FINANCIAL MANAGEMENT

Time Value of
Money

Reasons for time preference of

money
Preference

for present
consumption

Inflation
Risk

The Interest Rate

Which would you prefer Rs10,000
today or Rs10,000 in 5 years?
years
Obviously, Rs10,000 today.
today
You already recognize that there is
TIME VALUE TO MONEY!!
MONEY

Why TIME?
Why is TIME such an important element
in your decision?
TIME allows you the opportunity to postpone
consumption and earn INTEREST
A rupee today represents a greater real
purchasing power than a rupee a year hence
Receiving a rupee a year hence is uncertain so
risk is involved

Time Value Adjustment

Two most common methods of
adjusting cash 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.

Types of Interest

Simple Interest
Interest paid (earned) on only the original
amount, or principal borrowed (lent).

Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).

Simple Interest Formula

Formula

SI = P0(i)(n)

SI:

Simple Interest

P0 :

Deposit today (t=0)

i:

Interest Rate per Period

n:

Number of Time Periods

Simple Interest Example

Assume that you deposit Rs1,000 in an

account earning 7% simple interest for
2 years. What is the accumulated
interest at the end of the 2nd year?

SI

= P0(i)(n)
= Rs1,000(.07)(2)
= Rs140

Simple Interest (FV)

What is the Future Value (FV)

FV of the
deposit?
FV

= P0 + SI
= Rs1,000 + Rs140
= Rs 1,140

Future Value is the value at some future

time of a present amount of money, or a
series of payments, evaluated at a given
interest rate.

Simple Interest (PV)

What is the Present Value (PV)

PV of the
previous problem?
The Present Value is simply the
Rs 1,000 you originally deposited.
That is the value today!

Present Value is the current value of a

future amount of money, or a series of
payments, evaluated at a given interest
rate.

Future Value
Single Deposit
Assume that you deposit Rs 1,000
at a compound interest rate of 7%
for 2 years.
years

7%

Rs 1,000
FV2

Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1 = Rs 1,000 (1.07)
1,070

= Rs

FV2 = FV1 (1+i)1 = P0 (1+i)(1+i) =

Rs1,000(1.07)(1.07)
= P0 (1+i)2 =
Rs1,000
2 = Rs1,144.90
Rs1,000(1.07)
Rs1,000
You earned an EXTRA Rs 4.90 in Year 2 with
compound over interest.

General Future
Value Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.

General Future Value Formula:

FVn = P0 (1+i)n
or

FVn = P0 (FVIFi,n)

Problem
Reena wants to know how large her deposit of
Rs 10,000 today will become at a compound
annual interest rate of 10% for 5 years.
years

10%

Rs10,000

FV5

Solution

Calculation based on general formula:

FVn = P0 (1+i)n
FV5 = Rs10,000 (1+ 0.10)5
= Rs 16,105.10

Problems
Your uncle deposits Rs. 10,000 into a 4 year FD that pays 5%

annual interest. You will receive the money in 4 years. What is the
FV after 4 years?

You have Rs.2,000 and plan to purchase a 3 year CD that pays 4%

interest compounded annually. How much will you have when the
FD matures? Find when the interest rate is 5%,6% and 20%.

A companys sales in 2012 were Rs.100 million. If sales grow at

8%, what will they be 10 years later?

How much would 1 Re. growing at 5% p.a. be worth after 100

years? What would be FV if the growth rate was 10%?

If you deposit Rs.55,650 in a bank which was paying 15% rate of

interest on a 10 year time deposit, how much would the deposit
grow at the end of 10 years?

The PV of the wages receivable for the next 30 years for C is

Rs.4,00,000. if C saves 10% of his salary and invests the same
@12%, what is the value of savings after 30 years?

Variable compounding

In many cases interest may have to be compounded more

than once a year. Eg, banks may allow interest on quarterly
basis.

a company may allow compounding of interest twice a

year.

FV= PV(1+ i/m) mxn

Problems

Calculate the compound value of Rs.10,000 at the end

of 3 years @ 12% when I is calculated on a) yearly
basis b)quarterly basis.

