The Time Value of Money

Money NOW is worth more than money LATER!

To simplify this material as much as possible, you should understand that there are only a few basic types of problems, though each has several variations.
Future value or present value Future value of an annuity Present value of an annuity Perpetuities and growing perpetuities

Required Rate of Return

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: Compoundingthe process of calculating future values of cash flows and Discountingthe process of calculating present values of cash flows.

A sum of money today is called a present value.

We designate it mathematically with a subscript, as occurring in time period 0 For example: P0 = 1,000 refers to $1,000 today

A sum of money at a future time is termed a future value

We designate it mathematically with a subscript showing that it occurs in time period n.

For example: Sn = 2,000 refers to $2,000 after n periods from now.

As already noted, the number of time periods in a time value problem is designated by n.
n may be a number of years n may be a number of months n may be a number of quarters n may be a number of any defined time periods

The interest rate or growth rate in a time value problem is designated by i

i must be expressed as the interest rate per period. For example if n is a number of years, i must be the interest rate per year. If n is a number of months, i must be the interest rate per month.

The first of the general type of time value problems is called future value and present value problems. The formula for these problems is:

Sn = P0(1+i)n

An example problem:
If you invest $1,000 today at an interest rate of 10 percent, how much will it grow to be after 5 years? Sn = P0(1+i)n Sn = 1,000(1.10)5 Sn = $1,610.51 Table Sn = P0(CVFn,i) Compounded value factor

Future Value Example

If you deposited Rs 55,650 in a bank which was paying 15 percent rate of interest on a ten year time deposit how much the deposit grow at the end of ten years Sn = P0(CVFn,I
= 55650x 4.046 = 225,159.90 TABLE A Pg

796

Present Value of a Single Cash Flow

Assume you will receive an inheritance of $100,000, six years from now. How much could you borrow from a bank today and spend now, such that the inheritance money will be exactly enough to pay off the loan plus interest when it is received? Assume the bank charges an interest rate of 12 percent?

P0

Sn = P0(1+i)n so, P0 = Sn/(1+i)n P0 = 100,000/(1.12)6 P0 = $50,663 Table (Pg798) = Sn X PVFn,i

Example TABLE C Pg 798

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Another example problem:

How long will it take for $10,000 to grow to $20,000 at an interest rate of 15% per year?
Sn = P0(1+i)n 20,000 = 10,000(1.15)n n = 4.96 years (or, about 5 years)

One more example problem:

If you invest $11,000 in a mutual fund today, and it grows to be $50,000 after 8 years, what compounded, annualized rate of return did you earn?
Sn = P0(1+i)n 50,000 = 11,000(1+i)8 i = 20.84 percent per year

The next two general types of time value problems involve annuities
An annuity is an amount of money that occurs (received or paid) in equal amounts at equally spaced time intervals. These occur so frequently in business that special calculation methods are generally used.

For example:
If you make payments of $2,000 per year into a retirement fund, it is an annuity. If you receive pension checks of $1,500 per month, it is an annuity. If an investment provides you with a return of $20,000 per year, it is an annuity.

For the future value of an annuity:

FV = PMT[(1+i)n - 1]/i TABLE The term within bracket is the compounded value factor for an annuity of Re 1 which shall be FV = PMT CVFAn,i

An example problem:
If you save $5000 per year at 6percent per annum, how much will you have at the end of 4 years? Note that since time periods are months, i = 6% per period, for 4 periods. FV = PMT[(1+i)n - 1]/i FV = 5000[(1.06)4 - 1]/.06 FV = $21,873 TABLE =5000(CVFA4,0.06 = 5000x4.3746 = 21873 Table B Pg 800

Present Value of an Annuity

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Capital Recovery and Loan Amortisation

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Example Table D Pg 802

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Another example problem:

If you want to save $10,000 for retirement after 3 years, and you earn 9 percent per annum, how much must you save each year? FV = PMT[(1+i)n - 1]/i 10,000 = PMT[(1.09)3 - 1]/.9 PMT = $3,951 per year

An example problem:
If you borrow $100,000 today at 9 percent interest per annum, and repay it in equal annual payments over 10 years, how much are the payments?
PV = PMT[(1+i)n -1]/[i(1+i)n]
100,000 = PMT[(1+.09)10 -1]/[.09(1.09)10]

PMT = $15,582 per year

Loan Amortisation Schedule

End of Year 0 1 2 3
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Payment

Interest Principal Outstanding Repayment Balance 900 625 326 3,051 3,326 3,625* 10,000 6,949 3,623 0

3,951 3,951 3,951

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.

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PV of Uneven Cash Flows: Example

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A last type of time value problem involves what are called, perpetuities
A perpetuity is simply an annuity that continues forever (perpetually). The formula for finding the present value of a perpetuity is:

PV = PMT/i

Present Value of Perpetuity

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A variation to perpetuity problems is the case of growing perpetuities

If an annuity continues forever, and grows in amount each period at a rate g, then

PV = PMT1/(i - g)

An example problem:
If you invest in a stock that will pay a dividend of $10 next year and grow at 5 percent per year, and you require a 14 percent rate of return, how much is the stock worth to you today? PV = PMT1/(i - g) PV = 10/(.14-.05) PV = $111.11

Sinking Fund

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Example

Value of an Annuity Due

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Future Value of An Annuity: Example

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Future Value of an annuity due

Future Value of an annuity due = 1x4.375x1.06 = Rs 4637

Example
The present value of Re 1 paid at the beginning of each year for 4 years is 1 3.170 1.10 = Rs 3.487

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