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TIM E VAL UE OF

MONE Y
MAN AGEMENT FIN AN CE
TIME VALUE OF MONEY

 MONEY HAS TIME VALUE


 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

 (1+r)n Is called the future value interest factor or future value


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

 INVESTORS USUALLY ASK -When


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

 According to this rule, the


doubling period is
obtained by dividing 72 by
interest rate.

 Say, interest rate is 8%, the


doubling period is 9 years.(72/8)
Rule of 69

 According to this rule of thumb,


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

 What is the present value of


Rs1000/- receivable 6 years hence
if the rate of discount is 10%

 Rs 1000 x PVIF (1O%,6)


= Rs 1000 x (0.565) = Rs 565/-
PROBLEM-PRESENT VALUE

 What is the present value of


Rs 1000 receivable 20 yrs hence
if the discount rate is 8%

Suppose the table is not having


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

 In financial analysis we often


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

 An annuity is a stream of constant


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

 The future value of an annuity is


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

 The term (1+r)n-1 is future value interest factor


FUTURE VALUE OF AN ANNUITY

APPLICATIONS
Knowing what lies in store for you

 Suppose you have deposited Rs


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

 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.
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

=1.12n-1 = 2.4 +1 = 3.4


=n log 1.12 = log 3.4
n x 0.0492 = 0.5315
annuity
present
value
Present value of an annuity

 Suppose you expect to receive Rs


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

 Is referred as present value interest


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

1. How much can you borrow for a


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

 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
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

 The present value of an annuity Of Rs


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

 Your father deposit Rs 3,00,000 on


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

 Suppose someone offers you the


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/-

 The interest rate may be calculated in two steps


 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

 A cash flow that grows at constant rate


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

 Suppose you have the right to harvest a


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

 So far we have discussed ordinary


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

 Present value interest factor 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

 So far we assumed that


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

 Suppose you deposit Rs 5000 in a bank for 6


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/=