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Time Value of Money

A Rupee in hand today is worth more than a Rupee receivable after a year due to inflation, uncertainty, and investment opportunities that allow the initial Rupee to grow. The document then discusses concepts related to simple interest, compound interest, timelines, future value, present value, annuities, perpetuities, and effective interest rates as they relate to investments and loans over time. Worked examples are provided to illustrate calculations for compound interest, present/future value, annuities, loans, and effective interest rates.

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Sayantan Halder
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65 views

Time Value of Money

A Rupee in hand today is worth more than a Rupee receivable after a year due to inflation, uncertainty, and investment opportunities that allow the initial Rupee to grow. The document then discusses concepts related to simple interest, compound interest, timelines, future value, present value, annuities, perpetuities, and effective interest rates as they relate to investments and loans over time. Worked examples are provided to illustrate calculations for compound interest, present/future value, annuities, loans, and effective interest rates.

Uploaded by

Sayantan Halder
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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A Rupee in hand today is worth more

than a Rupee receivable after a year

Why???
 Inflation
 Uncertainty
 Investment (in Fd, bonds, stock market or
other projects)
 Simple interest- earned or paid only on the
principal amount invested or borrowed.

 Compound interest- earned or paid on the


principal amount as well as any previous
interest earned.
 Mr X has Rs. 1,000 to invest in n FD giving
simple interest at the rate of 10%. Find out
the value amount he would get if he invests
the amount for the following time periods .
 1 year
 3 years
 4 years
-1000 100 100 100 100 100
+1000

 Draw a timeline

 Amount at the end of 1 year = 1000+100


= Rs. 1,100

Amount at the end of 3 years = 1000+300


= Rs. 1,300

Amount at the end of 5 years = Rs. 1,500


 In compounding, we get the value of all our
cash flows at a certain point of time in the
future. It helps us to find out the Future
Value.
 Eg. Mr. X has Rs. 1000 to invest in an FD
giving a rate of interest of 10%. Find out the
value amount he would get if he invests the
amount for the following time periods .
 1 year
 3 years
 4 years
1000 1,100 1,210 1,331 1,464

*(1.10) *(1.10) *(1.10) *(1.10)

 Draw a timeline

 Amount at the end of 1 year = 1,000*(1.10)


= Rs. 1,100

Amount at the end of 3 years = 1,000*(1.10)*(1.10)*(1.10)


= 1,000*(1.10)^3 = Rs. 1,331

Amount at the end of 4 years = 1,000*(1.10)^4 = Rs.1,464


End Compounded Interest Scheme Simplified Future
of Calculation Value
Year
1 1,000 *(1.10) 1,000*(1.10) 1,100

2 [1,000*(1.10)] *1.10 1,000*(1.10)^2 1,210

3 [1,000*(1.10)*(1.10)]*1.10 1,000*(1.10)^3 1,331

4 [1,000*(1.10)*(1.10)*(1.10)]*(1.10) 1,000*(1.10)^4 1,464


For the purpose of simplicity, let us assume the
following :-

Rate of interest (in decimal terms) =r


No. of years of investment =n
Cashflow that occurs today = PV
Cashflow that occurs in the future = FV

FV = PV * (1+r)^n
 Discounting involves finding out the value of
various cash future cash flows at time 0 on
the timeline. It helps us to find the Present
Value. It is the reverse of compounding.

 Eg. You need an amount of Rs. 60,000 at the


end of 5 years. How much should you invest
in a scheme now that invests your money at
7% per annum.
 Ans: -
FV =60,000
r =.07
N=5

Applying the FV formula, we know that


60,000 = PV *(1.07)^5

PV = FV/(1+r)^n
= 60,000/(1.07)^5
= Rs. 42,780
For the purpose of simplicity, let us assume the
following :-

Rate of interest (in decimal terms) =r


No. of years of investment =n
Cashflow that occurs today = PV
Cashflow that occurs in the future = FV

PV = FV / (1+r)^n
 An annuity means a series of equal payments
occurring over a particular period at equal
intervals.
 Examples:
 Insurance premiums
 Recurring deposit
 Retirement savings
 Loan repayments
 You invest Rs. 20,000 from your annual
salary in a recurring deposit at the end of
every year for 3 years. How much will you get
at the end of 3 years if the RD pays a
compounded interest of 9% every year.
-20,000 -20,000 -20,000

