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TIME VALUE OF MONEY

Upon completion of this chapter, students should be able to Understand and use the concept of time value of money. Represent the cash flows occurred in different time period using the cash flow time line. Calculate the present value and future value of given streams of cash flows. Identify the impact of time period and required rate of return on present value and future value. Prepare amortization schedule for amortized term loan. Compare various types of interest rates.

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The concept of time value of money suggests that the money received at different point of time has different value. The financial manager must appreciate this fact and understand why they are different and how they are made comparable. Therefore, the basic objective of this chapter is to enable the student to calculate present and future value of cash flows and apply these concepts in addressing real life problems. This chapter begins with fundamental concepts of present value and future value and explains how they are calculated. Then it presents how the pattern of cash flows and required rate of return impact the present value and future value. Finally, different concepts related to interest rates have also been deat on for their proper uses by the students.

CONCEPT
Time !alue of mone" 1 concept to understand the value of cash flow occurred at different period

ime !alue of mone" is a concept to understand the value of cash flows occurred at different point in time. If we are given the alternatives whether to accept Rs 100 today or one year from now then we certainly accept Rs 100 today. It is !ecause there is a time value to money. "very sum of money received earlier has reinvestment opportunity. #or e$ample if we deposit Rs 100 today in saving account at % percent annual rate of interest it will increase to Rs 10% at the end of year one. &oney received at present is preferred even if we do not have reinvestment opportunity. 'he reason is that the money that we receive at future has less purchasing power than the money that we have at present due to the inflation. (hat happens if there is no inflation) *till many received at present is preferred. It is !ecause most of us have a fundamental !ehaviour to prefer current consumption to future consumption+ money at hand allows current consumption. 'hus ,i- the reinvestment opportunity or earning power of the money ,ii- the ,ris. of- inflation and ,iii- an individual/s preference for current consumption to future consumption are the reasons for the time value of money. 'he concept of time value of money is useful in addressing our real life pro!lems relating to planning for future family e$penditure. #or instance if we need Rs %00 000 after the retirement from 0o! in 1% years the amount we need to deposit at an interest rate every year from now until the retirement is conveniently determined !y using the time value of money concept. &any financial decisions of a firm require a consideration regarding time value of money. In chapter one we argued that a corporate manager must always concentrate on ma$imizing shareholders wealth. &a$imizing shareholders wealth to a larger e$tent depends on the timing of cash flows from investment alternatives. In this regard time value of money concept deserves serious considerations on all financial decisions. In the following sections

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we present some concepts and techniques to understand time value of money and apply them in financial decision.

SIGNIFICANCE OF THE CONCEPT OF TIME VALUE OF MONEY


'ime value of money is a widely used concept in literature of finance. #inancial decision models !ased on finance theories !asically deal with ma$imization of economic welfare of shareholders. 'he concept of time value of money contri!utes to this aspect to a greater e$tent. 'he significance of the concept of time value of money could !e stated as !elow2

Investment Decision
Investment decision is concerned with the allocation of capital into long3term investment pro0ects. 'he cash flows from long3term investment occur at different point in time in the future. 'hey are not compara!le to each other and against the cost of the pro0ect spent at present. 'o ma.e them compara!le the future cash flows are discounted !ac. to present value. 'he concept of time value of money is useful to securities investors. 'hey use valuation models while ma.ing investment in securities such as stoc.s and !onds. 'hese security valuation models consider time value of cash flows from securities.

Financin Decision
#inancing decision is concerned with designing optimum capital structure and raising funds from least cost sources. 'he concept of time value of money is equally useful in financing decision specially when we deal with comparing the cost of different sources of financing. 'he effective rate of interest of each source of financing is calculated !ased on time value of money concept. *imilarly in leasing versus !uying decision we calculate the present value of cost of leasing and cost of !uying. 'he present value of costs of these two alternatives are compared against each other to decide on appropriate source of financing. 4esides the concept of time value of money is also used in evaluating proposed credit policies and the firm/s efficiency in managing cash collections under current assets management.

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CASH FLOW TIME LINE


#ash flo$ time line 1 graphical presentation of cash flows at different time period

#ash flo$ time line is an important tool used to understand the timing of cash flows. It is a graphical presentation of cash flows occurring in different time periods and is helpful for analyzing the time value of cash flows. 'o gain an idea a!out timing of cash flows let us consider the following time line2

'ime

'he time line represents the time period stated a!ove the vertical scale. 'ime zero represents today or 0ust now or at the !eginning of period 1. 5ero states that the time period 0ust !egins from this point. 'ime 1 denotes the end of period one+ time 6 denotes the end of period two and so on. 7owever it should !e noted that the end of any period also means the !eginning of the succeeding period. #or e$ample time 1 states that the period one has 0ust !een ended and period two has 0ust !egan. 'ime period denoted in the scale has generally a length of one year from 0 to 1 from 1 to 6 from 6 to 8 and so on. 7owever it could !e for si$ months or three months or one month depending on the period for compounding or discounting used. 'he corresponding cash flows are placed !elow the scale as shown in the following time line of cash flows2

'ime

1 10

6 %0

8 >0

: 100

% ?0

Cash #lows 3100

9ote that Rs 100 in time zero has negative sign. 'he negative sign represents the cash outflows which means that Rs 100 is deposited or paid or cost incurred at time zero. 1ll other cash flows in time 1 6 8 : and % have positive signs. Positive sign is used to denote the cash inflows which means a cash receipt in the given time periods correspondingly. 'he time line of cash flow is also used to denote the interest rate that each cash flow earns. ;et us consider the following time line.

'ime

<@

Cash flow 3100


'he interest rate is placed in !etween two corresponding time periods. 'he interest rate < percent placed in !etween the time zero and one denotes that Rs 100 invested today will earn < percent interest in year 1 so that it grows to Rs 10< at the end of year one. *imilarly Rs 10< at the !eginning of year two earns < percent interest during the year two so that it grows to Rs 11=.=: at the end of year two and so on. If the interest rate for every period is similar it is not necessary to show in !etween of every time period in the scale. 7owever if the interest rates differ from year to year it should !e stated in !etween every time period.

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FUTURE VALUE AND COMPOUNDING


Future !alue 1 present sum of money plus stream of interest amount received during investment period

Future !alue of a sum of money is defined as the total of the sum of the money plus the stream of interest amount received for the period the money was invested. 'he process of finding future value is called %compoundin&'. Compounding is the process of determining the future value of a cash flow or series of cash flows when compound interest is used. #or instance if we invest Rs 1 000 today in a security at 10 percent annual interest rate for two #ompoundin& years we receive Rs 100 ,that is 10 percent of Rs 1 000 original investment- interest during 1 process of finding future year one so that we will end up with Rs 1 100 at the end of year one. 1gain we receive Rs value 110 on our investment of Rs 1 100 in year 6 ,that is 10 percent of Rs 1 100- interest at the end of year two plus Rs 1 100 investment during the year two so that our original investment Rs 1 000 grows to a total of Rs 1 610 at the termination of year two. 7ere Rs 1 610 at the end of year two is regarded as the future value of Rs 1 000 today compounded at 10 percent annual rate for two years. 'he following time line shows it2
'ime Cash flow 0 10@ 1 6

31 000 110 100 Interest income 1 100 1 610 Fear3end amount 'he future value of a sum of money compounded at /i/ percentage annual rate of

interest for AnB year is given !y the equation ,8.1-21


FVn ( )V *+ , i-n (here #Cn D future value of a sum of money at the end of period n. PC D present value or the sum of money today. i D the annual rate of interest at which the sum of money is invested. n D the num!er of years for which the sum of money is compounded. *./+-

Using equation ,8.1- the future value of the sum of Rs 1 000 compounded at 10 percent annual rate for 6 years is given !y2 #C6 D PC ,1 E i-6 D Rs 1 000 ,1 E 0.1-6 D Rs 1 000 $ 1.61 D Rs 1 610.
Tabular Solution

4esides equation ,8.1- the future value of a sum of money also could !e calculated !y using future value interest factor ,#CI#- ta!le ,in the appendi$-. It is given !y the equation ,8.6- as follows2
FVn ( )V *FVIF i, n*./0-

'his equation is derived as follows #C of PC at i percent for 1 period is #C1 D PC E I9' ,where I9' is the amount of interestD PC E PC ,iD PC ,1 E i#C of PC at i percent for 6 periods is #C6 D PC1 ,1 E iD PC ,1 E i- ,1 E iD PC ,1 E i-6 1ccordingly #C of PC at i percent for n periods is #Cn D PC,1 E i-n

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In our e$ample loo.ing at #CI# ta!le at 10 percent for 6 years the #CI# factor is 1.61 so that future value of the sum of Rs 1 000 compounded at 10 percent annual rate of interest for 6 years is given !y2
FV0 ( )V *FVIF +12, 0- ( 3s +,111 4 +/0+ ( 3s +,0+1

!raphic Vie" o# Compo$n%in &rocess


#uture value of a sum of money has positive relationship with the interest rate and the time period. 'his means larger the interest rate larger will !e the future value of a present sum of money. 'his relationship also holds with time period that is longer the time period larger will !e the future values. 'his relationship is shown in #igure 8.1.
FI6U3E ./+ Relationship !etween future values and interest rates over different time periods

#uture value of Rs 1
:.0

8.0

i D 1%@

6.0

i D 10@ i D %@

1.0 i D 0@

'ime periods 0 6 : = < 10

'he #igure 8.1 shows how a sum of rupee one will grow at different interest rates to different time periods in the future. It is o!served from the upward sloping curves that value grows over the time in future. *imilarly the growth in value is larger at higher rate of interest. 'he interest rate itself is the rate of growth in value. #or e$ample if we invest rupee one at 10 percent annual rate of interest the value of investment grows at the rate of 10 percent every year. 'he growth in value is larger at later years !ecause of the effect of compounding.

PRESENT VALUE AND DISCOUNTING


(e already mentioned that Rs 100 that we have at present has more value than Rs 100 received at future dates. It means the same amount received at two different dates are not compara!le. 'o ma.e them compara!le we need to discount the future value. 'he discounted )resent !alue value of the future sum is the present !alue. In other words the present value is the value 'he value of future sum of today of a future cash flow or a series of cash flows.
money

'he present value of a future sum of money is the amount of current money that is equally desira!le to a decision ma.er today against a specified amount of money to !e received or paid at a future date given the certain rate of interest. In our future value calculation we recognized that Rs 1 000 invested at 10 percent annual rate of return would grow up to Rs 1 610 in two years from now. In this e$ample Rs 1 000 today is called the present value of a future sum of Rs 1 610 after two years discounted !ac. at 10 percent rate of interest. 'he process of finding present value of future cash flows or series of cash flows is
5iscountin& 1 process of finding present value

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called %discountin&'/ Giscounting is 0ust reverse of compounding. ;et us consider the following time line to understand the discounting process.

