The Time Value of Money: Quantitative Methods

QUANTITATIVEMETHODS
THETIMEVALUEOF
MONEY
Reading 5
http://proschool.imsindia.com/ 1
Learning Objective Statements (LOS) LearningObjectiveStatements(LOS)
a Interest Rates as Required rate of return Discount Rate a. InterestRatesasRequiredrateofreturn,DiscountRate
andOpportunityCost
b. Interestrateanditscomponents
c. Effective annual interest rates and compounding c. Effectiveannualinterestratesandcompounding
periodsotherthanannual
d l d l f d ff f d. FuturevalueandPresentvalueofdifferentstreamsof
cashflow
e. TimelineandapplicationbasedquestionsforTime
Value of Money
ValueofMoney
What is Time Value of Money? WhatisTimeValueofMoney?
TVMisthebasicprinciplethatmoneycanearninterest,so p p y ,
somethingthatisworth$1todaywillbeworthmoreinthe
futureifinvested.
Definition:
Thedifferenceinthevalueofcashreceived(expended)now
l f h f versusitsvalueifreceivedsometimeinthefuture.
Applicationinreallife:
Th l f i d i d b i i h h f Thevalueofanassetisdeterminedbyestimatingtheworthof
thestreamoffuturecashflows.
ToRemember
Asinvestmentanalystswe
evaluateseveraltransactionswith
presentandfuturecashflows.
Compounding Compounding
Considerthefollowingtransaction:
Time
0 1
Entity You
OneYear
Bank You
10%
Rs.10,000 Rs.11,000
YoureceiveRs.11,000 Rs.10,000=Rs.1,000more,i.e.timevalueof
10%
PresentValue FutureValue
Rs.10,000 Rs.11,000
money.
ThisisexplainedasRs.10,000todayandRs.11,000inoneyearare
equivalentinvalue.
Thismethodtocomputefuturevaluesofallthecashflowsatthe
endofagiventimehorizonforadefinedrateofinterestisknown
as compounding
ascompounding.
Discounting Discounting
InDiscounting wecomputethepresentvaluesofallthe g p p
futurecashinflowsatagivenrateofinteresti.e.thevalueof
moneyattime0.
Time
(years)
0 1
Bank
V l
Rs.11,000
FutureValue
10%
You
One Year
Rs 10 000
Example
PresentValue
OneYear
Rs.10,000
Computethepresentvalueof$24,200tobegivenattheendof
2yearsforarateofinterestof10%.
PV=24200/(1+10%)
2
=20,000.
Interest Rate InterestRate
InterestRate
Interpretation Interpretation
Requiredrateofreturn
orMinimumexpected
rateofreturn
OpportunityCost Discountrate
Minimum return an
Isthevaluethat
i f b
Used to compute the Minimumreturnan
investormustreceiveto
acceptaninvestment
investorsforgoby
choosingaparticular
courseofaction
Usedtocomputethe
presentvalueofa
futurecashflow
Components of Interest Rate ComponentsofInterestRate
Mathematicallywecomputetheinterestrateas y p
r=Realriskfreeinterestrate+inflationpremium+defaultrisk
premium+liquiditypremium+maturitypremium
Itreflectsthetimepreferencesofindividuals
forcurrentversusfuturerealconsumption
Realriskfree
interestrate
Averageinflationexpectedoverthematurity
ofthedebt
InflationPremium
ToRemember
Compensatestheinvestorfordefaultin
paymentbytheborrower
DefaultRisk
Premium
Compensates for the risk of conversion of the
NominalRiskFreeRate
=RealRiskFreeRate+
Inflation
Compensatesfortheriskofconversionofthe
investmenttocash
Liquiditypremium
Longer the investment maturity, higher is the
Inflation
Longertheinvestmentmaturity,higheristhe
maturitypremiumneededforcompensating
investorneeds
MaturityPremium
Future value of single cash flow Futurevalueofsinglecashflow
Formula
FV=PV*(1+r)
N
Where,
FV=futurevalueoftheinvestmentNperiodsfromtoday
PV=presentvalueotheinvestment
r = rate of interest per period r=rateofinterestperperiod
0 1 2 3 N1 N 0 1 2 3 N 1 N
PV FV=PV*(1+r)
N
SalientPoints:
Allcashflowsshouldbebroughtinonetimeframe
F l i i h b f i d
Futurevalueincreasewithnumberofperiods
Futurevalueincreasewiththeinterestrates
Future Value of lump sum FutureValueoflumpsum
Example p
Abankoffersinterestrateof9%peryearcompoundedannually.
