Time Value of Money

Banikanta Mishra
Professor of Finance
Xavier Institute of Management, XUB
Bhubaneswar, India
 Real Rate
Even in the absence of inflation,
even assets without risk
(say a guaranteed bank deposit)
give a return (call it the interest rate)

Why?

What does this real rate depend upon?

7/10/2017 Professor Banikanta Mishra 2

 Computing Real Rate
t=0 Real Rate t=1
Lend Get back
25 Apples = (26-25) / 25 26 Apples

= 4.00%
People prefer
current consumption to future consumption
and, therefore,
demand a compensation for postponing consumption.
THAT REFLECTS IN THE REAL RATE (OF 4% HERE)
7/10/2017 Professor Banikanta Mishra 3
 Nominal Rate
$0.80 Price Per Apple $0.80

t=0 t=1
Lend Get back
$20 Nominal Rate = ??

20.80 20.00
------------------
20.00
This buys Should be able
25 apples = 4.00% to buy 26 apples
=> Need
$20.80 (=$0.80 x 26)
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 Inflation and Nominal Rate
$0.80 Price Per Apple $0.83

t=0 t=1
Lend Get back
$20 Nominal Rate = ??

21.58 20.00
------------------
20.00
This buys Should be able
25 apples = 7.90% to buy 26 apples
=> $0.83 x 26
= $21.58
7/10/2017 Professor Banikanta Mishra 5
 Nominal Rate: Fisher Effect
Nominal Rate =

[(1+Real Rate) x (1+ Expected Inflation)] 1*

Using notation, R = [ (1+r) (1+h) 1]

Here, R = [(1+4.00%) *( 1+3.75%)] 1 = 7.90%

R, a benchmark, is referred to as Nominal Risk-free Rate (or Rf )

Expected Inflation (in Apple Price)= (0.83 0.80) / 0.80 = 3.75%

[*Nominal Rate Approximately Equals Real Rate + Inflation Premium]

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 Risk Free Rate
Risk-free Rate is what we expect to earn
on a Risk-free Asset (asset that would never default)

Technically, only securities issued or guaranteed

by governments (federal, state, city, municipal)
are deemed to be risk-free

Treasury Securities (Treasury Bills, Notes, Bonds)

are the standard risk-free assets

Bank-deposits, to the extent guaranteed,

can also be taken as risk-free assets

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FUTURE VALUE: ONE PERIOD
Given Investment ( I ) and Expected Rate of Return (ERR),
find Future Value (FV1)
ERR = 8% (Let us take it as given)
t =0 t=1
Invest Receive
I FV1 = I x ( 1 + ERR )
= I + (I x ERR)
100 100 x (1 + 8%) = 108
[= 100 + (100 x 8%)]
(I is the PV or Present Value here)

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 Risk and ERR
ERR for a fairly priced asset
depends upon its risk.
Higher the risk, higher the ERR.
ERR = Riskfree Rate + Risk Premium
= Rf + RP
For a Riskfree Asset, ERR = Rf
For a Risky Asset, ERR > Rf

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FV1 for a Risky Investment
It is given that, ERR = Rf + RP = 8% + 6% = 14%
t =0 t=1
Invest Receive
I FV1 = I x ( 1 + ERR )
= I + (I x ERR)
100 100 x (1 + 14%) = 114
[= 100 + (100 x 14%)]

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Where does the $114 FV1 come from?
t=0 t=1
I CF1
102
100
126
FV1 = Average of CF1 (Cash Flow at t=1) = ( * 102) + ( * 126) = $114

2%
I
26%

ERR = Average of Actual Returns (over t=0 and t=1) = (*2%) + (*26%)]= 14%

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 Deriving ERR
Given I and FV1, derive ERR
(If a $100 investment would become $108 at the end of one period,
what is the ERR?)

t =0 t=1
I FV1
100 108
Ending Inflow Beginning Outflow FV1 - I
ERR = ---------------------------------------------- = --------------
Beginning Outflow I

=> ERR = [ (108 100) / 100 ] = 8.00%

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 FV in a Two-period Context
t=0 t=1 t=2
R01 = 8% R12 = 10%

I = 100 FV1 = 108 FV2 = 118.80

= I x (1+ R01) x (1+ R12)

= 100 (1+8%) (1+10%)

= 108 (1 + 10%)
Would FV2 be different if R01 = 10% and R12 = 8%?

