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Attribution Non-Commercial (BY-NC)

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MONE Y

MAN AGEMENT FIN AN CE

TIME VALUE OF MONEY

BECAUSE INDIVIDUALS PREFER

CURRENT CONSUMPTION TO

FUTURE CONSUMPTION

CAPITAL CAN BE EMPLOYED

PRODUCTIVELY TO GENERATE

POSITIVE RETURNS

TIME VALUE OF MONEY

An investment of one

rupee today would grow

to (1+r) after a year.

Hence ‘r’ is the rate of

return earned on the

investment

In an inflatory period, a

rupee today represents a

greater purchasing power

than a rupee a year hence

FUTURE VALUE OF A SINGLE

AMOUNT

FUTURE VALUE OF AN ANNUITY

PRESENT VALUE OF A SINGLE

AMOUNT

PRESENT VALUE OF AN ANNUITY

Suppose you have invested

Rs 1000 today and deposited

with financial institution which

pays 10% interest compounded

annually for a period of 3 years

Rs 1000 today and deposited with financial institution which pays 10%interest

compounded annually for a period of 3 years.

FIRST YEAR

Principal at the beginning 1000

Interest for the year (1000x0.10) 100

Principle at the end 1100

SECOND YEAR

Principal at the beginning 1100

Interest for the year (1000x0.10) 110

Principle at the end 1210

THIRD YEAR

Principal at the beginning 1210

Interest for the year (1000x0.10) 121

Principle at the end 1331

FORMULA

The process of investing money as well as reinvesting the

interest earned thereon is called compounding.

The future value or compounded value of an investment after n

years when the interest rate is r percent is

FVn = PV (1+r)n

factor which can be found as follows

Multiply 1.10 ie(1+r), 3 times (this is tedious when

period of investment is so long

BY CALCULATOR

Check you have key labeled Yx.

Enter1.10

Press the key labeled yx.

Enter3

Press=

FORMULA FOR FUTURE AVLUE

OF A SINGLE AMOUNT

The general formula for the future

value of a single amount is

FVn = PV (1+r)n

Where

FVn = future value n years hence

PV = Cash today (present value)

r = number of years for which

compounding is done

Value of FVIFr,n for various

combinations of ‘r’ and ‘n’

FVIF TABLE

Alternatively you can consult a

future value interest factor table

Suppose you deposit Rs 1000/- today

in a bank that pays 10% interest

compounded annually. How much

the deposit grow after 8 years and

12 years

After 8 years Rs 1000(1.10)8 = Rs 1000(2.144) =Rs 2144/-

COMPOUND AND SIMPLE

INTEREST

In compound interest each payment is

reinvested to earn further interest for

future period

In simple interest, no interest is earned on

interest

Exam pl e f or sim ple inter est

FUTURE VALE = PV[1+no of yrs x int.rate]

Rs 1000 invested at 10%for simple interest

for 100 yrs

1000x[1+100x .10] = 1000 x[ 1+10] = Rs

11, 000/ -

Exam pl e f or compound inter est

SEE THE DIFFERENCE !!!

Rs 1,37,80,612

or

Rs 137.8 lakhs

Or

DOUBLING PERIOD

my money will be doubled?

To answer this, we may look at the

future value interest factor table A

We can see that when interest rate

is 12%, it takes about 6 yrs to

double the amount . It will take 12

yrs at 6%

RULE OF 72

doubling period is

obtained by dividing 72 by

interest rate.

doubling period is 9 years.(72/8)

Rule of 69

the doubling period is equal to

0.35 +69/int rate

say int rate is 10%, doubling period

is

0.35 + 69/10 = 7.25

Finding growth rate-no of

employees

How many employees your company will have in

10 years, if the present strength is 5000 and

expected to grow by 5%

5000 X (1.05)10 = 5000 X 1.625 = 8149

ABC Ltd had a revenue of Rs 100 M in 1990

which increased to Rs 1000M in 2000. Find

growth in Revenue.

What was the compound growth in revenue?