Howmuchwillyouhaveattheendof5years,giventheamount
investedintheschemeisRs.50,000?
Solution:
Given:
UsingFinancialCalculator(TIBAII)
Steps
Press
Buttons
Remarks
0 1 2 3 4 5
50,000 FV=PV*(1+r)
N
r=9%
Buttons
1 2ND Selectsthesecondfunctionofthecalculator
2 CLRWORK Clearsmemory
3 50000 Numberfedonthescreen
4 PV
NumberappearingonthescreenisassigneedtothePV
(Present Value) memory
PV=50,000
r=9%
(PresentValue)memory
6 I/Y
NumberappearingonthescreenisassigneedtotheI/Y
(Interest,rememberthisisapercentmemorylocation)
memory
7 5 Number fed on the screen
N=5
FV=50000*(1+9%)
5
8 N
NumberappearingonthescreenisassigneedtotheN
(Numberofyears)memory
10 PMT
Numberappearingonthescreenisassigneedtothe
PMT (Payment or Annuity) memory
=76,931.20
PMT(PaymentorAnnuity)memory
11 CPT Putsthecalculatorincomputationmode
12 FV
ComputesFV(FutureValue)forthegivensetof
numbers
Future Value of lump sum (different annual time frame) FutureValueoflumpsum(differentannualtimeframe)
Example p
Howmuchwillyouhaveattheendof10years,giventhe
amountinvestedintheschemeisRs.50,000attheendof5
th
year?
How much will be the amount if we remain invested till 15 Howmuchwillbetheamount,ifweremaininvestedtill15
years,intheabovescheme?
Solution:
Given:
Attheendof5
th
year
PV=50,000
r=9%
N=5
FV=50000*(1+9%)
5
0 1 2 3 4 5 6 7 8 9 10
FV=PV*(1+r)
N
50000
r=9%,N=5
( )
=76931.20
Given
Attheendof5
th
year
PV=50,000
r = 9% r 9%
N=10
FV=50000*(1+9%)
10
= 118368 18
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
r=9%,N=10
50000 FV=PV*(1+r)
N
118368.18
Frequency of Compounding FrequencyofCompounding
Formula
Where,
r
s
mN
m
( )
1 FV PV = +
,
r
s
=rateofinterestperperiod
m=numberofcompoundingperiodsperyear
Future Value of lump sum (different time frame) FutureValueoflumpsum(differenttimeframe)
Example p
Abankoffersinterestrateof9%peryear.Howmuchwillyou
haveattheendof5years,giventheamountinvestedinthe
schemeisRs.50,000?
Ifcompoundingisannual?
If compounding is semi annual? Ifcompoundingissemiannual?
Ifcompoundingisquarterly?
Ifcompoundingismonthly? p g y
Ifcompoundingisdaily?
Future Value of lump sum (different time frame) FutureValueoflumpsum(differenttimeframe)
Solution
Formulae Used
PV = 50,000
N = 5
9%
FormulaeUsed
FV=PV*(1+r)
N
r = 9%
For Ann al Compo nding
ForSemiAnnual ForQuarterly
r
s
mN
m
( )
1 FV PV = +
ForAnnualCompounding
r = 9% r = 9% r = 9%
N = 5 N = 5 N = 5
m = 1 m = 2 m = 4
m = 1 m = 2 m = 4
FV = 76,931.20 FV = 77,648.47 FV = 78,025.46
F M hl
r = 9% r = 9%
N = 5 N = 5
ForMonthly
Compounding
ForDailyCompounding
m = 12 m = 365
FV = 78,284.05 FV = 78,411.26
Continuous Compounding ContinuousCompounding
Formula
Where,
(r
s
N)
FV = PV e *
,
r
s
e=2.7182818(constant)
Example
haveattheendof5years,giventheamountinvestedinthe
schemeisRs.50,000?
If compounding is continuous?
Ifcompoundingiscontinuous?
