Time Value of Money

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Time
value
of
money
Money has time value. Because it earns
interest.
As a result, a dollar/rupee
invested today can grow to a dollar plus
interest and interest-on-the interest at
some future date.
A rupee today is more valuable than a rupee
a year.
Why ? Hence, There are some
reasons;
- Individuals,

in general prefer current

consumption to future consumption.
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Time
Value
of
Money
- Capital can be employed productively
generate positive return.

to

An investment of

one rupee today would grow to (1+r)n a year

hence.
- In an inflationary period a rupee / dollar today

represents a greater real purchasing power

than a rupee a year.

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Time Preference for Money

Three reasons may be attributed to the

individuals time preference for money:

risk
preference for consumption
investment opportunities
The

time

preference

for

money

is

generally expressed by an interest rate.

This rate will be positive even in the
absence of any risk. It may be therefore
called the risk-free rate.
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Required Rate of Return

An

investor requires compensation for

assuming risk, which is called risk premium.

The investors required rate of return is:

Risk-free rate + Risk premium.

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Time Value
Two most common methods of adjusting cash
Adjustment
flows for time value of money:
Compoundingthe

process
of
calculating future values of cash flows;
and

Discountingthe

process
of
calculating present values of cash
flows.
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1. FUTURE VALUE
Compounding is the process of finding the
future values of cash flows by applying
the concept of compound interest.
Compound interest is the interest that is
received

on

the

original

amount

(principal) as well as on any interest

earned but not withdrawn during earlier
periods.
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Future Value
Simple

interest is the interest that is

calculated only on the original amount
(principal), and thus, no compounding of
interest takes place.

The general form of equation for calculating

the future value of a lump sum after n periods

may, therefore, be written as follows:
FVn = PV (1+r)n

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CF1

CF2

CF3

i%

CF0

Tick marks at ends of periods, so Time

0 is today; Time 1 is the end of Period
1; or the beginning of Period 2.
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i%

2 Year
100

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i%

100

100

100

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100

75

50

i%

-50

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10%

100

FV = ?

Finding FVs (moving to the right

on a time line) is called compounding.
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FV1 = PV + INT1 = PV + PV (i)

= PV(1 + i)
= $100(1.10)
= $110.00.

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FV2 = FV1(1+i) = PV(1 + i)(1+i)

= PV(1+i)2
= $100(1.10)2
= $121.00.

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FV3 = FV2(1+i)=PV(1 + i)2(1+i)

= PV(1+i)3
= $100(1.10)3
= $133.10
In general,
FVn = PV(1 + i)n.
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Future Value
The term (1 + i)n is the compound value
factor (CVF) of a lump sum of Re 1, and it
always has a value greater than 1 for positive i,
indicating that CVF increases as i and n
increase.
FVn = PV (CVF)n

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Example Future Value

If you deposited Rs 55,650 in a bank,

which was paying a 15 per cent rate of

interest on a ten-year time deposit, how
much would the deposit grow at the end of
ten years?

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Solution:
We will first find out the compound value factor
at 15 per cent for 10 years which is 4.046.
Multiplying 4.046 by Rs 55,650, we get Rs
225,159.90 as the compound value:
FV = 55650 x 4.046
= Rs.225,159.90

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Spreadsheet Solution
Use the FV function: see spreadsheet in

= FV(Rate, Nper, Pmt, PV)

= FV(0.10, 3, 0, -100) = 133.10

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Ex : Value of Rs.1000 invested @ 10% on Simple and

Compound interest:
Simple Int.
Yr. Beg.bal + Int = End

Compound Int.
Beg.bal + Int. = end.bal

1000 + 100 = 1100

1400 + 100 = 1500
1900 + 100 = 2000
2900 + 100 = 3000
5900 + 100 = 6000
=1,17,390
100 10900 + 100 = 11000
1,37,80,612
1
5
10
20
50

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1000 + 100 = 1100

1464 + 146 = 1610
2358 + 236 = 2594
6116 + 612 = 6728
106718 + 10672
12527829 + 1252783 =

Future Value of an
Annuity is a fixed payment (or receipt) each
Annuity
year for a specified number of years. If you
rent a flat and promise to make a series of
payments over an agreed period, you have
created an annuity.

