3b5a3lecture 3 Time Value of Money

Amity Business School
1
MBA Class of 2015, Semester II

Objective
At the end of this course the students will understand:

Understand what is meant by "the time value of money.

Understand the relationship between present and future value.

Describe how the interest rate can be used to adjust the value of cash
flows both forward and backward to a single point in time.

Calculate both the future and present value of: (a) an amount invested
today; (b) a stream of equal cash flows (an annuity); and (c) a stream of
mixed cash flows.

Distinguish between an ordinary annuity and an annuity due.

.
Use interest factor tables to find an unknown interest rate or growth rate
when the number of time periods and future and present values are
known.

Money has time value. A rupee earned today is
more valuable than a rupee a year hence.
WHY?
Future uncertainties
Preference for present consumption
Reinvestment opportunities
Therefore TVM is the Rate of Return which
an investor can earn by reinvesting its
present money.

This Rate of Return can also be expressed as
required rate of return to make equal the worth
of money of two different time period


TVM results from the concept of
Interest And the Time Gap
The Interest Rate
Which would you prefer -- $10,000
today or $10,000 in 5 years?
You already recognize that there
is TIME VALUE TO MONEY!!

Why is TIME such an important
element in our decision?
TIME allows you the opportunity to
postpone consumption and earn
INTEREST

How amounts in different time periods
can compare?

One can adjust values from different time periods
using an
Remember, one CANNOT compare numbers in different
time periods without first adjusting them using an
interest rate
The Timeline
A timeline is a linear representation of the
timing of potential cash flows.
Drawing a timeline of the cash flows will
help you visualize the financial problem
Example
Assume that you loan $20,000 to a friend. You will be
repaid in two payments, one at the end of each year
over the next two years.
Differentiate between two types of cash flows
I nflows are positive cash flows.
Outflows are negative cash flows, which
are indicated with a (minus) sign.

Example
Assume that you are lending $10,000 today and that the
loan will be repaid in two annual $6,000 payments.
The first cash flow at date 0 (today) is represented as a
negative sum because it is an outflow.
Timelines can represent cash flows that take place at the
end of any time period.

Comparison of cash flows of different time periods
necessitate the conversion of money to a common point of
time. And techniques used for doing so are:

Compounding Techniques: the process of calculating
future values of present cash flows and

Discounting Techniques: the process of calculating
present values of future cash flows

Compounding Techniques
Compounding concept
means the interest
earned on the initial
principal sum becomes
a part of the principal
or initial sum at the end
of the compounded
period.

Year 1 2 3
Beginning
Amount 1000 1050 1102.5
Interest rate 5% 5% 5%
Amount of
interest 50 52.5 55.125
Beginning
Principal 1000 1050 1102.5
Ending
Principal 1050 1102.5
1157.6
25
Future Value
The compounding technique is used to find out the
FUTURE VALUE of a present money.
It can further be explained with reference to:

The future value of a single cash flow (Lump sum
amount)

The Future value of a series of Cash Flows
(Annuity)

(i) The FV of Single Cash Flow
Formula
FV = PV (1+r)
n
FV
is Future Value
PV is Present Value
r is the interest rate
n is time period
If you deposited Rs 55,650 in a bank, which was
paying a 15 per cent rate of interest on a ten-year time
deposit, how much would the deposit grow at the end
of ten years?
The general form of equation for calculating the
future value of a lump sum after n periods may,
therefore, be written as follows:

The term (1 + r)
n
is the compound value factor
(CVF) of a lump sum of Re 1, and it always has
a value greater than 1 for positive i, indicating
that CVF increases as r and n increase.

