Time Value of Money

(Concepts and Problems)

 You have been hired by the basketball
team los Angeles Lakers to advise them on
bidding for players :
Payable on
Player 31 Dec 2015 31 Dec 2016
Kobe Bryant $23,500,000 $25,000,000
Joe Johnson $23,180,790 $25,319,210
Carmelo Anthony $25,624,401 $22,875,599
LeBron James $24,644,400 $23,855,600

1) All four players are equally good

2) You pay the player at the end of each year
3) You want to minimize cost 2
INTRODUCTION TO
TIME VALUE OF MONEY

3
 Key Objective
 Ability to compute the future value of an investment made
today
 Ability to compute the present value of cash to be received at
some future date
 Ability to compute the return on an investment
 Ability to compute the number of periods that equates a present
value and a future value given an interest rate
 Ability compute the effective rate of return if compounding is
half yearly/quarterly/monthly/daily

4
 Basic Definitions
 Present Value – earlier money on a time line
 Future Value – later money on a time line
 Interest rate – “exchange rate” between earlier money
and later money
◦ Discount rate
◦ Cost of capital
◦ Opportunity cost of capital
◦ Required return

5
Future Values
 Suppose you invest INR 1,000 for one year at 5% per
year. What is the future value in one year?
◦ Interest = 1,000(.05) = 50
◦ Value in one year = principal + interest = 1,000 + 50 =
1,050
◦ Future Value (FV) = 1,000(1 + .05) = 1,050
 Suppose you leave the money in for another year. How
much will you have two years from now?
◦ FV = 1,000(1.05)(1.05) = 1,000(1.05)2 = 1,102.50

6
Future Values: General Formula
 FV = PV(1 + r)t
◦ FV = future value
◦ PV = present value
◦ r = period interest rate, expressed as a decimal
◦ t = number of periods
 Future value interest factor = (1 + r)t

7
 Effects of Compounding
 Simple interest
 Compound interest
 Consider the previous example
◦ FV with simple interest = 1,000 + 50 + 50 = 1,100
◦ FV with compound interest = 1,102.50
◦ The extra 2.50 comes from the interest of .05(50)
= 2.50 earned on the first interest payment

8
Present Values
 How much do I have to invest today to have some
amount in the future?
◦ FV = PV(1 + r)t
◦ Rearrange to solve for PV = FV / (1 + r)t
 When we talk about discounting, we mean finding the
present value of some future amount.

9
 Present Value – One Period
Example
 Suppose you need INR10,000 in one year for the down
payment on a new car. If you can earn 7% annually, how
much do you need to invest today?
 PV = 10,000 / (1.07)1 = 9,345.79

10
 Present Values – Example 2
 You want to begin saving for your sisters college
education and you estimate that she will need
INR4500,000 in 17 years. If you feel confident that
you can earn 8% per year, how much do you need to
invest today?

11
 Present Values – Example 3
 Your parents set up a trust fund for you 10 years ago
that is now worth INR19,671.51. If the fund earned
7% per year, how much did your parents invest?
◦ 10,000

12
The Basic PV Equation - Refresher
 PV = FV / (1 + r)t
 There are four parts to this equation
◦ PV, FV, r and t
◦ If we know any three, we can solve for the fourth

13
Discount Rate
 Often we will want to know what the implied
interest rate is on an investment
 Rearrange the basic PV equation and solve for r
◦ FV = PV(1 + r)t
◦ r = (FV / PV)1/t – 1

14
Discount Rate – Example 1
 You are looking at an investment that will pay
INR1,200 in 5 years if you invest INR1,000
today. What is the implied rate of interest?
◦ r = (1,200 / 1,000)1/5 – 1 = .03714 = 3.714%

15
Discount Rate – Example 2
 Suppose you are offered an investment that will
allow you to double your money in 6 years. You
have INR10,000 to invest. What is the implied
rate of interest?

16
 Discount Rate – Example 3

 Suppose you have a 1-year old son and you want to

provide INR75,000 in 17 years towards his college
education.You currently have INR5,000 to invest.
What interest rate must help you to have the
INR75,000 when you need it?

