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FINANCIAL MANAGEMENT

TIME VALUE OF MONEY


MBA (FM/HR/IT)
III- Trimester

INTRODUCTION

In projects companies invest a sum of money in anticipation


of benefits spread over a period of time in the future

If we borrow `100 today @ 10% (i.e. 09-Aug-10) from SBI


than we will have to pay `110 (08-Aug-11), the additional
`10 is called interest or time value of money

Required rate of return = Risk free rate of return + risk


premium

Decision can be made by two methods:


Compounding method
Discounting method

FUTURE VALUE OF A SINGLE CASH


FLOW
It is the process of determining the future value
of a lump sum amount invested at one point of
time.
We calculate the future value of a single cash flow
compounded annually by

FV = PV(1+i) n
FV= Future value
PV = initial cash flow
i = interest rate per annum
n = the number of compounding periods

EXAMPLE

Suppose ` 1100 are placed in the saving


account of a bank at 5% pa. how much shall
it grow after 2 years if interest is
compounded annually

If compounding is done for shorter compounding


period, then:
FV = PV (1+ ) m x n
i
m

FV= Future value


PV = initial cash flow
i = interest per annum
m = number of times compounding is done in a year
n = the number of compounding periods

EXAMPLE

Suppose Vijaya Bank gives 10% pa interest


and interest is compounded quarterly then
calculate the return after two years if Harsh
deposit ` 1000 today in Vijaya Bank

SOLUTION
FV = PV (1+ mi ) m x n
= 1000(1+0.10/4) 4 x 2
= 1000(1+0.025) 8
= 1000 x 1.2184
= ` 1,218

FV= ?
PV= 1000
m= 4
n= 2

FUTURE VALUE OF MULTIPLE


FLOWS

Instead of investing lump sum at one time if money is invested in


multiple flows then how value of money will be affected?

Suppose Mr Paw Invests ` 1,000 now (at the beginning of one


year), ` 2,000 at the beginning of year 2 and ` 3,000 at the
beginning of year 3, how much these flows accumulate to at the
end of year 3 at a rate of 12% pa?

SOLUTION
FV3 = ` 1000 x FVIF(12,3) + ` 2000 x FVIF(12,2) + ` 3000 x FVIF(12,1)

=`[(1000x1.405)+(2000x1.254)+(3000x1.120)]
= ` 7273

FUTURE VALUE OF ANNUITY

Annuity is the term used to describe a series of periodic


flows of equal amounts.
The example of payment of Life insurance premium (` 2000
per annum) for next 20 years can be classified as an
annuity.
The future value of a regular annuity for a period of n
years at a rate of interest
i is given by the formula:
n

(1 i ) 1)
FVA A[
]
i

FVA AxCVFA(i ,n )

A= Amount deposited at the end of


every year
i= Interest rate
n= Time Horizon
FVA= Accumulation at the end of
n year

EXAMPLE

Suppose Mr Jain deposits ` 2000 at the end of


every year for 10 years at the interest rate of
10% per annum, then how much will be his
corpus after 20 years?

SOLUTION

(1 i ) 1)
FVA A[
] AxCVFA(i ,n )
i
n

(1 0.10) 1)
FVA 2000[
]
0.10
10

= 2000x 15.94
= ` 31880

SINKING FUND

It is used when we want to calculate how much


we have to deposit every year for X years at the
interest rate of i% pa to receive amount Y at the
end of X year.

We know that
FVA=A x CVFA(i,n)
A= FVA x 1/CVFA(i,n)

EXAMPLE

Suppose we want to accumulate ` 500,000 at the end of 10


years. How much should we deposit each year at an interest
rate of 10% per annum so that it grows to ` 500,000.

SOLUTION

PRESENT VALUE OF A SINGLE FLOW

With this approach, we can determine the present value of a


future cash flow or a stream of future cash flows

This is mostly used for evaluating the financial viability of


projects.