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Two-period FV with Constant Rates
R01 = R12 = R
t=0 t=1 t=2
R01 = 8% R12 = 8%

I = 100 FV2 = 116.64

= I x (1+ R01) x (1+ R12)

= I (1+R) (1+R)

= I (1 + R)2 = 100 (1+8%)2

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 Contribution of Compounding
FV under Simple Interest would have given as follows:

Principal [1 + (Rate per Period x Number of Periods)]

= 100 [1 + (8% x 2)] = 100 x 1.16 = 116.00

FV under Compounding gives as follows

Principal [ (1 + Rate per Period)Number of Periods ]

= 100 [ (1+8%)2 ] = 116.64

FV is $116.64 $116.00 = $0.64 extra

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 Interest: Simple and Compound
Simple Interest =

Principal x [Rate per Period x Number of Periods]

= 100 x [8% x 2] = 100 x 16% = $16.00

Compound Interest =

Principal x [(1 + Rate per Period)Number of Periods 1]

= 100 x [(1+8%)2 - 1] = 100 x 16.64% = $16.64

So, Interest is $16.64 $16.00 = $0.64 extra

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 t=0 t=1 t=2

100 100 * 1.08 = 108 100 * 1.082 = 116.64

Principal
100 100 100

Interest 8

8 8

0.64
Interest on Interest

CONCEPT OF COMPOUNDING

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 Compounding and EAR
Let us take each PERIOD as SIX MONTHS.

If the rate is 8% per period (i.e. six-months),

what is the correct RATE Per Year?

16.64% [ = (1+8%)2 1], as A Year = Two Periods

This is the EAR: Effective Annual Rate,
and is based on Compounding Interest principle

It differs from APR (Annual Percentage Rate)

or SAR (Stated Annual Rate) = 8% x 2 = 16%,
which is based on the Simple Interest principle.

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 FV in a Multi-period Context
t=0 t=1 t=2 . . . t=T

I FV1=I (1+ERR)
100 = 108

I FV2= I (1+ERR)2
100 = 116.64

I FVT= I (1+ERR)T
100 = 100 (1+8%)T

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 FVIF: Future Value Interest Factor
(1+ERR)T , or more generally, (1+R)T
is called the FVIFR,T ,
the Future Value Interest Factor
(or Future Value Factor)
for T periods and a rate of R per period

$1 invested now would grow to this value

at the end of T periods,
if it earns a rate of R per period
For example, FVIF8%,2 = (1+8%)2 = 1.1664
$1 invested now @8% per period would grow to
$1.1664 at the end of 2 periods (sounds familiar?)
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 Present Value
A bank promises to give you
$214 at t=1 (end of the first period)
If you deposit $200 now.

Would you accept the offer, if you can earn 8% elsewhere?

Question: How much is the future $214 worth today?

Why do you care? Because, you pay $200 TODAY.

Worth today is the PRESENT VALUE.

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 Concept of Present Value
How much do I need to invest today to get $214 at t=1?

t =0 t=1
I 214

We know that, @ERR=8%

I becomes I x (1+8%)
For I x (1 + 8%) to equal 214,
we require I = 214 / (1+8%) = 198.15

That is, we need to invest $198.15 today to get $214.00 at t=1

=> $198.15 is worth today or present-value of $214 at t=1

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 Computing PV (Present Value)
214
PV = ------------------------
1 + 8%

CF1
PV = ------------------------
1 + RRR

(CF1 is Cash Flow at t=1, RRR is Required Rate of Return)

RRR = ERR on the Next Best Investment of Same Risk

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 The Verdict
Since PV = $198.15

AND

Investment (or Deposit Required) = $200

Do not invest

RULE: DO NOT INVEST IF PV < I

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 Is the Decision Right?
Yes.