17
 Compare the two investments
 You are offered the following investments:

◦ You can invest INR500 today and receive INR600 in 5

years. The investment is low risk.

◦ You can invest the INR500 in a bank account paying

4%.

◦ Which investment should you choose?

18
 Number of Periods – Example 1

 You want to purchase a new car for

INR3,00,000. If you can invest at 10% per year
and you currently have INR100,000, how long
will it be before you have enough money to
pay cash for the car?

 300,000 = 100,000*(1.1)^n
 Formula: n = ln(300,000 / 100,000) / ln(1.1)
11.52670461
19
Non-annual Compounding
 So far we have assumed that the time period is equal to
a year
 However, there is no reason that a time period can’t be
any other length of time
 We could assume that interest is earned semi-annually,
quarterly, monthly, daily, or any other length of time
 The only change that must be made is to make sure that
the rate of interest is adjusted to the period length
 Non-annual Compounding (cont.)

 Suppose that you have INR1,000 available for investment.

After investigating the local banks, you have compiled the
following table for comparison. In which bank should you
deposit your funds?

Bank Interest Rate Compounding

First National 10% Annual
Second National 10% Monthly
Third National 10% Daily
 Non-annual Compounding (cont.)

 To solve this problem, you need to determine which bank

will pay you the most interest
 In other words, at which bank will you have the highest
future value?
 To find out, let’s change our basic FV equation slightly:

Nm
 i
FV  PV 1  
 m
In this version of the equation ‘m’ is the number of
compounding periods per year
 Non-annual Compounding (cont.)

 We can find the FV for each bank as follows:

FV  1,000110
.   1100
1
First National Bank: ,
12
 . 
010
Second National Bank: FV  1,000 1    1104
, .71
 12 
365
Third National Bank:  . 
010
FV  1,000 1    110516
, .
 365 
Obviously, you should choose the Third National Bank
 Continuous Compounding (cont.)

 Suppose that the Fourth National Bank is offering to pay

10% per year compounded continuously. What is the
future value of your INR1,000 investment?

0 .10 1
F  1,000e  110517
, .
 This is even better than daily compounding
 The basic rule of compounding is: The more frequently interest is compounded,
the higher the future value
ANNUITIES

25
 Annuities

 An annuity is a series of nominally equal payments equally

spaced in time
 Annuities are very common:
◦ Saving Schemes
◦ House Loan payments
◦ Car payment
◦ Pension income
 The timeline shows an example of a 5-year, INR100
annuity

100 100 100 100 100

0 1 2 3 4 5
 Present Value of an Annuity

 Using the example, and assuming a discount rate of 10%

per year, we find that the present value is:
100 100 100 100 100
PVA       379.08
110
. 
1
110
. 
2
110
. 
3
110
. 
4
110
. 
5

379.08 100 100 100 100 100

0 1 2 3 4 5
 The Future Value of an Annuity

 Using the example, and assuming a discount rate of 10%

per year, we find that the future value is:
FVA  100110
.   100110
.   100110
.   100110
.   100  610.51
4 3 2 1

}
146.41
133.10
121.00 = 610.51
110.00 at year 5
100 100 100 100 100

0 1 2 3 4 5
 Pointers
 If you have the PV you can find the FV of
the annuity without going back to annual
flows.

PV 379.08 FV 610.51
OR 379.08*(1.10)^5 = 610.51
 Present Value of an Annuity

 We can use a closed-form of the PVA

equation
The Future Value of an Annuity
 Just as we did for the PVA equation, we
could instead use a closed-form of the
FVA equation:
Using Excel Inbuilt functions

rate = rate of interest

nper – number of time periods
pmt = amount of installment (keep blank unless annuity)
fv = payment at the end of the period
pv = payment at the beginning of the period
The pv and fv should be entered with opposite signs
Type = enter 1 if payment at the beginning of the time period.

32
 You have invested your money in a saving
scheme that earn 8% interest per annum.
You plan to withdraw Rs 20,000 per
annum (at the end of each year) for 4
years.

