
  3. Future Value of a Single Cash Flow


Effective vs. Nominal Rate of Interest



Formula for effective rate of interest




k m
r = (1 + ) −1

m
Where r = effective rate of interest


 k = nominal rate of interest

 m = frequency of compounding per year


22 / 57
  3. Future Value of a Single Cash Flow


Example
Calculate the effective rate of interest, for the 12%

nominal rate of interest quarterly compounded.

Solution

Effective rate of interest


k m
r = (1 + ) −1
 m
 0.12 4
= (1 + ) −1
 = 1.034-14 …Refer FVIA(3,4) table
 = 1.126 -1
 = 0.126 or 12.6%
23 / 57
  4. Future Value of Multiple Flows and
Annuity


 0 1 2 3
 1000 2000 3000 Accumulation


 FV(3000)
 +
 FV(2000)
 +
 FV(1000)


 Suppose we invest Rs. 1000 now i.e. at the beginning of

year 1, Rs. 2000 at the beginning of year 2 and Rs. 3000
at the beginning of year 3. How much will these cash
flows accumulate at the end of year 3 at the rate of 12%
p. a.
24 / 57
  4. Future Value of Multiple Flows and
Annuity


 0 1 2 3
 1000 2000 3000 Accumulation


 FV(3000)
 +
 FV(2000)
 +
 FV(1000)



∴ Future value at the end of 3 years, at 12%
interest p.a.
 = FV(Rs. 1000) + FV (Rs. 2000) + FV(Rs. 3000)
 =1000 x FVIF(12,3) +2000 x FVIF(12,2) +3000 x FVIF(12,1)
 = 1000 x 1.405 + 2000 x 1.254 + 3000 x 1.12 25 / 57
  4. Future Value of Multiple Flows and
Annuity


By calculator


Future value at the end of 3 years



 = 1000 x 1.123 + 2000 x 1.122 + 3000 x 1.12

 = Rs. 7273.73

26 / 57
  4. Future Value of Multiple Flows and
Annuity 

Annuity
Annuity is a stream or series of periodic flows of equal

amounts. For example life insurance premium.

Regular Annuity or Deferred Annuity: When the equal

amounts of cash flows occur at the end of each period,

over the specified time horizon.
Annuity Due: When cash flows occur at the beginning of

each period, over the specified time horizon.

 0 1 2 3 4 5
6


 Future
FVAvalue of+ k)
6 = A(1 regular
6 −1
+ A(1annuity
+ k) 6-2 + A(1 + k) 6-3 + ... + A(1 + k) 6-6
27 / 57
  4. Future Value of Multiple Flows and
Annuity

FutureFVA
 value
n =ofA(1
regular
+ k) n −1annuity
+ A(1 + k) n -2 + A(1 + k) n -3 +... + A

 (1 + k) n − 1
Which reduces to
 FVAn = A  
 k 


Where, A = amount deposited /invested at the end of every

year for n years
 k = rate of interest, expressed in decimals
 n = time horizon
 FVAn = Accumulation
(1 +k) −1
n
at the end of n years.
The expression   is called the Future Value
 k 
Interest Factor for Annuity (FVIFA) and it accumulates
Rs. 1 invested or paid at the end of every year for a
period of n years at the rate of interest k.
FVIFA values are given in Table 2. 28 / 57
  4. Future Value of Multiple Flows and
Annuity


Example
Calculate the ‘Annuity regular’ for yearly annuity of Rs.

1000 invested with a 12 % interest for a period of 10

years.
Solution  (1 + k) n − 1
FVAn = A
 
  k 


 ∴ FVAn = A x FVIFA(k,n)
 = 1000 x FVIF(12,10)
 = 1000 x 17.549
29 / 57
  4. Future Value of Multiple Flows and
Annuity 

By calculator

 (1 + k) n − 1
FVAn = A  
  k 

 (1 + 0.12)10 − 1
FVAn = 1000  
 ∴  0.12 


 = 1000 x 17.54874
 = Rs. 17548.74

30 / 57
  4. Future Value of Multiple Flows and
Annuity


Example
Under a recurring deposit scheme of the bank, a fixed

amount is deposited every month. The rate of interest is

9% compounded quarterly. Calculate the maturity value
for a monthly installment of Rs. 500 for 12 months.
Solution

