PGDM BATCH TERM CLASS

HR III II 4th

BY : CA V.K.MAHIPAL FINANCE FACULTY

Topics Covered
y Concept of Time Value of Money y Concept of Present Value , Future Value.

Concept of Time Value of Money

y The concept Time Value of

Money means that money received today has more value than money received in future.
Money NOW is worth more than money LATER!

y In other words, a rupee today

is more valuable than a rupee in future.

Reasons why Money has time value

y Opportunity

cost - Money can be employed productively to generate real returns. For example Rs 100 invested in a bank deposit can become Rs 110 after one year . a higher purchasing power than a rupee in the future.

y Inflation - In an inflationary period, a rupee today has y Uncertainty -

Since future is characterized by uncertainty , individuals prefer current consumption to future consumption.

What is Present Value?

yA sum of money today is called a

present value. yWe designate it mathematically with a subscript, as occurring in time period 0 (t = 0) yFor example: PV0 = 1,000 refers to Rs 1,000 today

What is Future Value?

yA sum of money at a future time is

termed a future value yWe designate it mathematically with a subscript showing that it occurs in time period n (t = n). yFor example: FVn = 2,000 refers to Rs 2,000 after n periods from now.

Why TIME?
y When cash flows occur at different point in time they

are not strictly comparable because of TIMING differences.

y Thus in order to make the data comparable, they need

to be adjusted according to TIME. i.e. we need to calculate PV / FV of the two stream of cash flows .
y This adjustment in TIME factor can be dealt with in

either of the two ways - Compounding effect (Calculation of FV) - Discounting Effect (Calculation of PV)

Compounding Effect (Calculation of FV)

FVn = PV0

n (1+i)

Where: FVn means Future Value at time t = n PV0 means Present Value at time t = o i means compounded rate of interest p.a. n means time in number of years

Example 1:
Calculate the FV of Rs. 10,000 after 1 year given the rate of interest 10% p.a.

Solution 1:
After 1 year the value of Rs 10,000 will be as follows value after 1 year = principal + interest for 1 year = 10,000 + 10,000 x 10% = 10,000 + 1,000 = Rs. 11,000. Alternatively , Using the formula FVn = PV0(1+i)n
=

10,000(1+0.10)1
Rs 11,000

Example 2:
y Calculate the FV of Rs 1,000 after 5 years at the given

rate of interest 1.5 % p.m.

Solution 2:
Using the formula FVn = PV0(1+i)n
=

1,000(1+0.18)5 1,000(2.28775)

= Rs 2,287.75 Cross verifying:

y After 1 year value = 1000 + 1000 x 18% = 1180 y After 2 year value = 1180 + 1180 x 18% = 1392.40 y After 3 year value = 1392.40 + 1392.40 x 18% = 1643.03 y After 4 year value = 1643.03 + 1643.03 x 18% = 1938.78 y After 5 year value = 1938.78 + 1938.78 x 18% = 2287.76

Discounting Effect (Calculation of PV)

PV0 = FVn /
Where:

n (1+i)

FVn means Future Value at time t = n PV0 means Present Value at time t = o i means compounded rate of interest p.a. n means time in number of years

Example 3:
y Calculate the PV of Rs. 11,000 received after 1 year given

the rate of interest 10% p.a.

Solution 3:
PV0 = FVn / (1+i)n
= 11,000 / (1+0.10)1 = 11,000 / 1.10 = Rs. 10,000

Example 4:
y Calculate the PV of Rs 2287.75 receivable

after 5 years given the rate of interest 18% p.a.

Solution 4 :
PV0 = FVn / (1+i)n
= 2287.75 / (1+0.18)5 = 2287.75 / 2.28775 = Rs. 1,000

The Rule of 72 & 69 (Doubling Period)

y The rule gives the time period within which the amount

invested will be doubled given the rate of interest compounded p.a. y According to the Rule of 72 : Time ( no. of years ) required to double the investment = 72 / interest rate p.a. y According to the Rule of 69 : Time ( no. of years ) required to double the investment = 0.35 + 69 / interest rate p.a. Note : The Rule of 69 given a more accurate data.

Example 5:
y Given the interest rate of 6 % p.a. calculate the time

period in which the money will get doubled-

Solution 5:
y As per Rule 72

Time taken to double the money = 72/6 = 12 yrs

y As per Rule 69

Time taken to double the money = = 0.35 + 69/6 = 11.85 years

Annuity
y An annuity is an amount of money that occurs (received or paid) in equal amounts at equally spaced time intervals. y Example : EMI where a fixed amount is paid every month.

PV of an Annuity
y PV of Annuity means calculating the PV of all the cash flows in the form of an annuity up to a certain given period of time at a given rate of interest.