FV
n
= PV x CVF
r,n
We will first find out the compound value factor
at 15 per cent for 10 years which is 4.046.
Multiplying 4.046 by Rs.55,650, we get Rs
225,159.90 as the compound value:

FV= 55,650 X CVF 10, .15
= 55,650 X 4.046
= Rs. 225159.90
Non-Annual Compounding
Compounding is not always annually it may be half- yearly,
quarterly, monthly. So in this case compounding can be done
be using the following formula.
FV = PV(1+r/m)
mn
m is the number of time compounding is done in a year
n is the time period.
Compounding Period No of period (m)
Annually 1
Half- Yearly 2
Quarterly 4
Monthly 12
Note: More frequently the compounding is made, the faster is the growth
in the FV
Effective Rate of Interest
Effective rate of interest is a rate at which money held at
present actually increases in a year.

Sometimes it often happens that interest is compounded
more than once in a year. In such circumstances
effective rate of interest is different from given rate of
interest.
Formula for Effective Rate of Interest is:

r
e
= (1+r/m)
m
-1

Example:
A deposit of Rs.15000 is made in a bank for a period of
1year.
The Bank offers two options
(i) To receive interest at 12% p.a. compounded
monthly.
(ii) To receive interest at 12.25% p.a. compounded half
yearly.
Which option should be accepted?

Solution
option (i) option (ii)
Rate of interest =12% p.a. Rate of interest = 12.25%p.a.
PV is Rs.15000 PV is Rs.15000
Time 1yr (compounded monthly) Time 1yr (compounded
Half- yearly)
r
e
= (1+r/m)
m
-1 r
e
= (1+r/m)
m
-1
r
e
= (1+.12/12)
12
= (1+ .1225/2)
2
-1
= 1.1268-1 = 1.1263 -1
= .1268 = .1263
= 12.68% = 12.63%
(ii) Future Value of series of cash flow
(Annuity)
An Annuity represents a series of payments (or
receipts) occurring over a specified number of
equidistant periods
Types of Annuities
Ordinary Annuity: Payments or receipts
occur at the end of each period.
Annuity Due: Payments or receipts occur
at the beginning of each period

Examples of Annuities
Student Loan Payments
Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings
0 1 2 3
$100 $100 $100
(Ordinary Annuity)
End of
Period 1

End of
Period 2
Today
Equal Cash Flows
Each 1 Period Apart

End of
Period 3
PARTS OF ANNUITY
PARTS OF ANNUITY DUE
0 1 2 3
$100 $100 $100
(Annuity Due)
Beginning of
Period 1

Beginning of
Period 2
Today
Equal Cash Flows
Each 1 Period Apart

Beginning of
Period 3
Note
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
Formula for ordinary Annuity
As it is clear now that Annuity is a fixed payment (or
receipt) each year for a specified number of years. If
you rent a flat and promise to make a series of
payments over an agreed period, you have created an
annuity.

The term within brackets is the compound value factor
for an annuity of Re 1, which we shall refer as CVAF.
F
n
= A x CVAF
n,r

(1 ) 1
n
n
i
F A
i
(
+
=
(

Example of ordinary Annuity
FVA
3
= $1,000(1.07)
2
+
$1,000(1.07)
1
+ $1,000

= $1,145 + $1,070 + $1,000
= $3,215
$1,000 $1,000 $1,000
0 1 2 3 4
$3,215 = FVA
3
7%
$1,070
$1,145
Cash flows occur at the end of the period
Formula For Annuity Due

(1 ) 1
n
n
i
F A
i
(
+
=
(

(1+i)
FVAD
3
= $1,000(1.07)
3
+
$1,000(1.07)
2
+ $1,000(1.07)
1

= $1,225 + $1,145 + $1,070
= $3,440
$1,000 $1,000 $1,000 $1,070
0 1 2 3 4
$3,440 = FVAD
3

7%
$1,225
$1,145
Cash flows occur at the beginning of the period
Sinking Fund
Sinking fund is a fund, which is created out of fixed
payments each period to accumulate to a future sum
after a specified period. For example, companies
generally create sinking funds to retire bonds
(debentures) on maturity.
The factor used to calculate the annuity for a given
future sum is called the sinking fund factor (SFF).

=
(1 ) 1
n
n
i
A F
i
(
(
+

3b5a3lecture 3 Time Value of Money

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