Time is Money:

Personal Finance Applications

of the Time Value of Money

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 Time : A Financial Management
Tool
• “A penny saved is a penny earned”
• “Time is money”
• “I’m on the clock”
• “I’m buying myself some time”
• “Timing is everything”
• Albert Einstein: quote about compound interest
Too many young people don’t appreciate the
awesome power of the time value of money!!! 2
 So What Exactly Is The Time
Value of Money? (Review)
Key message of remainder of class:

Compound interest can be...

• Your worst enemy (credit card debt)
• Your best friend (5+ decades of compound
interest)
The choice is up to you!

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Ways to Calculate TV of Money
• Mathematically
• Financial calculator (e.g. TI-BA35)
• Computer spreadsheets with formulas
– (e.g., Microsoft Excel)

• TV of money interest factor tables

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 Time Value OF Money
• Compounding Techniques Table
1. Future value of single cash flow A-1
2. Future value of an Annuity A-2

• Discounting Techniques
1. Present value of single cash flow A-3
2. Present value of an Annuity A-4
 Let’s Review
• Future value of a lump sum
– Example: Value of $10,000 gift today in 20
years
– 8% i, N =20, FVF =4.6610 ($46,610)
• Present value of a lump sum
– Example: Value of a $10,000 gift in 20 years
today
– 8%i, N =20, PVF =.215 ($2,150)
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 More Review:
What Is An Annuity?
Two types of annuities (according to timing of
receipt or payment of $)
• Ordinary Annuity: payment at end of period
– Examples: bank account interest
• Annuity Due: payment at start of period
– Examples: insurance premiums

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 Key Variables in TV of Money
Problems
• N- Number of compounding periods
• % i- Interest rate (for compounding FV or
discounting PV)
• PV
• FV

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 Time Value of Money

Practical Application
of
Compounding & Discounting
 When FV is known
• Company is establishing a fund to retire for
Rs 5,00,000 at 6% for 10 years.
The company plans to put a fixed amount
into the fund for 10 years.
 Solution
• This problem is related to the process of
finding the compounded sum of an
annuity.
• And we know Table A-2 will solve this
purpose.
• So, finding the value in the table which
comes to 13.181
• =500000/ 13.181=37933.39 amount of
Rs. To be deposited each year @6%
for 10 years.
 When PV is known
• Taken a loan of Rs.10,00,000 at 12% for 5
years.
• Calculate EMI.
 Solution
• This problem relates to Loan amortization.
• The loan process involves finding the future
payments to be made.
• Under table A-4 THE value comes 3.605
• So, 1000000/ 3.605=277393
Thus 277393 is to be paid for 5 years to repay
the principal & interest on 1000000 @12%
for 5 years.
 A small example
• How the TOTAL Component is broken into:
1. Principal
2. Interest
3. Total payment (EMI)
4. Principal balance at end.
Loan amount:10000
Tenure:3 yrs.
Interest:10%
 Have a look 
• First see in table A-4
Which comes:2.487
• 10000 / 2.487=4020.9
EMI
Yr. Loan Interes Princi EMI Princip
O/S t. pal al at
end.
1 10000 1000 3021 4020 6978.8

2 6978.8 697.8 3323. 4020 3655.4

3 8
3 3655.4 365.5 3655. 4020 0
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 Risk & Return
• Know what is rate of return
• Determine risk and return of a portfolio
• Diversification and Portfolio risk
• Calculation of Beta
• Relationship between risk and return
 INTRODUCTION
• Risk is present in virtually every decision.
When a production manager selects on
equipment, or a marketing manager make an
advertising campaign, or a finance manager
make a portfolio of securities all of them face
uncertain cash flows. Assessing risks and
incorporating the same in the final decision is
an integral part of financial analysis.
• The objective in decision making is not to
eliminate or avoid risk - often it may be neither
feasible nor necessary to do so - but to properly
assess it and determine whether it is worth
bearing.
 RISK AND RETURN OF A SINGLE
ASSET
• Risk and return may be defined for a single
asset or a portfolio of assets. We will first
look at risk and return for a single asset and
then for a portfolio of assets.

• Rate of Return:-The rate of return on an

asset for a given period (usually a period of
one year) is defined as follows:

• Rate of return =Annual income/ dividend

+
Ending price - Beginning price
Beginning price
• To illustrate, consider the following
information about a certain equity stock.
• Price at the beginning of the year: Rs.
60.00
• Dividend paid at the end of the year: Rs.
2.40
• Price at the end of the year: Rs. 69.00
• The rate of return on this stock is calculated
as follows:

• 2.40 + (69.00 - 60.00)

60.00

= 0.19 or 19 %
• It is sometimes helpful to split the rate of
return into two components, viz., current
yield and capital gains/loss yield as follows:

Annual income + Ending price - Beging

price
Beginning Price Beginning price

• Current yield Capital gains/loss yield

• The rate of return of 19 per cent in our
example may be broken down as follows:

• 2.4 + 69-60
60 60
=4% + 15% =19%
current capital gain
yield yield
Interesting Rules

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 Rule of 72
• It tells about in in what period the money
will be doubled.
• Eg:- 72/ Interest rate= No. of yrs. Money
will get doubled
• 72/ No. of Yrs. = Interest rate
earning
• OTHERS:-- Rule of 114= Triple
• Rule of 144 = Quadruple
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INVESTMENT DECISIONS

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 CAPITAL BUDGETING
• The management of any business enterprise has to
make two type of decisions, short and long term.
The long term decisions relates to capital
budgeting which implies the budgeting of
expenditure on capital assets.
• Definitions:- capital budgeting generally refers to
acquiring inputs with long term returns.
• Definition:- capital budgeting is a long term
planning for making and financing proposed
capital outlays.
 Types of decisions
• Replacement

• Buy or lease

• Expansions

• Installation
 Data for capital expenditure
decisions
• Initial investments

• Cash inflows

• Treatment of depreciation

• Treatment of salvage value

• Working capital requirement

 Approaches to capital budgeting
decisions

1. Accept-reject approach

2. Ranking approach
 Methods of evaluating investment
proposals
A. TRADITIONAL METHODS
1. first year’s performance method

2. pay back period method

B. DISCOUNTED CASH FLOW TECHNIQUE

1. Discounted pay back period

2. Net present value method

3.Internal rate of return

 Capital Rationing
• Firms may have alternative and multiple projects to accept
but limited amount of money to invest. The company
under such circumstances, adopts policy of capital
rationing. Capital rationing is a process of capital
allocation or distribution of capital over capital projects
according to rank and their profitability.

• The objectives of capital rationing is to select the projects

that will maximize the owners wealth.
 IRR Approach
• This approach involves plotting IRR’s or yield, against total
rupees on the basis of decreasing yields.

• Suppose there are 6 projects for a fixed budget of Rs.250000.

The IRR and initial investment for each projects are given
below:
projects initial invest. IRR
A 80000 12%
B 70000 20%
C 100000 18%
D 40000 8%
The firm’s Cost of Capital is 10%. Advise the management as
regard to capital rationing.
 Solution:
• On the basis of internal rate of return the projects are ranked.
• Projects IRR Capital allocation Cumulative
• B 20% 70000 70 000
• C 18% 100000 1 70 000
• E 15% 60000 2 30 000
• A 12% 80000 ------
So, on the basis of internal rate of return the projects are ranked
because this is a rate which the companies earn on its investments.
And it is also to be compared with cost of capital to make financial
decisions.
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