(1 i ) 1
Fn A

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Ordinary Annuity
0

i%

PMT

PMT

PMT

PMT

PMT

Annuity Due
0
i%
PMT

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The term within brackets is the compound

value factor for an annuity of Re 1, which
we shall refer as CVFA.

Fn =A CVFA n, i
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Example : Ordinary
Suppose that a firm deposits Rs 5,000 at the
Annuity
end of each year for 4 years at 6 per cent rate

of interest. How much would this annuity

accumulate at the end of the fourth year?

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Solution:
We first find CVFA which is

4.3746. If we multiply
4.375 by Rs 5,000, we obtain a compound value
of Rs 21,875:
F4 = 5000 (CVFA 4,0.06)
= 5000 x 4.3746
= Rs.21,873

Spreadsheet Solution:
=FV(RATE,NPER,PMT,PV,TYPE)
=FV(6%,4,-5000,0,0)
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Annuities Due:
If each payment occurs at the beginning of
the period rather than at the end, then we
have an annuity due.

(1 i ) 1
Fn A

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( 1 + i)

Example:
Suppose that a firm deposits Rs 5,000 at the

beginning of each year for 4 years at 6 per

cent rate of interest. How much would this
annuity accumulate at the end of the fourth
year?

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Solution
:
We first find CVFA which is

4.3746. If we multiply
4.375 by Rs 5,000, we obtain a compound value
of Rs 21,875:
F4 = 5000 (CVFA 4,0.06) (1 + 0.6)
= 5000 x 4.3746(1.06)
= 5000 x 4.6370
= Rs.23,185.18

Spreadsheet Solution:
=FV(RATE,NPER,PMT,PV,TYPE)
=FV(6%,4,-5000,0,1)
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2.
PRESENT
VALUE

Present value of a future cash flow (inflow or

outflow) is the amount of current cash that is of
equivalent value to the decision-maker.

Discounting is the process of determining

present value of a series of future cash flows.

The interest rate used for discounting cash

flows is also called the discount rate.

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100

100

100

10%

90.91
82.64
75.13
248.69 = PV

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Present Value of a Single Cash

Flow
The

following general formula can be

employed to calculate the present value of a
lump sum to be received after some future
periods:

Fn
n

F
(1

i
)
n
n

(1 i )
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Present Value of a Single

Cash Flow
The term in parentheses is the discount

factor or present value factor (PVF), and it

is always less than 1.0 for positive i, indicating
that a future amount has a smaller present
value.

PV Fn PVFn ,i
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Example:

Suppose that an investor wants to find

out the present value of Rs 50,000 to be

received after 15 years. Her interest
rate is 9 per cent.

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Solution:
First, we will find out the present value

factor, which is 0.275. Multiplying 0.275

by Rs 50,000, we obtain Rs 13,750 as the
present value:
PV = 50,000 x PVF15,0.09
= 50000 X 0.275
= Rs.13,750

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Spreadsheet Solution
Use the PV function: see spreadsheet.
= PV(Rate, Nper, Pmt, Fv)
= PV(0.10, 3, 100, 0) = -248.69

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Present Value of an
Annuity

The computation of the present value of an annuity can be

written in the following general form:

1
1
P A

n
i i 1 i
(1+r)n - 1
P=

------------i (1+r)n

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OR

Present Value of an
Annuity
The term within parentheses is the present
value factor of an annuity of Re 1, which
we would call PVFA, and it is a sum of singlepayment present value factors.