Continuous Compounding ContinuousCompounding
Solution
ForContinuous
PV = 50,000
9%
Compounding
Formula
( N)
r = 9%
N = 5
1 57
(r N)
(r
s
N)
FV = PV e *
= 1.57
FV = 78,415.61
(r N)
e
Effective Rates EffectiveRates
Formula
For continuous compounding,
EffectiveAnnualRate = (1+PeriodicInterestRate)
1
m
Forcontinuouscompounding,
Where,
EAR = e 1
r
s
r = rate of interest per period r
s
m=numberofcompoundingperiodsperyear
Example
Abankoffersinterestrateof9%peryearcompoundedannually.How
muchwillyouhaveattheendof2.5years,giventheamountinvested
intheschemeisRs.50,000?
Effective Rates EffectiveRates
Solution
Steps
Press
Buttons
Remarks
3 1.09 Numberfedonthescreen
PV =50,000
r =9%(CompoundedAnnually)
4
y
x
Selectstheraiseto(index)function
5 0.5 Numberfedonthescreen
6 =
Carriesouttheoperation1.09
0.5
=1.0403
7 Subtractionsignpressed
8 1 Number fed on the screen
( p y)
N =2.5
m =2
Formula 8 1 Numberfedonthescreen
9 * Multiplicationsignpressed
11 = Outputobtainedis4.403
/
( )
Formula
9%=(1+Eff.SemiAnnualRate)
2
1
EffectiveAnnualRate = (1+PeriodicInterestRate)
1
m
12 I/Y (Interest,rememberthisisapercentmemorylocation)
memory
14 N
Eff.SemiAnnualRate =(1+9%)
(1/2)
1
Eff/SemiAnnualRate =4.403%
16 PV
NumberappearingonthescreenisassigneedtothePV
memory
Number appearing on the screen is assigneed to the
FV=PV*(1+Eff.SemiAnnualRate)
(m*N)
FV =62,021
18 PMT
20 FV ComputesFVforthegivensetofnumbers
Future Value of a series of cash flow FutureValueofaseriesofcashflow
EqualCashFlow OrdinaryAnnuity
Terms
q y y
Formula :
AnAnnuity isafinite
seriesofequalcashflows
Futurevalue
annuityfactor
Formula:
AnOrdinaryAnnuityhasa
firstcashflowthatoccurs
one period from now t =1
(1+r)
N
1
A
[ ]
r
FV=
Example
A bank offers interest rate of 9% per year
oneperiodfromnow,t=1.
An AnnuityDue hasa
firstcashflowthatoccurs
Abankoffersinterestrateof9%peryear
compoundedannually.Aninvestor
depositsRs.5000atequallyspaced
i l f f h 5
immediately,t=0
APerpetuity isaninfinite
intervalofoneyearforthenext5years.
Whatisthefuturevalueofthisordinary
annuityafterthelastdepositatt=5?
seriesofequalcashflows
startingfromt=1.
y p
Solution
Using Financial Calculator (TI BAII) UsingFinancialCalculator(TIBAII)
Steps
Press
Buttons
Remarks
2 I/Y
Numberappearingonthescreenisassigned
totheI/Y(Interest,rememberthisisa
percentmemorylocation)memory
Number appearing on the screen is
5000 5000 5000 5000 5000 FutureValue
0 1 2 3 4
5,000
N=0
5
4 N
Numberappearingonthescreenis
assigneedtotheN(Numberofyears)
memory
6 PV
5,450
5,941
6 475
N=1,r=9%
N=2,r=9%
N=3,r=9%
6 PV
assigneedtothePVmemory
8 PMT
assigneedtothePMT(PaymentorAnnuity)
memory
6,475
7,058
Total= 29,924
N=4,r=9%
memory
10 FV ComputesFVforthegivensetofnumbers
UnequalCashFlow OrdinaryAnnuity q y y
Attimescashflowstreamsareunequal
InsuchcasestheFVIFAformulacannotbeused
Example
r=9%
Time CashFlow
FutureValue
5 atyear5
t=1 2,000 ?
t=2 4,000 ?
t 3 6 000 ? t=3 6,000 ?
t=4 8,000 ?
t=5 10,000 ?
S ?
Whatisthefuturevalueafter5yearsforthegivencashflow
stream?
Sum= ?
stream?
