TIME VALUE OF MONEY

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.
 Individuals
prefer present consumption to future
consumption.

When there is inflation, the value of currency decreases

over time.

If there is any uncertainty (risk) associated with the cash

flow in the future, the less that cash flow will be valued.
Time Value Adjustment
Two most common methods of adjusting cash
flows for time value of money:

Compoundingthe process of calculating future

values of cash flows and

Discountingthe process of calculating present

values of cash flows.
 Time Line

A Time Line for Cash Flows: Rs 100 in Cash Flows Received

at the End of Each of Next 4 years
Cash Flows
Rs 100 Rs 100 Rs 100 Rs 100
100
0 1 2 3 4
Year
Future Value
Compounding is the process of finding the future values of
cash flows by applying the concept of compound interest.
Future Value

The general form of equation for calculating the future value

of a lump sum after n periods:

Fn P(1 i) n
Various ways to do sums on TVM
Use Value Tables
Use Scientific Calculator
Use Financial Calculator
Use EXCEL built in functions

We will use Scientific Calculators

 If you deposited Rs 55,650 in a bank, which was paying a 10
per cent rate of interest on a ten-year time deposit, how much
would the deposit grow at the end of ten years?

144,341.77
 You estimate that you will need 8,00,000 to send your child to
college in eight years. You have about 3,50,000 now. If you
can earn 10 percent per year, will you make it?
At what rate will you just reach your goal?

No. You will have Rs 750256.08 after 8 years.

10.89%
Using the formula for Growth rate

Fn = P (1+g)n
g=?
Because of an advertising campaign, a firms sales increased from
20 million to 35 million three years later. What has been the
average annual growth rate in sales?

20.51%

CAGR (Compounded Annual Growth Rate)

Rule of 72
How much time it will take to double the investment?
n = 72/i
i = rate of interest, n = number of years

If rate of interest is 12%

72/12 = 6 years to double

Using the formula

1(1.12)n = 2
n log 1.12 = log2
0.049218n = 0.30103
n = 6.12 years

In Excel: use NPER

Definitions
logb x = N means that bN = x.
log x means log10 x. When a logarithm is written
without a base it means common logarithm.
ln x means loge x, where e is about 2.718. When a
logarithm is written "ln" it means natural
logarithm. ln x is sometimes written Ln x or LN x.
Log Rules
logb(mn) = logb(m) + logb(n)
logb(m/n) = logb(m) logb(n)
logb(mn) = n logb(m)

In less formal terms, the log rules might be expressed as:

Multiplication inside the log can be turned into addition outside
the log, and vice versa.
Division inside the log can be turned into subtraction outside the
log, and vice versa.
An exponent on everything inside a log can be moved out front
as a multiplier, and vice versa.
Warning: The above rules work only if the bases are the same.
The expression "logd(m) + logb(n)" cannot be simplified, because the
bases (the "d" and the "b") are not the same.
 What is the time period required for the FV to
become 1.4 times your investment?

1(1.12)n = 1.4
n = 2.96 years
Future Value of an Annuity
Annuity is a fixed payment (or receipt) each year for a
specified number of years.

(1 i ) n 1
Fn A
i
 You deposit Rs 50,000 at the end of each year for four years
in a Recurring Deposit Account at 6 per cent rate of interest.
How much would this annuity accumulate at the end of the
fourth year?

218,730.80
 You want to buy a house after 5 years when it is expected to
cost Rs.2 crores. How much should you save annually if your
savings earn a compound return of 12 percent ?

31,48,194.64
 Futura Limited has an obligation to redeem bonds worth Rs.50
crores 6 years later. How much should the company deposit
annually in an account wherein it earns 14 percent interest to
cumulate Rs.50 crores in 6 years time ?

5,85,78,747.83
Present Value
Present value is the value today of future cash flows
discounted at a rate, called discount rate.

Discounting is the process of determining present value of

a series of future cash flows.

The interest rate used for discounting cash flows is also

called the discount rate.
 Present Value of a Single Cash Flow

The following general formula can be employed to calculate

the present value of a lump sum to be received after some
future periods:

Fn
P F
n (1 i ) n

(1 i ) n
 An investor wants to find out the present value of Rs 50,000 to
be received after 15 years. The interest rate is 9 per cent.

13726.90
Present Value of an Annuity
The computation of the present value of an annuity can be
written in the following general form:
1 1
P A
i i 1 i
n

1
1
(1 i ) n
A
i

 Mr. Khan is expecting to receive Rs 5,00,000 every year for
the next 4 years from an investment. His required rate of
return is 10%. How much should he be investing today?

15,84,932.72
How much can you borrow?

After reviewing your budget, you found out that you can
afford to pay Rs 12000 per month for 3 years towards a new
car (in the range of Rs 3 to 4 lakhs)
Magma Fincorp is offering you a rate of 18% per year (or
1.5% per month). How much can you borrow?

3,31,928.21
Equal Instalment

You take a 3 year loan of Rs 1,00,000 at 9% per annum from

a financier to buy a bike. If you have to pay 3 equal end of
year installments, what would be the annual installment?