Mr. D has placed a deposit of Rs.45,000 with A ltd @

15% interest compounded semi-annually. In 3 years
the investment will grow to?

What is the FV of Rs.100 after 3 years if the

appropriate interest rate is 8% compounded annually,
monthly.

The IDBI deep discount bonds offers investors

Rs.200,000 after 25 years, for an initial investment of
Rs.5,500. what is the interest rate implied?

Calculate the FV of Rs.1000 invested in SB cash

certificate scheme for 2 years @ 5.5%p.a.
compounded semi annually.

X ltd. had revenues of Rs.100 million in 2000 and

increased to Rs. 1000 Million in 2010. what was
the compound growth rate of revenues?

Multiple cash flows

Mr. Ravi Prasad and Sons invests Rs.500, Rs.
1,000, Rs.1,500, Rs.2,000 and Rs. 2,500 at the end
of each year. Calculate the compound value at the
end of the 5th year, compounded annually, when
the interest charged is 5% per annum.

Calculate the FV at the end of 5 years of the

following series of payments@ 10% at the end of
the year. 1- 1000,2- 2000, 3-3000, 4-4000, 5-5000.

Calculate the FV of cash flows compounded at

5% for 5 years at the beginning of the year. 12000, 2- 3000, 3- 4000, 4-5000, 5-6000.

Effective rate of interest

When frequency of interest compounding is more

than once a year, the amount grows faster. The
actual rate of interest realised is called the
effective rate. In case of multi period
compounding is more than the apparent annual
rate of interest called nominal rate.

EIR = (1+ i/m) mxn -1

i=nominal rate of interest

m= frequency of compounding per year

Effective vs. Nominal Rate of

Interest
Rs. 1000

Rs.1123.6

So,
Rs. 1000 grows @ 12.36% annually
Effective Rate of Interest
r = 1 + i/m

-1

Problem
Basket Wonders (BW) has a Rs1,000 CD at
the bank. The interest rate is 6%
compounded quarterly for 1 year. What is
the Effective Annual Interest Rate (EAR)?
EAR

EAR

= ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or
6.14%!

EIR

A company offers 12% rate of interest on

deposits. What is the EIR, if the compounding is
done half yearly, quarterly and monthly.

If the nominal rate of interest is 10% p.a. and the

frequency of compounding is 4 times a year, then
the EIR is ?

A bank pays 5% with monthly compounding on

its savings account. What is the EIR?

Double Your Money!!!

Quick! How long does it take to double
Rs 5,000 at a compound rate of 12%
per year (approx.)?

We will use the Rule-of-72.

Doubling Period = 72 / Interest Rate

6 years
For accuracy use the Rule-of-69.
Doubling Period
=0.35 +(69 / Interest Rate)

6.1 years

Discounting or Present Value

Techniques

PV shows what the value is today of some future

sum of money.

In compound or FV approach the money invested

today appreciates the CI is added to the principal.
The PV of money to be received on future date
will be less because we have lost the opportunity
of investing it at some interest.

The PV of money to be received in future will

always be less. Hence PV technique is called
diacounting.

General Present
Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
etc.

General Present Value Formula:

PV0 = FVn / (1+i)n
or

PV0 = FVn (PVIFi,n)

Present Value
Single Deposit
Assume that you need Rs 1,000 in 2 years.
Lets examine the process to determine
how much you need to deposit today at a
discount rate of 7% compounded annually.

7%

Rs 1,000
PV0

PV1

Present Value
Single Deposit (Formula)
PV0 = FV2 / (1+i)2
= FV2 / (1+i)2
0

7%

= Rs 1,000 / (1.07)2
= Rs 873.44
1

Rs 1,000
PV0

Problem
Reena wants to know how large of a
deposit to make so that the money will
grow to Rs 10,000 in 5 years at a discount
rate of 10%.

10%

5
Rs 10,000

PV0

Problem Solution

Calculation based on general formula:

PV0 = FVn / (1+i)n
PV0 = Rs 10,000 / (1+ 0.10)5
= Rs 6,209.21

Problems
What is the PV of Rs.1000 receivable 6 years hence@
10% p.a.