Suppose if we invest `1000 today at 10% pa for a period of 5


years, we know that we will get ` 1000 x FVIF(10,5)
=`1000x1.611 =`1,611 at the end of 5 years

So, the present value of `1,611 is `1000

Formula of calculating present value of a single flow is:

FV= PV x FVIF(i,n) ; PV =FV/FVIF(i,n) PV=


PV = FV x PVIF(i,n)

FV
(1 i )

PRESENT VALUE OF AN ANNUITY

The present value of an annuity A receivable at


the end of every year for a period of n years at a
rate of interest i is equal to:

(1 i ) 1
PVA A[
]
i (1 i )
n

PVA= A x PVIFA(i,n)

EXAMPLE

Suppose Mrs Ravina deposits ` 1000 every year


for 8 years with 15% interest rate per annum,
then what is the present value of her deposits?

SOLUTION
A = ` 1000
n= 8 years
i= 12%
PVA=?
PVA= A x PVIFA(i,n)
PVA = 1000 x PVIFA(12,8)
PVA = 1000 x 4.968
PVA = 4968

CAPITAL RECOVERY AND LOAN


AMORTIZATION

If HDFC housing finance gives home loan to a person


then they will decide the EMIs through this method.
P= A x PVFA(i,n)

1
A= P

PVAF
n ,i

A = P CRFn,i

Suppose Mr X takes a loan of ` 50,000 today to buy a


motor-cycle for his son. If interest rate is 10%, how
much Mr X will have to pay per year to repay his loan
in 3 equal end of year repayments? [`20104.543]

PRESENT VALUE OF PERPETUITY

Perpetuity is an annuity that occurs indefinitely.

It tells that how much shall we invest today so that we can


get equal amount every year for indefinite time

Present Value of Perpetuity = Perpetuity Interest rate

For example If Hari expects ` 5,000 from his investments


then how much he will have to invest today, if rate of
interest is 10% per annum
Present Value = 5000/0.10 = ` 50,000

VALUES OF AN ANNUITY DUE

When annuity is calculated from the beginning of


the year it is called annuity due
In the case of annuity due or when payment is
made at the beginning of the year, which means
last payment has completed one year at the time
of calculation

FUTURE VALUE OF ANNUITY DUE

Suppose that you deposit ` 1000 in saving account at


the beginning of each year for 5 years to earn 4%
interest rate

Future value of an annuity due= future value of an


annuity x (1+i)

(1 i ) n 1)
FVA A[
](1 i )
i
= A x CVFA(I,n) x (1+i)
= 1000 x 5.416 x 1.04
= ` 5632.64

PRESENT VALUE OF ANNUITY DUE

Suppose you deposit ` 500 at the beginning of each


year for 5 years at 10% interest rate. Calculate the
present value of annuity.
Present Value of Annuity due = present value of
annuity x (1+i)

(1 i ) 1
PVA A[
]
i (1 i )
n

PVA = A x PVFA(I,n) x (1+i)

= 500 x 3.791 x 1.10


= ` 2085.05

NET PRESENT VALUE (NPV)

Net Present Value (NPV) of a financial decision is


the difference between the present value of cash
inflows and the present values of cash outflows.

NPV = PV of Cash Inflows PV of Cash Outflows


If NPV is negative, it means investment in
project higher than the return. So, project will be
rejected.

EXAMPLE

Reliance industries is planning to start a project which


requires ` 1000 Cr at the beginning year and ` 200 Cr
at the beginning of second year. They are expecting to
get a return of ` 250 Cr at the end each year for next
5 years. Suggest whether reliance should go for the
project or not, If interest rate in the market is 10% per
annum.

SOLUTION
Year

Out flow (Cr)

PV Factor

Present

1/(1.10)T

Value (Cr)

`250

0.909

`227.25

T=2

`250

0.826

`206.5

T=3

`250

0.751

`187.75

T=4

`250

0.683

`170.75

T=5

`250

0.621

`155.25

T=0

`1000

T=1

`200

PV Factor

Present

1/(1.10)T

Value (Cr)

`1000

0.909

`181.8

Total

NPV = 947.5- 1181.8


= - ` 234.3 Cr

`1181.8

Inflow

`947.5