The Time Value of Money

THE TIME VALUE OF
MONEY
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Learning Objective Statements (LOS)
Learning Objective Statements (LOS)
a Interest
a. Interest Rates as Required rate of return, Discount Rate
Rates as Required rate of return Discount Rate
and Opportunity Cost
b. Interest rate and its components
c. Effective
Effective annual interest rates and compounding
annual interest rates and compounding
periods other than annual
d Future value and Present value of different streams of
d. l d l f d ff f
cash flow
e. Time line and application based questions for Time
Value of Money
Value of Money
What is Time Value of Money?
What is Time Value of Money?
• TVM is the basic principle that money can earn interest, so
p p y ,
something that is worth $1 today will be worth more in the
future if invested.
• Definition:
– The difference in the value of cash received (expended) now
versus its value if received sometime in the future.
l f h f
• Application in real life:
– Th
The value of an asset is determined by estimating the worth of
l f i d i db i i h h f
the stream of future cash flows.
To Remember
9As investment analysts we
evaluate several transactions with
present and future cash flows.
Compounding
• Consider the following transaction:
Time 0 1
Entity You
One Year
Bank You
Rs.10,000
, 10% Rs.11,000
,
Present Value Future Value
– You receive Rs.11,000 – Rs.10,000 = Rs.1,000 more, i.e. time value of
money.
– This is explained as Rs.10,000 today and Rs.11,000 in one year are
equivalent in value.
• This method to compute future values of all the cash flows at the
end of a given time horizon for a defined rate of interest is known
as compounding
as compounding.
Discounting
• In Discountingg we compute the present values of all the
p p
future cash inflows at a given rate of interest i.e. the value of
money at time 0.
Time
0 1
(years)
Bank
Rs.11,000
Future Value
Future Value
10%
You
Rs.10,000 One Year
Present Value
• Example
– Compute the present value of $24,200 to be given at the end of
2 years for a rate of interest of 10%.
– PV = 24200 / (1+ 10%)2 = 20,000.
Interest Rate
Interest Rate
Interest Rate
Interpretation
Required rate of return
or Minimum expected Opportunity Cost Discount rate
rate of return
Is the value that
Minimum return an
Minimum return an Used to compute the
Used to compute the
i
investors forgo by
f b
investor must receive to present value of a
choosing a particular
accept an investment future cash flow
course of action
Components of Interest Rate
Components of Interest Rate
• Mathematically we compute the interest rate as
y p
– r = Real risk free interest rate + inflation premium + default risk
premium + liquidity premium + maturity premium
Real risk free • It reflects the time preferences of individuals
interest rate for current versus future real consumption
• Average inflation expected over the maturity
Inflation Premium of the debt
To Remember
Default Risk • Compensates the investor for default in 9Nominal Risk Free Rate