 How much must you have in the

investment account at the beginning of
the first year?
• You wish to take a loan from the bank, and have the ability to
pay Rs 20,000 per year as installment (end of the year) for 4
years. How much money can you borrow. If the bank will
charge interest at the rate of
◦ 8% per annum ?
 If you deposit Rs 20,000 per year (at the end
of every year) in a scheme that earns 8%
interest per annum, What amount would you
have at the end of 4 years.
 What is the difference between an ordinary
annuity and an annuity due?

Ordinary Annuity
0 1 2 3
I%

PMT PMT PMT

Annuity Due
0 1 2 3
I%

PMT PMT PMT

5-36
 If you deposit Rs 20,000 per year (at the
beginning of every year) in a scheme that
earns 8% interest per annum, What amount
would you have at the end of 4 years.
 Solving for FV:
3-Year Ordinary Annuity of $100 at 10%
 $100 payments occur at the end of each
period

Excel: =FV(rate,nper,pmt,pv,type)
Here type = 0.

5-38
Solving for PV:
3-year Ordinary Annuity of $100 at 10%
 $100 payments still occur at the end of
each period

Excel: =PV(rate,nper,pmt,fv,type)
Here type = 0.

5-39
 Solving for FV:
3-Year Annuity Due of $100 at 10%
 Now, $100 payments occur at the beginning of each
period.
FVAdue= FVAord(1 + I) = $331(1.10) = $364.10

Excel: =FV(rate,nper,pmt,pv,type)
Here type = 1.

5-40
 Solving for PV:
3-Year Annuity Due of $100 at 10%
 Again, $100 payments occur at the beginning of each
period.
PVAdue = PVAord(1 + I) = $248.69(1.10) = $273.55

Excel: =PV(rate,nper,pmt,fv,type)
Here type = 1.

5-41
PV of a Perpetuity

 PV of perpetuity = A/R
A- annuity amount
R – rate of interest in perpetuity

42
 What is the PV of this uneven cash
flow stream?
0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV

5-43
Application
 As a winner of a breakfast cereal
competition, you can choose any of the
following prizes, using an interest rate of
12%:
◦ $ 100,000 now
◦ $ 180,000 at the end of five years
◦ $ 19,000 for each of 10 years with payments
made at the end of the year
◦ $ 19,000 for each of 10 years with the payment
made at the beginning of the year
◦ $ 11,400 a year forever
Problem
 When you start earning at the age of 25
years, you decide to save Rs.100,000 each
year in Public Provident Fund A/c. with
State Bank of India, earning interest at 9%
per annum, compounded annually. What
will be the amount accumulated at the
age of 50 years?

45
Problem 2
 You wish to accumulate INR 8,00,000 by
the end of 5 years by making equal annual
year-end deposits over the next 5 years.
Assuming 7 per cent rate of return, how
much should you deposit at the end of
each year to accumulate INR 8,00,000?
Problem 3
 An investor will retire at the age of 60. In
order to receive INR 2,00,000 annually
for 10 years after retirement, how much
amount should he have at the time of
retirement? Assume the required rate of
return is 10 per cent.
You Plan to save INR 2,000,000 in 5 years
post getting a new job…

◦ Interest rate 12%

◦ Time period 5 years
◦ Normal annuity
◦ What annual installments should be made?
 The Power of Compound Interest
A 20-year-old student wants to save $3 a day
for her retirement. Every day she places $3
in a drawer. At the end of the year, she
invests the accumulated savings ($1,095) in a
brokerage account with an expected annual
return of 12%.

How much money will she have when she is

65 years old?
5-49
 Solving for FV: If she begins saving
today, how much will she have when
she is 65?
 If she sticks to her plan, she will have
$1,487,261.89 when she is 65.