'ime Cash #low

0 31 000

10@

1 1 100

6 1 610 1.10

1.10

'he a!ove time line of cash flows shows that Rs 1 610 at the end of year two divided !y 1.10 two times produce Rs 1 000 present value. 'he present value of a future sum of money due in n years is calculated !y using the equation ,8.8- as follows26
)V ( *./.-

;et us suppose that we are offered the alternative of either Rs 1 881 after three years or a specified sum of money today. 1ssuming that any sum of money today could !e invested at 10 percent rate of return ,i.e required rate of return is 10 percent-. 'he present value of the future sum of Rs 1 881 after three years discounted !ac. at 10 percent required rate of return is given !y2
PC D D Rs 1 000
Tabular Solution

4esides the a!ove equation ,8.8- the present value of a sum of money also could !e calculated !y using present value interest factor ,PCI#- ta!le ,given in the appendi$-. 'he relationship is given in equation ,8.:- as follows.
)V ( FVn *)VIF, i, n*./7-

;oo.ing at the present value interest factor ta!le at 10 percent for 8 years the PCI# factor is 0.>%18 so that the present value of the sum of Rs 1 881 to !e realized at the end of year 8 discounted at 10 percent rate of interest is given !y2
PC D Rs 1 881 ,PCI# 10@ 8- D Rs 1 881 $ 0.>%18 D Rs 1 000

!raphic Vie" o# Disco$ntin &rocess


'he present value of a sum of money has inverse relation with the time period and interest rate. 1s the time period to receive a sum of money increases the present value of the sum of money will decline. 'his relationship also holds with interest rate that is larger the interest rate lower will !e the present value of a future sum. 'his relationship is depicted in #igure 8.6
FI6U3E ./0 Relationship !etween present values and interest rates over different time periods

Present Calues of Rs 1
1.00 i D 0@ 0.>% i D %@ 0.%0 i D 10@ 0.6% i D 1%@ Periods :

'his equation is derived as follows2 0 6 #Cn D PC,1 E i-n PC D

..... ,8.1-

<

10

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'he #igure 8.6 shows how the present value of rupee one declines with longer period and larger interest rate. #or e$ample the present value of a future sum is lower at 1% percent than at 10 percent interest rate. 'he present value also depends on time period. Hiven the interest rate the present value diminishes with longer period. #or e$ample at 10 percent discount rate the present value of a sum of money ,say Rs 10 000- will !e low ,Rs 8 <%%- in ten years as compare to Rs = 60? in five years.

FINDING DISCOUNT RATE AND NUMBER OF PERIODS


'o this point we e$plored some fundamental aspects relating to the calculation of present value and future value. It can !e o!served from equation ,8.1- and ,8.8- that the present value and future value are the reversal of each other. In the equation we see four !asic varia!les associated to present and future value calculationI present value ,PC- future value ,#C- time ,n- and interest rate ,i-. Hiven the values of any three varia!les in the equation we can reformulate !oth present value and future value equations to calculate the value of fourth varia!le which is un.nown.

Fin%in Interest 'ate


*uppose you deposit Rs 8 %00 in a saving account today that will grow to a future value of Rs % 000 at the end of five years. (hat rate of return will you earn annually from this investment) In this e$ample Rs 8 %00 today is the present value ,PC- and Rs % 000 to !e received five years from now is the future value ,#C %-. Hiven the information the appropriate annual rate of interest can !e found !y reformulating equation ,8.1- and ,8.8- and is stated in equation ,8.%- as follows28
i( 8+ #or our e$ample the appropriate annual interest rate is calculated !elow2 i D I 1 D 1.0>8? I 1 D 0.0>: or >.:@
Tabular Solution

*./9-

'he same solution could !e o!tained !y using present value interest factor ,PCI#- or future value interest factor ,#CI#- ta!le. ;et us refer to the equation ,8.:- that gives the ta!ular solution of present value as follows2
PC D #Cn ,PCI#i n... (3.4) *u!stituting the respective values of our e$ample in equation ,8.:-2 Rs 8 %00 D Rs % 000 ,PCI# i %D ,PCI# i %PCI#i % D 0.>

;oo.ing at PCI# ta!le at five year row the factor 0.> lies !etween > percent ,lower rate D ;R- and < percent ,higher rate D 7R-. 'herefore to o!tain the e$act interest rate we interpolate the result as follows2
8

'his equation is derived as follows2 PC D ,1 E i-n D ,1 E i- D i D I1

... ,8.8-

Interest rate ,i-

TIME VALUE OF MONEY Chapter 3 D ;R E J,#actor at ;R3"$act factor-K,#actor at ;R I#actor at 7R-L D >@ E J,0.>1803 0.>-K,0.>180 I 0.=<0=-L D >@ E ,0.0180K0.086:- D >.:@

67

'he a!ove result shows that if Rs 8 %00 is deposited today it will grow to Rs % 000 at the end of year five. 'his will yield an annual >.: percent return to the investor.

Fin%in the N$m(er o# &erio%s )Time*


*uppose Rs 6 000 is deposited today at < percent annual interest rate then in how many years this will dou!le) 'his solution could !e found out !y solving for num!er of periods or time ,n- in equation 8.1. In this e$ample Rs 6 000 today is the present value ,PC- at annual interest rate ,i- of < percent it will dou!le to Rs : 000 future value ,#C- at the end of certain years.

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Chapter 3

BUSINESS FINANCE Using equation ,8.1#Cn D PC ,1Ei-n //// (3.1) Rs : 000 D Rs 6 000 ,1.0<-n ,1.0<-n D 6 'a.ing logarithm in !oth sides n log 1.0< D log 6 n D log6Klog1.0< n D 0.8010K0.088: D ?.01 years.

'he a!ove solution shows that Rs 6 000 deposited today at < percent annual interest rate will dou!le in nearly ? years.
Tabular Solution

'he same solution could !e again o!tained !y using the present value interest factor ,PCI#ta!le. ;et us refer to the equation ,8.:-2
PC D #Cn ,PCI#i n- ... (3.4) Rs 6 000 D Rs : 000 ,PCI# PCI#<@ n D 0.%
<@n

;oo.ing into the PCI# ta!le at < percent interest rate the factor 0.% is close to ? year/s factor ,that is 0.%006-. 'herefore the respective time period that Rs 6 000 dou!les at < percent annual interest rate is ? years ,that is n D ? years-.

ANNUITY
Annuit" 1n annuit" is defined as a series of payment of fi$ed amount at each specified interval of 1 series of equal payment at equal interval of time for a given time for a given num!er of periods. 1n annuity can !e an ordinar" annuit" or annuit" due. num!er of periods In case of an ordinary annuity each equal payment is made at the end of each interval of time

throughout the period. (hereas in case of annuity due equal payments are made at the !eginning of each interval throughout the periods.
Ordinar" annuit" #or e$ample if an individual promises to pay Rs 1 000 at the end of each of three *eries of equal payments at the years for amortization of a loan then it is called an ordinary annuity. If it were the annuity end of each period Annuit" due due each payment would !e made at the !eginning of each of the three years. 'hey are *eries of equal payments at the illustrated in the following time line of cash flows2 !eginning of each period

'ime
Mrdinary annuity

<@

1
1 000

6
1 000

8
1 000

'ime
1nnuity due

0
1 000

<@

1
1 000

6
1 000

'he a!ove time lines show that each cash flow occurs one period earlier in annuity due than in the ordinary annuity.

F$t$re Va+$e o# an Or%inar, Ann$it,


*uppose we invest Rs 1 000 at the end of each year for there years in a security paying < percent annual interest how much would we have at the end of three years)

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Chapter 3

'his is a pro!lem concerning to the future value of an ordinary annuity. In this e$ample the first year3end payment of Rs 1 000 is compounded at < percent for the rest of two years second Rs 1 000 year3end payment is compounded for one year and the last Rs 1 000 year3end payment is not compounded at all since it is only made at the end of year 8 the end of compounding period. *uch pro!lems of ordinary annuity are solved !y using the equation ,8.=- presented !elow2:
FVAn ( (here
#C1n D future value of an ordinary annuity for AnB years P&' D annual amount of equal payment. D Rs 1 000 n D num!er of compounding periods D 8 years i D annual rate of interest at which each payment is compoundedD < percent or 0.0<

*./:-

*u!stituting the respective values in equation ,8.=- the future value of Rs 1000 ordinary annuity for three years compounded at < percent annual rate is given !y2
#C18 D D Rs 8 6:=.:

'he following time line gives an idea a!out compounding of each annual payment and their future value at the end of year three.

'ime

<@

1 1 000
1 000 O 1.0<6

6 1 000
1 000 O 1.0<

8 1 000 1 0<0 1 1==.:

Mrdinary annuity

Tabular Solution

#C18 D Rs 8 6:=.:

'he future value of annuity stated in a!ove e$ample also could !e found !y using the future vale interest factors ta!le. It is shown in 'a!le 8.1.
TA>LE ./+ #uture value of a 8 years ordinary annuity of Rs 1 000 compounded at < percent per year

End of Year 1 2 3

Payment (PMT) Rs 1,000 1,000 1,000 Future value of annuity

FVIF at 8% 1.1664 1.0800 1.0000

FV Rs 1,166.4 1,080.0 1,000.0 Rs 3,246.4

9ote that in a!ove calculation in ta!le 8.1 the first yearBs payment of Rs 1 000 occurs at the end of year 1 so that it is compounded for two years. *imilarly the second year3end payment of Rs 1 000 is compounded for one year. 1nd the last payment is not compounded at all as it occurs at the end of year three. 4y using future value interest factor of annuity ta!le we can calculate the future value of an ordinary annuity as follows.
FVAn ( )MT ;FVIFAi,n < *./=-

;oo.ing at #CI#1 ta!le at < percent for three years the factor is 8.6:=:. 9ow su!stituting the respective values in equation ,8.>-2
#C18 D P&' J#CI#1 i nL D Rs 1 000 J#CI#1<@ 8L

'his equation is derived as !elow2 #C1n D P&' ,1 E i-nI1 E P&' ,1 E i-nI6 E ... ... E P&' ,1 E i-1 E P&' ,1 E i-0 D P&' D N ,8.=-

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D Rs 1 000 $ 8.6:=: D Rs 8 6:=.:

F$t$re Va+$e o# an Ann$it, D$e


If Rs 1 000 annuity is the annuity due such that each payment occurs at the !eginning of each of the three year the future value of annuity due is given !y equation ,8.<- as follows2
FVAn *due- ( *+,i*./?-

*u!stituting the respective values in equation ,8.<- the future value of three3year annuity due of Rs 1 000 compounded at < percent per year is given !y2 #C18 ,due- D ,1 E 0.0<- D Rs 8 6:=.: ,1.0<D Rs 8 %0=.11 'his calculation process of future value of annuity due is easily understood with the help of cash flow time line2

'ime 1nnuity Gue

0 1 000

<@

1 1 000
1 000 O 1.0<
6

6 1 000
1 000 O 1.0<

1 0<0 1 1==.: 1 6%?.>1

1 000 O 1.0<8

#C18 D 8 %0=.11
Tabular Solution

'he future value of annuity due stated in a!ove e$ample also could !e found !y using the future value interest factors ta!le. It is shown in the 'a!le 8.6.
TA>LE ./0 #uture value of a 8 years annuity due of Rs 1 000 compounded at < percent per year

Beginning of Year 1 2 3

Payment (PMT) Rs 1,000 1,000 1,000 Future value of annuity due

FVIF 8% 1.2597 1.1664 1.0800

FV 1,259.7 1,166.4 1,080.0 Rs 3,506.1

In 'a!le 8.6 the first yearBs payment of Rs 1 000 occurs at the !eginning of year 1 hence it is compounded for three years. 'he second year payment of Rs 1 000 is compounded for two years. 1nd the last payment is compounded for one year only. 4y using future value interest factor of annuity ta!le we can calculate the future value of an annuity due as follows2
FVAn *due- ( )MT ;FVIFAi,n< *+,i*./@-

