Concept Note on Time Value of Money Prof.

Bhavana Raj WHY TIME VALUE:A rupee today is more valuable than a rupee a year hence. Why ? (1)Preference for current consumption over future consumption (2) Productivity of capital (3) Inflation. Many financial problems involve cash flows occurring at different points of time. For evaluating such cash flows, an explicit consideration of time value of money is required. Time Preference for Money: Time preference for money is an individuals preference for possession of a given amount of money now, rather than the same amount at some future time. Three reasons may be attributed to the individuals time preference for money: (1) risk (2) preference for consumption and (3) investment opportunities. Required Rate of Return: The time preference for money is generally expressed by an interest rate. This rate will be positive even in the absence of any risk. It may be therefore called the risk-free rate. An investor requires compensation for assuming risk, which is called risk premium. The investors required rate of return Risk-free rate + Risk premium. Would an investor want Rs. 100 today or after one year? Cash flows occurring in different time periods are not comparable. It is necessary to adjust cash flows for their differences in timing and risk. Example : If preference rate =10 percent An investor can invest if Rs. 100 if he is offered Rs 110 after one year. Rs 110 is the future value of Rs 100 today at 10% interest rate. Also, Rs 100 today is the present value of Rs 110 after a year at 10% interest rate. If the investor gets less than Rs. 110 then he will not invest. Anything above Rs. 110 is favorable. Time Value Adjustment: Two most common methods of adjusting cash flows for time value of money: (1)Compoundingthe process of calculating future values of cash flows and (2)Discountingthe process of calculating present values of cash flows. Future Value: (1)Compounding is the process of finding the future values of cash flows by applying the concept of compound interest. (2)Compound interest is the interest that is received on the original amount (principal) as well as on any interest earned but not withdrawn during earlier periods. (3)Simple interest is the interest that is calculated only on the original amount (principal), and thus, no compounding of interest takes place. NOTATION: (1) PV : Present value (2) FVn : Future value n years hence (3) Ct : Cash flow occurring at the end of year t (4) A : A stream of constant periodic cash flow over a given time (5) r : Interest rate or discount rate (6) g : Expected growth rate in cash flows (7) n : Number of periods over which the cash flows occur. FUTURE VALUE OF A SINGLE AMOUNT: FUTURE VALUE = PRESENT VALUE (1+r)n DOUBLING PERIOD: (1)Thumb Rule : Rule of 72Doubling period = 72 / Interest rate (2)A more accurate thumb rule : Rule of 69 Doubling period=[ 0.35 ]+{ [69 / Interest rate] } PRESENT VALUE OF A SINGLE AMOUNT: PV = FVn [1/ (1 + r)n]

PRESENT VALUE OF AN UNEVEN SERIES:

PVn=*A1/(1 + r)1++ *A2/(1 + r) 2++.+ *An/(1 + r)n+=(t=1 to n) *At/(1 + r)t+

FUTURE VALUE OF AN ANNUITY: An annuity is a series of periodic cash flows (payments and receipts ) of equal amounts. Future value of an annuity{A [(1+r)n-1]}/r PRESENT VALUE OF AN ANNUITY: Present value of an annuity A*{[1-(1/(1+r)n)]/r} PRESENT VALUE OF PERPETUITY A /r SHORTER COMPOUNDING PERIOD: Future value Present value*[1+(r/m)]m*n, where, r = nominal annual interest rate, m = number of times compounding is done in a year and n = number of years over which compounding is done. EFFECTIVE VERSUS NOMINAL RATE r = (1+k/m)m 1,where, r = effective rate of interest, k = nominal rate of interest and m = frequency of compounding per year. FUTURE VALUE:

FUTURE VALUE OF AN ANNUITY:

SINKING FUND:

Present Value: (1)Present value of a future cash flow (inflow or outflow) is the amount of current cash that is of equivalent value to the decision-maker. (2)Discounting is the process of determining present value of a series of future cash flows. (3)The interest rate used for discounting cash flows is also called the discount rate. PRESENT VALUE OF A SINGLE CASH FLOW:

PRESENT VALUE OF AN ANNUITY:

CAPITAL RECOVERY & LOAN AMORTISATION:

Present Value of an Uneven Periodic Sum: In most instances the firm receives a stream of uneven cash flows. Thus the present value factors for an annuity cannot be used. The procedure is to calculate the present value of each cash flow and aggregate all present values. Present Value of Perpetuity: Perpetuity is an annuity that occurs indefinitely. Perpetuities are not very common in financial decision-making. The PV of an annuity is

Present value of perpetuity=[Perpetuity / Interest rate]

Present

Value

of

Growing

Annuities:

Value of an Annuity Due:

Multi-Period Compounding:

Continuous Compounding:

Net Present Value:

Internal Rate of Return:

Present Value and Rate of Return: (1)A bond that pays some specified amount in future (without periodic interest) in exchange for the current price today is called a zero-interest bond or zero-coupon bond. (2)In such situations, one would be interested to know what rate of interest the advertiser is offering. One can use the concept of present value to find out the rate of return or yield of these offers. (3)The rate of return of an investment is called internal rate of return since it depends exclusively on the cash flows of the investment. SUMMING UP: (1)Money has time value. A rupee today is more valuable than a rupee a year hence. (2)The general formula for the future value of a single amount is :

Future value = Present value (1+r)n

(3)The value of the compounding factor, (1+r)n, depends on the interest rate (r) and the life of the investment (n). (4)According to the rule of 72, the doubling period is obtained by dividing 72 by the interest rate. (5)The general formula for the future value of a single cash amount when compounding is m*n done more frequently than annually is: Future value = Present value [1+r/m] (6)An annuity is a series of periodic cash flows (payments and receipts) of equal amounts. The future value of an annuity is: Future value of an annuity

= Constant periodic flow [(1+r)n 1)/r]

(7)The process of discounting, used for calculating the present value, is simply the inverse of compounding. The present value of a single amount is:

Present value = Future value x 1/(1+r)n

(8)The present value of an annuity is: Present value of an annuity

= Constant periodic flow [1 1/ (1+r)n] /r

(9)A perpetuity is an annuity of infinite duration. In general terms:

Present value of a perpetuity = Constant periodic flow [1/r]