Amount of deposit = Rs. 500 per month

Rate of interest = 9% compounded quarterly

k m
Effective rate of interest r = (1 + ) −1
m
 0.09 4
= (1 + ) − 1 = 0.0931 or 9.31%
4
31 / 57
  4. Future Value of Multiple Flows and
Annuity


= (1 + r)1/12 −1


Rate of interest per month


= (1 + 0.0931)1/12 − 1


 = 0.0074 or 0.74%


Maturity value of an annuity  (1 + k) n − 1



FVAn = A  
 k 
 (1 + 0.0074) 12− 1
= 500  
 0.0074 

= 500 x 12.50 = Rs. 6250

32 / 57
  4. Future Value of Multiple Flows and
Annuity


If the payments are made at the beginning of every year,



then the value of such an ‘annuity due’ is calculated by

modifying the formula of ‘annuity regular’ as follows


 FVAn(due) = A (1+k) FVIFA(k,n)

33 / 57
  4. Future Value of Multiple Flows and
Annuity


Example
A person aged 20 is insured for a policy of Rs. 10,000. The

term of policy is 25 years and the annual premium is Rs.

41.65. Calculate the rate of return the person gets.
Solution

Premium = Rs. 41.65 per annum

Term of policy = 25 years

Value at the maturity = P (1+K) FVIFA

(k,n) , since the
premium is paid at the beginning of the year.
 ∴ 10,000 = 41.65 (1+k) FVIFA(k,25)
34 / 57
  4. Future Value of Multiple Flows and
Annuity


 From Table 2, we get

 (1+0.14) FVIFA(14,25) = 1.14 x 181.871 = 207.33
 and
 (1+0.15) FVIFA(15,25) = 1.15 x 212.793 = 244.71
 By interpolation 240.1 − 207.33
244.71 − 207.33
 k = 14% + (15% - 14%) x
 = 14 + 1 x 32.77 /37.38
 = 14 + 0.87 %
 = 14.87 %
35 / 57
 5. Present Value of a Single Cash Flow


Discounting: Using this approach we can find present



value of a future cash flow or a stream of future cash

flows. Present value approach is commonly followed for
evaluating financial viability of projects.
 FVn = PV(1+k)n
 = PV x FVIF(k,n)
FVn FVn
 ∴ PV = or PV =
FVIF(k, n) (1 + k) n
The inverse of FVIF
(k,n) is defined as PVIF(k,n)
∴ The Present Value Interest Factor for k and n
 PV = FVn x PVIF(k,n)
36 / 57
 5. Present Value of a Single Cash Flow


To determine the present value of a future sum, we have to



just multiply future value by PVIF factor for the values

of k and n. PVIF values are provided in Table 3.
Example: Calculate the issue price of a zero coupon bond


with a face value of Rs. 1000, redeemable after 5 years

with 12% interest p.a.
Solution: PV
 = FV x PVIF(k,n)
 = 1000 x PVIF(12,5)
 = 1000 x 0.567 = Rs. 567 37 / 57
 5. Present Value of a Single Cash Flow


By calculator


 FVn
PV =

(1 + k) n
1000
=

(1 + 0.12) 5

= Rs. 567.43

38 / 57
 5. Present Value of a Single Cash Flow


Example: A bank certificate having value of Rs. 100 after



a year is to be issued with a 12% interest p.a. quarterly

compounded. Calculate the issue price of a certificate.
Solution


 Effective rate of interest k m

r = (1 + ) −1
m

0.12 4
= (1 + ) −1 = 0.1255 or 12.55%
4
 Issue price of the certificate is FVn
PV =
(1 + k) n
100
= = Rs. 88.85
(1 + 0.1255)
39 / 57
 5. Present Value of a Single Cash Flow


Example: A bank wishes to issue a cash certificate of Rs.