If we invest $200 elsewhere,

our ERR = 8%

So, we would end up with

FV1 = $200 x (1+8%) = $216

So, $214 at t=1 is NOT acceptable?

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 Evaluating Decision using IRR
IRR is that DR (Discount Rate) that makes
DVCI (Discounted Value of Cash Inflows) = I

t=0 t=1

200 214

I = 200 DVCI = 214/(1+DR)

200 = 214 / (1+DR) => DR = 7% => IRR = 7%
As wee see, in this context, IRR equals ERR.

Since IRR < RRR, do NOT invest

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 PV of CF after Two Periods
You need $605 at the end of two years.
Toward that,
you want to deposit enough money in the bank today.
How much need you deposit,
if the bank gives a rate of 10% per year?
t=0 t=1y t=2y
605
605
PV = ---------- = 500
(1 + 10%)2

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 The Discounting Formulae
t=0 t=1 t=2 t=3 t=T

PV CF1
= CF1 / (1+RRR)

PV CF2
= CF2 / (1+RRR)2

PV CF3
= CF3 / (1+RRR)3

PV CFT
= CFT / (1+RRR)T
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 Discounting Examples
t=0 t=1 t=2 ... t=T
PV CF1
= CF1 / (1+RRR)
PV 108
=108 /(1+8%)
=100
PV CF2
= CF2 / (1+RRR)2
PV 233.28
=233.28 / (1+8%)2 = 200
PV CFT
= CFT / (1+RRR)T
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 Time Value of Money
Discounting implies that
$1 received on a future-date is worth less than $1 today
For a given amount,
as the future-date moves farther and farther away,
the worth today (or present value) becomes less and less
(as shown below for RRR = 8%)

t=0 t=1 t=2 t=3 t=10

0.93 1
0.86 1
0.79 1
0.46 1
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 PVIF: Present Value Interest Factor
1/(1+RRR)T, or more generally, 1/(1+R)T
is called the PVIFR,T ,
the Present Value Interest Factor
(or Present Value Factor)
for T periods and a rate of R per period

$1 to be received at t=T has this value today (or PV)

if the rate per period is R
For example, PVIF7%,25 = (1+7%)25 = 0.1842
[ 25 N; 7 I/Y; 1 FV; CPT PV -> -0.1842 ]

To receive $1 at t=25, we need to invest today $0.1842,

if the rate is 7% per period

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 Solving for the Unknown
The FV Equation: FVT = I (1 + ERR)T
CFT
The PV Equation: PV = ------------
(1 + RRR)T

COMMON FORM: FVT = PV (1 + R)T

FOUR variables: FVT , PV, R, T

Given any THREE, solve for the FOURTH

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SOLVING FOR FVT AND T
t=0 t=1 t=2 . . . t=T
PV FVT = PV (1 + R)T

If $100 is invested @8%, how much is received at end of 9 periods?

0 T=9
@ERR= 8%
100 FVT = 100 (1 + 8% )9 = 199.90

If $100 is invested @8%, how much time it takes to double?

0 T=?
@ERR= 8%
100 FVT = 100 (1 + 8% )T = 200.00
=> T = Ln (200/100) / Ln (1.08) = 9.006 years
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 SOLVING FOR R (RRR or ERR) AND PV (or I)
At what rate should $100 be invested to give $200 at end of 9 years?

0 T=9
@ERR = ?
100 FVT = 100 (1 + ERR)9 = 200.00
=> ERR = (200 / 100)1/9 1 = 8.006%

How much needs to be invested @8% to give $200 at end of 9 years?

0 T=9
I =? @ERR=8% FVT = I (1 + 8%)9 = 200.00
=> PV or I = 200 / (1.089) = 100.05

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 PV of Cash Flow Stream
t=0 t=1 t=2 ... t=T
PV CF1 CF2 CFT
= CF1 / (1+R)
+ PV
= CF2 / (1+R)2

+ PV
= CFT / (1+R)T

Present Value of this Cash Flow stream

[Here, R represents the RRR, Required Rate of Return]

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 Two Different Streams
What is the PV of a security that pays

$108.00 at t=1 AND $116.64 at t=2?