Premium payment by the borrower
= Real Risk Free Rate +
• Compensates for the risk of conversion of the
Compensates for the risk of conversion of the Inflation
Liquidity premium investment to cash
• Longer the investment maturity, higher is the
Longer the investment maturity, higher is the
Maturity Premium maturity premium needed for compensating
investor needs
Future value of single cash flow
Future value of single cash flow
• Formula
FV = PV * (1+r)N
Where,
– FV = future value of the investment N periods from today
– PV = present value o the investment
– r = rate of interest per period
r = rate of interest per period
0 1 2 3 … N‐1
N 1 N
N
PV FV = PV * (1 + r)
• Salient Points:
– All cash flows should be brought in one time frame
F l i ih b f i d
– Future value increase with number of periods
– Future value increase with the interest rates
Future Value of lump sum
• Example
p
– A bank offers interest rate of 9% per year compounded annually.
How much will you have at the end of 5 years, given the amount
invested in the scheme is Rs.50,000?
• Solution:
– Given:
0 1 2 3 4 5
N
50,000 FV = PV * (1 + r)
r = 9%
PV = 50,000
r = 9%
N = 5
FV = 50000 * ( 1 + 9%)5
= 76931.20
Future Value of lump sum (different annual time frame)
Future Value of lump sum (different annual time frame)
• Example
p
How much will you have at the end of 10 years, given the
amount invested in the scheme is Rs.50,000 at the end of 5th
year?
– How much will be the amount, if we remain invested till 15
How much will be the amount if we remain invested till 15
years, in the above scheme?
• Solution:
– Given:
At the end of 5th year
PV = 50,000
r = 9% 0 1 2 3 4 5 6 7 8 9 10
N
N = 5 50000 FV = PV * (1 + r)
r = 9%, N = 5
)5
FV = 50000 * ( 1 + 9%)
(
= 76931.20
– Given
PV = 50,000
r = 9%
r 9%
N = 10 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
N
50000 FV = PV * (1 + r)
FV = 50000 * ( 1 + 9%)10 r = 9%, N = 10
= 118368.18
118368 18
Frequency of Compounding
Frequency of Compounding
• Formula
rs mN
FV = PV ( 1 +
m )
Where,,
– rs = rate of interest per period
– m = number of compounding periods per year
Future Value of lump sum (different time frame)
• Example
p
– A bank offers interest rate of 9% per year. How much will you
have at the end of 5 years, given the amount invested in the
scheme is Rs.50,000?
• If compounding is annual?
• If compounding is semi annual?
If compounding is semi annual?
• If compounding is quarterly?
• p g y
If compounding is monthly?
• If compounding is daily?
• Solution Formulae Used
Formulae Used
PV = 50,000 N
FV = PV * ( 1 + r )
N = 5
r = 9%
FV = PV ( 1 + mr ) mN
s
For Semi Annual For Quarterly
For Ann al Compo nding
For Annual Compounding
Compounding Compounding
r = 9% r = 9% r = 9%
N = 5 N = 5 N = 5
m = 1 m = 2 m = 4
FV = 76,931.20 FV = 77,648.47 FV = 78,025.46
FFor Monthly
M hl
For Daily Compounding
Compounding
r = 9% r = 9%
N = 5 N = 5
m = 12 m = 365
FV = 78,284.05 FV = 78,411.26
Continuous Compounding
• Formula (rs N)
FV = PV * e
Where,,
– e = 2.7182818 (constant)
• Example
have at the end of 5 years, given the amount invested in the
scheme is Rs.50,000?
If compounding is continuous?
• If compounding is continuous?
• Solution
For Continuous
Compounding
PV = 50,000 Formula
r = 9% ( s N)
(r
FV = PV * e
N = 5
(r N)
e = 1.57
1 57
FV = 78,415.61
Effective Rates
Effective Rates
• Formula
Effective Annual Rate = ( 1 + Periodic Interest Rate )m ‐ 1
F di ,
For continuous compounding
i
rs
EAR = e ‐ 1
Where,,
– m = number of compounding periods per year
• Example
E ample
How much will you have at the end of 2.5 years, given the
y y ,g
amount invested in the scheme is Rs.50,000?
Effective Rates
Effective Rates
• Solution
PV = 50,000
r = 9% (Compounded Annually)
N = 2.5
m = 2
Formula
Effective Annual Rate = ( 1 + Periodic Interest Rate )m ‐ 1
2
9% = ( 1 + Eff.Semi Annual Rate) ‐ 1
(1/2)
Eff.Semi Annual Rate = (1 + 9%) ‐ 1
Eff/ Semi Annual Rate

Eff/ Semi Annual Rate = 4.403%
4.403%
(m*N)
FV = PV * ( 1 + Eff. Semi Annual Rate)
FV = 62,021
Future Value of a series of cash flow
Equal Cash Flow –
q Ordinary Annuity
y y Terms
9 An Annuity is a finite
Future value
annuity factor series of equal cash flows
• Formula :
Formula :
9 An Ordinary Annuity has a
N
FV = A [ (1+r) r ‐ 1
] first cash flow that occurs
one period from now t =1
one period from now, t =1.
• Example 9 An Annuity Due has a
– A
A bank offers interest rate of 9% per year
bank offers interest rate of 9% per year first cash flow that occurs
compounded annually. An investor immediately , t = 0
deposits Rs.5000 at equally spaced 9 A Perpetuity is an infinite

