Money has time value...

Even when you dont do

anything with it.
Why?
Inflation!
Future Value
If the compound interest rate is i %,
future value is the value that the rupees
grow to after a period of time.
If i = 10%, Rs100 grows to Rs110 after
one year and so the future value of Rs100
after one year (written as FV1 ) is Rs110.
After two years? FV2 is Rs121.
After n years? FVn is Rs100(1.1)n.
Future Value

In general, if the rate is i %, then the future value of P rupees

one period from today is PV(1+i),
two periods from today is PV(1+i)2 ,
n periods from today is FVn = PV(1+i)n

0 1 2 3 n

PV FVn = PV(1+i)n
Present Value
If the compound interest rate is i %, present
value of FVn rupees is the value PV to be
invested n periods back that grows to FVn.
If i = 10% and FV1 = Rs100, the present value
PV = Rs90.91
because Rs90.91 grows to Rs100 after one year.
If FV2 = Rs100, what is PV?
PV = Rs82.64.
If FVn = Rs100, what is PV?
PV = Rs100/(1.1)n.
Present Value of a Cash Flow

In general, if the discount rate is i %,

present value of
FV1 rupees is FV1/(1+i),
FV2 is0 FV2/(1+
1 i)2
2 3 n
FV
PV = FVn / is
(1+i)
n FV
n n /(1+i)n. FVn
Example
Mansingh, a courtier of Akbar, purchased
a township land near Agra, from the local
villagers for approximately Rs24 in 1636.
It is often claimed that the villagers got a
raw deal.
What do you think?
 Example
What would Rs24 in 1636 be worth in
2006? Certainly more than Rs24 if invested
prudently.
Rs ?

Rs24

1626 2006
Example

Assess the worth of Rs24 today if invested

in a conservative project that earns 8%
per year for 370 years.
FV1 = 24(1.08) = Rs25.92
Rs24 Rs 25.92

1636 1637
Example

After two years?

FV2 = 24(1.08)2 = Rs28.00

Rs24 Rs 28.00

1636 1638
Example

After fifty years?

FV50 = 24(1.08)50 = Rs1125.64

Rs24 Rs 1126

1636 1686
 Example

After 370 years?

Rs55,847,118,732,148 = Rs55 trillion plus!
 Example

If Rs500 grows to Rs1039.50 at a rate of 5%.

How many years was the amount invested?
1039.50 = 500(1+0.05)n and we need to solve
for n.
Take the logarithm?
FV = Rs1039.50, PV = -Rs500, Rate = 5%,
Time = 15 years
Example
A zero-coupon bond is a bond that pays no
coupon and sells at a discount.
A zero-coupon bond promises to pay Rs1000
after 28 years.
The appropriate discount rate for the bond
(given its risk characteristics) is 9.5%.
What is the bonds current market price?
Market Price = PV = 1000/(1+0.095)28 =
Rs78.78.
 Example
If you believe that the proper discount rate for
the bond is 9.2%, would you buy or sell it at the
market price of Rs78.78?
By your reckoning PV = 1000/(1+0.092)28 =
Rs85.07.
So you will buy the bond at Rs78.78 until......the
price rises to Rs85.07 ...or until you change your
mind about the discount rate of 9.2% seeing
that several investors in the marketplace believe
that the discount rate is above 9.2%.
PV of Multiple Cash Flows
What happens when you have two or more
cash flows? Can we write their present
value? Suppose r = 10% and we have:

0 1 2 3
100/(1.1) 100 225 140
225/(1.1)2
140/(1.1)3

Therefore, present value (PV) of the cash flows is

the sum of the present values of the three flows,
i.e., 90.91+185.95+105.18 = Rs382.04
Present Value of Multiple
Cash Flows
Consider a set of cash flows {PMTt} and a
discount rate i. The cash flows can be
depicted on a time line:

0 1 2 3 n
PMT1 PMT2 PMT3 PMTn
 Perpetuity

Perpetuity is a constant payment of Rs PMT

every period forever. By assumption, the
payment PMT occurs at the end of each period.
The first payment occurs at t=1, the second at
t=2, etc.:

0 1 2 n

PMT PMT PMT

Present Value of a Perpetuity

The present value of a perpetuity is:

PMT PMT PMT PMT
PV ...
( 1 i) ( 1 i) ( 1 i)
2 3
( 1 i) n

Multiplying the equation by (1+i):

PMT PMT PMT
( 1 i) PV PMT ... n 1

( 1 i) ( 1 i) 2
( 1 i)