;oo.ing at #CI#1 ta!le at < percent for three years the factor is 8.6:=:. 9ow su!stituting the respective values in equation ,8.?-2
#C18 ,dueD P&' J#CI#1i nL ,1EiD Rs 1 000 J#CI#1<@ 8L ,1E0.0<D Rs 1 000 $ 8.6:=: $ 1.0< D Rs 8 %0=.11

&resent Va+$e o# an Or%inar, Ann$it,


If you are given the alternatives of accepting either a three3year annuity with a payment of Rs 1 000 at the end of each year or a lump sum payment of Rs 6 %00 today which alternative

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would you prefer) 'his pro!lem could !e solved !y calculating present value of ordinary annuity. If the lump sum payment today is equal to the present value of three3years annuity of Rs 1 000 each year discounted at a given rate of return ,that is the required rate of return or the opportunity cost of funds- we would !e indifferent in choosing either of the alternatives otherwise we would prefer the higher value. 'he present value of an annuity is calculated either !y using formula or !y using present value interest factor of annuity ta!le. 'he present value of an annuity for n years discounted at /i/ percent required rate of return is given !y equation ,8.10- as follows2%
)VAn ( )MT *./+1-

;et us suppose that opportunity cost of funds is 10 percent so that present value of three3year annuity of Rs 1 000 each year is given !y2
PC18 D Rs 1 000 D Rs 1 000 $ 6.:<=< D Rs 6 :<=.<

'hat is Rs 1 000 8 years annuity discounted each year at 10 percent interest rate will have a present value of Rs 6 :<=.<. 'hus we would !e indifferent !etween a lump sum of Rs 6 :<=.< received at present and an ordinary annuity of Rs 1 000 for three years. In the a!ove e$ample if the choice were !etween an annuity of Rs 1 000 for three years and a lump sum of Rs 6 %00 at present we would choose higher value i.e. Rs 6 %00.
Tabular Solution

1nother method of calculating the present value of an annuity is to use the present value interest factor for an annuity ,PCI#1- ta!le. In this method the annuity is multiplied !y the factor at i percent for n years !y referring the PCI#1 ta!le as given in the equation ,8.11-.
)VAn ( )MT ;)VIFAi, n< *./++-

;oo.ing at PCI#1 ta!le at 10 percent for three years the present value interest factor of an annuity is 6.:<=<. 4y su!stituting the respective values in equation ,8.11- we get Rs 6 :<=.< the present value of annuity2
PC18 D Rs 1 000 JPCI#1 10 8L D Rs 1 000 $ 6.:<=< D Rs 6 :<=.<

&resent Va+$e o# an Ann$it, D$e


If each payment were made at the !eginning of each year instead of at the end what would !e the present value of the annuity) 'he simple consideration required is that each of three payments would shift one year earlier so that each of them is discounted for one year less. 'he formula for present value of an annuity is2
)VAn *due- ( )MT *+,i* ./+0-

;et us refer the same e$ample. If each Rs 1 000 annual payment is made at the !eginning of each of three years the present value of annuity due is given !y2
PC1n ,dueD Rs 1 000 ,1E0.1D Rs 1 000 $ 6.:<=< $ 1.10 D Rs 6 >8%.:<

9ote that present value of an annuity due is greater than the present value of an ordinary annuity !ecause each payment occurs one period earlier.
Tabular Solution
%

'his equation is derived as !elow2 PC1n D P&' J1K,1 E i-1L E P&'J1K,1 E i-6L E ... ... E P&' J1K,1 E i-nL D P&' D P&' N ,8.10-

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1nother method of calculating the present value of an annuity due is to use the present value interest factor for an annuity ,PCI#1- ta!le. 'he annuity is multiplied !y the factor at /i/ percent for /n/ years !y referring to the PCI#1 ta!le and the product is further multiplied !y ,1 E i- as given in the equation ,8.18-.
)VAn *due- ( )MT ;)VIFA i, n< *+,i*./+.-

;oo.ing at PCI#1 ta!le at 10 percent for three years the present value interest factor of an annuity is 6.:<=<. *u!stituting the respective values in equation ,8.11- the present value of annuity due of Rs 1 000 for 8 years at 10 percent is2
PC18 D Rs 1 000 JPCI#1 10@ 8L ,1E0.1D Rs 1 000 $ 6.:<=< $ 1.10 D Rs 6 >8%.:<

SOLVING FOR INTEREST RATES IN ANNUITIES


If we were told to invest a lump sum of Rs 10 000 today in a security that pays Rs : 061.68 at the end of each of ne$t 8 years what rate of return would we generate from our investment) In this pro!lem we have one un.nown varia!le A.B3 the interest rate. Rs 10 000 today represents a present value of Rs : 061.68 three years ordinary annuity so that the interest rate ,.- could !e found !y using the relationship of present value of an ordinary annuity as given !y equations ,8.10 or 8.11-. 7ere we are using equation ,8.11PC1n D P&' JPCI#1 i nL .... (3.11) Rs 10 000 D Rs : 061.68 JPCI#1i 8L JPCI#1i 8L D Rs 10 000KRs : 061.68 JPCI#1i 8L D 6.:<=<

;oo.ing at PCI#1 ta!le for three years the a!ove factor 6.:<=< is e$actly equal to PCI#1 at 10 percent for three years. It means that the rate of return we would earn is 10 percent.

PRESENT VALUE OF PERPETUITY


In the previous sections we dealt with annuity payments of fi$ed maturity period say a three3 year annuity a five3year annuity a ten3year annuity and so on. 7owever some annuities may go for paying equal installment at each equal interval of time indefinitely. *uch annuities are )erpetuit" called perpetuities. In other words perpetuity is a stream of equal payment made at the end 1n infinite stream of equal of equal interval of time to indefinite period. 'he present value of perpetuity is calculated as payment follows2
)V)E3)ETUITY ( ( *./ +7-

#or e$ample the present value of a perpetuity of Rs 1 000 each year at 10 percent interest rate is2
PC P"RP"'UI'F D D D D Rs 10 000.

TIME VALUE OF MONEY

Chapter 3

73

UNEVEN CASH FLOW STREAMS


In our previous section we noted that annuities call for a stream of equal payment over the time. 7owever in many cases in a stream of cash flow the cash flow in each period may differ from period to period. *uch cash flows are called uneven stream of cash flows. In case of uneven stream of cash flows the calculation process of present value and future value is discussed !elow.

&resent Va+$e o# Uneven Cash F+o" Stream


Present value of an uneven cash flow stream is simply the sum of the present value of each of the cash flow occurred throughout the stated period to maturity. 'he present value equation for uneven stream of cash flows could !e stated as follows2
)V ( , , , / / / / / / , *./+9-

#or instance let us suppose a security provides the following stream of cash flows till its maturity in five years.
End of Year Cash Flo !Rs " 1 100 2 150 3 200 4 250 5 400

If appropriate discount rate is 10 percent the present value of this uneven stream of cash flows is calculated as follows2
TA>LE ./. Present value of an uneven cash flow stream

Year 1 2 3 4 5

a!" F#o$! Rs 100 150 200 250 400

PVIF 1%% 0.9091 0.8264 0.7513 0.6830 0.6209

PV Rs 90.91 123.96 150.26 170.75 248.36 Rs 784.24

#$ of uneven CF strea%

'he present value of the a!ove uneven cash flow stream is Rs ><:.6:.

F$t$re Va+$e o# Uneven Cash F+o" Streams


#uture value of uneven cash flow stream is the sum of the future value of each cash flow compounded to the end of the stream at required rate of return. It is calculated !y using the following relationship2
FVn ( #F+*+,i-nA+ , #F0*+,i-nA0 , #F.*+,i-nA. , / / / / / / , #Fn*+,i-1 *./+:-

;et us consider the same cash flow stream as a!ove and a 10 percent rate of compounding. 'he future value is computed as follows2
TA>LE ./7 #uture value of an uneven cash flow stream

Year 1 2 3 4 5

a!" F#o$! Rs 100 150 200 250 400

1%%FVIF !1.1" & 1.4641 !1.1"3 & 1.3310 !1.1" & 1.2100 !1.1"1 & 1.1000 !1.1"0 & 1.0000
2 4

FV Rs 146.41 199.65 242.00 275.00 400.00 Rs 1,263.06

F$ of uneven CF strea%

74

Chapter 3

BUSINESS FINANCE

9ote that in a!ove future value calculation the first year3end cash flow is compounded for four years the second year3end cash flow is compounded for three years and so on.

SEMIANNUAL AND OTHER COMPOUNDING PERIODS


In all preceding discussions we have considered interest rate compounded annually. It is called simple or quoted rate. 7owever in many cases the interests are paid monthly or quarterly or semiannually or any other periods which is less than one year. It is called periodic rate. In such cases interests are compounded more than once during the year. #or instance if interest is paid quarterly it is compounded four times during the year. If it is paid semiannually it is compounded two times during the year. 'he num!er of compounding periods during the year is denoted as AmB. #or any compounding period less than one year we ma.e following two changes in all our present and future value calculation2 first the rate of interest ,i- is divided !y the num!er of compounding periods ,m- during the year+ and second the num!er of years that cash flow occurs ,n- is multiplied !y the num!er of compounding periods during the year. ;et us illustrate a future value calculation for semiannual compounding. 1ssume that we place a Rs 10 000 today for % years in a security paying interest rate of 10 percent. If interest is compounded semiannually we receive % percent interest for each of the si$3 monthly period through a total of 10 si$3monthly periods. 'he #C of this semiannual compounding appears as2
FVmn ( )V ;+,iBm<mn *./+=-

*u!stituting the respective values in equation ,8.1>-2


#Cmn D Rs 10 000 J1E0.10K6L6 $ % D Rs 10 000 ,1.0%-10 D Rs 10 000 $ 1.=6<? D Rs 1= 6<?

Effecti!e annual rate 1n annual equivalent rate of some semiannual or other rates less than one year

In this calculation we have simply changed a 10 percent annual interest directly to a % percent semiannual interest. 7owever it should !e noted that each % percent interest payment occurs earlier so that they could !e reinvested for rest of the periods during the year. 4ecause of this reason effecti!e annual rate ,"1R- is somewhat greater than annual percentage rate of 10 percent. "ffective annual rate is the rate that would produce same terminal value if the annual compounding was used. It is calculated as follows2
EA3 ( 8 + *./+?-

(ith reference to our e$ample for semiannual compounding the effective annual rate ,"1Ris2
"1R DI1 D I 1 D J1.0%L6 I 1 D 1.106% I 1 D 0.106% or 10.6%@.

'hat is if the initial deposit of Rs 10 000 were compounded annually at 10.6% percent for % years this would result into a terminal value of Rs 1= 6<? at the end of % years. 9ote that this is equal to the amount which we calculated !y using % percent semiannual rate for 10 semiannual periods. 'he future value calculated using semiannual compounding is always greater than that of annual compounding. It occurs !ecause of more compounding periods during the year.