100 (1+g)10 =1000

(1+g)10 =1000/100 = 10

1+g = 101/10

g = 101/10 – 1

=1.26-1=0.26 = 26%

PRESENT VALUE OF A SINGLE

AMOUNT

Suppose some one promise Rs 1000/-

a year hence. The value will be

definitely less than 1000

we already know the formula for

future value - FVn = PV (1+r)n.

Dividing both sides by (1+r)n we get

PV = FVn[ 1/ (1+r)n]

The factor [1/ (1+r)n] is called the

present value index factor for

different combinations of r and n.

Table for PVIF for different r,n

[ 1/ (1+r)n]

PROBLEM-PRESENT VALUE

Rs1000/- receivable 6 years hence

if the rate of discount is 10%

= Rs 1000 x (0.565) = Rs 565/-

PROBLEM-PRESENT VALUE

Rs 1000 receivable 20 yrs hence

if the discount rate is 8%

value for 20 yrs, we get as below

1000 x (1/1.08)20 = 1000 (1/1.08)10 x (1.08)10

1000 x (0.463) x (0.463) = 214/=

Present value of an uneven series

come across uneven cash flow.

In such cases, calculate individual

cases and add

The formula is

PVn = A1/(1+r) + A2/(1+r)2 +.. An/(1+r)n

Present value of an uneven series

annuity

Future

value

FUTURE VALUE OF AN

cash flow occurring at regular

intervals of time

When cash flow occurs at the end

of the period, the annuity is called

an ordinary annuity or a deferred

annuity(LIC Premium)

If it occurs at the beginning of

each period, annuity is called

Future value of an annuity

Suppose you invest Rs 5000 annually

in a bank for 5 yrs at

10 %, what will be the value of this

series of deposit after 5 years.

Assuming that each deposit occurs at

the end of each year, the future value

of each annuity will be

1000(1.10)4+1000(1.10)3+1000(1.10)2+1000(1.10)1+1000

1000x1.465+1000X1.331+1000X1-21+1000X1.10+1000

=RS 6105

TIME LINE FOR ANNUITY

1 2 3 4 5

10011000 1000 1000 1000

1100

1210

1331

1464

--------------

6105

----------------

Value of FVIFArn for various

combinations of r and n

FORMULA

given by the following formula

FVAn = A (1+r)n-1

r

Where FVAn is the future value of an

annuity which has a duration of n yrs.

A= constant periodic flow

r = interest rate per period

n = duration of an annuity

FUTURE VALUE OF AN ANNUITY

APPLICATIONS

Knowing what lies in store for you

30000/year in your PPF account for 30

years. What will be accumulated

amount in your PPF at the end of 30

years if the interest rate is 11%

= Rs 30000(FVIFA 11%30YRS)

=30000X (1+r)n-1 = 30000x(1.11)30-1

r 0.11

= 30000x199.03

= Rs 59,70,600

How much should you save

annually

You want to buy a house after 5

years when it is expected to cost

Rs 2m. How much should you save

annually if your savings earn a

compound rate of 12%

FVIFA (n=5, r=12%)= (1+0.12)5-1

0.12

= Rs 2000000

6.53

Annual deposit in a sinking

fund

Abc ltd has an obligation to redeem

Rs 5000m bonds 6 years hence. How

much the company deposit annually

in the fund account where in it earns

14% interest to accumulate Rs 500m

in 6years time.

FVIFA n=6,r=14 = (1+r)n-1 = (1+0.14)6-1

r 0.14

= 8.536

THE ANNUAL SINKING FUND DEPOSIT

Finding interest rate

pay a lump sum of Rs 8000 at the

end of 6 years to investors who

deposit annually Rs 1000 for 6

years. What interest rate is

implicit in this offer.

A finance coy advertise that it will pay a lump

sum of Rs 8000 at the end of 6 years to investors

who deposit annually Rs 1000 for 6 years. What

interest rate is implicit in this offer.

