Financial Management I

Session 8

Time Value of Money

Understanding role of the dimension of time in changing/ affecting value of money.

Preference of money
Liquidity preference theory
Risk aversion (uncertainty and risk) Preference for consumption (now then later) Investment opportunities (to earn more)

Compensation for parting with liquidity (preference)

Required rate of return = Risk free rate + Risk premium = opportunity cost of comparable risk

Common methods of adjusting cash flows for time value of money

Compounding process of calculating future values of cash flows Discounting process of calculating present values of cash flows

PV & NPV
Investment project Vs. Financing project Present value (PV) = C1/(1+r) Net Present Value (NPV) = C0 + {C1/(1+r)} where, C0 is normally negative in an investment project We have seen that; PV= {C1/(1+k)1} + {C2/(1+k)2}++{(Cn/(1+k)n}

NPV=Wealth = {C1/(1+k)1} + {C2/(1+k)2}++{(Cn/(1+k)n} C0 Return is defined as rt=(pt-p0)/p0 to make it annual ra=365/t for a period t

Present & Future value

Rs. Next Year

114 107

Ram wants to consume now but Shikha wants to wait. But both want to invest. Shikha, who is aggressive, prefers to invest in a high risk high return instrument giving her 14% return and would wait till the maturity. Whereas Ram, who is also in the same risk class, would invest and simultaneously borrow Rs. 106.54 at risk free rate of @7%. He will use the borrowed money Rs 106.54 for immediate Consumption and would payoff the loan and the interest the next year with his Investment of Rs.100 @ 14%.
NPV of Shikhas investment (114/1.07) -100 = 6.54 NPV of Rams investment 106.54 -100 = 6.54

100

106.54

Rs. Now

Future Value
Concept of simple interest & compounded interest Future value of a single cash flow

Future sum=principal + interest on principal F1=P + P x i =P(1+i)

Future sum=principal + interest on principal + interest on interest F2=F1 + F1x i = F1 (1+i) = P (1+i) (1+i) = P (1+i)2 General form Fn= P (1+i)n Here, (1+i)n is known as Compounded value factor (CVF) of Rs.1 (or any currency). Its value will be >1 for any positive I (why?).
Future value of F at i rate of interest for n period Fn= P x CVF n.i

Annuity
Fixed payment/receipt every year/period Over a specified period E.g. Annual lease rent, repayment of house loan in equal installments End of year Deposit at the end of the year
1 Rs.1 2 Rs.1 3 Rs.1 4 Rs.1.000 Rs.1.060 Rs.1.124 Rs.1.191 Rs.4.375

Future sum

Future Value of an annuity

F4= A(1+i)3 +A(1+i)2 + A(1+i) + A = A {(1+i)3 +(1+i)2 + (1+i) + 1} General form Fn = A [{(1+i)n 1} / i]

Where, [{(1+i) 1}/ i] is known as Compounded Value Factor for an Annuity (CVFA) for Rs. 1 (or any currency)
Future value = Annuity cash flow x compounded value factor for annuity of Rs. 1 Fn= A x CVFA n,i

Sinking Fund
How much should we deposit per annum/period to accumulate x amount at the end of n period when the interest rate is i? Created to retire debt, special provision/reserve Problem is just opposed to Future Value of Annuities here for a given Future value, we are required to create annuities.

Annuity in a sinking fund

Sinking Fund Factor (SFF)
Its range is between 0 and 1 Its basically the reciprocal of CVFA, i.e., SFF=(1/CVFA) CVFA and SFF are related in the following way;
Fn = A x CVFA n,i Fn / CVFA n,i =A Since we have defined SFF as 1/CVFA, thus, A = Fn x SFF n,i

Sinking fund annuity = Future Value / Compounded value factor of an annuity of Rs. 1 The general form is A = Fn [ i / {(1+i)n -1}] (how?)

Present Value
Present value of cash flow (inflow or outflow?) What is the present value of future flows For comparison and decision making Net Present value (negative vs. positive) Signs (- / +) of cash flows (Investment project and Financing/borrowing project)

Present value of a single cash flow

Future value of Principal + interest (for one year) F1 = P (1+i)1

Present value of Principal + Interest (for one year) P = F1 / (1+ i) 1

Future value of Principal + interest (for two years) F2 = P (1+i)2

Present value of Principal + Interest (for two years) P = F2 / (1+ i)2

The general form P = Fn / (1+i)n = Fn {(1+i) -n } = Fn { 1/ (1+i)n} Where, { 1/ (1+i)n} is discount factor or present value factor Present value = Future value x present value factor of Rs.1 PV = Fn x PVF n,i

Things to dofor you!

Use excel examples in text book to create excel sheets for calculating Time value under discussed schemes/topics Look at the end of the text book to find and see different tables (detailed) discussed. Solve problems under the discussed topics

Study from your text to prepare for the next class which will be continuation of the current topic under discussion (Present value onwards).