39505.48
Loan Amortization Schedule

Beginning Principal Remaining

Year amount Installment Interest repaid balance

1 100000.00 39505.48 9000.00 30505.48 69494.52

2 69494.52 39505.48 6254.51 33250.97 36243.56

3 36243.56 39505.48 3261.92 36243.56 0.00

Present Value of Perpetuity
Perpetuity is an annuity that occurs indefinitely.
Perpetuity
Present value of a perpetuity
Interest rate

UBI raised Rs 300 crore through an issue of perpetual bonds in December

2012. These bonds carry an interest rate of 9.27 per cent.
Reliance Industries Ltd (RIL), raised $800 million via a perpetual bond sale at
5.875 per cent coupon in January 2013
Bank of India has raised Rs 1,250 crore via perpetual Tier-I bonds with a
coupon of 11%. The issue opened on July 25 2014.
 An investor will get an interest @ 9.27 % every year from a
perpetual bond issued by UBI for an infinite period of time.
The face value of the bond is Rs 1000. His expected interest
rate is 10%. How much should he invest today in each bond?

Rs 927
Value of an Annuity Due

Annuity due is a series of fixed receipts or payments starting at

the beginning of each period for a specified number of periods.

Future Value of an Annuity Due

Fn = FV Annuity Multiplied with (1+i)

Present Value of an Annuity Due

P = PV Annuity Multiplied with (1+i)

Rent or lease payments typically made at beginning of each

period rather than at end
FV Annuity Due
You deposit Rs 50,000 at the beginning of each year for four
years in a Recurring Deposit Account at 6 per cent rate of
interest. How much would this annuity accumulate at the end of
the fourth year?

2,31,854.65
PV Annuity Due

Mr. Khan is expecting to receive Rs 5,00,000 in the beginning

of every year for the next 4 years, from an investment. His
required rate of return is 10%. How much should he be
investing today?

1,743,426.00
Present Value of an Uneven Periodic Cash Flows

Formula for an annuity cannot be used.

The procedure is to calculate the present value of each cash
flow and aggregate all present values.

Kapoor & Company has an opportunity of receiving Rs 10

crores, Rs 15 crores, Rs 8 crores, Rs 11crores, and Rs 4
crores respectively at the end of the every year for five
years from an investment made in a new factory. Find the
PV of this stream of uneven cash flows, if the companys
required rate is 8 percent.

39.28 crores
Multi-Period Compounding

m is the number of compoundings

You invest Rs 1000 for 1 year at 10% interest.

You end up with 1000 (1.1) = Rs 1100 after one year

You invest Rs 1000 for 1 year at 10% interest with semi annual
compounding
You end up with 1000 (1.05) (1.05) = Rs 1102.50 after one year
 You deposit Rs.5000 with a bank for 6 years. If the interest
rate is 12 percent which is compounded quarterly, how much
will your receive at the end of 6 years.

5000[1+ (0.12/4)]4x6 = 5000 (1.03)24

Rs.10,163.97

FV with compounding once a year: 5000 (1.12)6

Rs 9869.11
Multi period discounting

A GOI bond (issued at a discount to the face value) promises

to pay Rs 1000 (face value) at the end of 3 years at an
annual interest rate (nominal) of 10 percent with semi annual
discounting. How much should you be paying for the bond
today?

746.22

If annual,
751.32
Continuous Compounding

The continuous compounding function takes the form of the

following formula:
F = P * ei*n

Where e=2.718281828
Also called Eulers number

Present value under continuous compounding:

Fn
P i n Fn e i n
e
You deposit Rs.5000 with a bank for 6 years. If the interest rate is 12
percent which is compounded continuously, how much will your receive
at the end of 6 years.

Compoundings FV

yearly 1 9869.11

semi-annually 2 10060.98

quarterly 4 10163.97

monthly 12 10235.50

weekly 52 10263.65

daily 365 10270.95

hourly 8760 10272.12

every minute 525600 10272.17

every second 31536000 10272.17

continuous 10272.17
 ey = x
y = ln x or logex
 You deposit Rs.5000 with a bank for 6 years. If the interest
rate is 12 percent which is compounded continuously, how
much will your receive at the end of 6 years.

On your scientific calculator, press ex, then (0.12*6), then =,

then multiply with 5000

10,272.17
 A GOI bond (issued at a discount to the face value) promises
to pay Rs 1000 (face value) at the end of 3 years at an
annual interest rate (nominal) of 10 percent with continuous
compounding. How much should you be paying for the bond
today?

740.82
Effective Annual Interest Rate
If compounding is done more than once a year, the actual
annualised rate of interest would be higher than the nominal
interest rate and it is called the effective annual interest rate.
 What is the effective interest rate for a nominal
rate of 10% compounded each month.

10.47%
PV of constantly growing Annuity

For i g

For i = g

A is assumed to be end of year

 Mr A promises his son (aged 8 years) a pocket
money of Rs 1000 per year (end of each year) for
the coming 5 years which will increase by 10%
every year.
If the required rate of return for his son is assumed
to be 12%, what is the PV of the pocket money?

4307.6
 You have the rights to a gold mine for the next 20 years, over
which you plan to extract 50 kgs of gold every year. The price
of gold per gram now is Rs 3000 and is expected to increase
3% per year. The appropriate discount rate is 10%. What is
the present value of gold extracted from this mine?

A = 3000*(1.03)*50*1000
161,45,97,997.86
PV of constantly growing perpetuity

A is assumed to be end of year

 A company is expected to give dividends of Rs 66
per share at the end of year 1. They are assume to
grow infinitely at the rate of 10% every year. Mr X
wants to invest in the shares of this company. The
discount rate is 21% for Mr X. He wants to find the
PV of all the dividends. Can you help him?

600
FV of constantly growing annuity

Where i g :

Where i = g :
 Julia decides to save 10% of her salary per year in an
account that has a yield of 3% per year.
She has a salary of Rs $20,000 per annum which she
gets at the end of each year (let us assume that).
She expects to receive a 5% raise on her pay every
year.
What would her savings balance be after 5 years?

11700.75