TIME VALUE OF MONEY

SOUMENDRA ROY
 INTRODUCTION
• Money has time value. A rupee today is more
valuable than a rupee a year hence. Why?
• REASONS:
i. Individuals, in general, prefer current consumption to
future consumption.
ii. Capital can be employed productively to generate
positive returns. An investment of one rupee today
would grow to (1+r) a year hence (r is the rate of
return earned on the investment).
iii. In an inflationary period a rupee today represents a
greater real purchasing power than a rupee a year
hence.
 INTRODUCTION
• Most financial problems involve cash flows
occurring at different points of time.
• These cash flows have to be brought to the same
point of time for comparison and aggregation.
• Hence one should understand the tools of
compounding and discounting which underlie most
of what we do in finance –
from valuing securities to analyzing projects
from determining lease rentals to choosing the right
financing instruments
from setting up the loan amortization schedule to
valuing companies, so on and so forth.
 TIME LINE & NOTATION
• When cash flows occur at different points in time, it
is easier to deal with them using a time line.
• A time line shows the timing and the amount of
each cash flow stream.
• Thus a cash flow stream of Rs. 10,000 at the end of
the next five years can be depicted on a time line as
follows:
Part A
0 12% 1 12% 2 12% 3 12% 4 12% 5
I-----------I-----------I-----------I-----------I-----------I
10,000 10,000 10,000 10,000 10,000
 TIME LINE & NOTATION
Part B
0 12% 1 12% 2 12% 3 12% 4 12% 5
I----------I-----------I-----------I-----------I-----------I
10,000 10,000 10,000 10,000 10,000
• The figures above refers to the present time.
• A cash flow that occurs at the time 0 is already in present value terms
and hence does not require any adjustment for time value of money.
• The cash flow that occurring at point 1 is the cash flow that occurs at
the end of period 1 (Part A)
• If the cash flow occurs at the beginning, rather than at the end, of
each year, the time line would be as shown in Part B of the above
figure.
• Cash flows can be positive or negative. A positive cash flow is called a
cash inflow, a negative cash flow, a cash outflow.
 PROCESS OF COMPOUNDING & DISCOUNTING
• Process of compounding:
 The process of investing money as well as reinvesting
the interest earned thereon is called compounding.
 For example: If the initial cash outflow of a project is
Rs. 10,000 and the inflow patterns are as flows
Year 1:Rs.2,500;Year 2 :Rs. 5,000; Year 3:Rs. 7,500
Year 4:Rs. 7,500.
 The future value of the initial outflow of Rs. 10,000 as
at the end of year 4 will be the sum of the future values
of the yearly cash inflows at the end of year 4.
PROCESS OF COMPOUNDING & DISCOUNTING
• Process of discounting:
 The process of discounting, used for calculating the
present value, is simply the inverse of
compounding.
 The method of discounting reckon the time value of
money now i.e. at time 0 on the time line.
 So, we will be comparing the initial outflow with the
sum of the present values ( PV ) of the future
inflows at a given rate of interest.
 FUTURE VALUE OF A SINGLE FLOW
• Suppose you invest Rs. 10,000 for three years in a savings
account that pays 10% interest per year. If you let your
interest income be reinvested, your investment will grow as
follows:
First year: Principal at the beginning 10,000

