Lecture 9

Module III

The Time Value of Money

Money has time value. A rupee today is more valuable than a rupee a year or years after. There are several reasons: 1. 2. Individuals, in general, prefer current consumption to future consumption. Capital can be employed productively to generate positive returns. An investment of 1 rupee today would grow to (1 + r) a year hence (r is the rate of return earned on the investment). In an inflationary period a rupee today represents a greater real purchasing power than a rupee a year after.
Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

3.

(Contd.)
The following Notations will be used in discussions

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Future Value of a Single Amount.

Suppose you invest Rs. 1000 for three years in a saving account that pays 10 percent interest rate per year. If interest income is reinvested, your investment will grow as follows:

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Compounding
Process of investing money as well as reinvesting the interest earned thereon is called compounding. The future value or compounded value of an investment after n years when the interest rate is r percent is

In this (1+r)n is called future value interest factor (FVIF) or simply the future value.

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

(Contd.)

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Compound and Simple Interest

Earlier we have assumed that money is invested at compounded interest rate. That is each interest earned is reinvested to earn further interest in future period. But if no interest is earned on interest then it is called simple interest. Investment grows as follows in simple interest.

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

(Contd)

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Doubling Period
For calculating doubling period there is rule of thumb which is called rule of 69. According to this rule of thumb, doubling period is equal to:

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Present Value of single amount and Discounting

Suppose someone promises to give you Rs. 1000 after three years. What is the present value of this amount if the interest rate is 10 % The present value can be calculated by discounting Rs. 1000, to present point of time as follows:

= 1000 * 0.7513 = 751.30

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Formula

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Present Value of Uneven Cash flow.

In financial analysis we often come across uneven cash flow streams. For example the cash flow associated with a capital investment project is typically uneven. Similarly the dividend stream associated with an equity share is usually uneven and perhaps growing. The present value of cash flow stream uneven or even, may be calculated with the help of following formula.

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

(Contd.)

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Annuity and its Future value Annuity:

An annuity is a stream of constant cash flow (payment or receipt) occurring at regular intervals of time. For example premium payment of life insurance policy is an annuity. When the cash flows occurs at the end of each period, the annuity is called an ordinary annuity or a deferred annuity. When the cash flows occur at the beginning of each period, the annuity is called an annuity due.

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

(Contd.)
Suppose you deposit Rs. 1000 annually in a bank for 5 years and your deposits earn a compound interest rate of 10 %. What will be the value of this series of deposits (an annuity) at the end of 5 years? Assuming that each deposit occur at the end of the year, the future value of this annuity will be.

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

(Contd.)

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Formula

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

How Formula for future value of annuity derived.

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Applications

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Present Value of Growing Annuity

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Formula derived as follows

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Contd.

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

Present Value of Perpetuity

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai

End of Lecture 9

Prof. B. N. Bhasme, Sardar Patel College of Engineering, Mumbai