i
interval of one year for the next 5 years.
l f f h 5 series of equal cash flows
What is the future value of this ordinary starting from t = 1.
annuity after the last deposit at t=5?
y p
• Solution
5000 5000 5000 5000 5000 Future Value
0 1 2 3 4 5
N =0
5,000
N 1 r 9%
N = 1, r = 9%
5,450
N = 2, r = 9%
5,941
N = 3, r = 9%
6,475
N = 4, r = 9%
7,058
Total = 29,924
Unequal Cash Flow –
q Ordinary Annuity
y y
– At times cash flow streams are unequal
– In such cases the FVIFA formula cannot be used
• Example
– r = 9% Future Value
Time Cash Flow
at year 5
5
t = 1 2,000 ?
t = 2 4,000 ?
t 3
t = 3 6 000
6,000 ?
t = 4 8,000 ?
t = 5 10,000 ?
S
Sum = ?
– What is the future value after 5 years for the given cash flow
stream?
• Solution
– Given
r = 9%
Compounding Future Value
Cash Flow
Cash Flow
Period at year 5
t = 4 2000 2,823 Formula
t = 3 4000 5,180
N
t = 2 6000 7,129 FV = PV * ( 1 + r )
*( )
t = 1 8000 8,720
t = 0 10000 10,000
Sum = 33,852
Present value of single cash flow
Present value of single cash flow
• Formula
FV = PV * (1+r)N
Æ PV = FV / (1+r)N
Where,
– r = rate of interest per period
0 1 2 3 … N‐1 N
FV
N
PV FV / (1 )
PV = FV / (1 + r)
Present Value of lump sum
• Example
p
How much will you invest today to earn Rs.50,000 at the end of
5 years?
• Solution
– Given:
0 1 2 3 4 5
50,000
N
PV = FV / (1 + r)
r = 9%
FV = 50,000
FV 50 000
R = 9%
N = 5
N 5
PV = 50000 / (1+9%)5
= 32,496.57
Present value of single cash flow (different annual time frame)
Present value of single cash flow (different annual time frame)
• Example
p
– Bank fixed deposit will give Rs.5,00,000 after 10 years for the
investment you make today. How much will this investment
grow to at the end of 4 years from now? Interest rate offered by
bank is 9% per year compounded annually.
• Solution:
0 1 2 3 4 5 6 7 8 9 10
500000
r = 9%, N = 6
PV = FV / ( 1 + r )N
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)
• Example
p
invest today to earn Rs.50,000 at the end of 5 years?
• If compounding is annual?
• If compounding is semi annual?
• If
If compounding is quarterly?
di i t l ?
• If compounding is monthly?
• co pou d g s da y
If compounding is daily?
• If compounding is continuous?
• Solution Formulae Used

