TimE Value Of Money

Time Value Of money

 Time Preference for Money
 Time preference for money is an individual’s preference
for possession of a given amount of money now, rather than
the same amount at some future time.

 Three reasons may be attributed to the individual’s time

preference for money:

 risk
 preference for consumption
 investment opportunities

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  What is the value at the end of 5th year if amount deposited at
the end of each year as follows and I=5%:
 End of 1st Year: 1000
 End of 2nd Year: 2000
 End of 3rd Year: 3000
 End of 4th Year: 4000
 End of 5th Year: 5000

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 Required Rate of Return

 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.

 An investor requires compensation for assuming risk, which is

called risk premium.

 The investor’s required rate of return is:

Risk-free rate + Risk premium.

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 Required Rate of Return
 Would an investor want Rs. 100 today or after one year?
 Cash flows occurring in different time periods are not comparable.
 It is necessary to adjust cash flows for their differences in timing and risk.
 Example : If preference rate =10 percent
 An investor can invest if Rs. 100 if he is offered Rs 110 after one year.
 Rs 110 is the future value of Rs 100 today at 10% interest rate.
 Also, Rs 100 today is the present value of Rs 110 after a year at 10% interest
rate.
 If the investor gets less than Rs. 110 then he will not invest. Anything
above Rs. 110 is favourable.

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 Time Value Adjustment

 Two most common methods of adjusting cash flows for time

value of money:

 Compounding—the process of calculating future values of

cash flows and

 Discounting—the process of calculating present values of

cash flows.

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 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not withdrawn during earlier periods.

 Simple interest is the interest that is calculated only on the

original amount (principal), and thus, no compounding of interest
takes place.

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 Future Value

Future Value (FV) is a formula used in finance to calculate the

value of a cash flow at a later date than originally received.

This idea that an amount today is worth a different amount than at

a future time is based on the time value of money.

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Given a present value (PV), we can compound to return a
future value (FV).

FV2 = $1,254.40

t=0 t=1 t=2 r = 12%

r = 12% t=0 t=1 t=2

PV0 = $1,000
 Future Value: Example
An individual would like to determine their ending balance after one year
on an account that earns .5% per month and is compounded monthly. The
original balance on the account is $1000.

For this example, the original balance, which can also be referred to as
initial cash flow or present value, would be $1000, r would be .005(.5%),
and n would be 12 (months).
Putting this into the formula, we would have:

After solving, the ending balance after 12 months would be $1061.68.

As a side note, notice that 6% of $1000 is $60. The additional $1.68 earned in this
example is due to compounding.
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 Example: Future Value of a Lump Sum

 Your bank offers a CD FV  PV * (1  i ) n

with an interest rate of 3%

for a 5 year investments.  $ 1500 * (1  0 .03 ) 5
 $ 1738 .1111145
 You wish to invest $1,500
for 5 years, how much will n 5
your investment be worth? i 3%
PV 1,500
FV ?
Result 1738.911111

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Given a future value (FV), we can discount it to return a
present value (PV).

FV3 = $25,000

r = 9%
t=0 t=1 t=2 t=3

t=0 t=1 t=2 t=3 r = 9%

PV0 = $19,604.59
 Example: Present Value of a Lump
Sum

 You have been offered

$40,000 for your printing FV
business, payable in 2 years. PV 
(1  i ) n
 Given the risk, you require a 40,000
return of 8%. 
(1  0.08) 2
 What is the present value of  34293.55281
the offer?  $34,293.55 today

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Problems

 Calculate the present value of 600

 (a) received 1 year from now

 (b) received at the end of 5 years
 (c) received at the end of 5 years

 Assume a 5% rate

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Problems

 Assume 10% discount rate,

 Compute the present value of 1100,900, 1500 and 700
received at the end of 1 through 4 years.

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Problems

 Determine the present value of cash inflows of 3000 at

the end of each year for the next 4 years and 7000 and
1000 respectively, at the end of years 5 and 6.

 The discount rate is 14%

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Problem

 XYZ bank pays 12% and compounds quarterly.

 If 1000 is deposited initially, how much shall it grow at

the end of 5 years

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 You expect to receive
100000 after 5 years. If
your required rate of
return is 10%, what is the
present value of 100000?