TIME VALUE OF MONEY

Chapter 3

75

CONTINUOUS COMPOUNDING
In addition to semiannual and other compounding sometimes interest is compound continuously. ;et us recall the "quation ,8.1?- for semiannual and other compounding.
FVmn ( )V ;+,iBm<mn *./+@-

In "quation ,8.1?- when num!er of compounding period AmB approaches to infinity we get continuous compounding and the compounding factor AJ 1 E iKmL mnB approaches Aei $ nB. 'herefore when interest is compounded continuously the "quation ,8.1?- could !e re3written as follows 2
FVn ( )V*e-i 4 n *./01-

In "quation ,8.60- AeB is called an e$ponential terms whose numerical value appro$imates to 6.>1<6<. 'o illustrate let us suppose if we deposit Rs 1 000 today at an annual interest rate of 16 percent for five years. 'he future value of this present sum Rs 1 000 at the end of year five when interest is compounded continuously is given !y2
FVmn ( )V*e-i 4 n ( 3s +,111 4 *e-/+0 4 9 D Rs 1 000 $ 1.<66116 D Rs 1 <66.16 9ote that the future value of any given amount of present sum is comparatively larger when continuous compounding is used than any other compounding periods. It happens !ecause num!er of compounding period is significantly larger under continuous compounding. 'he "quation ,8.60- in case of continuous compounding also can !e restated as follows to calculate the present value of a future sum2 )V ( FVn 4 *./0+'he present value calculated !y using "quation ,8.60- in case of continuous compounding is lower than in any other compounding periods !ecause of significantly larger num!er of discounting periods.

FRACTIONAL TIME PERIODS


In our previous section we noted how present values and future values are calculated using semi3annual and other compounding periods such as three monthly compounding monthly compounding and so on. 'his section deals with compounding and discounting when payment occurs in some fractional period. ;et us suppose for e$ample you deposit Rs % 000 in 7imalayan 4an. account that pays annual interest of 16 percent. 'he interest is compounded daily !y the !an.. If you hold your deposit for 66= days what will !e the future value of this deposit at the termination of deposit period) If !an. compounds interest daily the periodic rate that is daily rate is 0.086<>> percent assuming 8=% days in a year. 'herefore future value is given !y2 #C D Rs % 000 ,1 E 0.00086<>>-66= D Rs% 8<%.%?. 'hat is sum of Rs % 000 deposited today will grow to Rs % 8<%.%? at the end of 66=days at a 16 percent interest rate assuming the interest is compounded daily.

76

Chapter 3

BUSINESS FINANCE

AMORTI!ED LOANS
AmortiCed loan refers to the loan that is to !e repaid in equal periodic installments including
AmortiCed loan !oth principal and interest. 'he concepts of present value and compound interest rate are used 1 loan to !e repaid in equal to amortize a loan over the time in equal installments. installments throughout the given periods ;et us suppose a loan of Rs 10 000 is to !e repaid in : equal installments including

principal and 10 percent interest per annum. (e apply the following steps to determine the annual payment and set up an amortization schedule of the loan.
Determining annual payment

'he annual amount of installments to !e paid off that includes !oth principal and interest amount is calculated as follows2
)MT ( D D D Rs 8 1%:.=> *./00-

It means an installment of Rs 8 1%:.=> paid annually for four years will pay off !oth principal and interest of the loan.
Setting loan amortization schedule

Mnce the annual amount of installment is determined the loan amortization schedule could !e set up as follows2
TA>LE ./9 ;oan amortization schedule

Year (1) 1 2 3 4

Beginning &mo'nt (2) Rs 10,000.00 7,845.30 5,475.16 2,868.01

Payment (3) Rs 3,154.67 3,154.67 3,154.67 3,154.67

Intere!t (4) ( (2) ) %*1% Rs 1,000.00 784.53 547.52 '286.66

+e,ayment of Prin-i,a# (5) ( (3) . (4) Rs 2,154.67 2,370.14 2,607.15 2,868.01

Ending Ba#an-e (/) ( (2) . (5) Rs 7,845.33 5,475.16 2,868.01 (

Interest payment in the 4th year has been rounded to make the sum of principal plus interest equal to the annual payment of Rs 3,154. !.

COMPARISON OF DIFFERENT TYPES OF INTEREST RATES


'o this point we used three types of interest rates2 simple or quoted rate periodic interest rate and effective annual rate. 'his section compares them and e$plains their uses.
Simple or quoted interest rate Eimple rate 'he interest rate quoted !y interest rate. 'he practitioners in the stoc. !ond commercial loan !an.ing and finance lender companyBs loan e$press all financial contracts in terms of simple loan. *imple rate of interest

'he rate of interest which is quoted !y !orrowers and lenders is .nown as simple or Duoted

is the general rate that we use in practice while tal.ing a!out !orrowing and lending. 7owever the quotation of simple rate must also include the num!er of periods used in compounding per year. #or e$ample a !an. may offer 10 percent simple interest loan compounded monthly or quarterly or semiannually or annually. It should !e noted that the simple rate of one instrument could !e compared with other only when they have same num!er of compounding periods during the year. 'his means if is a !an. offers < percent simple interest loan with quarterly compounding where as another !an. offers <.% percent simple interest loan compounded semiannually then they can not !e

TIME VALUE OF MONEY

Chapter 3

77

compared on the !asis of simple interest rate !ecause of difference in compounding periods used in a year.
Periodic rate )eriodic rate 'he interest rate for each interest period such as monthly quarterly semiannually annually

'he rate of interest charged !y lender or paid !y !orrower at each interest period is .nown as periodic rate of interest. It can !e stated as interest rate per year or interest rate per si$ month or per quarter or per month and so on. Periodic rate is calculated as simple interest rate divided !y num!er of period in a year as given in equation ,8.68-.
)eriodic 3ate *i)E3- ( *./0.-

1!ove equation shows that if periodic rate is multiplied !y num!er of compounding period during the year then the periodic rate is stated on appro$imate annual rate. 'his appro$imate annual rate of periodic rate is .nown as annual percentage rate ,1PR-. It is to !e noted that the 1PR never is used in actual calculations+ it is simply reported to !orrowers. 'he periodic interest rate is equal to simple interest rate only if there is only one interest payment in the year that is once in a year. 4ut when interests are paid more frequently than once in a year and the payment is made on each compounding date then periodic interest rate is different from simple rate.
Effective annual rate

"ffective annual rate ,"1R- is the annual equivalent interest rate of a given periodic rate. 7owever it is not the 1PR. 'he 1PR does not consider the compounding effect of periodic rate whereas the "1R considers it. #or e$ample if we use 8 percent periodic rate per quarter its 1PR is 16 percent !ut "1R is more than 16 percent !ecause of compounding effect. 'he !asic use of "1R is that it facilitates the comparison of different interest rates with different num!er of compounding period during the year. #or e$ample if we are going to compare a < percent simple interest loan paying interest every si$ month against a >.% percent simple interest loan paying interest every three months !oth the simple rates must !e converted into effective annual rate.

ILLUSTRATIVE PROBLEMS
Illustration
Present and future values a.

#ind the following present and future values2 1n initial Rs %00 compounded for 1 year at = percent. !. 1n initial Rs %00 compounded for 6 years at = percent. c. 'he present value of Rs %00 due in 1 year at a discount rate of = percent. d. 'he present value of Rs %00 due in 6 years at a discount rate of = percent. a. Hiven Present value ,PC- D Rs. %00 Interest rate ,i- D =@
0 3 %00 =@ 1 #C D )

E OL U T I O N

!.

D PC,1 E i-n D PC ,1 E i-1 D Rs. %00 ,1 E 0.0=-1 D Rs. %80 Present value ,PC- D Rs. %00 Interest rate ,i- D =@ #Cn #C1

78

Chapter 3

0 3 %00

BUSINESS FINANCE

=@

6 #C D )

c.

D PC,1 E i-n D PC ,1 E i-6 D Rs. %00 ,1 E 0.0=-6 D Rs. %=1.<0 #uture value ,#C- D Rs. %00 Interest rate ,i- D =@ 9o. of periods ,n- D 1 #Cn #C6
0 PC D ) =@ 1 #C D %00

PC d.

D D D D D Rs. :>1.>0 #uture value ,#C- D Rs. %00 Interest rate ,i- D =@ 9o. of periods ,n- D 6 Present value ,PC- D )
0 PC D ) =@ 1 6 #C D %00

D D D D D Rs. ::% Illustration *uppose &r. *harma deposits Rs 10 000 in a !an. account that pays 10 percent interest annually. #uture value 7ow much money will !e in his account after % years) 2
EOLUTION

PC

7ere

Present value ,P- D Rs 10 000 Interest rate ,.- D 10@ 9um!er of years ,n- D % years #uture value ,#C%- D ) 0 10@ 1 6 8 % #C D )

Rs10000

(e have #C% D PC O ,1 E .-n D Rs 10 000 O ,1.10-% D Rs 10 000 O 1.=10% ( 3s +:,+19/+1 &r. *harma will have Rs1= 10%.10 at the end of year % in his account.

Illustration

Present value

(hat is the present value of a security that promises to pay you Rs % 000 in 60 years) 1ssume that you can earn > percent if you were to invest in other securities of equal ris.) 7ere #uture value ,#C- D Rs % 000 9um!er of years ,n- D 60 years Interest rate ,.- D >@ Present value ,PC- D ) 0 >@ 1 6 8 60 Rs% 000

EOLUTION

PC D )

TIME VALUE OF MONEY

Chapter 3

(e have PC D D D D 3s +,0@0/1@

Illustration

'ime for a lump sum to you to dou!le your money) dou!le

If you deposit money today into an account that pays =.% percent interest how long will it ta.e for

EOLUTION

7ere

Interest rate ,i- D =.%@ 9um!er of period ,n- D ) Present value ,PC- D Rs 1000 ,assume#uture value ,#C- D Rs 6000 0 =.%@ 1 6 8 nD)

(e have Present value ,PC- D or Rs 1000 D or ,1 E 0.0=%-n D or ,1.0=%-n D 6 .... ,i'rying at n D 11 (e get If n D 11 the left hand side in a!ove equation ,i- is appro$imately equal to 6. 7ence the required no. of years to dou!le the sum of money is 11 years.

PC D Rs1000

#C D Rs6 000

Illustration

#uture value of annuity at a. different compounding periods

#ind the future values of the following ordinary annuities2 #C of Rs :00 each = months for % years at a simple rate of 16 percent compounded semiannually. !. #C of Rs 600 each 8 months for % years at a simple rate of 16 percent compounded quarterly. c. 'he annuities descri!ed in parts a and ! have the same amount of money paid into them during the %3year period and !oth earn interest at the same simple rate yet the annuity in part ! earns Rs 101.=0 more than the one in part a over the % years. (hy does this occur) a. 7ere Periodic equal payment ,P&'- D Rs. :00 9um!er of period ,n- D % years Interest rate ,i- D 16@ semiannual compounding #uture value of an annuity ,#C1- D ) #C1 D P&' D Rs. :00 D Rs. :00 O 18.1<0< D Rs. %6>6.86 7ere Periodic equal payment ,P&'- D Rs. 600 9um!er of periods ,n- D % years Interest rate ,i- D 16@ compounded quarterly #uture value of an ordinary annuity ,#C1- D ) #C1 c. D P&' D Rs. 600 D Rs. 600 O 6=.<>0: D Rs. %8>:.0< It is !ecause other things held constant higher the num!er of compounding higher will !e the #C and vice versa.

E OL U T I O N

9ow !.