Subtracting the first equation from

the second: PV
PMT
i
Example
In the 1800s, the British Government decided to
consolidate all its debt thru a single issue of 2.5%
consols.
A 2.5% consol was a perpetuity promising to pay
25 British Pounds each year forever.
Suppose the appropriate discount rate for a consol
is 10.5%. What is the price of a consol?
PV = PMT / i = 25/0.105 = 238.09 British Pounds.
Growth Perpetuity
A growth perpetuity is a payment that starts
with Rs PMT and grows every period at a growth
rate g forever. By assumption, the payment
occurs at the end of each period. The first
payment occurs at t=1, the second at t=2, etc.:

0 1 2 n

PMT PMT(1+g) PMT(1+g)n-1

Present Value of a
Growth Perpetuity
We can write the present value of a
growth perpetuity as:
PMT PMT (1 g ) PMT (1 g ) 2 PMT (1 g ) n 1
PV ...
(1 i) (1 i) 2 (1 i)3 (1 i) n

The sum of this infinite series is finite if

i > g and can be written as:
PMT
PV
ig
Example
A business house proposes to endow a chair at
Indian Institute of Management
The proposal is to provide Rs1,500,000 plus a raise
of 5% each year.
Suppose the interest rate earned by endowments is
10%. How much should the benefactor donate?
0 1 2 t

1,500,0001,500,000(1.05) 1,500,000(1.05)t-1
 PMT
PV
ig

1500,000

0.10 0.05

Rs 30,000,000
Annuity
An annuity is like a perpetuity except that it
does not go on forever: it is a constant
payment PMT every period until time n.
By assumption, the payment PMT occurs at
the end of each period. The first payment
occurs at t = 1, the second at t = 2, etc..
The present value of an annuity is easiest to
work out by thinking of it as a difference
between two perpetuities.
Hmmm....Thisll take
some thinking!
Present Value of an Annuity
0 1 2 n n+1 n+2

PMT PMT PMT PMT PMT

-PMT -PMT
PMT PMT PMT
PVAn ...
( 1 i) ( 1 i) 2 ( 1 i) n

PMT PMT PMT PMT PMT PMT PMT

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

PMT PMT PMT PMT PMT 1 PMT PMT

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

PMT 1
1
n
i ( 1 i)
Another Lively Example
MCD is considering offering 60 year care contracts for its
parks.
It estimates that maintenance will average Rs250,000
every year.
If the appropriate discount rate is 5.5%, how much one
needs to charge to break even on a perpetual care
contract?
Rs 250000 1
PV 1 60
Rs 4,362,460.
0.055 (1 0.055)
Future Value of an Annuity

PVA
PMT 1 1
n i n
(1 i )

FVA (1 i ) n PVA
n n

PMT (1 i ) n 1
i
A Retirement Puzzle...
Rahul plans to retire in 40 years.
He wishes to plan for 30 years beyond retirement.
Also, given his present status, he proposes to consume
an additional Rs75,000 each year.
Suppose he can invest money at 8%.
How much does he need to have at retirement?

Rs 75,000 1
1 30
Rs 844,333.75
0.08 (1 0.08)
A Retirement Puzzle...
How much Rahul needs to save every year for 40 years
to have Rs844,333.75 at the end if he can invest money
at 8%.

RsPMT
0.08

(1 0.08) 1 Rs 844,333.75
40

PMT Rs 3259.27 / year
Compounding
Compounding does not have to be on an annual
basis.
Compounding can be done quarterly, monthly,
daily, or even continuously!
What is the effect of compounding two times
during the same year? Or more times?
Intuitively, the money should grow faster. Why?
Because interest is paid earlier and reinvested.
Compounding
The same formulas still work, but
n now becomes the number of compounding periods

i becomes the interest earned in a compounding period

For example, if we compounded monthly for 4 years at

12%, the number of compounding periods n would be

48, and the interest rate i would be 1%.