PVA0

=A

[1- {1/(1+i)n }] i

Example 6:
y suppose you are required to pay Rs 1,000 at

the end of every year for 3 years, given the rate of interest at 10% p.a. then the PV will be PVA0 =1,000[1{1/(1+0.10)3 }]
0.10

= Rs 2486.85

y Cross Verify :

yPV0

= FVn / (1+i)n
1 = 2 = 3 =

y PV of 1,000 payable after 1 yr = 1000/ (1+.10) y PV of 1,000 payable after 2 yr = 1000/ (1+.10) y PV of 1,000 payable after 3 yr = 1000/ (1+.10) y Total PV

909.09 826.45 751.31

Rs 2486.85

FV of an Annuity
y FVn = y

i i

PV of a Perpetuity
y Perpetuity is an Annuity with indefinite life time . i.e. n = infinity.

PVA0

= A /i

y A perpetuity is simply an annuity that continues forever. y For example: y The PV of a perpetuity (continuous annuity) of Rs 1,000 at an interest rate of 10% p.a =

= 1,000 / 0.10 = Rs. 10,000. It means Rs 10,000 if invested at an interest rate of !0% p.a. would give a continuous annual return (annuity)of Rs 1,000 forever .

PV of Multiple Uneven Flows

The cumulative present value of future cash flows can be calculated by summing the contributions of FV from periods o to n .

Example 7:
y Suppose you are expecting to receive the

following amounts at the end of year 1 to 4 Rs 3ooo at the end of year 1 Rs 5ooo at the end of year 2 Rs 10ooo at the end of year 3 Rs 120oo at the end of year 4
y Calculate the PV of the future flows

Solution 7 :
3,000 receivable after 1 yr = 3000/ (1+.10) 1 = 5,000 receivable after 2 yr = 5000/ (1+.10) 2 = 10,000 receivable after 3 yr = 10000/ (1+.10) 3 12,000 receivable after 4 yr = 12000/ (1+.10) 4 Total PV =

PV PV PV PV

of of of of

2727.27 4132.23 = 7513.15 = 8196.16

Rs 22568.81

Growing Annuity
y An annuity that grows at a constant rate for a specified

period of time is called growing annuity . The PV of a growing annuity is

PVA0

= A [1- {(1+g)/(1+i)}n ] i -g PVA0 = A /i g

y FVn = A {(1+i)n (1+ g)n} y

i -g

y Where g is the growth rate

Change in frequency of compounding

y Normally, the compounding is done annually, but at

times the frequency of compounding may differ like monthly , quarterly, half yearly etc. In such a case rate of interest (i) and time (n ) will change. And the adjusted formula will be -

PV0 = FVn /

mxn (1+k/m)

FVn = PV0
y Where

mxn (1+k/m)

k is the nominal interest rate p.a. m is the number of times compounding is done during a year

Example:
y Calculate the FV of an amount of Rs 1,0oo deposited

for 2 years at interest @ 10% p.a. compounded quarterly.

Solution:

FVn = PV0
=

mxn (1+k/m)

y FV = 1000(1+ 0.10/4)4 x 2

1000( 1.025)8

= 1,218

More than year compounding

y In case compounding is done for more than a year then

the adjusted formula will be -

PV0 = FVn / (1+k

n/m *m)

FVn = PV0
y Where

n/m (1+k*m)

k is the nominal interest rate p.a. m is the number of years in which compounding is done

Example:
y Calculate the FV of an amount of Rs 1,0oo deposited

for 4 years at interest @ 10% p.a. compounded after every 2 years .

Solution:

FVn = PV0
=

n/m (1+k*m)

y FV = 1000(1+ 0.10 x 2)4/2

1000( 1.20)2

= 1,440

Effective Vs Nominal rate of Interest

y In situations where the compounding is not done annually , the nominal rate of return and the effective rate of return tends to differ . y The relationship between the two is as follows

Effective interest rate = (1 + k/m)m 1

y Where

k is the nominal interest rate p.a. m is the number of times compounding is done during a year

Example :
y Calculate the effective rate of interest if the nominal

rate of interest is 12% p.a. and interest is compounded quarterly.

Solution:
Effective interest rate = (1 + k/m)m 1 = (1 + 0.12 / 4 )4 1 = 12.55%

Continuous Compounding PV0FVn = n / 0 X e i*n VPV(1 / )

y Where

e = 2.7183 (constant) (i) means rate of interest p.a. n means the number of years

Example:
y Calculate the FV of Rs 1000 deposited now fro 2 years

@ 8% p.a. compounded comtinuously.

Solution:
FVn = PV0 x e i*n = 1,000(2.7183)0.08* 2
=

1,173.50

Thank You & Have a nice Day