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LESSON 7:
CHAPTER 5: FINANCIAL SECURITIES,
TIME VALUE OF MONEY
MARKETS AND VALUATION MODELS
For finding future value of each cash flow in case of series of ....................................................…….+ A[1 / (1 + r) n ]
cash flows, we can use the formula FV n = PV(1+r) n or FV n = Since the future cash flow of annuity is same for every period,
PV(FVIFrn ) and add up to ascertain the Future Value. the formula is,
Annuities PVAn = A{ [1 / (1 + r) 1] + [ 1 / (1 + r) 2] + ………
An annuity is a series of equal cash flows occurring over a ...............................................……….+ [1 / (1+r) n ] }
specified number of periods. When cash flows occur at the end = A {[ (1 + r) n – 1] / [(1+r) n X r]} * mathematical derivation
of each period, it is called an Ordinary Annuity. is given at the end of the chapter
Future or Compound Value of Annuity It will be more clear for you looking at Graphically the Present
FVAn = A (1 + r) n-1 + A (1 + r) n-2 +…..................................... Value of an annuity of FV, say, of Re. 1 with discounting rate
...........................................…+ A (1 + r) 1 + A (1 + r) 0 of 10%
= A {[ (1 + r) n – 1] / r} *mathematical derivation is given at
the end of the chapter
The term [ (1 + r) n – 1] / r is referred to as the Future Value
0 1 2 3 4 5
Interest Factor for an Annuity,
Receipt at the end of
FVAn = A (FVIFA rn ) the year Re.1 Re.1 Re.1 Re.1 Re.1
Where FVIFA stands for the Future Value Interest Factor of an 0.909
0.826
Annuity at i% for n periods.
Time Line: The series of cash flows can be represented on a 0.751
time line as below, PV of Re.1 at 5% interest: 0.683
0 1 2 3 4 5 0.621
--------
Deposit at the end of 3.790
the year Re.1 Re.1 Re.1 Re.1 Re.1
PVA = A --------------------
For a series of cash flows the formula to be expanded as
r
PV = FV 1 [1 / (1 + r) 1] + FV 2[ 1 / (1 + r) 2] + …………
..............................................…….+ FV n [1 / (1 + r) n ]
In case of Annuity, Since any denominator of infinite nature, including any term
raised to the power infinity, is zero,
table as below
FVADn = A (FVIFA rn ) (1+r) Where C0 is Cash Outflow and r may represent the Opportunity
Similarly Present Value of Annuity Due can be calculated. Since Cost of Capital.
the first cash flow is immediate at the beginning, the Present
Internal Rate of Return
Value is equal to absolute value and hence the cash flow series
The Internal Rate of Return is the rate which equates the
will be as below:
Present Value of Cash Inflows with the Present Value of Cash
PVADn = A {1+[1 / (1 + r) 1] + [1 / (1 + r) 2] + Outflows of an investment. It is the rate at which the Present
……………….+ [1 / (1+r) n-1] } Value of the proceeds and the outlays are equal. In other
A {[(1 + r) n – 1] / [(1+r) n X r]} (1+r) * mathematical words, it is the rate at which the Net Present Value is (PV of
derivation is given at the end of the chapter Cash Outflows – PV of Cash Inflows) is zero.
Multi-period or Semi-annual and other compounding As you know we use the following formula to find the Present
Normally interest rate is expressed for a year. In case, com- Value of Cash inflows:
pounding is done semi-annually or quarterly or monthly or FV 1 [1 / (1 + r) 1] + FV 2[ 1 / (1 + r) 2] + …………
weekly, interest rate & compounding to be adjusted accordingly ...................................................…….+ FV n [1 / (1 + r) n ]
to alter the number of time periods. The formula FV n = (1+r) n Since PV of Cash Outflows (Co) is also known, we may use the
will get altered as below: following equation to find out r:
mn {FV 1 [1 / (1 + r) 1] + FV 2[ 1 / (1 + r) 2] + ………
r ..........................................……….+ FV n [1 / (1 + r) n ]} – Co = 0
FVn = PV 1 + ------
Mathematical Derivation of Formula for Future/Compound
m
Value of Annuity
where m is the number of compounding per year. FVAn = A (1 + r) n-1 + A (1 + r) n-2 +…………
………......................................……+ A (1 + r) 1 + A (1 + r) 0
When we take out A in every item, the series is as below:
The interest rate specified on annual basis is known as the
Nominal Interest Rate. If compounding done in a year is more (1 + r) n-1 + (1 + r) n-2 +……………
than once, the actual rate of interest is called the ............................................…………+ (1 + r) 1 + (1 + r) 0
Effective Interest Rate (EIR) /Annual Percentage Rate (APR), We may rewrite the series as below also:
which can be ascertained as below: (1 + r) 0 + (1 + r) 1 + …………………
.......................................................….+ (1 + r) n-2 + (1 + r) n-1
mn
r This series of n terms is in Geometric Progression with a
FVn = PV 1 + ------ - 1 common ratio. The Common Ratio is arrived at by dividing
m the following term by the preceding term in the series.