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 What Are Annuities?
Annuities are essentially a series of fixed payments required from you
or paid to you at a specified frequency over the course of a fixed time
period.

The most common payment frequencies are yearly, semi-annually

(twice a year), quarterly and monthly.

There are two basic types of annuities:

1. ordinary annuities and
2. Annuities due.

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 Ordinary Annuity
Payments are required at the end of each period.

(a fixed sum of money paid to someone each year, typically for

the rest of their life)

For example, straight bonds usually pay coupon payments at the

end of every six months until the bond's maturity date.

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 Annuity Due
Payments are required at the beginning of each period.

Ex. Rent is an example of annuity due.

You are usually required to pay rent when you first move in at
the beginning of the month, and then on the first of each month
thereafter.

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 Calculating the Future Value of an
Ordinary Annuity
If you know how much you can invest per period for a certain time
period, the future value of an ordinary annuity formula is useful for
finding out how much you would have in the future by investing at
your given interest rate.

If you are making payments on a loan, the future value is useful in

determining the total cost of the loan.

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 Ex: annuity cash flow schedule

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 To calculate the future value of the annuity, we have to calculate the
future value of each cash flow.

Let's assume that you are receiving $1,000 every year for the next
five years, and you invested each payment at 5%.

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$1000*[5.53]= $5525.63
 Calculating the Present Value of an
Ordinary Annuity

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$1000*[4.33]= $4329.48
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 Problem

 If you require a 9 percent annual return on your investments,

you would prefer $15,000 five years from today rather than
an ordinary annuity of $1,000 per year for 15 years.

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Problem

 If you receive Rs 25,000 at the end of 1 year, Rs 50,000

at the end of 2 year, Rs 75,000 at the end of 3 year and
Rs 90,000 at the end of 4th year.

 Assume rate of interest of 16% per annum.

 What is the total present value these cash flows?

Problem
 You have been offered a prize. Out of following which
one will you prefer? Assume discount rate of 15% per
annum.

 1) Rs 5,00,000 today

 2) Rs 75,000 per year for next 10 years

 3) Rs 10,00,000 at the end of 5th year

 Problem

 Suppose I want to be able to withdraw $5000 at the end of 5

years and withdraw $6000 at the end of 6 years, leaving a
zero balance in the account after the last withdrawal.

 If I can earn 5% on my balances, how much I deposit today to

satisfy my withdrawal needs?

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 Present Value of a Single Cash Flow

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 Example

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 Present Value of an Uneven Periodic
Sum

 In most instances the firm receives a stream of uneven cash

flows. Thus the present value factors for an annuity cannot be
used.

 The procedure is to calculate the present value of each cash

flow and aggregate all present values.

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 PV of Uneven Cash Flows: Example

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 Present Value of Perpetuity

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 Present Value of a Perpetuity: Example

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Rule of 72

 The 'Rule of 72' is a simplified way to determine how long

an investment will take to double, given a fixed annual rate of
interest.

 By dividing 72 by the annual rate of return, investors can get

a rough estimate of how many years it will take for the initial
investment to duplicate itself.
 Example

 The present value of Re 1 paid at the beginning of each year

for 4 years at 10 percent is

1 × 3.170 × 1.10 = Rs 3.487

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 Multi-Period Compounding

 APR

 EIR/EAR

 Frequency of compounding

 EAR differ from APR except in case of annual compounding

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 Multi-Period Compounding

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 Effective Interest Rate: Example

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 Problem

 How much interest on interest is earned in an account at the

end of 5 years if 100000 is deposited and interest is 4% per

year compounded quarterly?

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 Problem

 Suppose you want to have 500000 saved by the time you

reach age 30 and suppose that you are 20 years old today. If
you can earn 5% on your funds, how much you have to invest
today to reach your goal?

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 Problem

 If interest is paid at the rate of 5% Per year compounded

quarterly, What is the

 Annual Percentage rate?

 Effective Annual Rate?