9ow

80

Chapter 3

Illustration
E OL U T I O N

"ffective rate of interest

BUSINESS FINANCE Four !ro.er offers to sell a note for Rs 186%0 that will pay Rs 68:%.0% per year for 10 years. If you !uy the note what rate of interest will you !e earning) Calculate to the closest percentage. 7ere Present value of annuity ,PC1- D Rs. 18 6%0 Periodic equal payment ,P&'- D Rs. 68:%.0% 9o. of periods ,n- D 10 years Interest rate ,i- D ) 'ime ;ine
0
PC1 D 186%0

1
68:%.0%

6
68:%.0%

8
68:%.0%

>

<

10

68:%.0% 68:%.0%

68:%.0% 68:%.0%

68:%.0% 68:%.0% 68:%.0%

(e have PC1 D P&' O PCI#1 i O n yrs. or Rs. 18 6%0 D Rs. 68:%.0% O PCI#1i@ 10 yrs or PCI#1i@ 10 yrs D %.=%06 #rom the PCI#1 ta!le the value of %.=%06 in 10 years lies at 16@. 'he required interest rate is 16@.

Illustration
EOLUTION

"ffective rate of interest

Four parents are planning to retire in 1< years. 'hey currently have Rs 6%0 000 and they would li.e to have Rs 1 000 000 when they retire. (hat annual rate of interest would they have to earn on their Rs 6%0 000 in order to reach their goal assuming they save no more money) 7ere #uture value ,#C- D Rs 1 000 000 Present value ,PC- D Rs 6%0 000 'ime period ,n- D 1< years Interest rate ,i- D ) 0 Rs6%0 000 (e have #C D PC ,1 E i-n or Rs 1 000 000 D Rs 6%0 000 ,1 E i-1< or ,1 E i-1< D or ,1 E i-1< D : or 1 E i D ,:-1K1< or i D 1.0< 3 1 D 0.0< or ?2 'he required rate of interest to reach the goal is <@. iD) 1 6 8 1< Rs1 000 000

Illustration
EOLUTION

#uture value of an annuity 'he rate of interest is > percent.

(hat is the future value of a %3year ordinary annuity that promises to pay you Rs 800 each year)

7ere

#uture value of annuity ,#C1- D ) Payment ,P&'- D Rs 800 9um!er of period ,n- D % years Interest rate ,i- D >@ 0 >@ 1 6 Rs800 8 Rs800 % Rs800 #C1 D )

Rs800

TIME VALUE OF MONEY

Chapter 3

81

(e have #C1 D P&' D Rs 800 D Rs 800 O %.>%0> D 3s +,=09/0+

Illustration

#uture value of an annuity due EOLUTION

(hat is the future value of a %3year annuity due that promises to pay out Rs 800 each year) 1ssume that all payments are reinvested at >@ a year until year %.

7ere

#uture value of annuity due ,#C1due- D ) Payment ,P&'- D Rs 800 9um!er of period ,n- D % years Interest rate ,i- D >@ 0 >@ 1 6 8 % #C1 ,due- D )

Rs800 Rs800 Rs800 Rs800 (e have #C1due D P&' ,1 E iD Rs 800 ,1 E 0.0>D Rs 800 O %.>%0> O 1.0> ( 3s +,?79/@=

1n investment pays you Rs 100 at the end of each of the ne$t 8 years. 'he investment will then pay you Rs 600 at the end of year : Rs 800 at the end of year % and Rs %00 at the end of year =. If Present and future value of a the rate of interest earned on the investment is < percent what is its present value) (hat is its cash flow stream future value)

Illustration

10

EOLUTION Year + 0 . 7 9 : #ash flo$ 3s +11 +11 +11 011 .11 911 )resent !alue )VIF at ?2 1/@09@ 1/?9=. 1/=@.? 1/=.91 1/:?1: 1/:.10 T)V )V 3s @0/9@ ?9/=. =@/.? +7= 017/+? .+9/+1 3s @0./@? Future !alue FIVE at ?2 FV +/7:@. +7:/@. +/.:19 +.:/19 +/09@= +09/@= +/+::7 0../0? +/1?11 .07/11 +/1111 911/11 TVF 3s +,7::/0.

Illustration

;oan amortization and effective car. Under the terms of the loan it will !e fully amortized over % years ,=0 months- and the interest rate nominal rate of interest will !e 16 percent with interest paid monthly. (hat would !e the monthly

11 Fou are thin.ing a!out !uying a car and a local !an. is willing to lend you Rs 60 000 to !uy the
payment on the loan) (hat would !e the effective rate of interest on the loan) 7ere

EOLUTION

Price of the car ,PC1- D Rs 60 000 n D % years Interest rate ,i- D 16@ annually ,i.e monthly interest rate is 1@&onthly installment ,P&'- D ) "ffective interest rate ,"IR- D ) (e have P&' D D D D Rs :::.<<? "IR D 3 1.0 D 3 1.0 D 1.16=< 3 1 D 0.16=< or +0/:?2 Illustration 12 9epal 7orticulture ;td. invests Rs : million to clear a tract of land and to set out some young pine "$pected rate of return trees. 'he trees will mature in 10 years at which time the company plans to sell the forest at an e$pected price of Rs < million. (hat is company/s e$pected rate of return)

82
EOLUTION

Chapter 3

BUSINESS FINANCE

7ere

#uture value ,#C- D Rs < 000 000 Present value ,PC- D Rs : 000 000 'ime period ,n- D 10 years "$pected rate of return ,i- D ) #irst set up time line as follows2 0 Rs: million iD) 1 6 8 10 Rs< million

(e have #C or or or or

D PC ,1 E i-n Rs < 000 000 ,1 E i-10 ,1 E i-10 1Ei i

D Rs : 000 000 ,1 E i-10 D D6 D ,6-1K10 D 1.0>1< 3 1 D 0.0>1< or =/+?2

Illustration

13 Fou need to accumulate Rs 10 000. 'o do so you plan to ma.e deposits of Rs 1 6%0 per year with

Reaching a financial goal

the first payment !eing made a year from today in a !an. account which pays 16 percent annual interest compounded annually. Four last deposit will !e less than Rs 1 6%0 if less is needed to round out to Rs 10 000. 7ow many years will it ta.e you to reach your Rs 10 000 goal and how large will the last deposit !e) 7ere 1nnual payment ,P&'- D Rs 1 6%0 #uture value of annuity ,#C1n- D Rs 10 000 Interest rate ,i- D 16@ 'ime to maturity ,n- D ) ;ast deposit D ) 0 16@ 1 6 8 n D)

EOLUTION

;ast deposit D ) #C1 D Rs10 000 #irst we determine the num!er of periods of the financial goal. 'his is calculated using future value of annuity formula as follows2 (e have #C1n D P&' O #CI#1i n Rs 10 000 D Rs 1 6%0 O PCi#116 n #CI#116 n D D< ;oo.ing #CI#1 ta!le the value < at 16 percent interest rate lies appro$imately in = years. 'herefore the num!er of years to reach the financial goal is = years. 9ow we calculate the future value of Rs 1 6%0 for % years at 16@ it is Rs > ?:1.0= #C D Rs 1 6%0 O #CI#116 % D Rs 1 6%0 O =.8%6< D Rs > ?:1 Compounding this value after = years and !efore the last payment is made it is Rs > ?:1 ,1.16- D Rs < <?8.?6. 'hus we will have to ma.e a payment of Rs 10 000 3 Rs < <?8.?6 D Rs 1 10=.0< at year = therefore it will ta.e = years and Rs 1 10=.0< must !e paid in the last installment. &r. Gha.al is in the process of negotiating his first contract. 1 Company has offered him three Present value of a cash flow possi!le contracts. "ach of the contracts lasts for : years. 1ll of the money is guaranteed and is stream paid at the end of each year. 'he terms of each of the contracts are listed !elow2
#ontract + )a"ment #ontract 0 )a"ment #ontract . )a"ment

Rs1 6%0 Rs1 6%0 Rs1 6%0

Illustration

14

TIME VALUE OF MONEY

3s 0 million . million 7 million 9 million

Chapter 3

83
3s = million + million + million + million

Year + Year 0 Year . Year 7

3s . million . million . million . million

'he &r. Gha.al discounts all cash flows at 10 percent. (hich of the three contracts offers him the most value)
EOLUTION Year )VIF at +12 + 0 . 7 1/@1@+ 1/?0:7 1/=9+. 1/:?.1 #ontract + *In Million#F )V . 0/=0=. . 0/7=@0 . 0/09.@ . 0/17@1 T)V @/91@7 #ontract 0 #ontract . *In Million*In Million#F )V #F )V 0 +/?+?0 = . 0/7=@0 + 7 ./1190 + 9 ./7+91 + T)V +1/=+=: T)V

:/.:.= 1/?0:7 1/=9+. 1/:?.1 ?/:077

'he total present value of the Contract 6 is the largest so that it offers him the most value.

Illustration

PC and effective annual rate !ro.erage firm and her !oss is selling some securities which call for : payments Rs %0 at the end

15

1ssume that you inherited some money. 1 friend of yours is wor.ing as an unpaid intern at a local of each of the ne$t 8 years plus a payment of Rs 1 0%0 at the end of year :. Four friend says she can get you some of these securities at a cost of Rs ?00 each. Four money is now invested in a !an. that pays an < percent nominal ,quoted- interest rate !ut with quarterly compounding. Fou regard the securities as !eing 0ust as safe and as liquid as your !an. deposit so your required effective annual rate of return on the securities is the same as that on your !an. deposit. Fou must calculate the value of the securities to decide whether they are a good investment. (hat is their present value to you) 7ere Payment D Rs %0 #ourth year payment D Rs 1 0%0 Cost of the securities D Rs ?00 Interest rate D <@ Compounding D Puarterly compounding "ffective interest rate ,"1R- D ) PC D ) #irst we calculate the effective annual rate2 "ffective interest rate ,"1R- D ,1 E 0.0<K:-: 3 1 D <.6:@ Calculation of the present value of cash flow stream at <.6:@ effective rate
Year + 0 . 7 #ash flo$ 91 91 91 +,191 )VIF F ?/072 1/@0.@ 1/?9.9 1/=??: 1/=0?9 )V )V 7:/+@9 70/:=9 .@/7. =:7/@09 3s ?@./009

EOLUTION

'he present value of this cash flow stream is Rs <?8.66% which is less than their current selling price so that they are not a good investment

Illustration

;oan amortization

16

Four Company is planning to !orrow Rs 1 000 000 on a %3year 1% percent annual payments fully amortized term loan. (hat fraction of the payment made at the end of the second year will represent repayment of principal) 7ere ;oan amount ,PC1- D Rs 1 000 000 9um!er of years ,n- D % years Interest rate ,i- D 1%@ #irst we determine the annual installment or payment ,P&'(e have P&' D D D D Rs 6?8 811.%% Preparation of 1mortization *chedule

EOLUTION

84

Chapter 3

Year + 0

BUSINESS FINANCE

AmortiCation schedule
)a"ments 3s 0@?,.++/99:: 0@?,.++/99:: Interest )a"ment of )rincipal 3s +91,111 3s +7?,.++/99:: +0=,=9./0::9 +=1,99?/0@1+ Endin& >alance 3s ?9+,:??/77.7 :?+,+.1/+9..

2 principal in 6nd year D D ( 9=/+=2 'hat is %>.1>@ of the payment in second year represents the principal.