1,00,000 to be received after 10 years, at the rate of 10%
interest p.a. compounded quarterly. Calculate the issue
price of this certificate.
Solution

 Effective rate of interest k

r = (1 + ) m −1
 m
0.10 4

= (1 + ) −1 = 0.1038 or 10.38%
4
 Issue price of the certificate is
FVn
PV =
(1 + k) n
100000
= = Rs. 37247.41
(1 + 0.1038) 10
40 / 57
  6. Present Value of
 Multiple Flows and Annuity


 0 1 2 3
 Accumulation 1000 2000 3000


 PV(1000)
 +
 PV(2000)
 +
 PV(3000)



∴ Present value at the end of 3 years, at 12%
interest p.a.
 = PV(Rs. 1000) + PV (Rs. 2000) + PV(Rs. 3000)
 =1000 x PVIF(12,3) +2000 x PVIF(12,2) +3000 x PVIF(12,1)
 = 1000 x 0.893 + 2000 x 0.797 + 3000 x 0.712 = Rs.
41 / 57
  6. Present Value of
 Multiple Flows and Annuity


Project is said to be financially viable if the present value



of the cash flows exceeds the present value of the cash

outflows.

42 / 57
  6. Present Value of an Annuity


When an annuity is receivable at the end of every year for



a period of n years at the interest rate of k, then the

present value is equal to
 A A A A
PVAn = + + + ... +
 (1 + k) (1 + k) 2 (1 + k) 3 (1 + k) n

This reduces to
  (1 + k) n − 1
PVAn = A  n 
  k(1 + k) 
The expression  (1 + k) n is

− 1called
 the PVIFA, Present Value
 n 
k(1 +
Interest Factor for Annuity
k)  and it represents the present
value of a regular annuity of Rs. 1 for a given value of k
and n.
43 / 57
  6. Present Value of an Annuity


PVIFA values are given in Table 4 for various values of k



and n.


These values are used with following conditions



• The cash flows are equal

• The cash flows occur at the end of every year

44 / 57
  6. Present Value of an Annuity


Example: Calculate the investment to receive a yearly

regular income of Rs. 10,000 for 10 years at the rate of 12
% p.a.
Solution: PVA = 10,000 x PVIFA(12,10)
n
 = 10,000 x 5.65 = Rs. 5650


 By calculator  (1 + k) n − 1
PVAn = A  n 
 k(1 + k) 
 (1 + 0.12)10 − 1 
= 10,000  10 
 0.12(1 + 0 . 12) 
 2.10585 
= 10,000   = Rs. 5650.23
 0.3727  45 / 57
  6. Present Value of an Annuity


Example: Calculate the initial deposit amount to receive a

monthly payment of Rs. 1000 for 12 month. The rate of
interest is 12% p.a. quarterly compounded.
Solution: Effective rate of interest k
r = (1 + ) m −1
m
 0.12 4
= (1 + ) − 1 = 0.1255 or 12.55%
 Effective rate of interest per month 4 = (1.1255)1/12 -1
 = 0.0099

 (1 + k) n − 1  (1 + 0.0099) 12 − 1 
PVAn = A  n 
= 1000  12 
 k(1 + k)   0.0099(1 + 0.0099) 
 0.1255 
= 1000  = 1000 x 11.26336 = Rs.11,263.36
 0.01114 46 / 57
  6. Present Value of an Annuity


Example: If an initial deposit of Rs. 4610 is done in a bank

for an annuity period of 60 months. Rate of interest is
11% p. a. quarterly compounded. Calculate the value of
monthly annuity income a person can receive.
Solution: Effective rate of interest k
r = (1 + ) m −1
 m
0.11 4

= (1 + ) − 1 = 0.1146 or 11.46%
4 1/12
 Effective rate of interest per month = (1.1146) -1.
 = 0.00908
 Monthly annuity can be calculated as  (1 + k) n − 1

PVAn = A  n 
 k(1 + k) 
 ∴ ∴
 (1 + 0.00908) − 1 
60 A = Rs. 99.8833
4610 = A  60 
 0.00908(1 + 0.00908)  47 / 57
  Capital Recovery Factor


Rearranging the equation for present value of an annuity,



we get n
 (1 + k) − 1

PVAn = A  n 
 k(1 + k) 

−1
 ∴  (1 + k) n − 1
A = PVAn  n 
  k(1 + k) 

 k(1 + k) n 
 = PVAn  
 (1 + k) n
− 1 


 The term is known as a capital recovery

 k(1 + k) n 
factor. 
(1 + k) n − 1

 

48 / 57
  Capital Recovery Factor


Example: A loan of Rs. 10,000 is repaid in 5 equal



installments. The loan carries a interest rate of 14% p. a.