P = A PVAFn, i
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10
0

10
0

10%

10
0

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PV and FV of Annuity
Due
PV of annuity due:
vs.
Ordinary
Annuity
= (PV
of ordinary annuity)
(1+i)
= (248.69) (1+ 0.10) = 273.56
FV of annuity due:

= (FV of ordinary annuity) (1+i)

= (331.00) (1+ 0.10) = 364.1

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Excel Function for

Change the formula to:
Annuities
Due
=PV(10%,3,-100,0,1)
The fourth term, 0, tells the function there are

no other cash flows. The fifth term tells the

function that it is an annuity due. A similar
function gives the future value of an annuity
due:
=FV(10%,3,-100,0,1)
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100

300

300

-50

10%

90.91
247.93
225.39
-34.15
530.08 = PV

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Doubling
Period:
How long would it take to double the amount at
a given rate of interest.
Rule 72: The doubling period is obtained by
dividing 72 by the interest rate.
Ex: If the interest rate is 8 percent, the
doubling period is about 9 years. (72/8)
Rule 69: A more accurate rule of thumb is ;
69
0.35 + --------------Interest rate
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3. Multi-Period Compounding

Nominal rate
Stated in contracts, and quoted by banks and
(ibrokers.
)
Nom
Not used in calculations or shown on time

lines
Periods per year (m) must be given.
Examples:
8%; Quarterly
8%, Daily interest (365 days)
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Periodic rate (iPer )

iPer = iNom/m, where m is number of

compounding periods per year. m = 4 for

quarterly, 12 for monthly, and 360 or 365 for
daily compounding.
Used in calculations, shown on time lines.
Examples:
8% quarterly: iPer = 8%/4 = 2%.
8% daily (365): iPer = 8%/365 =

0.021918%.
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The Impact of
Compounding
Will the FV of a lump sum be larger or smaller
if we compound more often, holding the
stated I% constant?
Why?

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The Impact of
Compounding
LARGER!
(Answer)
If compounding is more frequent than once a

year--for example, semiannually, quarterly, or

daily--interest is earned on interest more
often.

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iNom

FVn = PV 1 +

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mn

iNom

FVn = PV 1 +

m
FV5S

mn

0.12

= $100 1 +

2
= $100(1.06)10
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2x5

= $179.08

Example:
You deposit Rs.5000 in a bank for 6 yrs. If the
interest rate is 12% and the frequency of
compounding is 4 times a year, your deposit
after 6 years will be;
=Rs.5000 [1+0.12/4]4 x 6
= Rs. 10,164.00

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FV(Annual)= $100(1.12)5 = $176.23.

FV(Semiannual)= $100(1.06)10=$179.08.
FV(Quarterly)= $100(1.03)20 = $180.61.
FV(Monthly)= $100(1.01)60 = $181.67.
FV(Daily) = $100(1+(0.12/365))(5x365)
= $182.19.
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4.
Sinking
Fund
Sinking fund is a fund, which is created out
of fixed payments each period to accumulate
to a future sum after a specified period.
For example, companies generally create
sinking funds to retire bonds (debentures) on
maturity.

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The factor used to calculate the annuity for

a given future sum is called the sinking

fund factor (SFF).

i
A = Fn
n

(1 i ) 1
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5. Effective Annual
Rate
(EAR
= rate
EFF%)
The EAR
is the annual
which causes PV
to grow to the same FV as under multiperiod compounding.

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Effective Annual Rate

Example: Invest $1 for one year at 12%,
Example
semiannual:

FV = PV(1 + iNom/m)m
FV = $1 (1.06)2 = 1.1236.
EFF% = 12.36%, because $1 invested for one

year at 12% semiannual compounding would

grow to the same value as $1 invested for one
year at 12.36% annual compounding.

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Comparing Rates
An investment with monthly payments is

different from one with quarterly payments.

Must put on EFF% basis to compare rates of
return. Use EFF% only for comparisons.
Banks say interest paid daily. Same as

compounded daily.

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(
) -1
= (1 + 0.12) - 1.0
2

iNom
EFF% = 1 +
m

= (1.06)2 - 1.0
= 0.1236 = 12.36%.
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EARAnnual

= 12%.

EARQ

= (1 + 0.12/4)4 - 1

= 12.55%.

