Time Value of Money

Suggested Readings:
Chapter 2, I M Pandey
Chapter 3, Van Horne / Dhamija
Sanjay Dhamija/ FM-I/2015/ TVM

What is Time Value of Money?

Relationship between Re.1 today and
Re.1 in the future.
Two methods for accounting for time
value of money
Compounding
Finding the future value of a present sum of
money

Discounting
Finding the present value of a future sum of
money

What is Time Value of Money?

Future Value (FV)
Value of a sum after
investing over one or
more periods.

FV C (1 r )

C = Sum invested today

r = Interest rate

Present Value (PV)

Value of a sum today
which is received after
one year or more
periods.

C
PV
(1 r ) n
C= Sum received n year hence
r = Interest rate

Future Value and Compounding

The general formula for the future value of an investment
over many periods can be written as:
FV = C0(1 + r)n
where
C0 is cash flow at date 0,

r is the appropriate interest rate, and

n is the number of periods over which the cash is
invested.
(1 + r)n = Future Value Interest Factor
(FVIFr,n)

Future Value and Compounding

FVIF Table
Interest rate
Period

6%

7%

8%

1.0600

1.0700

1.0800

1.1236

1.1449

1.1664

1.1910

1.2250

1.2597

1.2625

1.3108

1.3605

FV of Re.1 after three years at the interest rate of 7%.

Also termed as FVIF(7%,3)

Present Value and Discounting

Present value of a future sum can be written as

1
PV Cn
n
(
1

r
)

where, PV = Present value of the future sum C n

n = number of years until the payment will
be received
r = annual discount (or interest) rate
1/(1+r)n is termed as Present Value Interest
Factor (PVIFr,n)

Present Value and Discounting

PVIF Table
Interest rate
Period

7%

8%

9%

0.9346

0.9259

0.9174

0.8734

0.8573

0.8417

0.8163

0.7938

0.7722

0.7629

0.7350

0.7084

PV of Re.1 received after three years at the interest rate of 8%.

Also termed as PVIF(8%,3)

Annuities: A Level Stream

An annuity is defined as a level stream of
regular payments that lasts for a fixed
number of periods.
Regular Annuity cash flow at the end of
each period
Annuity Due cash flow at the beginning of
each period

Future Value of an Annuity

Future value of an annuity can be written as

1 r n 1
FVn A

where
FVn = Future value of the annuity at the end of the period
r = The annual rate of interest
n = number of years for which annuity lasts
{(1+r)n-1}/r = Future Value Interest Factor of an
Annuity (FVIFAr,n)

Future Value of an Annuity

Interest rate
Period

5%

6%

7%

1.000

1.000

1.000

2.050

2.060

2.070

3.152

3.184

3.215

4.310

4.375

4.440

Future value of Re.1 received (paid) periodically for 4 years, with the
Interest rate being at 6%. Also termed as FVIFA(6%,4)

Present Value of an Annuity

The formula for the present value of an annuity is:

1 r n 1
PVn C

n
(1 r ) r
where
PV = Present value of a regular annuity
C = Annual Contribution at the end of each period
r = The annual rate of discount
n = number of years for which annuity lasts

Present Value of an Annuity

Interest rate
Period

7%

8%

9%

19

10.336

9.604

8.950

20

10.594

9.818

9.129

25

11.654

10.675

9.823

30

12.409

11.258

10.274

Present value of Re.1 received (paid) periodically for 30 years, with the
Interest rate being at 7% p.a.. Also termed as PVIFA(7%,30)

Perpetuity
A constant stream of cash flows that lasts forever.

The formula for the present value of a perpetuity is:

C
PV
r

Implied Rate of Return

To find the rate of interest where
inflow and outflows are given
An investment of Rs.1,000 becomes
Rs.2,000 in 9 years
1000 x FVIF(r, 9) = 2000
FVIF (r,9) = 2000/ 1000 = 2

Look for the factor 2 in FVIF table in

the row for 9 years
r = 8% (approximately)

Sinking Fund Factor

To compute the amount that has to be
invested at the end of every year for a
period of n years at k% rate of interest,
in order to accumulate a given amount at
the end of the period.
It is the inverse of the FVIFA.
SFF = 1/ FVIFA (r,n)

Capital Recovery Factor

Capital Recovery Factor helps in computing:
Loan installment to liquidate a loan
Amount that can be withdrawn periodically when
a particular amount is invested now.

The Capital Recovery Factor is the inverse of

PVIFA
CRF = 1/ PVIFA

Installment Structure

Cost of Equipment = Rs.50 lakhs

Required rate of return = 16%
Lease Period = 5 years
Residual Value = Nil
Equated
LR x PVIFA(16%,5) = Rs.50 lakhs
LR = Rs.50 lakhs/PVIFA(16%,5)
= Rs.50 lakhs/3.274 = Rs.15.272 L

Installment Structure
Stepped - 10% increase every year
Year
LR
1 L
2 Lx 1.1
3
L x (1.1)^2
4
L x (1.1)^3
5
L x (1.1)^4

PVIF(16%,y)
LR x PVIF (16%,y)
.862
.862 L
.743
.8173 L
.641
.7756 L
.552
.7347L
.476
.6969 L
3.8865 L
3.8865 L = Rs.50 lakhs
L = Rs.12.865,
12.865, 14.152, 15.567, 17.123, 18.836

Installment Structure
Ballooned - 5 lakhs for first four years
5 x PVIFA(16%,4) + L x PVIF (16%,5) = Rs.50 lakhs
5 x 2.798 + L x .476 = Rs 50 lakhs
11.192 + .476 L = Rs. 50 lakhs
L = (50-11.192)/.476 = Rs.81.53 Lakhs

Installment Structure
Deferred for 2 years
L x PVIF (16%,3) + L x PVIF (16%,4) + L x PVIF
(16%,5) = Rs.50 Lakhs
L x (0.641) + L (.552) + L (.476) = Rs.50 lakhs
L (1.669) = Rs.50 lakhs
L = 50/1.669 = Rs.29.958

Installment Structure
Advance Installments Equated Rental
with one advance installment

LR + LR x PVIFA(16%,4) = Rs.50 lakhs

LR+LR x 2.798 = Rs.50 Lakhs
3.798 LR = Rs.50 Lakhs
LR = Rs.50 lakhs/3.798
= Rs.50 lakhs/3.798 = Rs.13.165 L

Rental Structure-Comparison
Year Equated Stepped Ballooned Deferred Advance
0
1
2
3
4
5

15.272
15.272
15.272
15.272
15.272

12.865
14.152
15.567
17.123
18.836

5.00
5.00
5.00
5.00
81.53

Nil
Nil
29.958
29.958
29.958

13.165
13.165
13.165
13.165
13.165
Nil

TVM Formulas
Future Value

FV A (1 r )
FVRA

Present Value
n

1 r n 1
Ax

A
PV
(1 r ) n

PVRA

1 r n 1
Ax

n
(1 r ) r

FVAD FVRA x (1 r)

PVAD PVRA x (1 r)

1
SFF
FVIFA (r, n)

CRF

1
PVIFA (r,n)

Learning
Time Value of Money
Discounting
Compounding

Annuity

Regular
Annuity Due

Implied Rate of Return

Applications of Time Value of Money
Sinking Fund
Capital Recovery

Use of Financial Tables and Excel functions

Explore..
DCF approaches to valuation
Bills Discounting
Rental Discounting / Lease
Discounting
Mark to Market Loss.

Rental