Mr.X is to receive Rs.5000 after 5 years from now. His

time preference for money is 10% p.a. Calculate its PV.

What is the PV of Rs.4500 receivable in 7 years @ 15%

discount.

A person invests Rs.2895 for 10 years, to obtain Rs.

7500. what is the implicit interest rate.

If Rs.20000 is to be received after 5 years whose

present value is Rs.14,940 what should be the time
preference for money?

Mixed Flows Example

Reena will receive the set of cash
flows below. What is the Present
Value at a discount rate of 10%?
10%
0

PV0

10%
600

600

400

400 100

Solution
0

10%
600

600

400

400 100

545.45
495.87
300.53
273.21
62.09

Rs 1677.15 = PV0 of the Mixed Flow

PV of uneven cash flows

Calculate the PV of the following cash flows

assuming a discount rate of 10%.
1

5,000

10,000

10,000

3,000

2,000

What is the minimum amount which a person

should be ready to accept today from a debtor
who otherwise has to pay a sum of Rs.4,000
today, Rs.5,000, Rs.7,000, Rs. 8000 and Rs.10,000
at the end of 1,2,3,and 4 years respectively from
today @ 14%.

Problems

What is the minimum amount which a person should

be ready to accept today from a debtor who
otherwise has to pay a sum of rs.4,000 today,
Rs.5,000, Rs.7,000, Rs.8,000 and Rs. 10,000 at the
end of 1,2,3 and 4 from today @ 14%.

Find the PV of the following cash flows assuming a

discount rate of 8%.
1

30,000

20,000

10,000

10,000

Types of Annuities

An Annuity represents a series of equal

payments (or receipts) occurring over a
specified number of equidistant periods.

Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period.

Annuity Due:
Due Payments or receipts
occur at the beginning of each period.

Examples of Annuities

Student Loan Payments

Car Loan Payments

Insurance Premiums

Retirement Savings

FV of Annuity

An annuity is a series of equal payments lasting for

some specified duration. Eg; premium payments of
LIC.

When the cash flows occur at the end of each

period, the annuity is called regular annuity or
deferred annuity.

FV of an annuity = FV(A, r ,n)= A{ (1+r)n - 1}

r

If the cash flows occur at the beginning of each

period, the annuity is called annuity due.

FV of an annuity due =

FV(A, r ,n)= A{ (1+r)n - 1} (1+i)

r

Parts of an Annuity
(Ordinary Annuity)
End of
Period 1

1
Rs 100

Today

End of
Period 2

End of
Period 3

2
Rs 100

3
Rs 100

Equal Cash Flows

Each 1 Period Apart

Parts of an Annuity
(Annuity Due)
Beginning of
Period 1

Beginning of
Period 2

Rs 100

Today

Beginning of
Period 3

Rs 100

Rs 100

Equal Cash Flows

Each 1 Period Apart

Ordinary Annuity -- FVA

Cash flows occur at the end of the period

. . .

i%
A

A = Periodic
Cash Flow

FVAn = A(1+i) + A(1+i)

... + A(1+i)1 + A(1+i)0
n-1

n-2

FVAn

n+1

Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period

7%
Rs1,000

Rs1,000

Rs1,000

Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period

7%
Rs1,000

Rs1,000

Rs1,000
Rs1,070
Rs1,145

FVA3 = 1,000(1.07)2 +
1,000(1.07)1 + 1,000(1.07)0
= 1,145 + 1,070 + 1,000
= Rs 3,215

Rs3,215 =
FVA3

General Formula for Calculating

Future Value of an Ordinary
Annuity

FVAn A(1 i )

n 1

A(1 i )

(1 i ) 1
A

n2

... A

Annuity Due -- FVAD

Cash flows occur at the beginning of the period

i%
R

. . .

FVADn = R(1+i)n + R(1+i)n-1 +

... + R(1+i)2 + R(1+i)1
= FVAn (1+i)

n-1

FVADn

Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period

7%
1,000

1,000

1,000

1,070
Rs1,145
Rs1,225

FVAD3 = 1,000(1.07)3 +
1,000(1.07)2 + 1,000(1.07)1
= 1,225 + 1,145 + 1,070
= Rs 3,440

Rs 3,440 =
FVAD3

FV of Annuity

Mr.A deposits Rs.1000 at the end of every year for 4

years and the deposit earns a CI @ 10%. Determine
how much money he will have at the end of 4 years.