Excel: =FV(.12,45,-1095,0,0)

5-50
Solving for FV: If you don’t start saving
until you are 40 years old, how much
will you have at 65?
 If a 40-year-old investor begins saving
today, and sticks to the plan, he or she will
have $146,000.59 at age 65. This is $1.3
million less than if starting at age 20.
 Lesson: It pays to start saving early.
Excel: =FV(.12,25,-1095,0,0)

5-51
How much must the 40-year old deposit
annually to catch the 20-year old, if he/she
has a saving or $ 30,000 available at the
beginning?
 To find the required annual contribution,
enter the number of years until retirement
and the final goal of $1,487,261.89, and
solve for PMT with the 30,000 available
upfront. (Note the signs)

Excel: =PMT(rate,nper,pv,fv,type)
=PMT(.12,25,30000,-1487262,0) 5-52
Application
 Ms Punam is interested in a fixed annual
income. She is offered three possible
annuities. If she could earn 8% on her money
elsewhere, which of the following
alternatives, if any, would she choose? Why?
◦ Pay Rs 80,000 now in order to receive Rs 14,000
at the end of each year for the next 10 years
◦ Pay Rs 1,50,000 now in order to receive Rs
14000 at the end of each year for the next 20
years
◦ Pay Rs 1,20000 now in order to receive Rs 14000
at the end of each year for the next 15 years
Applications
 You are planning to save for retirement over the next
30 years. To do this, you will invest Rs 80,000 a year in
a stock account and Rs 30,000 a year into a bond
account. Investments are made at the end of each
year. The returns on the stock account are expected
to be 15% per annum and 8% per annum on the bond
account. When you retire, you will combine your
money into an account with a 10% return.
 What is the lump sum amount at the time of
retirement?
 How much can you withdraw annually at the end of
each year from your account after retirement (a)
assuming a 20 year withdrawal period? (b) assuming
perpetuity?
Internal Rate of Return
 It is rate at which present value of all future returns is
equal to the present investment
 Determine whether the investment project depicted by
the cash flow given in the table satisfies minimum
expected return of 14 percent per year.
Year Cash Flow in $
0 -200,000
1 0
2 0
3 40,000
4 60,000
5 80,000
6 100,000
Internal Rate of Return
 Determine whether investment project depicted in the
table has a rate of return greater than or equal to 12
percent per year.
Year Cash Flow in $
0 -100,000
1 400000
2 400000
3 400000
4 400000
5 400000
6 400000
APPLICATIONS IN THE
FINANCE WORLD

57
Break up of Interest and Principal

Prepare a loan amortization schedule

Case1
 Suppose you borrowed $30,000 on a
student loan at a rate of 8% and must
repay it in 3 equal installments at the end
of each of the next 3 years. How large
would your payments be, how much of
the first payment would represent
interest, how much would be principal,
and what would your ending balance be
after the first year?
Case 2
 For an apartment value of Rs 3,700,000; the buyer is required to
pay 20% of the value upfront and finance the balance 80% with a
loan. The current interest rates are 9% per annum. As per the “No
EMI until possession” scheme, the builder will pay the interest on
the home loan until possession after which the EMI will start.You
plan to take a 15 year loan with monthly installemts. The apartment
is expected to be ready in two years, during which time the builder
will pay the interest on the loan. Work out:
 The EMI amount once the EMI kicks in
 You have read that builders overcharge to cover the interest during
the “no EMI” period. What do you think should be the cost of the
apartment at market rate if the “No EMI until possession” scheme
was not offered. . Make assumptions if required & show all
workings.
 How much you will have to pay if you are required to pay only
the interest till possession.
Case 3
 John and Daphne are saving for their daughter Ellen's
college education. Ellen just turned 10 at (t = 0), and she will
be entering college 8 years from now (at t = 8). College
tuition and expenses at State U. are currently $14,500 a year,
but they are expected to increase at a rate of 3.5% a year.
Ellen should graduate in 4 years--if she takes longer or wants
to go to graduate school, she will be on her own. Tuition and
other costs will be due at the beginning of each school year
(at t = 8, 9, 10, and 11).
 So far, John and Daphne have accumulated $15,000 in their
college savings account (at t = 0). Their long-run financial
plan is to add an additional $5,000 in each of the next 4
years (at t = 1, 2, 3, and 4). Then they plan to make 3 equal
annual contributions in each of the following years, t = 5, 6,
and 7. They expect their investment account to earn 9%.
How large must the annual payments at t = 5, 6, and 7 be to
cover Ellen's anticipated college costs?