Basic Techniques of Financial

Prof. Anirban, Management

CCIM,
B’lore
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Time Preference for Money

 Time value of money means the value of an unit of
money is different in different time periods.
 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 & Uncertainty
 Inflation
 Preference for consumption
 Investment opportunities

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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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.

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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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.

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Present Value
 Present value of a future cash flow (inflow
or outflow) is the amount of current cash
that is of equivalent value to the decision-
maker.
 Discounting is the process of determining
present value of a series of future cash
flows.
 The interest rate used for discounting cash
flows is also called the discount rate.

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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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any interest earned but not withdrawn during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.

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Future Value
 The general form of equation for calculating
the future value of a lump sum after n
periods may, therefore, be written as
follows:
Fn  P (1  i )
n

 The term (1 + i)n is the compound value

factor (CVF) of a lump sum of Re 1, and it
always has a value greater than 1 for
positive i, indicating that CVF increases as i
and n increase. F =P  CVF
n n,i

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Example
 If you deposited Rs 55,650 in a bank, which
was paying a 15 per cent rate of interest on
a ten-year time deposit, how much would
the deposit grow at the end of ten years?

 We will first find out the compound value

factor at 15 per cent for 10 years which is
4.046. Multiplying 4.046 by Rs 55,650, we
get Rs 225,159.90 as the compound value:
FV  55,650 × CVF10, 0.12  55,650  4.046  Rs 225,159.90

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Future Value of an Annuity

 Annuity is a fixed payment (or receipt) each
year for a specified number of years. If you
rent a flat and promise to make a series of
payments over an agreed period, you have
created an annuity.  (1  i ) n  1 
Fn  A  
 i 
 The term within brackets is the compound
value factor for an annuity of Re 1, which
we shall refer as CVFA.
Fn =A CVFA n, i

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Example
 Suppose that a firm deposits Rs 5,000 at the
end of each year for four years at 6 per cent
rate of interest. How much would this
annuity accumulate at the end of the fourth
year? We first find CVFA which is 4.3746.
If we multiply 4.375 by Rs 5,000, we obtain
a compound value of Rs 21,875:

F4  5,000(CVFA 4, 0.06 )  5,000  4.3746  Rs 21,873

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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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 
Prof. Anirban, Sr.Lecturer, CCIM, B’lore
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Present Value of a Single Cash Flow

 The following general formula can be employed to
calculate the present value of a lump sum to be
received after some future periods:
Fn
P  F 
n  (1  i ) n

(1  i ) n

 The term in parentheses is the discount factor or

present value factor (PVF), and it is always less
than 1.0 for positive i, indicating that a future
amount has a smaller present value.
PV  Fn  PVFn ,i

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Example

 Suppose that an investor wants to find out

the present value of Rs 50,000 to be
received after 15 years. Her interest rate is
9 per cent. First, we will find out the
present value factor, which is 0.275.
Multiplying 0.275 by Rs 50,000, we
obtain Rs 13,750 as the present value:
PV = 50,000  PVF15, 0.09 = 50,000  0.275 = Rs 13,750

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Present Value of an Annuity

 The computation of the present value of an
annuity can be written in the following
general form:
1 1 
P  A  
 i i  1  i  
n

 The term within parentheses is the present

value factor of an annuity of Re 1, which
we would call PVFA, and it is a sum of
single-payment present value factors.
P = A × PVAFn, i

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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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  A = P × CRFn,i
 PVAFn ,i 
 The reciprocal of the present value annuity
factor is called the capital recovery factor
(CRF).

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Present Value of an Uneven Periodic Sum

 Investments made by of a firm do not

frequently yield constant periodic cash
flows (annuity). 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.

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Present Value of Perpetuity

 Perpetuity is an annuity that occurs

indefinitely. Perpetuities are not very
common in financial decision-making:

Perpetuity
Present value of a perpetuity 
Interest rate

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Present Value of Growing Annuities

 The present value of a constantly growing
annuity is given below:
A  1 g  
n

P= 1    
i  g   1  i  

 Present value of a constantly growing

perpetuity is given by a simple formula as
follows:
A
P=
i–g

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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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 )

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Multi-Period Compounding

 If compounding is done more than once a

year, the actual annualised rate of interest
would be higher than the nominal interest
rate and it is called the effective interest
rate.
n m
 i
EIR = 1   –1
 m

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Continuous Compounding

 The continuous compounding function takes

the form of the following formula:
Fn  P  ei n  P  e x

 Present value under continuous compounding:

Fn i n
P  Fn × e
ei n

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Doubling Period
 According to the Rule of 72, the doubling
period can be obtained by dividing 72 by the
interest rate.
 Another rule is the rule of 69. According to
that the doubling period is equal to

.35 + (69 / Interest Rate)

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Problems
1 A deposit Rs. 1000 today in a bank that pays
10% interest compounded annually. How much
will the deposit grow after 8 `and 12 years.
[Ans : 2144, 3138]
2 If the rate of interest is 10% how long it will
take to double the amount?[
3 A company had revenues of Rs. 1000 in 1990
which increased to Rs. 100000 in 2000.What
was the compound growth rate in revenue.
[pg166]
4 A promises to give you 1000, 3 years hence.
What is the present value of this amount if the
interest is 10%.[167]

Prof. Anirban, Sr.Lecturer, CCIM, B’lore

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Problems

5. Mr. B decided to deposit Rs. 30000 in his

PPF for 30 years. If the interest rate is
11% then what will be the accumulated
sum after 30 years?

Prof. Anirban, Sr.Lecturer, CCIM, B’lore