Compounding
An annual interest rate of 10% compounded four
times a year, is an interest rate of 2.5% paid
every quarter.
If we invest Rs1 for one year at this rate, we
would use our compounding formula with n = 4
and i = 2.5% to find out its future value after a
year.
Therefore, after one year Rs1 becomes...
Rs1 x (1 + 0.025)4 = Rs1.1038.
Compounding
Therefore, Rs1 invested at an annual rate of 10%
compounded quarterly becomes Rs1.1038 in a year.
It was as if a rate of 10.38% was applied only one time
during that year.
We refer to the nominal rate of 10% as the Annual
Percentage Rate (APR).
Also, we refer to the annualized rate of 10.38% that
incorporates the effect of compounding, as the Effective
Annual Rate (EAR).
Compounding

In general, if Rs PMT is invested at an APR

of i % and compounded m times during
the year, we can write the following
relation between APR and EAR:
m
APR
1 EAR 1
m
Compounding
Alternatively, if Rs PMT is invested at an APR of i %
compounded m times during a year, for n years, we
can write its future value after n years as:

mn
APR
FV PMT 1
n m
This also means that the present value of Rs PMT
that is received after n years, is:
PMT
PV
mn
APR
1 m
An Yield Example

Mera Bank
Save Short, Earn Tall
One-Year FD
Yield Rate

8.82 8.55
An Yield Example
m
0.0855
1.0882 1
m

We want to compound 8.55% sufficient number of

times to make it yield 8.82%.
You can solve the equation mathematically, or by trial
and error.
The answer is m = 4 and so Mera Bank will compound
an annual APR of 8.55% each quarter, giving you a
quarterly rate of 2.1375%.
Continuous Compounding
We know that if Rs PMT is invested at an APR of i %
compounded m times during a year, for n years, its
future value after n years is:
mn
APR
FV PMT 1
n m

If m approaches infinity, we get:

FV PMT e
n APR
n
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.
The factor used to calculate the annuity
for a given future sum is called the
sinking fund factor (SFF).
i
A = Fn
(1 i ) n
1
Capital Recovery and
Loan Amortisation
Capital recovery is the annuity of an
investment made today for a specified period of
time at a given rate of interest. Capital recovery
factor helps in the preparation of a loan
amortisation (loan repayment) schedule.
1
A= P
PVAFn ,i

A = P CRFn,i
The reciprocal of the present value annuity factor
is called the capital recovery factor (CRF).
Value of an Annuity Due
Annuity due is a series of fixed
receipts or payments starting at the
beginning of each period for a specified
number of periods.
Future Value of an Annuity Due
Fn = A CVFA n, i (1 i)

Present Value of an Annuity Due

P = A PVFA n, i (1 + i)
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.

n
Ct
NPV = t
C0
t 1 (1 + k )
Present Value and Rate of
Return
A bond that pays some specified amount in
future (without periodic interest) in exchange
for the current price today is called a zero-
interest bond or zero-coupon bond. In such
situations, you would be interested to know
what rate of interest the advertiser is offering.
You can use the concept of present value to
find out the rate of return or yield of these
offers.
The rate of return of an investment is called
internal rate of return since it depends
exclusively on the cash flows of the investment.
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. n
Ct
NPV = t
C0 0
t 1 (1 + r )
Interest Earned on Rs1,000
at 10% Interest for 1 Year
106
105
104
Interest Earned

103
102
101
100
99
98
97
1 2 4 12 52 365 Continuous
Compounding Periods per Year
Quiz 1
Compute the annual percentage rate (APR) on
an investment if Rs1,580 invested today and
compounded every week yields Rs2,120 in three
and a half years.

2120
1560
1 r 182

r 0.7%
APR 8.4%
Quiz 1

Hritik proposes to set aside Rs950 toward retirement

every month for the next 20 years. If the annual
interest rate is 13.6% compounded every month,
how much will Hritik have in the retirement account
in 20 years?

FV
950
0.011333


1 0.011333 1
240


FV Rs1,169,333
Quiz 1

Vivek proposes to sell land for Rs17,71,400 and invest the

proceeds in shares. Vivek expects the investment to pay Rs6200
next month and an amount that grows at an annual 3.5% paid
every month subsequently forever. What is the annual
percentage rate on the investment?

Rs 6200
Rs17,714,00
0.035
r
12
r 0.6417%
APR 7.7%
Amortization
A loan of Rs6000 at 15% interest rate is to be
repaid in four equal installments at the end of
each year.
What is the annual payment of the loan?

PMT 1
1 4
6000
0.015 1 0.015

PMT Rs 2,101.58
KBC Winner
Raju has won Rs3 million in Kaun Banega Crorepati!
To be paid in Rs1 lac installments at the end of each of
the next 30 years, of course!
If the appropriate discount rate is 7.5%, what is the
amount really worth?

Rs1,00,000 1
PV 1 30
Rs11,81,038.
0.075 (1 0.075)