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Problem
 How much must you deposit at the end of each year in an

account that pays an annual interest rate of 20 percent, if at

the end of 5 years you want 10,000 in the account?

 a. 1,500

 b. 1,250.66

 c. 1,393.47

 d. 1,343.72
Problem
 You have 10,000 to invest. Assuming annual compounding,

how long will it take for the 10,000 to double if it is invested

at an annual interest rate of 14 percent?

 a. 6 years

 b. 4.5 years

 c. 5.29 years

 d. 6.14 years
Problem
 What is the present value of $800 to be received at the end of

8 years, assuming an interest rate of 20 percent, quarterly

compounding?

 a. $165.00

 b. $172.39

 c. $167.89

 d. $169.89
Problem
 What would you pay for an ordinary annuity of $2,000 paid

every six months for 12 years if you could invest your money
elsewhere at a nominal interest rate of 10% compounded
semiannually?

 a. $13,798.60

 b. $25,500.35

 c. $27,597.20

 d. $26,957.20
 Problem
 What is the present value of $800 to be received at the end of

8 years, assuming an annual

 interest rate of 8 percent?

 a. $425

 b. $432

 c. $441

 d. $437

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Problem
 A Baldwin United Company agent has just presented the following offer.

If you deposit $25,000with the firm today, it will pay you $10,000 per
year at the end of years 8 through 15. If you require a 15 percent annual
rate of return on this type of investment, would you make this
investment?

 a. $16,871

 b. $15,871

 c. $16,852

 d. $16,911
 In 2 years you are to receive 10,000. If the interest rate were
to suddenly decrease, the present value of that future amount
to you would __________.

 Fall
 Rise
 Remain unchanged
 The correct answer cannot be determined without more
information.
 Interest paid (earned) on both the original principal
borrowed (lent) and previous interest earned is often
referred to as __________.

 Present value
 Simple interest
 Future value
 Compound interest
 If interest is paid at the rate of 5 percent Per year
compounded quarterly, What is the Annual Percentage rate?

 5percent
 5.09 percent
 20 percent
 5.25 percent
 What is the present value of a 1,000 ordinary annuity that
earns 8% annually for an infinite number of periods?

 80
 800
 1,000
 12,500
 Future value of an amount allowed to grow at a given interest
rate over a period of time is known as the:

a) future value - single amount

b) present value - single amount
c) future value - annuity
d) present value – annuity
 A series of consecutive cash flows of equal amounts is known
as:

a) a present value
b) a compound sum
c) a present sum
d) an annuity
 More frequent compounding results in ………..future
values

a) Lower
b) Higher
c) Same
d) Depends on other parameters
 Time value of money supports the comparison of cash flows
recorded at different time period by

a) Discounting all cash flows to a common point of time

b) Compounding all cash flows to a common point of time
c) Using either a or b
d) None of the above.
 If the nominal rate of interest is 10% per annum and there is
quarterly compounding, the effective rate of interest will be:

a) 10% per annum

b) 10.10 per annum
c) 10.25%per annum
d) 10.38% per annum
 Time value of money indicates that

a) A unit of money obtained today is worth more than a unit

of money obtained in future

b) A unit of money obtained today is worth less than a unit of

money obtained in future

c) There is no difference in the value of money obtained

today and tomorrow

d) None of the above

 Concept of present value and future value are:

 Proportionately related
 Inversely related
 Directly related
 Not related
 Equal annual amounts occurring in the beginning of certain
years are known as:

 Annuity
 Perpetuity
 Annuity due
 Deferred payments
 A student deposits some amount daily to accumulate Rs 5000
to pay his tuition fees after one year. Which of the following
compounding methods of interest should be opted by him:

 Compounded quarterly
 Compounded daily
 Compounded half yearly
 Compounded annually
 Future value of one rupee invested today is:

 More than one rupee

 Equal to one rupee
 Equal to present value
 Less than one rupee
 A series of constant cash flows occurring at regular intervals
forever is known as:

 Growing annuity
 Perpetuity
 Growing perpetuity
 Annuity
 Which of the following is called an annuity:

 A lump sum after few years

 A series of equal and regular amounts
 A series of unequal amounts
 A series of equal and irregular amounts
 What is ignored in principle of profit maximisation

 Time value of money

 Risk
 Wealth creation
 All of the above