*(1.09)^2 *(1.09)

Total cashflow
20,000
+
21,800
+
23,762
=
65,562

Amount at the end of 3 years = 20,000 * (1.09)^2


+20,000*(1.09)+20,000
=Rs. 65,562
Let us assume the following :-

Rate of interest (in decimal terms) =r


No. of years of investment =n
Annuity at the end of every period = A
Value of the annuity in the future = FVA

FVA = A *[(1+r)^n-1]
r
 You have taken a personal loan today, such
that you have to pay an annual installment of
Rs. 15,650 every year for the next 4 years. If
the rate of interest charged by the bank is
10%, can you find out the amount of loan
taken today?
 Draw a timeline
 Present value of the annuity=
15650/(1.0)
+ 15650/(1.10)^2
+ 15650/(1.10)^3
+ 15650/(1.10)^4

= Rs. 49,608
Let us assume the following :-

Rate of interest (in decimal terms) =r


No. of years of investment =n
Annuity at the end of every period = A
Value of the annuity at time 0= PVA

PVA = A *[1-(1+r)^(-n)]
r
A perpetuity is an annuity that goes on forever

PVP = A
r
Eg. Suppose a retirement fund gives you a
cashflow of Rs. 2,00,000 for the rest of your
life . Find out the amount to be invested today
if the rate of investment is 6% pa.
Ans : 2,00,000/.06
= Rs. 33,33,000
If an annuity occurs at the beginning of the
period rather than at the end of the period, it is
called an annuity due.

In such a case, we multiply the present


value/future of a regular annuity by (1+r) to
get the present value of an annuity due.
 Read the problem thoroughly
 Determine if it’s a PV or an FV problem
 Determine if it’s a single flow or a multiple
cashflow problem
 Create a timeline
 Put the cashflows on the timeline
 Solve the problem
 Check your calculations
 Eg. Suppose a project involves an initial
investment of Rs. 10 lakh and generates net
inflows as follows:-
End of Year Inflow (in Rs.)
1 2 lakh
2 4 lakh
3 6 lakh

 What is the present value of the above cashflows?


(Assume that the funds are discounted at a rate
of interest of 12% pa)
Ans :-

PV = 2 /(1.12) + 4/(1.12)^2 +
6/1.12)^3 = 9.25 lacs

Note: Since the initial investment is Rs. 10 lac and


the present value of cash inflows is Rs. 9.25 lacs,
the investment is not viable.
If m is the number of compounding periods in
a year, then the compounding period becomes
m*n and the interest rate becomes r/n.

The effective rate of interest = EIR

EIR = [(1+r/m)^m-1)
 Rita has a Rs. 1000 FD with Sahara
Investments. The interest rate is 7%
compounded on a monthly basis for 1 year.
What is the Effective Annual Interest Rate.
 What is the EIR if the interest is compounded
quarterly.
 What is the EIR if the interest is compounded
on a monthly basis.
EIR if the interest is compounded monthly=
[(1+ .07/12)^12 ] -1
= 7.23%
EIR if the interest is compounded quarterly =
7.19%

EIR if the interest is compounded semi annualy


= 7.12%
Solve yourself
You have invested in a fund that pays a compounded
interest every quarter at 10% per annum for 5 years.
Find out the amount you get at the end of 5 years.
*Here, the amount is compounded or discounted every quarter,
the number of periods of compounding becomes (5*4=20) and
the interest rate becomes (10%/4= 2.5%)

What will be the amount that you get if the interest is


compounded on a
a. monthly basis.
b. Semi annual basis
c. Daily basis
You take a loan for Rs.10,000 at an interest
rate of 7 percent per year. The bank wants you
to make a series of payments that will pay off
the loan and the interest over six years.
Determine the annual equal instalments that
you would have to pay to the bank.
 Determine the installment per period
 Make a loan table with the 5 headings

 Opening balance
 Installment
 Interest
 Repayment
 Closing balance

 Calculate the interest on the opening balance in the first period.


 Deduct the interest from the installment in the first period to
find out the repayment.
 Determine the closing balance at the end of the first period.
 Repeat the step for the rest of the periods.
PVA = Rs 10,000
N = 6 years
R = 7%
A = Rs. 2,098
Ref: Financial management by IM Pandey,
Financial management by Khan & Jain

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