Calculate the amount of each installment.
Solution


 PVAn = A x PVIFA(k,n)
 ∴ 10,000 = A x 3433
 ∴ A = 10,000 / 3,433
 = Rs. 29,129

49 / 57
  Capital Recovery Factor


 By Calculator
 (1 + k) n − 1


PVAn = A  n 


 k(1 + k) 


 ∴  k(1 + k) n 
A = PVAn  
  (1 + k) n
− 1 

 0.11(1 + 0.11)5 
 = 10,000  = Rs. 29,129
 (1 + 0.11) − 1 
5

 This method is very useful for deciding an equal amount

of installments for a loan repayment scheme.
50 / 57
  7. Present Value of Growing Annuity


 0 1 2 3 n




A(1+g) A(1+g)2 A(1+g)3 A(1+g)n
A cash flow that grows at a constant rate for a specified
period of time is a growing annuity.
Formula for the present value of growing annuity


 (1 + g) n 
 PV of Growing Annuity 1 - (1 + k) n 
= A(1 + g)  
  k -g 
 
 where g is a growth rate and k is adiscount
 rate.
Above formula is used when g<k or g>k. However it does

not work when g=k. In this case the present value is

equal to nA.

51 / 57
  7. Present Value of Growing Annuity


Example: Suppose you have a right to harvest a teak

plantation for the next 20 years over which you expect to
get 1,00,000 cubic feet of teak per year. The current price
of teak per cubic feet is Rs. 500 and it is expected to
increase at a rate of 8% p.a. The discount rate is 15%.
Calculate the present value of the teak that you can
harvest.  (1 + g) n 
Solution: PV of Growing Annuity 1 - (1 + k) n 
 
= A(1 + g)
  k -g 
 
  
 (1 + 0.08) 20 
 ∴ PV of teak 1 - (1 + 0.15) 20 
= Rs. 500 x 1,00,000 x (1 + 0.08)   = Rs.55,17,3 6,683
 0.15 - 0.08 
 
  52 / 57
  8. Present Value of
 Perpetuity and Growing Perpetuity


An annuity of an infinite duration is known as perpetuity.

The present value of such perpetuity is expressed as
 P∞ = A x PVIFA(k,∞)
 Where PVIFA(k,∞) is a present value interest factor
∞
1 1
for a perpetuity. Value of PVIFA(k,∞)
= ∑is =
t =1
t
(1 + k) k


A
 ∴ P∞ =
r
Present value interest factor of a perpetuity is one divided
by interest rate (expressed in decimal form).
Present value of a perpetuity is equal to the constant

annuity divided by the interest rate.

53 / 57
  8. Present Value of
 Perpetuity and Growing Perpetuity


Example: How much I should invest in a bank to offer a



scholarship of Rs. 10,000 per annum perpetually

(forever) to a bright student with 10% p.a.
Solution


A

P∞ =
r

10,000
= = Rs.1,00,00 0
0.10

54 / 57
  8. Present Value of
 Perpetuity and Growing Perpetuity


Example: How much I should invest in a bank to offer a



scholarship of Rs. 1000 per month perpetually (forever)

to a bright student with 10% p.a.
Solution:


Effective rate of interest per month = (1.10)1/12 -1



 = 0.007974 or 0.7974%

A
P∞ =
 r
1000
= = Rs.1,25,40 8
0.007974 55 / 57
 8. Present Value of a Growing Perpetuity


 0 1 2 3




A(1+g) A(1+g)2 A(1+g)3
A perpetuity growing at a constant rate is called growing
perpetuity. We assume that the increase will continue
indefinitely. For example, rent is a growing perpetuity.
 PV of Growing Perpetuity

A A(1 + g) A(1 + g) 2 A(1 + g) n -1
= + + + ... + + ...
 (1 + k) (1 + k) 2
(1 + k) 3
(1 + k) n

 This reduces to
 PV of growing PerpetuityA

=
k -g
 Where g is a growth rate and k is a discount rate.

56 / 57
 8. Present Value of a Growing Perpetuity


Example: An office is expected to have rent of Rs. 30,000

next year. It is expected to increase by 5% every year.
We assume that the increase will continue indefinitely. If
the discount rate is 10%, calculate the present value of
the rental stream.
Solution

 This is a growing perpetuity with g= 5% and

k=10%.

A
 ∴ PV of Growing =
Perpetuity
k -g

30,000
= = Rs. 6,00,000
 0.10 - 0.05
57 / 57