Illustration

;oan amortization '.U. 441 600: EOLUTION

17

Fou are !ranch manager of 9epal 4an. ;imited 4ala0u. 1 !orrower approaches you for a term loan of Rs%00 000. Fou agreed to give loan to !e fully amortized in a period of % year at 10 percent annual payment. (hat will !e the size of each installment) (hat fraction of the payment made at the end of second year represents repayment of interest) 7ere ;oan amount ,PC1- D Rs %00 000 9um!er of years ,n- D % years Interest rate ,i- D 10@ #irst we determine the annual installment or payment ,P&'(e have P&' D D D D Rs 181<?<.6< Preparation of 1mortization *chedule AmortiCation schedule
Year 1 6 >e&innin& balance Rs%00 000 :1< 101.>6 )MT Rs181 <?<.6< 181 <?<.6< Interest Rs%0 000 :1 <10.1> 3epa"ment of principal Rs<1<?<.6< ?0 0<<.11 Endin& balance Rs:1< 101.>6 86< 018.=1

2 interest in 6nd year D D ( .+/=2 'hat is 81.>@ of the payment in second year represents the interest.

Illustration

9on annual compounding

18

a.

!.

It is now Qanuary 1 600>. Fou plan to ma.e % deposits of Rs 100 each on every = months with the first payment !eing made today. If the !an. pays a nominal interest rate of 16 percent !ut uses semiannual compounding how much will !e in your account after 10 years) 'en years from today you must ma.e a payment of Rs 1 :86.06. 'o prepare for this payment you will ma.e % equal deposits !eginning today and for the ne$t : quarters in a !an. that pays a nominal interest rate of 16 percent quarterly compounding. 7ow large must each of the % payments !e) 7ere 9um!er of deposits ,n- D % deposits+ *emiannual ,every = months- payment D Rs 100+ 9ominal interest rate ,i- D 16@ Present value of annuity ,PC1- D ) 0 Rs100 =@ Rs100 1 6 10 #C D )

EOLUTION

a.

Rs100 Rs100 Rs100

(e have #C1 D P&' O ,1 E i- D Rs 100 ,1 E 0.0=D Rs 100 O %.=8>1 O 1.0= D Rs %?>.%86= 9ow remaining period is 1% periods ,60 periods 3 % periods- so we calculate the future value of this Rs %?>.%86= for remaining periods. (e have #C D PC ,1 E i-n D Rs %?>.%86= ,1 E 0.0=-1% ( 3s +,7.0/10 !. 7ere #uture value at the end of 10 years D Rs 1 :86.06+ n D 8% periods !ecause quarterly compounding ,in 10 years there are :0 quarters-+

TIME VALUE OF MONEY

Chapter 3

85

Puarterly interest rate D 8@ P&' D ) PC D ) 0 8@ 1 10

P&' D ) P&' D ) P&' D ) P&' D ) P&' D ) #C D Rs1 :86.06 (e have PC D D D D Rs %0<.?1 9ow we calculate the payment ,P&P7ere n D % periods i D 8@ PC D )+ #C D Rs %0<.?1 #C1 D Rs %0<.?1 P&' D ) (e have #C1 D P&' ,1 E ior Rs %0<.?1 D P&' ,1 E 0.08or Rs %0<.?1 D P&' O %.80?1 O 1.08 P&' D D Rs ?8.0=

Illustration +@ 19

'he prize in last wee./s 7imalayan ;ottery was estimated to !e worth Rs 8% million. If you were luc.y enough to win the 7imalayan will pay you Rs 1.>% million per year over the ne$t 60 years. Calue of an annuity 1ssume that the first installment is received immediately. a. If interest rates are < percent what is the present value of the prize) !. If interest rates are < percent what is the future value after 60 years) c. 7ow would your answers change if the payments were received at the end of each year) 7ere Payment ,&P'- D Rs 1.>% million 9um!er of periods ,n- D 60 years a. Present value of annuity ,PC1- D ) interest rate ,i- D <@ PC1 D P&' O ,1 E i- D Rs 1.>% ,1 E 0.0<D Rs 1.>% O ?.<1<1 O 1.0< D 3s +?/9: million !. #uture value of annuity ,#C1- D ) Interest rate ,i- D <@ #C1 D P&' ,1 E iD Rs 1.>% ,1 E 0.0<D Rs 1.>% O :%.>=60 O 1.0< ( 3s ?:/7@ million c. PC1 and #C1 assuming payments received at the end of year. Present value of annuity ,PC1- D ) Interest rate ,i- D <@ (e have PC1 D P&' O D Rs 1.>% D Rs 1.>% O ?.<1<1 ( 3s +=/+? million #uture value of annuity ,#C- D ) Interest rate ,i- <@ #C1 D P&' D Rs 1.>% D Rs 1.>% O :%.>=60 ( 3s ?1/1? million

EOLUTION

Illustration

20

#uture value of an annuity

Four client is :0 years old and wants to !egin saving for retirement. Fou advise the client to put Rs % 000 a year into the stoc. mar.et. Fou estimate that the mar.et/s return will !e on average 16 percent a year. 1ssume the investment will !e made at the end of the year. a. If the client follows your advice how much money will she have !y age =%) !. 7ow much will she have !y age >0) 7ere a. Four client is :0 years old Payment ,P&'- D Rs % 000 Interest rate ,i- D 16@ Investment will !e made at the end of the year #uture value of annuity ,#C1- at the age of =%) 9um!er of periods ,n- D =% 3 :0 D 6% years #C1 D P&' D Rs % 000 D Rs % 000 O 188.888< ( 3s :::,::@

EOLUTION

86

Chapter 3

!.

BUSINESS FINANCE #uture value of annuity ,#C1- at the age of >0) 9um!er of periods ,n- D >0 3 :0 D 80 years #C1 D P&' D Rs % 000 D Rs % 000 O 6:1.886> ( 3s +,01:,::

Illustration

21

*olving for payment

&r. ;amsal has inherited Rs 6% 000 and wishes to purchase an annuity that will provide him with a steady income over the ne$t 16 years. 7e has heard that the local savings and loan association is currently paying = percent compound interest on an annual !asis. If he were to deposit his funds what year3end equal rupee amount ,to the nearest rupee- would he !e a!le to withdraw annually such that he would have a zero !alance after his last withdrawal 16 years from now) 7ere Present value of annuity ,PC1- D Rs 6% 000 9um!er of years ,n- D 16 years Interest rate ,i- D =@ "qual annual withdraw ,P&'- D ) PC1 D P&' O or Rs 6% 000 D P&' or Rs 6% 000 D P&' O <.8<8< P&' D Rs 6 ?<1.?:1:

EOLUTION

Illustration

Fou need to have Rs %0 000 at the end of 10 years. 'o accumulate this sum you have decided to save a certain amount at the end of each of the ne$t 10 years and deposit it in the !an.. 'he !an. *olving for payment pays < percent interest compounded annually for long term deposits. 7ow much will you have to save each year ,to the nearest rupee-) #C1 or Rs %0 000 or Rs %0 000 P&' D P&' D P&' D P'& O 1:.:<== D ( 3s .,79+/7:

22

EOLUTION

Illustration
EOLUTION

1nnual interest rate this amount if she contracts to pay them Rs 1= 000 at the end of the three years. (hat is the

23

&rs. Rar.i wishes to !orrow Rs 10 000 for three years. 1 group of individuals agrees to lend her implicit compound annual interest rate you receive ,to the nearest whole percent-) 7ere Present value ,PC- D Rs 10 000 9um!er of year ,n- D 8 years #uture value ,#C- D Rs 1= 000 "nd payment interest rate ,i- D ) (e have #C D PC ,1 E i-n or Rs 1= 000 D Rs 10 000 ,1 E i-8 or 1.= D ,1 E i-8 or ,1.=-1K8 3 1 D 1 or i D 0.1=?% or +:/@92

Illustration
EOLUTION

*olving for interest rate each of the four years. 'he price of the note to you is Rs 10 600. (hat is the implicit compound

24

Fou have !een offered a note with four years to maturity which will pay Rs 8 000 at the end of annual interest rate implied !y this contract ,to the nearest whole percent-) 7ere Payment ,P&'- D Rs 8 000 per year "nd payment years ,n- D : years Present value ,PC- D Rs 10 600 Interest rate ,i- D ) (e have PC1 D P&' O or Rs 10 600 D Rs 8 000 O PCI#1i@ : years

TIME VALUE OF MONEY Chapter 3 87 or Rs 10 600KRs 8 000 D PCI#1i@ : years or 8.: D PCI#1i@ % years 1ccording to PCI#1 ta!le the value of 8.: at :3year lies !etween =@ and >@. #or the actual e$pected return interpolate !etween these two rates. 1ctual e$pected return D ;ow rate E D =@ E ( :/?.92

Illustration

PC of uneven cash flow provide cash flows as follows2 stream Year #ash flo$ + 3s +,011 0 0,111 . 0,711

25

'he *riram 4ric. Company is considering the purchase of a de!ar.ing machine this is e$pected to
End of Year 7 9 +,@11 +,:11

: +,711

= +,711

? +,711

@ +,711

+1 +,711

If the appropriate annual discount rate is 1: percent what is the present value of this cash flow stream)
EOLUTION

#alculation of present !alue


Year + 0 . 7 9 :A+1 #ash flo$ 3s +,011 0,111 0,711 +,@11 +,:11 +,711 SPCI#1 for =310 )VIF at +72 1/?==0 1/=:@9 1/:=91 1/9@0+ 1/9+@7 +/=?.1G Total present !alue D PCI#1 for 10 years 3 PCI#1 for % years D %.61=1 3 8.:881 D 1.><80 )V 3s +,190/:7 +,9.@ +,:01 +,+07/@@ ?.+/17 0,7@:/0 3s ?,::./?=

Illustration

PC and #C of uneven cash flow stream '.U. 441 600:

26

'he following cash flow stream needs to !e analyzed


#ash flo$ stream T F + Rs100 600 0 Rs600 0 End of "ear . 7 Rs600 Rs800 %00 0 9 Rs800 800

a. !. E OL U T I O N a.

Calculate the present value of each T cash flow at 1: percent discount rate. Calculate the future value of each F cash flow at 10 percent discount rate. Calculation of present value of cash flow stream T at 1: percent discount rate
Year 1 6 8 : % #ash flo$ %H' +72 )VIF Rs100 0.<>>6 600 0.>=?% 600 0.=>%0 800 0.%?61 800 0.%1?: 'otal present value )V Rs<>.>6 1%8.?0 18%.00 1>>.=8 1%%.<6 Rs>10.0> FV Rs6?6.<6 0 =0%.00 0 800.00 Rs11?>.<6

!.