You plan to buy an asset 5 years from now and you

estimate that you can save 2500 per year. You plan
to deposit the money in a bank that pays 4% and
you will make the first deposit at the end of the year.
How much will you have after 5 years? How will you
answer change if interest rate is increased to 6% or
lowered to 3%.

Mr.X deposits Rs.5000 at the beginning of each year

for 5 years in a bank and the deposit earns a CI 8%.
Determine how much money he will have at the end
of 5 years.

Ordinary Annuity -- PVA

Cash flows occur at the end of the period

n+1

. . .

i%
R

R
R = Periodic
Cash Flow

PVAn

PVAn = R/(1+i)1 + R/(1+i)2

+ ... + R/(1+i)n

Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period

7%
Rs1,000

Rs1,000

Rs1,000

Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period

7%
934.58
873.44
816.30

Rs1,000

Rs 2,624.32 = PVA3

Rs1,000

PVA3 =

Rs1,000

1,000/(1.07)1 +
1,000/(1.07)2 +
1,000/(1.07)3

= 934.58 + 873.44 + 816.30

= 2,624.32

General Formula for Calculating

Present Value of an Ordinary
Annuity
A
A
A
PVAn

...
2
n
(1 i ) (1 i )
(1 i )

(1 i ) n 1
A
n
i (1 i )

Annuity Due -- PVAD

Cash flows occur at the beginning of the period

PVADn

. . .

i%
R

n-1

R: Periodic
Cash Flow

PVADn = R/(1+i)0 + R/(1+i)1 + ... + R/(1+i)n-1

= PVAn (1+i)

Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period

7%
1,000.00
934.58
873.44

1,000

1,000

2,808.02 = PVADn

PVADn = 1,000/(1.07)0 + 1,000/(1.07)1 +

1,000/(1.07)2 = Rs 2,808.02

Problems

A person receives an annuity of Rs.5,000 for 4 years. If

the rate of interest is 10%, wht is the PV of annuity?

Mr.X has to receive Rs.2,000 per year for 5 years.

Calculate the PV of annuity assuming that he can earn
interest on investment @ 10% p.a.

Ms.Kusum received Rs.5 lakhs as her retirement benefits

which she had invested in a bank at 15% . If she expects
to live independently for another 15 years, how much
money she can withdraw at the end of every year so as to
leave a nil balance in her account at the end of maturity?

Mr.A has to receive Rs.1000 at the beginning of each year

for 5 years. Calculate the PV of annuity due assuming
10% rate of interest.

Hi-tech Ltd. Offers a scheme under which an

investor has to deposit rs.1500 for a period of 10
years after which he can get back Rs.23,905 at
the end of 10th year. What is the relevant interest
rate?(excel if 1500 is annuity)

X deposited Rs.1,00,000 on retirement in a bank

which can be withdrawn Rs.16,274 annually for a
period of 10 years. What is the interest rate?
(excel)

Shorter Discounting Periods

General Formula:
FVn = PV0(1 + [i/m])mn
Or
= PV0 * PVIF i/m,m*n
n:
Number of Years
m:
Compounding
Periods per Year i:
Annual Interest Rate
FVn,m: FV at the end of Year n
PV0:

PV of the Cash Flow today

Example
Reena has Rs1,000 to invest for 1 year
at an annual interest rate of 12%.
Annual

FV

= 1,000(1+
[.12/1])(1)(1)
1,000
= 1,120

Semi

FV

= 1,000(1+
[.12/2])(2)(1)
1,000
= 1,123.6

Perpetuity
A perpetuity is an annuity with an infinite number

of cash flows. Eg; irredeemable pref shares(Pref

share without any maturity).
Perpetuity is so long that n approaches infinity

that(1+i)^n tends to become 0.

Therefore PV of perpetuity is perpetuity/interest

rate =A/i
The present value of cash flows occurring in the

distant future is very close to zero.