EARM

= (1 + 0.12/12)12 - 1

= 12.68%.

EARD(365)

= (1 + 0.12/365)365 - 1 = 12.75%.
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Can the effective rate

ever
be
equal
to
the
Yes, but only if annual compounding is used,
nominal
i.e., if m = 1. rate?
If m > 1, EFF% will always be greater than the

nominal rate.

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6. Amortization

If we make an investment today for a given

period of time at a specified rate of interest, we
may like to know the annual income is called
Capital Recovery or If a loan is to be repaid in
equal periodic amounts (monthly, quarterly or
annually) is said to be an amortized loan.
Construct an amortization schedule for a

$1,000, 10% annual rate loan with 3 equal

payments.
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PMT

PMT

PMT

10%

-1,000

(
1

i
)

1
A( PVFAn ,i ) P A

n
OR
i (1 i )

(1 0.10) 3 1
1000 A
3
0.10(1 0.10)
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= $ 402.12

INTt = Beg balt (i)

INT1 = $1,000(0.10) = $100.

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Repmt = PMT - INT

= $402.11 - $100
= $302.11.

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End bal = Beg bal - Repmt

= $1,000 - $302.11 = $697.89.

Repeat these steps for Years 2 and 3

to complete the amortization table.

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Amortization Table
YEAR

BEG
BAL

$1,000

$402

$100

$302

$698

698

402

70

332

366

366

402

37

366

1,206.34

206.34

1,000

TOT

PMT

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INT

PRIN
PMT

END
BAL

Interest declines
because outstanding
balance declines.

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Amortization tables are widely used--for

home mortgages, auto loans, business

loans, retirement plans, and more. They are
very important!
Financial calculators (and spreadsheets) are

great for setting up amortization tables.

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Ex:
Suppose you have borrowed a 3 year loan of

Rs.10,000 at 9 percent from your employer to

buy a vehicle. If your employer requires three
equal end-of-year repayments, then the annual
instalment will be;
P = A x PVFA
10,000 = A x 2.531
10,000
A = --------- = Rs.3,951
2.531
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7. Present Value of
Perpetuity
Perpetuity is an annuity

that occurs
indefinitely. Perpetuities are not very
common in financial decision-making:

Perpetuity
Present value of a perpetuity
Interest rate
In the case of irredeemable Preference
shares, the company is expected to pay
preference dividend perpetually.

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Example:

An investor expects a perpetual

sum of Rs.500 annually from his
investment. What is the present
value of this perpetuity if his
interest rate is 10 percent?
500
p = ------- = Rs.5,000
0.10
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8.
Net
Present
Value
Net present value (NPV) of a financial
decision is the difference between the present
value of cash inflows and the present value of
cash outflows.

Ct
NPV =

C
0
t
t 1 (1 + k )
n

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9.
Internal
Rate
of
Return

The formula for Internal Rate of Return is

given below. Here, all parameters are given
except r which can be found by trial and
error.

Ct
NPV =

0
0
t
t 1 (1 + r )
n

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Comparing
You are offered a note which pays $1,000 in 15
Investments
months (or 456 days) for $850. You have $850
in a bank which pays a 6.76649% nominal
rate, with 365 daily compounding, which is a
daily rate of 0.018538% and an EAR of 7.0%.
You plan to leave the money in the bank if you
dont buy the note. The note is riskless.
Should you buy it?

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iPer = 0.018538% per day.

0

365

-850

456 days
1,000

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Three solution methods

1. Greatest future wealth: FV
2. Greatest wealth today: PV

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Find FV of $850 left in bank for 15

months and compare with notes
FV = $1,000.
FVBank

=
=

$850(1.00018538)456
$924.97 in bank.

Buy the note: $1,000 > $924.97.

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Find PV of note, and compare

with its $850 cost:
PV =
$1,000/(1.00018538)456
=
$918.95.
PV of note is greater than its $850
cost, so buy the note. Raises your
wealth.
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