Calculation of future value of cash flow F at 10 percent compounding rate


Year 1 6 8 : % #ash flo$ %Y' +12 FVIF ( *+ , i-n A t Rs600 ,1.1-: D 1.:=:1 0 ,1.1-8 D 1.8810 %00 ,1.1-6 D 1.6100 0 ,1.1-1 D 1.1000 800 ,1.1-0 D 1.0000 'otal future value

Illustration

Uneven cash flow stream interest is 1: percent per annum discounted semiannually. '.U. 441 600%

27

Calculate the present value of the following cash flow stream. 1ssume that the stated rate of Cash flow 1000 0 1=00 1%00 <%0 8

"nd of year

88

Chapter 3

BUSINESS FINANCE

EOLUTION

If stated annual rate is 1: percent discounted semiannually first we calculate the effective annual rate as follows2 "ffective interest rate ,"1R- D ,1 E 0.1:K6-6 3 1 D 1:.:?@ 9ow present value of given cash flow stream discounted at 1:.:? percent effective annual rate is calculated as follows2
Year 0 1 6 8 #ash flo$ +7/7@2 )VIF Rs1 000 1.0000 1 =00 0.<>8: 1 %00 0.>=6? <%0 0.===8 'otal present value )V Rs1 000.00 1 8?>.:: 1 1::.8% %==.8= Rs: 10<.1%

SUMMARY
'ime value of money is a concept to understand the value of cash flow occurred at different point in time. #inancial decisions concerned with !usiness firm require a consideration regarding time value of money. &a$imizing shareholder wealth to a larger e$tent depends on the timing of cash flows from investment alternatives. Cash flow time line is used to understand the timing of cash flow. #uture value of a sum of money is defined as the total of the sum of the money plus the stream of interest amount received for the period of time the money invested. 'he process of finding future value is called /compounding/. Present value of a future sum of money is the amount of current money that is equally desira!le today against a specified amount of money to !e received or paid at a future date. 'he process of finding present value is called discounting. 1nnuity is series of equal payment occurred at equal interval of time throughout a given period. 'here are two types of annuities3 ordinary annuity and annuity due. #or ordinary annuity the series of equal payment occurs at the end whereas it occurs at the !eginnings of each equal interval of time for annuity due. (hen a series of equal payment occurs for indefinite period of time it is called a perpetuity.

REVIEW "UESTIONS
Indicate $hether the follo$in& statements are %True' or %False'/ Eupport "our ans$er $ith reason 1. Rs 100 worth today is equal to Rs 100 worth at the end of year 1. 6. 'he process of finding future value is called /compounding/. 8. 'he present value of a future sum of money is the amount of current money that is equally desira!le to a decision ma.er today against a specified amount of money to !e received or paid at a future date.

TIME VALUE OF MONEY

Chapter 3

:. %. =.

>. <. ?. 10. 11. 16.

Giscounting is 0ust reverse of compounding. 1n annuity is a series of payment of fi$ed amount at each specified interval of time for a given num!er of periods If lump sum payment today is equal to the present value of 83years annuity of Rs 1000 each year discounted at a given rate of return we would not !e indifferent in choosing either of the alternatives. In semi3annual compounding the compounding periods are dou!led. 'he loan to !e repaid in equal periodic installments is called amortized loan. 'he present value of a security that promises to pay Rs % 000 in 60 years at > percent discount rate is Rs 18?6.10. Hiven the monthly periodic rate of 1 percent the annual percentage rate is 16 percent. If monthly periodic rate of interest is 6 percent the effective annual rate is 6: percent. If your investment dou!les in 10 years you earn appro$imately ? percent return in a year.

#hoose the most appropriate ans$er for the follo$in& 18. Cash flow time line is a .......... presentation of cash flows associated with different time period. a. ta!ular !. formula c. graphic d. linear 1:. If we deposit Rs 1000 today at an annual interest rate of 10 percent it is compounded to ........... at the end of year 6. a. Rs 1000 !. Rs 6000 c. Rs 1610 d. Rs 1:10 1%. 'he present value of Rs 1100 due in year 1 discounted at 10 percent is .......... a. Rs 1 000 !. Rs ?00 c. Rs 1 100 d. Rs ?%0 1=. If equal amount of payment occurs at the !eginning of each equal interval of time for the given period the payment is called ........... a. an ordinary annuity !. an annuity due c. present value d. future value 1>. 1 stream of equal payment occur at equal interval of time to infinity is called ......... a. present value of annuity !. future value of annuity c. cash flow d. perpetuity 1<. In a stream of cash flow if the cash flow in each period differs from period to period it is called ........... a. perpetuity !. payment c. uneven cash flow streams d. amortization schedule 1?. 'he loan to !e repaid in equal periodic installment is called .......... a. future value !. present value c. long3term loan d. amortized loan 60. 1 sum of money due at some future date is called ......... a. time value !. intrinsic value c. present value d. future value

"UESTIONS
1. 6. 8. :. U1 rupee in hand today is worth more than a rupee to receive ne$t yearU. "$plain. (hat is discounting) 7ow it is related to compounding) (hat do you mean !y present value) 7ow it is calculated) (hat do you mean !y future value) 7ow it is calculated)

Chapter 3

%. =. >. <. ?. 10.

BUSINESS FINANCE (hat do you mean !y cash flow time lie) (hat does it show) Illustrate with e$ample. (hat is the difference !etween ordinary annuity and annuity due) Illustrate with the help of cash flow time line. (hat do you mean !y perpetuity) 7ow present value of perpetuity is calculated) Illustrate. (hat do you mean !y uneven stream of cash flow) Illustrate how the future value of the uneven stream of cash flow is calculated) (hat annuity has a greater future value3an ordinary annuity or an annuity due) (hy) "$plain. (hat is the difference !etween annual percentage rate ,1PR- and effective annual rate ,"1R-) Illustrate with suita!le e$ample.

PROBLEMS
.8+
Present and future values a.

Calculate present and future values of the following2 1n initial Rs %00 compounded for 10 years at = percent. !. 1n initial Rs %00 compounded for 10 years at 16 percent. c. 'he present value of Rs %00 due in 10 years at = percent discount rate. d. 'he present value of Rs 1%%6.?0 due in 10 years at ,i- a 16 percent discount rate and ,iia = percent rate. Hive a ver!al definition of the term present "alue and illustrate it using a cash flow time line with data from this pro!lem. 1s part of your answer e$plain why present values are dependent upon interest rates. (hich amount is worth more at 1: percent2 Rs 1 000 in hand today or Rs 6 000 due in = years) 'o the closest year how long will it ta.e Rs 600 to dou!le if it is deposited and earns the a. c. > percent. 1< percent !. d. 10 percent 100 percent.

Present and future values

.80 .8.

*olving for num!er of following rates) periods

.87

*hitalnagar Mil CorporationBs 600= sales were Rs 16 million. *ales were Rs = million % years

*olving for interest rate or earlier ,in 6001-. rate of growth a. 'o the nearest percentage point at what rate have sales !een growing)

*uppose some one calculated the sales growth for &C corporation in part a as follows2 V#ales doubled in 5 years. $his represents a %ro&th of 1'' percent in 5 years, so di"idin% 1'' percent by 5, &e find the %ro&th rate to be (' percent per year. W "$plain what is wrong with this calculation. .89 #ind the future value of the following annuities2 #uture value of annuities a. Rs :00 per year for 10 years at 10 percent. !. Rs 600 per year for % years at % percent. c. Rs :00 per year for % years at 0 percent. d. 9ow rewor. parts a ! and c assuming that payments are made at the !eginning of each year+ that is they are annuities due. .8: #ind the present value of the following ordinary annuities2 Present value of annuity a. Rs :00 per year for 10 years at 10 percent. !. Rs 600 per year for % years at % percent. c. Rs :00 per year for % years at 0 percent. d. 9ow rewor. parts a ! and c assuming that payments are made at the !eginning of each year+ that is they are annuities due. .8= #ind the interest rates or rates of return on each of the following2

!.

TIME VALUE OF MONEY

Chapter 3

#inding interest rates a.

!. c. d. .8?

Fou !orrow Rs >00 and promise to pay !ac. Rs >:? at the end of 1 year. Fou lend Rs >00 and receive a promise to !e paid Rs >:? at the end of 1 year. Fou !orrow Rs <%000 and promise to pay !ac. Rs 60166? at the end of 10 year. Fou !orrow Rs ?000 and promise to ma.e payments of Rs 6=<:.<0 per year for % years.

(hat is the present value of a perpetuity of Rs 100 per year if the appropriate discount rate is 1: percent what would happen to the present value of the perpetuity)

Present value of perpetuity > percent) If interest rates in general were to dou!le and the appropriate discount rate rose to

Uneven cash flow consideration2

.8@

#ollowing are the cash flow streams associated to two investment proposals under
Year 1 2 3 4 5 a!" F#o$ 0tream! 1 Y Rs 100 Rs 300 400 400 400 400 400 400 300 100

a. !.

If the appropriate interest rate is < percent what is the present value of each cash flow streams) (hat is the value of each cash flow stream at a 0 percent interest rate)

.8+1 Represent the following cash flows in time line and calculate the present value of the stream
Uneven cash flow of cash flows at 11 percent discount rate. 'he cash flow stream is Rs%00 000 in year zero

3Rs600 000 at the end of year 0ne Rs600 000 at the end of year two Rs800 000 at the end of year three and Rs:00 000 at the end of year :.
#uture values at different a. compounding periods

.8++ #ind the amount to which Rs %00 will grow under each of the following conditions2 16 percent compounded annually for % years. !. 16 percent compounded semiannually for % years. c. 16 percent compounded quarterly for % years. d. 16 percent compounded monthly for % years. .8+0 #ind the present values of Rs %00 due in the future under each of the following conditions2 16 percent simple interest rate compounded annually. !. 16 percent simple rate semiannual compounding discounted !ac. % years. c. 16 percent simple rate quarterly compounding discounted !ac. % years. d. 16 percent simple rate monthly compounding. Giscounted !ac. 1 year. .8+. Fou 0ust started your first 0o! and you want to !uy a house within 8 years. Fou are currently

Present values at different a. compounding periods

#uture value saving for the down payment. Fou plan to save Rs % 000 the first year. Fou also anticipate the

amount you save each year will rise !y 10 percent a year as your salary increases over time. Interest rates are assumed to !e > percent and all saving occurs at year end. 7ow much money will you have for a down payment in 8 years)

.8+7 4an. 1 pays < percent interest compounded quarterly on its money mar.et account. 'he manager of 4an. 4 want its money mar.et account to equal 4an. 1Bs effective annual rate !ut interest is to !e compounded on a monthly !asis. (hat simple rate must !an. 4 set)
"ffective annual rates 94 !an. pays =.% percent interest compounded quarterly.

.8+9 'he 7imalayan 4an. pays > percent interest compounded annually on time deposits. 'he a. !. 4ased on effective interest rates in which !an. would you prefer to deposit your money) Could your choice of !an.s !e influenced !y the fact that you might want to withdraw your funds during the year as opposed to at the end of the year) In answering this

Chapter 3

BUSINESS FINANCE

question assume that funds must !e left on deposit during the entire compounding period in order for you to receive any interest. .8+: &r. Gha.al invested Rs 1%0000 eighteen months ago. Currently the investment is worth Rs
"ffective interest rate 1=<?6%. &r. Gha.al .nows the investment has paid interest every three months !ut he does

not .now what the yield on his investment is. 7elp &r. Gha.al. Compute !oth the annual percentage rate ,1PR- and the effective annual rate of interest.
"ffective rate of interest Rs <6>8.%? per year for 80 years. (hat interest rate is the mortgage company charging you)

.8+= 1 mortgage company offers to lend you Rs <%000+ the loan calls for payments of .8+? Fou are thin.ing to !uy a car and a local !an. is willing to lend you Rs60 000 to !uy the

1mortized loan car. Under the terms of the loan it will !e fully amortized over % years ,=0 months- and the

nominal rate of interest will !e 16 percent with interest paid monthly. (hat would !e the monthly payment on the loan) (hat would !e the effective rate of interest on the loan) .8+@ &adhyamanchal Inc. 0ust !orrowed Rs 6%000. ;oan is to !e repaid in equal installments at the
1mortization schedule end of each of the ne$t % years and the interest rate is 10 percent.

a. !. c.