The interest rate may be calculated in 2 stages

1ST STEP

find FVIFA,r6 for this contract as follows

Rs 8000 = Rs 1000xFVIFAr6

FVIFA, r6= Rs Rs8000/Rs1000 = 8

2nd STEP

Look at FVIFAr,n table and read the row corresponding

to 6 years until you find close to 8.00

FVIFA 12% ,6 IS 8.115

SO CONCLUDE THE RATE OF INTEREST -12%

HOW LONG SHOULD U WAIT

You want to take a trip abroad

which costs Rs 1000000/-

You can save annually Rs 50000/-to

full fill the desire. How long will

have to wait if your savings earn

an interest of 12%

You want to take a trip abroad which costs Rs 1000000/-

You can save annually Rs 50000/-to full fill the desire. How long will

have to wait if your savings earn an interest of 12%

The future value of an annuity of Rs 50000/- that earns 12% is

equal to Rs 1000000/-

50000xFVIFA n=?,12% = 1000000

=50000 x(1+r)n-1 = 1000000

r

=50000 x1.12n-1 = 1000000

0.12

=1.12n-1 = 1000000 X 0.12 = 2.4

500000

=n log 1.12 = log 3.4

n x 0.0492 = 0.5315

annuity

present

value

Present value of an annuity

1000/- annually for 3 years, each

receipt occurring at the end of the

year. What is the present value of

this stream of benefits if the discount

rate is 10%

The present value is the sum of the

present values of all inflows of this

annuity

Rs 1000(1/1.10) +Rs 1000(1/1.10)2 +Rs 1000(1/1.10)3

=Rs 1000x0.9091+Rs1000x0.88+Rs 1000x0.7513

=Rs 2478.8

The time line for Rs 1000/-

0 1 2 3

901.1

826.4

751.3

2478.8 =present value

Formula

In general terms, the present value of

an annuity may be expressed as

follows

PVAn = A + A + ----A + A

1+r (1+r)2 (1+r)n-1 (1+r)n

A 1 + 1 + ----1 + 1

1+r (1+r)2 (1+r)n-1 (1+r)n

A 1 1

(1+r)n

formula

A 1 1

(1+r)n

r

factor for an annuity

(PVIFA r,n)

A-Constant periodic flow

Table for value of PVIFAr,n for different

combinations of r and n

APPLICATIONS

car

2. Period of loan amortation

3. Determining the loan amortation

schedule

4. Determining periodic withdrawal

5. Finding interest rate

How much can you borrow

You can afford to pay per Rs 12000/- per

month for 3 years for a new car. Interest rate

advised by the company is 1.5% per month

for 36 months. How much can you borrow.

To determine how much you can borrow, you

have to calculate the present value of Rs

12000/-month for 36M at 1.5%

PVIFAr,n = 1-1/1/(1+r)n/r

1-1/1/(1.05)36/0.015 = 27.70

Present value = Rs 12,000x27.70

You can borrow = Rs 332400

PERIOD OF LOAN AMMORTATION

to buy a flat. You approach a

housing finance company which

charges 12.5 interest. You can pay

Rs 1,80,000 per year towards loan

ammortation. What should be the

maturity period of loan

You want to borrow Rs 10,80,000/- to buy a flat. You approach a housing

finance company which charges 12.5 interest. You can pay Rs 1,80,000 per

year towards loan ammortation. What should be the maturity period of loan

180000/- is set equals to 1080000

180000 x PVIF n,r = 1080000

180000xPVIFn=?r=12.5%=1080000

180000[ 1-1/(1.125)n/0.125 ] = 1080000

Given this equality, the value of n is

[ 1-1/(1.125)n/0.125 ] = 1080000/180000=6

1-1/(1.125)n = 0.75

1/(1.125)n = 0.25

1= 0.25 x (1.125)n

1.125n = 4

n log 1.125 = log4

n x 0.0512 = 0.6021

Determining the loan ammortization

schedule

Most of the loans are paid in equal

periodic installments(monthly, quarterly,

annually), which cover interest as

well as principal repayment. Such

loans are called amortized loans.

For an amortized loan we should like

to know (a) the periodic installment

payment and (b) the loan

amortization schedule showing break

up of periodic installment between

the interest component and principal

repayment component.

Determining the loan ammortization

schedule

Suppose a firm borrow 1000000 at an interest of

15% and loan is to be paid in 5 equal installments,

payable at the end of next 5 years.

The annual installment payment A is obtained by

solving the following equation

Loan amount = A X PVIFA n=5,r=15%

1000000 = A X 3.3522

Hence A = 298312.

