Time Value of Money-II

Session Plan
Effective Annual Interest rate/yield
Future value of uneven multiple cash flows
Present value of uneven multiple cash flows
Annuities
Future value of an annuity
Present value of an annuity
Present value of a Perpetuity

1. Effective Annual Interest rate/yield

Effective annual interest rate is an investment's annual rate of interest when compounding
occurs more often than once a year. Calculated as the following:

m
r
( )
i= 1+
m
1

i= Effective Annual Interest Rate

r=Nominal Interest Rate

Example: Calculate the effective annual rates of following nominal annual rates.

I. 12% annual interest rate compounding semi annually

II. 12% annual interest rate compounding quarterly
III. 12% annual interest rate compounding monthly.

2. Future value of uneven multiple cash flows

In this case, each cash flow must be calculated separately and added to the total future value
of the asset. Each cash flow must be evaluated separately to find its incremental contribution
to the total future value.

Example: Suppose that an investor is interested in finding the future value of an asset. The
investor estimates the future cash flows and has determined that an 8% required return is
necessary given the risk of realizing the cash flows associated with the asset. The estimated

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cash flows are as follows. Calculate the future value of these cash flows at after 5 years from
today.

Year 0: Rs.5,000 Year 1: Rs. 2,000 Year 2: Rs. 500 Year 3: Rs. 10,000

3. Present value of uneven multiple cash flows

In this case, each cash flow must be calculated separately and added to the total present value
of the asset. Each cash flow must be evaluated separately to find its incremental contribution
to the total present value.

Example: Suppose that an investor is interested in finding the present value of an asset. The
investor estimates the future cash flows and has determined that an 12% required return is
necessary given the risk of realizing the cash flows associated with the asset. The estimated
cash flows are as follows. Calculate the present value of these cash flows.

Year 0: Rs.5,000 Year 1: Rs. 2,000 Year 2: Rs. 500 Year 3: Rs. 10,000

4. Annuities
An annuity is a financial plan having a series of sequential payments or deposits for definite
period. It can also be understood as series of fixed payments, which might be over a fixed
number of years or as a series of equal cash flows occurring over a specified number of fixed
interval periods. E.g. monthly rent, insurance premia, preference share dividend, Treasury bill
interest and debenture interest

Ordinary and Due Annuity

Ordinary Annuity

An ordinary annuity, also known as deferred annuity, consists of a series of equal payments at
the end of each period.

Annuity Due

An annuity due consists of a series of equal payments at the beginning of each period.

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 5. Future value of an annuity
The future value of an annuity is the value of a group of payments at a specified date in the
future. These payments are known as an annuity, or set of cash flows. The future value of an
annuity measures how much you would have in the future given a specified rate of return.
The future cash flows of the annuity grow at the compounding rate, and the higher the
compounding rate, the higher the future value of the annuity.

Method 01

A[ ( 1+r )n1 ]
Future Valueof an Annuity=
r

(A- Annuity; r - annual

interest rate; n number of
years)

Method 02

Future Value of an annuity = A x FVIFAn, i

Example: Suranimala
plans to invest Rs. 2000/= at the
end of each year for next three
years.What is the future value of this investment at the end of year 03.

6. Present value of an annuity

The present value of an annuity is the current value of a set of cash flows in the future, given
a specified discount rate. The future cash flows of the annuity are discounted at the discount
rate, and the higher the discount rate, the lower the present value of the annuity.

Method 01

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 Present Value of an annuity = A* 1- (1+r)-n
r

Method 02

Present Value of an annuity = A x PVIFA n, i

Example: Samanmali plans to

invest Rs. 2000/= at the end of
each year for next three years.What is the present value of this investment?

7. Present value of a Perpetuity

Perpetuity can be defined as an annuity with a stream of equal payments. For instant
retirement plan, irredeemable preference shares dividend can be considered as perpetuities.

Assume an investment of Rs. 10,000/= will be deposited for 100 years at an interest rate of
10%. The present value of the annuity would be Rs. 99,993.74. Now think that the same
investment is made for 1,000 years period, then the present value of the annuity would be Rs.
100,000/=.

Based on the relationship now we can say that the present value of a perpetuity as follows;

Present Value of Perpetuity = Constant cash flow

r

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Theory review questions
1. Your father wishes to invest Rs. 10,000/= every year in a bank account starting from
the next year for 10 years for your future studies. Bank agrees to pay 12% annual
interest on the investment. At the 10 th year what would be the amount you can
withdraw from the account.

2. Mr. Ramesh currently works a finance executive. He pals to start his own business
after 5 years from now. He estimated that the initial capital requirement of the
business would be Rs. 500,000/=. He opened a special account at a finance company
where he agreed deposit a fixed sum from his salary every year. If the bank offered an
interest rate of 15% per annum, what would be the amount Mr. Ramesh should
deposit every year if he wishes to receive the initial capital requirement of the
business?

3. Nipun has just won the lottery. He can elect to receive her winnings in equal payments
of Rs. 200,000 a year for the next 10 years or to receive Rs. 1,800,000 immediately. If
the current interest rate is 6%, which choice will provide the highest amount?

4. You are planning to purchase a vehicle on a Rs. 500,000 loan. The loan should be
settled by 10 equal installments, payable at the end of each year. If the interest rate is
18%, compute the value of the installment.

5. Nehara has given a loan to her friend Dilumi. Dilumi is going to pay Rs. 1,000/=
commencing from a year from now for 4 years to pay off the debt. If the time value of
money is 5% what would be the value of the loan granted to Dilumi.

No one saves us but ourselves. No one can and no one may. We ourselves
must walk the path.
- Buddha

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