*et up an amortization schedule for the loan. 7ow large must each annual payment !e if the loan is for Rs %0000) 1ssume that the interest rate remains at 10 percent and the loan is paid off over % years. 7ow large must each payment !e if the loan is for Rs %0000 the interest rate is 10 percent and the loan is paid off in equal installments at the end of each of the ne$t 10 years) 'his loan is for the same amount as the loan in part ! !ut the payments are spread out over twice as many periods. (hy are these payments not half as large as the payments on the loan in part !)

.801 'he management of Campaign for Peace in 9epal ;imited decided to !uy a printing press !y
1mortization schedule ta.ing a loan of Rs1 %00 000 for : years from Peace Cooperative ;imited. 'he loan !ears a

compound annual interest of 16 percent and calls for equal annual installment payments at the end of each of the : years. a. (hat is the amount of annual payments) !. Prepare a schedule showing the fraction of interest and principal payment for each year. c. (hat fraction of payment made in year 6 represents the principal) d. (hat fraction of payment made in year : represents the interest)
1mortized loan amortized term loan. (hat fraction of payment made at the end of second year will represent

.80+ Fou are planning to !orrow Rs 1 000 000 on a %3year 16 percent annual payment fully the payment of interest) (hat fraction of payment made at the end of third year will represent the repayment of principal) (hat would !e the amount of interest and principal paid in the final year)

#uture value savings account that pays < percent.

.800 1ssume that it is now Qanuary 1 600=. Mn Qanuary 1 600> you will deposit Rs 1000 into a a. !. c. d. If the !an. compounded interest annually how much will you have in your account on Qanuary 1 6010) (hat would your Qanuary 1 6010 !alance !e if the !an. used quarterly compounding rather than annual compounding) *uppose you deposited the Rs 1000 in : payments of Rs 6%0 each on Qanuary 1 of 600> 600< 600? and 6010. 7ow much would you have in your account on Qanuary 1 6010 !ased on < percent annual compounding) *uppose you deposited : equal installments in your account on Qanuary 1 of 600> 600< 600? and 6010. 1ssuming an < percent interest rate how large would each of your payments have to !e for you to o!tain the same ending !alance as you calculated in part a)

TIME VALUE OF MONEY

Chapter 3

.80. Rrishna 9epal is =8 years old and recently retired. 7e wishes to provide retirement income for himself and is considering an annuity contract with the 9ational ;ife Insurance 'ime value of money Corporation. *uch a contract pays him an equal rupee amount each year that he lives. #or this cash flow stream he must put up a specific amount of money at the !eginning. 1ccording to actuary ta!les his life e$pectancy is 1% years and that is the duration on which the insurance company !ases its calculations regardless of how long he actually lives. a. If the Insurance Company uses a compound annual interest rate of % percent in its calculations what must &r. 9epal pay at the outset for an annuity to provide him with Rs10 000 per year) ,1ssume that the e$pected annual payments are at the end of each of the 1% years!. (hat would !e the purchase price if the compound annual interest rate is 10 percent) c. &r. 9epal had Rs80 000 to put into an annuity. 7ow much would he receive each year if the insurance company uses a % percent compound annual interest rate in its calculation) .807 Fou opened an account in 4an. of Rathmandu ,4MR-. 'he !an. pays interest at the rate of 8
'ime value of money percent per annum and compounds quarterly.

a. !. c. d.

If you deposit Rs% 000 now how much shall it grow at the end of % years) (hat rate will you earn if the money deposited in the !an. account dou!les in % years) 7ow long will it ta.e to grow Rs % 000 to Rs 10 ?%% if the !an. pays interest at : percent per annum compounded annually) 1ssume that you deposit Rs% 000 at the end of each quarter for : years. (hat will !e the !alance in your account at the end of fourth year if the !an. pays interest at : percent per annum compounded quarterly)

.809 1ssume that it is now Qanuary 1 600= and you will need Rs 1000 on Qanuary 1 6010. Four
'ime value of money !an. compounds interest at an < percent annual rate.

a. !. c. d. e. f.

g.

7ow much must you deposit on Qanuary 1 600> to have a !alance of Rs 1000 on Qanuary 1 6010) If you want to ma.e equal payments on each Qanuary 1 from 600> through 6010 to accumulate the Rs 1000 how large must each of the : payments !e) If your father offered either to ma.e the payments calculated in part ! or to give you a lump sum of Rs >%0 on Qanuary 1 600> which would you choose) If you have only Rs >%0 on Qanuary 1 600> what interest rate compounded annually would you have to earn to have necessary Rs 1000 on Qanuary 1 6010) *uppose you can deposit only Rs 1<=.6? each Qanuary 1 from 600> through 6010 !ut you still need Rs 1000 on Qanuary 1 6010. (hat interest rate with annual compounding must you see. out to achieve your goal) 'o help you reach your Rs 1000 goal your mother offers to give you Rs :00 on Qanuary 1 600>. Fou will get a part time 0o! and ma.e = additional payments of equal amounts each = months thereafter If all this money is deposited in a !an. that pays < percent compounded semiannually how large must each of the = payments !e) (hat is the effective annual rate !eing paid !y the !an. in part f)

.80: 'o complete your last year in !usiness school and then go through law school you will need
Present value of annuity Rs 10000 per year for : years starting ne$t years ,that is you will need to withdraw the first

Rs 10000 one year from today-. Four rich uncle offers to put you through school and he will deposit in a !an. paying > percent interest a sum of money that is sufficient to provide the four payments of Rs 10000 each. 7is deposit will !e made today. a. 7ow large must the deposit !e) !. 7ow much will !e in the account immediately after you ma.e the first withdrawal) 1fter the last withdrawal)

Chapter 3

BUSINESS FINANCE

.80= &rs. Rita wants a refrigerator that costs Rs 16000. *he has arranged to !orrow the total *olving for payment purchase price of refrigerator from a finance company at a simple interest rate equal to 16 percent. 'he loan requires quarterly payments for a period of three years. If the first payment is due three months after purchasing the refrigerator what will !e the amount of her quarterly payments on the loan)
*olving for payment official visits you for advice. 7e needs to have Rs %00000 at the end of 8 years for his

.80? Fou are the manager of 9epal 4angladesh 4an. 4utwal 4ranch. &r. ;amsal a government daughterBs enrolment in &41. 'o accumulate this sum he has decided to deposit certain amount at 94 !an. at the !eginning of every year for 8 years. 7ow much will &r. ;amsal have to deposit each year at the 94 !an. that pays interest at % percent compounded annually)

*olving for time Rs 16 000 in student loans at an annual interest rate of ? percent. If &r. Chhetri repays

.80@ (hile &r. 1.R Chhetri was a student at the 'ri!huvan University he !orrowed Rs 1%00 per year how long to the nearest year will it ta.e him to repay the loan)

*olving for present value that will pay Rs 100 000 when you turn 6% years. If the relevant discount rate is 11 percent

.8.1 *uppose you had 0ust cele!rated your 1?th !irthday. 1 rich uncle set up a trust fund for you how much is this fund worth today) .8.+ Fou have 0ust 0oined the investment3!an.ing firm of Pandey and Pandey Company. 'hey

"valuation cash flow have offered you two different salary arrangements. Fou can have Rs 80 000 per year for ne$t

two years or Rs 60 000 for the ne$t two years along with a Rs 80 000 signing !onus today. If the interest rate is 16@ compounded quarterly which do you prefer) .8.0 Fou need to accumulate Rs 10 000. 'o do so you plan to ma.e deposits of Rs 1>%0 per year
*olving for time and with the first payment !eing made a year from to day in a !an. account which pays = percent payments annual interest. Four last deposit will !e more than Rs 1>%0 if more is needed to round out to

Rs 10 000. 7ow many years will it ta.e you to reach your Rs 10 000 goal and how large will the last deposit !e)

*olving for time

.8.. &r . *harma has Rs :61<0.%8 in !ro.erage account and plans to contri!ute an additional Rs %000 every year at an annual interest rate of 16 percent. If &r. *harma has to accumulate Rs 6%0 000 how many years will it ta.e for him to reach his goal) .8.7 1 1%3year security has a price of Rs 8:0.:=<?. 'he security pays Rs %0 at the end of each of ne$t % years and then it pays a different cash flow amount at the end of each of the following 10 years. Interest rates are ? percent. (hat is the annual cash flow amount !etween = and 1% years) .8.9 &iss *a!ita has 0ust own the 9ational ;ottery and has three award options to choose from.

*olving for payment

"valuating cash flow *he can elect to receive a lump sum payment today of Rs =1 million 10 annual end3of3year

payments of Rs ?.% million or 80 annual end3of3year payments of Rs %.% million. If she e$pects to earn an < percent annual return on her investment which option should she choose) .8.: &r. 7ari li.e many college students recently filled out a credit card application. 9ot surprisingly his application was accepted at a nominal interest rate of 6: percent. Upon Reaching a financial goal receiving the credit card he purchased a new stereo which costs him Rs 80%.:: with the card. Upon receiving his first !ill he was delighted to learn that the credit card company only requires a minimum payments of Rs 10 per month. a. If 7ari ma.es the minimum payment every months how many months will it !e !efore the account is completely paid off) !. If 7ari continues to ma.e the minimum payment how much will the final payment !e) 1ssume that the last payment occurs at the end of the month rather than in the middle of the !illing period.

TIME VALUE OF MONEY

Chapter 3

MINI CASE
Case 1:
&r. Ramesh &ahar0an has 0ust completed his 4achelor Gegree in 4usiness 1dministration from 'ri!huvan University. 1ssume that it is now Qanuary 1 600> and he is planning to accumulate Rs 1%0 000 in Qanuary 6016 for his post graduate study in a!road. 'oday he is thin.ing for an investment in a security that pays 16 percent annual interest. 7is only source of income today is his monthly salary of Rs 10 000 from his 0o! in *tandard Chartered 4an. main !ranch Rathmandu. Mut of his monthly income he spends =0 percent amount for his living. 7e has also saved Rs 100 000 in his !an. account from his 0o! over the years. In adherence to his plan a!out further study you are required to answer the following2 a. 7ow much must he deposit in lump sum on Qanuary 1 600> to accumulate a !alance of Rs 1%0 000 on Qanuary 1 6016) !. If he wants to ma.e equal payments on each Qanuary 1 from 600< through 6016 to accumulate Rs 1%0 000 how large must each annual payments !e) c. If he wants to invest his monthly net saving in the security the first payment !eing made one month from now how much he could accumulate in Qanuary 1 6016) 1ssume interest is compounded monthly. d. If he invests his monthly saving into the security the first payment !eing made today how many months it would ta.e him to accumulate the sum of Rs 1%0 000) e. (hat is the effective annual rate of monthly compounded interest rate in part AcB) f. Instead if he could invest Rs 6% 000 every year starting one year from now at what annual rate of interest he could accumulate Rs 1%0 000 on Qanuary 1 6016) g. If his !an. !alance of Rs 100 000 today pays 10 percent annual interest compounded quarterly in how many years he could accumulate required sum of Rs 1%0 000) h. If his !an. !alance of Rs 100 000 today pays 10 percent annual interest compounded quarterly to which value it will grow on Qanuary 1 6016)

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