What is the PV of a security that pays

$54.00 at t=1 AND $174.96 at t=2?

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 An Example
t=0 t=1 t=2
PV 108.00 116.64
= 108 / (1+8%)
= 100
+ PV
= 116.64 / (1+8%)2
= 100
Equivalent CF Streams

200

54 174.96
PV = 50
+ 150

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 Equivalent Cash Flow Streams
The two above CF streams

have the same risk and SAME PV.

So, we would refer to them

as Equivalent Cash Flow Streams

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 IRR REVISITED
What is the IRR, given the following I and CFs?

t=0 t=1 t=2

I CF1 AND CF2

200 108 116.64
DVCI
200 = 108
------------ + 116.64
-----------
(1+R) (1+R)2

=> R (By Trial & Error) = 8% This is the IRR.

[Enter CFs as follows: -200, 108, 116.64. IRR CPT 8.00]

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PV of an Annuity
t=0 t=1 t=2 ... t=T
PV Y Y Y
= Y / (1+R)
+ PV
= Y / (1+R)2
+ PV
= Y / (1+R)T

Present Value of this Annuity

(1+R)T - 1
= Y * [1/(1+R) + 1/(1+R)2 + + 1/ (1+R)T ] = Y ------------
R (1+R)T

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PVIFA: Present Value Interest Factor for Annuity

(1+R)T 1
------------ is called PVIFAR,T
R (1+R)T
This is the Present Value of
a CF stream that would pay
$1 per period for T periods,
given discount-rate (or RRR) of R

For a Perpetuity, T = , and, so, PVIFA = 1/R

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 Finding PV of an Annuity
t=0 t=1 t=2
PV 121 121
= 121 / (1+10%)
= 110
+ PV
= 121 / (1+10%)2 R= 10%
= 100

210
OR Directly: PV = 121 x PVIFA10%,2 = 121 x 1.7355 = 210
-121 PMT; 2 N; 10 I/Y, CPT PV 210.00

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 Finding Equal Annual Installments for a Loan
t=0 t=1 t=2
Take Loan of REPAY

$210 EAI EAI

@10% (Equal Annual Installments)
for 2 years
Fair Deal =>
Loan Amount = PV of Installments
$210 = PV of this CF stream
= EAI x PVIFAR,T
= EAI x PVIFA10%,2
= EAI x 1.7355

EAI= 210 / 1.7355 (= Loan / PVIFAR,T) = 121

210 PV; 2 N; 10 I/Y; CPT PMT -121.00
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 Does $121 EAI Pay Off the Loan Exactly?
(1) (2) (3) (4) (5) (6)
t= Principal Total Interest Principal Principal
Outstanding Pmt Paid Repaid Outstanding
At Beginning =10% = Col.3 At Period End
x Col.2 - Col.4 =Col.2 - Col.5

1 210 121 21 100 110

2 110 121 11 110 0

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 Another Example: Finding EMI
You have taken a
four-year loan
of $20,000
@0.75% per month.

What is EMI?

$480.65 $497.70 None of These

7/10/2017 Professor Banikanta Mishra 45

Finding Interest Rate of a Loan Scheme
You have taken a loan of $210.
It has to be paid off in
Two Equal Annual Installments.
IF EAI = $121,
what is the implied rate in the loan?

$210 = $121 x PVIFAR, 2

PVIFAR, 2 = 210 / 121 = 1.7355
[which we know equals {(I+R)2 1}/{R (1+R)2}

R (By Trial & Error) = 10%

Easy with TI BA II Plus Professional:
210 PV; -121 PMT; 2 N; CPT I/Y 10.00

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 Finding R: Another Example

You have to repay

a $10,000 loan
in 60 EMIs of $207.58.

What is the interest-rate?

