TIME VALUE OF MONEY

Which is a more preferable option? 10,000 INR today OR 10,000 INR in 5 years???

Importance of Time
a) b) c)

Gives the opportunity to/for Postpone consumption and earn interest Inflation Uncertainty/Risk
Nominal or market rate of interest = Real rate of interest + Expected rate of Inflation + Risk of premiums to compensate uncertainty

Time value of Money

Need to understand Time value Shows how the timing of cash flows along with opportunity cost of capital affects the financial asset values Acts as a powerful tool for wealth maximization
Discounting : Translating a value to the present Compounding : Translating a value to the future

Simple interest : Interest earned on only the principal borrowed ( or lent)

Compound interest :Interest earned on any previous interest earned as well as the principal borrowed

Formula SI = P0(i)(n)
Where,

SI: Simple Interest P0:Deposit today (t=0) i: Interest Rate per Period
n: Number of Time Periods

Future value

Future value is the value at some future time of a present amount of money, or a series of payments, evaluated at a given interest rate.

Present value

Present Value is the current value of a future amount of money, or a

series of payments, evaluated at a given interest

Present value = PV = FV / (1 + i) n Where: PV = present value (today's value), FV = future value (a value or cash flow sometime in the future) i = interest rate per period and n = number of compounding periods [(1 + i) n] is the compound factor.

Future value Vs Present value

FV

Pv0( 1+ i) n

PV = FV/ ( 1+i) n

Short cut techniques by using ordinary calculator.

Future value at 10% Year 1. 1.1 Year 2. 1.1*= Year 3. 1.1*= = Year 5. 1.1*= = = =

Present value by ordinary calculator

1st year 1.1/= 2nd year 1.1/= = 6th year 1.1/= = = = = =

Rule of 72

Used to calculate the time required to double investment.

How long does it take to double $5,000 at a compound rate of 12% per year (approx.)?

Annuities

An Annuity represents a series of equal payments (or receipts)

occurring over a specified number of equidistant periods.

Can be equal annual deposits, withdrawals, payments or receipts.

a) Ordinary Annuity : Payments or receipts occur at the end of each period. b) Annuity Due: Payments or receipts occur at the beginning of each period.

Ordinary annuity
End of period 1 End of period 2 End of period 3

1
Today

1
$100

2
$100

3
$100

4
$100

5
$100

Equal cash flows

Annuity due
Beginning of period 1 Beginning of period 2 Beginning of period 3

1
Today

1
$100

2
$100

3
$100

4
$100

5
$100

Equal cash flows

Valuation: The future value of an ordinary annuity can be viewed as occurring at the end of the last cash flow period, whereas the future value of an annuity due can be viewed as occurring at the beginning of the last cash flow period.

The present value of an ordinary annuity can be viewed as occurring at the beginning of the first cash flow period, whereas the present value of an annuity due can be viewed as occurring at the end of the first cash flow period.

Examples of annuities

Student Loan Payments Car Loan Payments Insurance Premiums Mortgage Payments Retirement Savings

Compounding annuities
Translate each cash flow to the present using appropriate discount rate and number of discount periods For Rs 100 deposited at end of each year at 5% interest

Year 1 : 100 Year 2 : 100 * 0.05 = Rs.5.00 + 100 + 100 = 205 Year 3 : 205 * 0.05 = Rs 10.25 + 100+ 205 = 315.25

Compounding annuities

FVAn = A( 1+K)n-1 + A( 1+K)n-2 +A( 1+K)n-3. FVAn = A ( 1+K)n 1

K

Where A= Amount deposited at the end of every year K= Rate of interest ( in decimals) n = time horizon