Time Value of Money

TVM..

Value of a unit of money is different at different time periods. What would you prefer $100,000 now or after 1 year? Why ?

Reasons for time preference of money

* Alternative uses/ Opportunity cost * Inflation * Uncertainty

Expression of time preference for money

In order to have a logical and meaningful comparison between cash flows that accrue in different time periods, it is necessary to convert the sums of money to a common point of time. This is also, referred to as time preference for money

Required rate of return = Risk free rate + Risk Premium Also known as OPPORTUNITY COST of CAPITAL

Basics

Discounting Compounding Principal Interest Annuity Future value of Annuity Perpetuity (is an annuity that occurs indefinitely, e.g. dividend on irredeemable preference shares)

Techniques of conversion
Discounting
Present value = PV = FV / (1 + i) ^ n or PV = FV * {1 / (1 + i) ^ n} Where: PV = present value (today's value), FV = future value (a value or cash flow sometime in the future), i = interest rate per period, and n = number of compounding periods [1/(1 + i) ^ n] = the discounting factor

Compounding
FV = PV*(1+i)^n

Where, A = Amount or future value after n years P = Principal or cash flow today i = Nominal Interest rate per annum n = Number of years for which compounding is done (1+i)^n = compounding factor

Time Value of Money

Basic concepts: FV = PV x CF (compounding factor) PV = FV x DF (discounting factor) See TABLE of PV,FV, PVIFA,CVIFA/FVIFA

Future value of a single amount

Q1) Mukesh has invested Rs. 10000 in a Bank certificate of deposit for 2 years at 8% interest. How much will he receive on maturity? Ans: FV = PV x CF FV = 10000 x (1+0.08)^2 FV = 10000 x 1.1664 = Rs. 11664 at maturity of 2 years (also see table)

Q2) Copylal deposits Rs. 100,000 with a bank which pays 10 percent interest compounded annually, for 3 years. How much amount he would get at maturity? Ans: FV = PV x CVIFr,n FV = 100000 x (1+0.10)^3 FV = 100000 x 1.331 = Rs. 133100. He will get this amount after 3 years. (also see table) alternatively, FV = 100,000 * CVIF10%,3 years

PRESENT VALUE of a Single amount

PV of a future cash flow is the amount of current cash that is EQUIVALENT value to the decision maker. Q3) Find the PV of Rs. 10,000 receivable 6 years hence if the rate of interest is 10 per cent Ans: PV = FV x DFr,n [also, DF = 1 / (1+r)^n] PV = 10000 x [1 / (1+0.1)^6] PV = 10000 x 0.5645 PV = 5645

Q4) Find the present value of Rs. 50,000 to be received at the end of four years at 12 per cent interest compounded

Ans: PV = FV x DF PV = FV x PVIFr,n at 12% PV = 50000 x 0.636 PV = 31,800 (also see table) Or: FV = PV x (1+r)^n 50000 = PV x (1+0.12)^4 PV = 50000 / 1.5735 PV = 31775 (approx.)

C) Future value of an Annuity [say you open a recurring a/c]

Annuity is a fixed payment (or receipt) each year for a specified number of years. Example: if you rent a flat and promise to make a series of payments you have created an ANNUITY. Example: EMI payable on housing loan is an ANNUITY

FVA = A * {(1+r)^n 1} / [r] where A = annuity/periodic

cash payments, r = annual interest rate. OR FVA = A x CVIFAr,n [table factor]

Q5) Four equal annual payments of Rs. 5000 are made into a recurring deposit account that pays 8 per cent interest per year. What is the future value of this annuity at the end of four years?

Ans: FVA = 5000 x (FVIFA8%,4) FVA = 5000 x 4.5061 = Rs. 22530.50 (also see table)

Q6) A bank advertises that it will pay a lump sum of Rs. 45740 at the end of 8 years to investors who deposit annually Rs. 4000 for 8 years. What is the rate of interest rate bank is paying?

Ans: The Interest rate is calculated in two stages: i)) Find FVIFA for 45740. FVA = A x FVIFA 45740 = 4000 x (FVIFA) FVIFA = 11.435 ii) Look for 11.435 in FVIFA table, the rate closet to it is the interest rate. In this case we get FVIFA 10%, 8 years = 11.435 and hence the Interest rate = 8%.

Q7) You can save Rs. 20000 a year for 5 years and Rs. 3000 a year thereafter for 10 years. What will these savings cumulate to at end of 15 years if the rate of interest is 10%?

FVA = A x FVIFAr,n [table factor] The future value of annuity = 20000 x FVIFA @10% for 5 years + 3000 x FVIFA @10% for 10 years = 20000 x 6.1051 + 3000 x 15.937 = 169,913.

D)) Present value of an uneven series of payments:

Q8) Find the PV of the following cash flows streams. The discount rate is 10 per cent. Year cash stream 1 1000 2 4000 3 4000 4 4000 5 3000 Solution: Year payments 1 2 3 4 5

Payment 1000 4000 4000 4000 3000

PVIF x x x x x

PV of Individual 0.9091 0.8264 0.7513 0.6830 0.6209 PV = sum = 11814.60 909.10 3305.60 3005.20 2732.00 1862.70

Q9) Mr. Shah has invested Rs. 50000 on Xerox machine on 1.1.2002. He estimates net cash income from Xerox machine in next five years as under. Year Estimated Inflows 2012 12000 2013 15000 2014 18000 2015 25000 2016 30000 Calculate the PV of all future cash flows.

Ans: Year 2012 2013 2014 2015 2016 Estimated Inflows 12000 15000 18000 25000 30000 PVIF @ 10% x 0.9091 x 0.8264 x 0.7513 x 0.6830 x 0.6209 PV = sum = PV of Inflows = 10909 = 12396 = 13523 = 17075 = 21732 75635

E) PRESENT VALUE OF AN ANNUITY

An investor may have an Investment opportunity of receiving an ANNUITY (e.g. pension) a constant periodic amount for a certain number of specified years. We use PV of annuity. Many times investors want to know the PV which must be invested today in order to provide an annuity for several future periods. We calculate PV of all future cash flows. PVA = A {(1+r) ^n 1} / [r (1+r)^n] OR PVA = A x PVIFAr,n Example: let us suppose that a person receives an annuity of Rs. 5000 for four years. If the rate of interest is 10 per cent, the PV of 5000 annuity is : PV = 5000 x 3.170 = Rs. 15850

Q10) What is the present value of a four year annuity of Rs. 8,000 at 12% interest?

PVA = A x PVIFAr,n PV = 8000 x 3.0373 PV = 24298.

Doubling rules

Rule of 72 : Your money will double in 72 / Interest rate E.g. how much time will it take for your money to double if the rate of return is 12%. Ans: 72 / 12 = 6 years However many analysts suggest the doubling rule as follows: 0.35 + {69 / Interest rate} For the above example:0.35 + {69/12} = 6.1 years

F) Effective annual rate:

Q11) Find the EAR if the nominal rate is 6% compounded semi-annually for Re. 1 for 1 year FV = PV x (1 + r/2)n x2 FV = 1 x (1+0.06/2)1x2 FV = 1 x 1.0609 = 1.0609 Therefore the EAR = 1.0609 1 = 0609 x 100 = 6.09% Assignment problems: ..\time value of money\tvm1.pdf ..\time value of money\tvm2.pdf ..\time value of money\tvm3.pdf