Solution
Given
r=9%
Compounding
Cash Flow
FutureValue
Period
CashFlow
atyear5
t=4 2000 2,823
t=3 4000 5,180
Formula
* ( )
N
t=2 6000 7,129
t=1 8000 8,720
t=0 10000 10,000
FV=PV*(1+r)
N
Sum= 33,852
Present value of single cash flow Presentvalueofsinglecashflow
Formula
FV=PV*(1+r)
N
PV=FV/(1+r)
N
Where,
r=rateofinterestperperiod
0 1 2 3 N1 N
FV
PV FV / (1 )
N
PV=FV/(1+r)
N
Present Value of lump sum PresentValueoflumpsum
Example p
HowmuchwillyouinvesttodaytoearnRs.50,000attheendof
5years?
Solution
Given:
0 1 2 3 4 5
Steps
Press
Buttons
Remarks
FV 50 000
50,000
PV=FV/(1+r)
N
r=9%
4 FV
NumberappearingonthescreenisassigneedtotheFV
memory
FV=50,000
R=9%
N = 5
6 I/Y
(Interest,rememberthisisapercentmemorylocation)
memory
N 5
PV=50000/(1+9%)
5
=32,496.57
8 N
10 PMT
12 PV ComputesPVforthegivensetofnumbers
Present value of single cash flow (different annual time frame) Presentvalueofsinglecashflow(differentannualtimeframe)
Example p
BankfixeddepositwillgiveRs.5,00,000after10yearsforthe
investmentyoumaketoday.Howmuchwillthisinvestment
growtoattheendof4yearsfromnow?Interestrateofferedby
bankis9%peryearcompoundedannually.
Solution:
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
r=9%,N=6
500000
PV = FV / ( 1 + r )N
Attheendof4
th
year
PV=FV/(1+r)N
FV=5,00,000
r=9%
N = 6 N=6
PV=500000/(1+9%)
6
=2,98,133.66
Present value of single cash flow (different time frame) Presentvalueofsinglecashflow(differenttimeframe)
Example p
investtodaytoearnRs.50,000attheendof5years?
Ifcompoundingisannual?
Ifcompoundingissemiannual?
If di i t l ? Ifcompoundingisquarterly?
Ifcompoundingismonthly?
Ifcompoundingisdaily? co pou d g s da y
Ifcompoundingiscontinuous?
Present value of single cash flow (different time frame) Presentvalueofsinglecashflow(differenttimeframe)
Solution
Formulae Used
FV = 50,000
N = 5
FormulaeUsed
PV=FV/(1+r)
N (r
s
N)
PV = FV
/
e
r = 9%
For Annual Compounding
ForSemiAnnual ForQuarterly
r
s
mN
m
+
)
/
PV = FV
(
1
ForAnnualCompounding
r = 9% r = 9% r = 9%
N = 5 N = 5 N = 5
m = 1 m = 2 m = 4
m = 1 m = 2 m = 4
PV = 32,496.57 PV = 32,196.38 PV = 32,040.82
For Monthly
F C i
r = 9% r = 9% r = 9%
N = 5 N = 5 N = 5
ForMonthly
Compounding
ForDailyCompounding
ForContinuous
Compounding
(r N)
m = 12 m = 365 = 1.57
PV = 31,934.98 PV = 31,883.18 PV = 31,881.41
(r N)
e
Present Value of a series of cash flows PresentValueofaseriesofcashflows
Formula
A A A A A
(1+r)
1
(1+r)
2
(1+r)
3
(1+r)
4
(1+r)
N
PV + + + + + =
OR
1 1/(1+r)
N
] [
Where,
1 1/(1+r)
]
r
PV = A
[
Where,
A=annuityamount
r=interestrateperperiod p p
N=numberofannuitypayments
Present Value of ordinary Annuity PresentValueofordinaryAnnuity
Example p
AninvestordepositsRs.5000atequallyspacedintervalofone
yearforthenext5years,paymenthappensatthestartofyear.
Whatisthepresentvalueofthisannuity?
Present Value of ordinary Annuity PresentValueofordinaryAnnuity
Solution
SettheFinancialCalculator(TIBAII)into(oroutof)beginningmode
Steps
Press
Buttons
Remarks
PresentValue 5000 5000 5000 5000 5000
0 1 2 3 5
5,000
4
N = 0 r = 9%
4 PMT
Selectsthesecondfuntion"BGN"Beginning
4,587
4,208
3,861
N=0,r=9%
N=1,r=9%
N=2,r=9%
3 9%
4 PMT
modeofcalculator
6 ENTER
Setsthecalculatorintothebeginningmode
"SET"
3,861
3,542
Total= 21,199
N=4,r=9%
N=3,r=9%
SET
8 CPT
Selectsthesecondfuntion"QUIT"to
complete the selection
Aftersettingthecalculatorinthebeginning
modesolvethequestionasperpreviously
discussed steps PMT = 5000 N = 5 I/Y =9 FV =
completetheselection
discussedsteps.PMT=5000,N=5,I/Y=9,FV=
0,CPTPV
Projected Present Value of ordinary Annuity ProjectedPresentValueofordinaryAnnuity
Example p
yearforthe5years,paymenthappensattheendofyear.What
isthepresentvalueofthisordinaryannuity?