0.50% 0.75% ??

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 Investment Choice
You have $1500 with you.

Should you

Deposit it in bank @5%

OR

Buy a security giving

a guaranteed $425 per year
for 4 years

7/10/2017 Professor Banikanta Mishra 48

 Keeping in Bank in Amortizing Scheme
Keeping in Amortizing Scheme is like
giving a loan.

=> You deposit a lump-sum amount today

and, in return,
receive Fixed Amounts each period
(say, each month or year)
for a given number of periods.

t=0 t=1 t=2 t=3 t=T

Deposit Receive
I Y Y Y Y
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 Amortizing Scheme: Equal Annual Receipt
Suppose you choose to receive
Equal Annual Installments (or Receipts),
over each of next FOUR years.
How much would you receive?
t=0 t=1 t=2 t=3 t=4
Deposit Receive
$1,500 Y Y Y Y
Fair Deal Implies P V of Receipts
I = 1,500 = Y x PVIFA5%, 4
Y = $1,500 / PVIFA5%, 4 = $423 (per year for four years)
So, buy security, as it gives more, $425 per year
7/10/2017 Professor Banikanta Mishra 50
 An Alternative Approach
t=0 t=1 t=2 t=3 t=4
Invest RECEIVE

1,500 425 425 425 425

I PV of this Cash Flow Stream

= 425 x PVIFA5%,4 = 425 x 3.5460 = $1,507

Since the securitys

PV > I,
BUY (or invest in) the security

Prof. Banikanta Mishra, XIMB 51

Another Alternative: IRR Approach
t=0 t=1 t=2 t=3 t=4
Invest Inflows

1,500 425 425 425 425

I Discounted Value of this Cash Inflow Stream

425 x PVIFAR,4
where R is the Discount Rate

IRR is that R which makes 425 x PVIFA5%,R = 1500

PVIFAR,4 = 1500 / 425 = 3.53 => R (By Trial & Error) = 5.20%

Calculator: -1,500 PV; 4 N; 425 PMT; CPT I/Y 5.20

BUY security, as its IRR of 5.20% > RRR of 5% (= ERR of bank deposit)
Prof. Banikanta Mishra, XIMB 52
 You have taken a loan of 60,000 @7%
Agreeing to return 1,200 per month
How many months to repay completely?

t=0 t=1m t=2m t=3m t=Tm (?)

1200 1200 1200 1200

We Should Have
60,000 = PV = 1200 * PVIFARm,T
(where Rm is the monthly rate)

Ln [1 (Rm * PVIFA)]
PVIFARm,T = 60,000 / 1200 = 50 => T = - Ln (1 + Rm)
If Rm = (1 + 7%)1/12 1 = 0.565% Plug In to get T = 58.91

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 Growing Annuity
PV of an Annuity
whose CFs grow at
a constant-rate per period (say g)

T

CF1 1 1 g
R g 1 R

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 Growing Annuity: Example
A new high-tech company wants you to join as CEO,
quitting your current five-year contract with another firm.

It has agreed to pay you One Million Dollars

as the joining-bonus to compensate you for
foregoing your current secured, fat salary
($20,000 at month-end, growing @0.25% per month).

If the proper RRR for your salary is 9%

(that is 0.75% per month),
is the offered joining-bonus enough?

YES NO CANT SAY

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 t=0 t=1 t=2 ... t=

PV 121 121 121

= 121 / (1+10%)
+ PV
= 121 / (1+10%)2
+ PV
= 121 / (1+10%)
= 121 / 10%

= 1210 = Present Value of this Perpetuity

Verify: If deposit 1210 @10% and withdraw interest every year

the cash-flow stream would be equal to $121 per year for ever
7/10/2017 Professor Banikanta Mishra 56
 Growing Perpetuity
PV of a Perpetuity, whose CFs grow at
a constant-rate per period (say g)
CF1
R g

If a sweepstakes you have won gives you two choices:

Lump-sum $10,000,000 now OR
$1,000,000 at the end of the year, growing thereafter @10%

If the proper RRR for the second choice is 18%,

which of the two choices would you go for?