At 10% interest, the PV of Rs 100 cash flow

occurring 50 years from today is Rs 0.85!

Present Value of a
Perpetuity
A
A
A
PVAn

...
2
n
(1 i ) (1 i )
(1 i )

When n=
PVperpetuity =

[A/(1+i)]
[1-1/(1+i)]

= A(1/i) = A/i

Present Value of a
Perpetuity
What is the present value of a perpetuity of
Rs270 per year if the interest rate is 12% per
year?

A
PV

perpetuity
i

Rs270 Rs 2250

0.12

Problems

Calculate the PV of Rs.1000 received in perpetuity

for an infinite period @ 10%.

What is the amount that should be deposited now

so that a constant monthly income of Rs.1000 can
be withdrawn indefinitely, if the rate of interest is
12% p.a.

What is the PV of a perpetuity of Rs.800 starting

in the beginning of the year 3 @ 18%.

Capital Recovery Factor

It is the annuity of an investment made today for

a specified period of time at a given rate of
interest.

It helps in the preparation of a loan amortisation

schedule or loan repayment schedule.

Steps to Amortizing a Loan

1.

Calculate the payment per period.

2.

Determine the interest in Period t.

Loan balance at (t-1) x (i%)

3.

Compute principal payment in Period t.

(Payment - interest from Step 2)

4.

Determine ending balance in Period t.

(Balance - principal payment from Step 3)

5.

Start again at Step 2 and repeat.

Usefulness of Amortization
1. Determine Interest Expense -Interest expenses may reduce
taxable income of the firm.
2.

Calculate Debt Outstanding -- The

quantity of outstanding debt
may be used in financing the
day-to-day activities of the firm.

Amortizing a Loan Example

Reena is borrowing Rs10,000 at a compound
annual interest rate of 12%. Amortize the loan
if annual payments are made for 5 years.
Step 1: Payment
PV0

= A(PVIFA i%,n)

Rs10,000 = A(PVIFA 12%,5)

Rs10,000 = A(3.605)
A = Rs10,000 / 3.605 = Rs2,774

Amortizing a Loan Example

End of
Year
0
1
2
3
4
5

Payment

Interest

Principal

Ending
Balance

Amortizing a Loan Example

End of Payment
Year
0
--1

Rs2,774

Interest Principal
--Rs1,200

--Rs1,574

Ending
Balance
Rs10,000
8,426

2
3
4
5

[Last Payment Slightly Higher Due to Rounding]

Amortizing a Loan Example

End of Payment
Year
0
---

Interest Principal
---

---

Ending
Balance
Rs10,000

Rs2,774

Rs1,200

Rs1,574

8,426

2,774

1,011

1,763

6,663

2,774

800

1,974

4,689

2,774

563

2,211

2,478

2,775

297

2,478

Rs13,871

Rs3,871 Rs10,000

[Last Payment Slightly Higher Due to Rounding]

EXERCISE
Ashish

recently obtained a
Rs.50,000 loan. The loan carries
an 8% annual interest. Amortize
the loan if annual payments are
made for 5 years.

SOLUTION
50000

0.08
12523

TIME

PAYMENT INTERESTPRINCIPAL
0
1
2
3
4
5

12523
12523
12523
12523
12522

4000
3318
2582
1786
928

AMOUNT
OUTSTANDING
50000
8523
41477
9205
32272
9941
22331
10737
11594
11594
0

EXERCISE
Compute

the present value of the

following future cash inflows,
assuming a required rate of 10%:
Rs. 100 a year for years 1
through 3, and Rs. 200 a year
from years 6 through 15.
ANS: 1011.75

Solution
Cash flows occur at the end of the period

. . .

i%
100
200

100

100

200
th

Till 5 year
248.70
763.05
1011.75

1228.9

15

. . .
200

Suppose you have borrowed a 3 year loan of Rs.

10,000 @ 9% from your employer to buy a
motorcycle. If your employer requires 3 equal end
of year repayments, then the annual instalment
will be?

X borrows Rs.10,00,000 @ 15% for 5 years.

Prepare the amortization schedule showing
annual instalments.