Formulae Used
FV = 50,000 (rs N)
PV = FV / ( 1 + r ) N PV = FV / e
N = 5
r = 9% rs mN
PV = FV / ( 1 +
m )
For Semi Annual For Quarterly
r = 9% r = 9% r = 9%
N = 5 N = 5 N = 5
m = 1 m = 2 m = 4
PV = 32,496.57 PV = 32,196.38 PV = 32,040.82
For Monthly
For Monthly FFor Continuous
C i
For Daily Compounding
r = 9% r = 9% r = 9%
N = 5 N = 5 N = 5
(r N)
m = 12 m = 365 e = 1.57
PV = 31,934.98 PV = 31,883.18 PV = 31,881.41
Present Value of a series of cash flows
Present Value of a series of cash flows
• Formula
A A A A A
PV = 1 + 2 + 3 + 4 + … + N
(1+r) (1+r) (1+r) (1+r) (1+r)
OR
N
1 ‐ 1/(1+r)
PV = A [ r ]
Where,
– A = annuity amount
– r = interest rate per period
p p
– N = number of annuity payments
Present Value of ordinary Annuity
• Example
p
An investor deposits Rs.5000 at equally spaced interval of one
year for the next 5 years, payment happens at the start of year.
What is the present value of this ordinary annuity?
• Solution
Present Value 5000 5000 5000 5000 5000
0 1 2 3 4 5
5,000
N = 0, r = 9%
4,587
N = 1, r = 9%
4,208
N = 2, r = 9%
3,861
N = 3, r = 9%
3,542
N = 4, r = 9%
Total = 21,199
,
Projected Present Value of ordinary Annuity
• Example
p
year for the 5 years, payment happens at the end of year. What
is the present value of this ordinary annuity?
• Solution
Present Value 5000 5000 5000 5000 5000
0 1 2 3 4 5
4,587
N = 1, r = 9%
,
4,208
N 2
N = 2, r = 9%
9%
3,861
N = 3, r = 9%
3 542
3,542
N = 4, r = 9%
3,250
N = 5, r = 9%
Total = 19,448
Present Value of Perpetuity
• Formula ∞ 1
PV = A ∑ (1+r)
t
t = 1
For r >0,
PV = A / r
PV A/r
• Example
p y p y
year till perpetuity. What is the present value of this ordinary
annuity?
it ?
• Solution
PV 5000 / 0 09 55 555 56
– PV = 5000 / 0.09 = 55,555.56
Present Value of Perpetuity…
• Example
– A bank offers interest rate of 9% per year compounded annually. An
investor deposits Rs.5000 at equally spaced interval of one year till
p p
perpetuity. First payment starting 5 years from now. What is the
y p y g y
present value of this ordinary annuity?
A A ………… A A
• Solution
0 1 2 3 4 5 6 …… ∞
PV 1 = A / r
N r = 9%, N = 4
PV = FV / ( 1 + r )
/( )
PV1 = 5000 / 0.09
= 55555 56
= 55555.56
PV = PV1 / (1+ 0.09)4
= 55555.56 / 1.094
= 39,356.96
Present Value of a series of unequal cash flow
• Example
p
– r = 9%
Present
Time Cash Flow
Cash Flow
Value
t = 1 2,000 ?
t = 2 4,000 ?
t = 3 6,000 ?
t = 4 8,000 ?
t = 5 10,000 ?
Sum = ?
– What is the present value for the given cash flows?
h h l f h h fl
• Solution
r = 9%
r 9%
Present
Time Cash Flow
V l
Value
t = 1 2,000 1,835 Formula Used
t = 2 4,000 3,367
t = 3 6,000 4,633 PV = FV / ( 1 + r ) N
t = 4 8,000 5,667
t = 5
t 5 10,000 6,499
Sum = 22,001
Solving for interest rates
Solving for interest rates
• Formula
FV = PV * (1+r)N
Æ r = (FV / PV)(1/N) – 1
• Example
– How much is the interest rate offered by a bank, if an
investment of Rs.50,000 becomes equal to Rs.1,00,000 at the
end of 5 years?
• Solution
– PV = 50000, FV = ‐ 100000, N = 5, PMT = 0
– Compute
Compute ÆÆ I/Y = 14 87%
I/Y = 14.87%
Solving for number of periods
Solving for number of periods
• Example
p
• In how many years, an amount of Rs.50,000 will double, given
the rate of interest is 9%?
• Solution
– PV = 50000, FV = ‐ 100000, I/Y = 9, PMT = 0
– Compute Æ N = 8.04 years
Solving or annuity
Solving or annuity
• Example
p
– For a given loan of Rs.2,00,000, what will be the equated
monthly installment, given an interest rate of 9% per year.
Tenure of loan is 5 years?
a. If compounding is annual?
b
b. If compounding is monthly?
If compounding is monthly?
• Solution
For Annual Compounding For Monthly Compounding
PV = 200,000 PV = 200,000
FV = 0 FV = 0
N = 60 N = 60
(1/12)
Eff. Monthly Rate = 1.09 ‐1 r = 9 / 12
= 0.721% = 0.75
PMT = 4,117.66 PMT = 4,151.67

Thank You…

The Time Value of Money

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The Time Value of Money

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THE TIME VALUE OF

Default Risk • Compensates the investor for default in 9Nominal Risk Free Rate

Eff/ Semi Annual Rate

• Example 9 An Annuity Due has a

deposits Rs.5000 at equally spaced 9 A Perpetuity is an infinite

5000 5000 5000 5000 5000 Future Value

• Solution Formulae Used

Present Value 5000 5000 5000 5000 5000

PMT = 4,117.66 PMT = 4,151.67

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