Let us take the first term (1 + r) 0 which is 1 (anything raised to
Similar to Future Value, Present Value of cash flows more than the power of 0 is equal to 1). Dividing the second term by the
once a year can be discounted with the following formula: first term 1, we get (1 + r) i.e. (1 + r) 1 / 1. Next we shall divide
the third item (1 + r) 2 by (1 + r) 1 which is again (1 + r). Hence
the Common Ratio in our series is (1 + r).
1 1+ r – 1 r
Sn = (1 + r) 0 + (1 + r) 1 +.….+ (1 + r) n-2 + (1 + r) n-1 …….Eqn.1 1- (1+r) -1 = 1 - ------ = ----------- = ------------
Multiplying both sides by ‘(1 + r)’ we have, 1+r 1+r 1+r
(1+r)Sn = (1+r) (1 + r) 0 + (1+r) (1 + r) 1 + ……………...... Simplifying the numerator,
.............................................. + (1+r) (1 + r) n-2 + (1+r) (1 + r) n-1
1 1 (1+r)n - 1
(1+r)Sn = (1+r) + (1 + r) 2 + …. ............................. (1 + r)-1 - (1 + r)-n-1 = -------------- - ------------ = ----------------
+ (1 + r) n-1 + (1 + r) n ..............................................…Eqn. 2 (1 + r) (1 + r)n+1 (1 + r)n+1
Now Subtracting Equation 2 from Equation 1, we have Using the simplified numerator and denominator,
n
Sn – (1 + r)S n = 1 - (1 + r)
(1 + r)n -1
Sn [1- (1+r)] = 1 - (1 + r)n -------------
(1 + r)n+1 [(1+r)n – 1] (1 + r)
Sn = ------------------------ = -------------- X -----------
1 - (1 + r) n -[(1+r)n –1] (1+r) n –1 r (1+r)n+1 r
Sn = -------------------- = --------------- = -------------- -----------
[1- (1+r)] 1-1-r r 1+r
..........................................................….+ A[1 / (1 + r) n ] Multiplying with A, which was removed in the beginning, the
We may rewrite the equation as follows: formula is
PVAn = A [ (1 + r) -1] + A[ (1 + r) -2] + …………… A {[ (1 + r) n – 1] / [(1+r) n X r]}
.......................................................….+ A[(1 + r) -n ]
Mathematical Derivation of formula for Present Value of an
When we take out A in every item, the series is as below: Annuity Due
(1 + r) -1 + (1 + r) -2 + ……………….+ (1 + r) -n PVADn = A {1+[1 / (1 + r) 1] + [1 / (1 + r) 2] +
This series of n terms is in Geometric Progression with a ……………….+ [1 / (1+r) n-1] }
common ratio. The Common Ratio is arrived at by dividing Multiplying and dividing the whole expression by (1+r), we get
the following term by the preceding term in the series.
A (1+r) {1+[1 / (1 + r)1 ] + [1 / (1 + r)2 ] + ……………….+ [1 / (1+r)n-1 ] }
Dividing the second term by the first term, we get (1 + r) -1. -------
(1+r)
Next we shall divide the third item (1 + r) -3 by (1 + r) -2 which is
again (1 + r) -1. Hence the Common Ratio in our series is (1 + r) - A (1+r) {1+[1 / (1 + r)1 ] + [1 / (1 + r)2] + ……………….+ [1 / (1+r)n-1] } x [1/(1+r)]
1
. A (1+r) {[1 / (1 + r)] + [1 / (1 + r)2 ] + ……………….+ [1 / (1+r)n] }
We get Sn by adding the above n number of terms in the series Keeping the term A(1+r), the other term is in geometric
Sn = (1 + r) -1 + (1 + r) -2 + ………….+ (1 + r) -n …......Eqn.1 progression with common ratio as 1/(1+r). Hence applying the
Multiplying both sides by ‘(1 + r) -1’ we have, formula for sum of geometric progression i.e. Sn = a(rn – 1) / r
–1 where a is the first term and r is the common ratio, we get
(1+r) -1Sn = (1 + r) -1(1 + r) -1 + (1 + r) -2 (1 + r) -1 + ……………
........................................................….+ (1 + r) -n (1 + r) -1 (1 + r) n – 1 / [(1+r) n X r
Using the concept of am X an = am+n, we get Adding the term already removed we have A (1+r) [(1 + r) n – 1
/ [(1+r) n X r]
(1+r) -1Sn = (1 + r) -2 + (1 + r) -3 + ……………….+ (1 + r) -n-1
…………Eqn. 2 Points to Ponder
Now Subtracting Equation 2 from Equation 1, we have • Capital budgeting methods includes NPV and IRR which
are said to be the discounted methods as annual cash flows
-1 -1
S n – (1 + r) Sn = (1 + r) - (1 + r)
-n-1
are discounted using time value of money.
-1 -1 -n-1 • Project Appraisal and Selection is made considering present
S n [1- (1+r) ] = (1 + r) - (1 + r)
value of future cash flows.
-1 -n-1
(1 + r) - (1 + r) Review Questions
Sn = ------------------------
[1- (1+r)-1] 1. If you invest Rs.3000 today at a compound interest of 9%,
what will be its future value after 50 years?
Simplifying the denominator, 2. What is the present value of Rs.80,000 receivable 15 years
from now, if the discount rate is 10%?