Projected Present Value of ordinary Annuity ProjectedPresentValueofordinaryAnnuity
Solution
PresentValue 5000 5000 5000 5000 5000
0 1 2 3 4
4,587
4,208
5
N=1,r=9%
N 2 9%
,
3,861
3 542
N=2,r=9%
N=3,r=9%
3,542
3,250
Total= 19,448
N=5,r=9%
N=4,r=9%
Present Value of Perpetuity PresentValueofPerpetuity
Formula
1
(1+r)
t
PV =

A
t=1
Forr>0,
PV = A / r PV A/r
Example
Abankoffersinterestrateof9%peryearcompoundedannually. p y p y
yeartillperpetuity.Whatisthepresentvalueofthisordinary
it ? annuity?
Solution
PV 5000 / 0 09 55 555 56
PV=5000/0.09=55,555.56
Present Value of Perpetuity PresentValueofPerpetuity
Example p
year till perpetuity First payment starting 5 years from now yeartillperpetuity.Firstpaymentstarting5yearsfromnow.
Whatisthepresentvalueofthisordinaryannuity?
Solution
A A A A
0 1 2 3 4 5 6
PV
1
=A/r
PV
1
= 5000 / 0.09
PV=FV/(1+r)
N
r=9%,N=4
PV
1
5000/0.09
=55555.56
PV=PV
1
/(1+0.09)
4
/
4
=55555.56/1.09
4
=39,356.96
Present Value of a series of unequal cash flow PresentValueofaseriesofunequalcashflow
Example p
r=9%
Time Cash Flow
Present
Time CashFlow
Value
t=1 2,000 ?
t=2 4,000 ?
t=3 6,000 ?
t=4 8,000 ?
t=5 10,000 ?
h h l f h h fl
Sum= ?
Whatisthepresentvalueforthegivencashflows?
Present Value of a series of unequal cash flow PresentValueofaseriesofunequalcashflow
Solution
r = 9% r 9%
Time CashFlow
Present
V l Value
t=1 2,000 1,835
t=2 4,000 3,367
FormulaUsed
t=3 6,000 4,633
t=4 8,000 5,667
t = 5 10,000 6,499
PV=FV/(1+r)
N
t 5 10,000 6,499
Sum= 22,001
Solving for interest rates Solvingforinterestrates
Formula
FV=PV*(1+r)
N
ToRemember
Infinancialcalculator
r=(FV/PV)
(1/N)
1
addthePVandFV
valueswithopposite
signs (+ & )
Example
Howmuchistheinterestrateofferedbyabank,ifan
signs( + & )
investmentofRs.50,000becomesequaltoRs.1,00,000atthe
endof5years?
Solution Solution
PV=50000,FV= 100000,N=5,PMT=0
Compute I/Y = 14 87%
ComputeI/Y=14.87%
Solving for number of periods Solvingfornumberofperiods
Example p
Inhowmanyyears,anamountofRs.50,000willdouble,given
therateofinterestis9%?
Solution
PV=50000,FV= 100000,I/Y=9,PMT=0
ComputeN=8.04years
Solving or annuity Solvingorannuity
Example p
ForagivenloanofRs.2,00,000,whatwillbetheequated
monthlyinstallment,givenaninterestrateof9%peryear.
Tenureofloanis5years?
a. Ifcompoundingisannual?
b If compounding is monthly? b. Ifcompoundingismonthly?
Solution
ForAnnualCompounding ForMonthlyCompounding
PV = 200,000 PV = 200,000
FV = 0 FV = 0
N = 60 N = 60
Eff.MonthlyRate =1.09
(1/12)
1 r =9/12
= 0.721% = 0.75
PMT = 4,117.66 PMT = 4,151.67
Thank You

The Time Value of Money: Quantitative Methods

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