The ammortization schedule is shown in the next

slide

(NB – interest is calculated by multiplying the

beginning loan balance by interest rate.

- principal repayment is equal to annual

Ammortization Schedule

Determining the periodic withdrawal

retirement in a bank which pays

10% annual interest. How much

can be withdrawn annually for a

period of 10 years.

300000 = A X PVIFA 10%, 10 yrs

A = 300000/6.145

= Rs 48819

Finding interest rate

following financial contract.

If you deposit Rs 10,000 with

him he promises to pay Rs 2500/-

annually for 6 years. What

interest rate do you earn on this

deposit

Refer next slide

Finding interest rate ?Suppose someone offers you the following

financial contract.

If you deposit Rs 10,000 with him he promises to pay Rs 2500/-

Step 1 – find PVIFr,6 for the contract by dividing

Rs 10,000 by Rs 2,500

PVIFA r,6 = Rs 10000/2500 = 4

Step 2 – look at the PVIFA table and read the row

corresponding to 6 yrs until you find a value close

to 4

Doing so, you will find

PVIFA 12%6 = 4.111 &

PVIFA 14%6 = 3.889

Since 4 lies in the middle of these values, interest

rate lies (approx) in the middle. So interest rate is

13%

Present value of a growing annuity

for a specified period of time is a

growing annuity

The time line of the growing annuity is

shown below

A(1+g) A(1+g)2 A(1+g)n

0 1 2 n

The present value of a growing annuity

can be determined using the following

formula

PV of the growing annuity is

PV of growing annuity

teak plantation for next 2o years over

which you expect to get 100000/- cubic

feet of teak/year. The current price per

cubic feet is Rs 500/= but is expected to

grow (increase)at the rate of 8% per

year. The discount rate is 15%. The

present value of teak that you can

harvest from the teak forest can be

determined as follows

PV of teak is Rs

500x100000(1.08)(formula)

A note on annuity due

annuities in which cash flows

occur at the end of each period.

In the case of annuity due, cash

flows occur at the beginning of

each period.

Eg, lease for an appartment

Time line for ordinary annuity and

annuity due.

Ordinary annuity

A A A A

0 1 2 n-1 n

Annuity due

A A A A

0 1 2 n-1 n

Since cash flows of an annuity due occur one

period earlier in comparison to cash flows on an

ordinary annuity, the following relationship holds

Annuity due value =

Ord. annuity value x (1+r)

So first calculate present and future values as

though it were ordinary annuity.

Present value of a perpetuity

A perpetuity is an annuity of

infinite duration

Formula is

P<> = A X PVIF r, <>

Where P<> = present value of a

perpetuity

A = constant annual payment

PVIFA r <> = present value interest

factor for a perpetuity –

Present value of a perpetuity

is 1 divided by the interest rate expressed in

decimal form. Hence, the present value of a

perpetuity is simply equal to the constant

annual payment divided by the interest rate .

For example, the present value of a

perpetuity is Rs 10,000 and interest rate is

10% is equal to 10000/0.10=100000.

This is quite convincing because an initial

sum of Rs 100000 would if invested at the

rate of interest of 10% provide a constant

annual income of Rs 10000 for ever.

INTRA-YEAR COMPOUNDING &

DISCOUNTING

compounding is done

annually and now consider

the case where

compounding is done more

frequently.

Intra year compounding

Eg- deposit Rs 1000/- at 12% semi annual

First 6 months

Principal at beginning= 1000

Int for 6m(1000x0.12/2) = 60

Principal at end = 1060

Second six months

Principal at beginning= 1060

Int for 6m(1060x0.12/2) = 63.6

Principal at end = 1123.6

If the compounding is done annually, the principal

at the end of one year would be 1000 (1.12) =

1120

The difference 3.6 represents interest on interest

Intra year compounding

The general formula for future value of a

single cash flow after n years when

compounding is done m times a year is

FVn = PV [ 1+r/m] m x n

yrs and its interest rate is 12% and the

frequency of compounding is 4 times a year,

your deposit after 6 years will be

5000 x [ 1 + 0.12/4] 4x6

5000(1.03)24

5000 x 2.0328 = Rs 10164/=

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