7/10/2017 Professor Banikanta Mishra 57

 Annuity Due
t=0 t=1 t=2 t=3
$Y $Y $Y

FV3 = Y x FVIFAR,3 x (1+R)

If you have just deposited $10,000
in an account paying 8%
and plan to make same deposit next two year-ends,
how much would you end up with
at the end of the third year (t=3)?
$32.464.00 $35,061.12 $38,000.96

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 Finding R of Annuity Due
A bank tells you that,
if you deposit $1,000 at end of each of the FOUR years starting now,
then it would give you $5,000 at the end of the FOURTH year (t=4).
t=0 t=1 t=2 t=3 t=4
-1,000 -1,000 -1,000 -1,000
+5,000
What rate is the bank offering on your deposit?
2ND PMT/BGN; 2ND ENTER/SET; 2ND CPT/QUIT
(Now Calculator is in Annuity-Due Mode)

-1,000 PMT; 4 N; 5,000 FV; CPT I/Y 9.13

Can we solve the problem as a regular annuity?

7/10/2017 Professor Banikanta Mishra 59

t=0 t=1 t=2 ... t=T-1 t=T

CF1 CF2 ... CFT-1 CFT

+
CFT-1(1+R)
+
CF2 (1+R)T-2
+
CF1 (1+R)T-1

Cash Flow Streams Future Value at T

[R is the ERR = Expected Rate of Return]

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 FV of Multiple CFs: Example
Suppose you invest $1000 in a mutual-fund today
and add another $500 next year (at t=1).

If the fund pays 10% per year,

how much would you have at the end of two years (t=2)?

$1,650? $1,760? $1,815

7/10/2017 Professor Banikanta Mishra 61

t=0 t=1 t=2 ... t=T-1 t=T

Y Y ... Y Y
+
Y(1+R)
+
Y (1+R)T-2
+
Y (1+R)T-1

Annuitys Future Value at T

(1+R)T 1
= Y * [1 + (1+R) + (1+R)2 ++ (1+R)T-1 ] = Y ------------
R

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 FVIFA: Future Value Interest Factor for Annuity

(1+R)T 1
------------ is called FVIFAR,T
R
If we deposit $1 per period (from t=1)
at a rate of R per period,
then our balance would at end of t=T
would grow to the above value
FVIFAR,T = PVIFAR,T x (1+R)T
Looks familiar?
7/10/2017 Professor Banikanta Mishra 63
How much will I have at year-end if I deposit $100 p.m. @1% p.m?
t=0 t=1m t=2m ... t=11m t=T=12m
100 100 ... 100 100
+
100(1+1%)1
+
100 (1+1%)10
+
100 (1+1%)11

(1+1%) 12 1
= Y * FVIFA1%,12 OR Y * ---------------- = Y * 12.6825 = 1268.25
1%
Calculator: 12 N; -100 PMT; 1 I/Y; CPT FV 1,268.25

7/10/2017 Professor Banikanta Mishra 64

 FV of Annuity: Another Example
You have just joined high-school.
Your mother wants to give you $50,000
when you join college after four years.
She plans to deposit $10,000
at the end of each of the next four years
in a bank that gives 6% per year.
Just realizing that she would fall short,
she has decided to make a lump-sum deposit today
to meet the shortfall after four years.
Roughly how much does she need to deposit today?
$4,687 $4,953 $5,216
7/10/2017 Professor Banikanta Mishra 65
 You need to accumulate 60,000
You can deposit 1,200 per month
If ERR = 7%, how many months will it take?

t=0 t=1m t=2m t=3m t=Tm (?)

1200 1200 1200 1200

We require that FV = 1200 * FVIFARm,T = 60,000

Ln [1+ (Rm * FVIFA)]

FVIFARm,T = 60,000 / 1200 = 50 => T = Ln (1 + Rm)
Rm = (1 + 7%)1/12 1 = 0.565% Plug In to get T = 44.16

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