Interest for the year ( Rs. 10,000 x 0.10) 1,000

Principal at the end 11,000
Second year: Principal at the beginning 11,000
Interest for the year ( Rs. 11,000 x 0.10 ) 1,100
Principal at the end 12,100
Third year: Principal at the beginning 12,100
Interest for the year ( Rs. 12,100 x 0.10 ) 1,210
Principal at the end 13,310
 FUTURE VALUE OF A SINGLE FLOW
• The future value or compounded value of an investment after n
years when the interest rate r % is :
FVn = PV (1+ r )n
• In this equation ( 1+ r )n is called the future value interest factor or
simply the future value factor (FVIF – Future Value Interest Factor).
• To calculate the future value of any investment for a given value of
‘r’ and ‘n’, the corresponding value of (1+r) n from the table has to
be multiplied with the initial value.
DOUBLING PERIOD:
• Investors commonly ask the question: How long would it take to
double the amount at a given rate of interest ?
• To answer this question we may look at the future value interest
factor table.
 RULE OF 72 AND 69
• The above question can be answered by a rule known as
the rule of ‘72’.The doubling period is obtained by dividing
72 by the interest rate. For example, if the interest rate is
8%, the doubling period is about 9 years (72/8).
• If you are inclined to do a slightly more involved calculation,
a more accurate rule of thumb is the rule of 69. According
to this thumb rule, the doubling period is equal to:
69
0.35 + ---------------
Interest Rate
• As an illustration of this thumb rule, the doubling period is
calculated for two interest rates,10% and 15%.
BUSINESS APPLICATION OF FUTURE VALUE
FINDING THE GROWTH RATE:
The formula used to calculate future value is quite
general and it can be applied to answer other types
of questions related to growth. Suppose your
company currently has 5,000 employees and this
number is expected to grow by 5% per year. How
many employees will your company have in 10
years ? The number of employees 10 years hence
will be:
5,000 x (1.05)10 = 5,000 x 1.629 = 8,145
 FUTURE VALUE OF MULTIPLE FLOWS
Suppose we invest Rs. 10,000 now i.e. at the
beginning of year 1, Rs. 20,000 at the beginning of
year 2 and Rs. 30,000 at the beginning of year 3,
how much will these flows accumulate to at the end
of year 3 at a rate of interest of 12% p.a.?
FV(Rs.10,000) + FV(Rs. 20,000) + FV(Rs.30,000)
To determine the accumulation of multiple flows as
at the end of a specified time horizon, we have to
find the accumulations of each of these flows using
the appropriate FVIF and sum up these
accumulations
 FUTURE VALUE OF ANNUITY
• A annuity is a stream of constant cash flow (payment or
receipt) occurring at regular intervals of time for a finite
number of years.
• When the cash flows occur at the end of each period, the
annuity is called ordinary or deferred annuity.
• When the cash flows occur at the beginning of each period,
the annuity is called annuity due.
• The future value of an annuity is given by the formula:
FVAn = A ( 1+ r )n-1+A ( 1+ r)n-2 +…+A
= A [ ( 1 + r )n-1] / r
where FVAn = future value of an annuity which has a

duration of n periods.
A = constant periodic flow
r = interest rate per period
 FUTURE VALUE OF ANNUITY
• The term [ ( 1+r )n – 1] / r is referred to as the future
value interest factor for an annuity (FVIFAr,n).
• Suppose you deposit Rs. 1,000 annually in a bank
for 5 years and your deposits earn a compound
interest rate of 10%. What will be the value of this
series of deposits at the end of 5 years?
Rs. 1,000(1.10)4 + Rs. 1,000(1.10)3 + Rs.
1,000(1.10)2 + Rs. 1,000(1.10) + Rs. 1,000
= Rs. 1,000(1.464) + Rs. 1,000(1.331) +
Rs. 1,000(1.21) + Rs. 1,000(1.10) + Rs. 1,000
= Rs. 6,105
 APPLICATIONS

KNOWING WHAT LIES IN STORE FOR YOU:

Suppose you have decided to deposit Rs. 30,000 per
year in your PPF account for 30 years. What will be
the accumulated amount in your PPF account at
end of 30 years if the interest rate is 11% ?
The accumulated sum will be:
Rs. 30,000 ( FVIFA11%,30yrs)
= Rs. 30,000 { (1.11)30-1/0.11}
= Rs. 30,000 [ 199.02 ]
= Rs. 59,70,600
HOW MUCH SHOULD YOU SAVE ANNUALLY:
You want to buy a house after 5 years when it is expected to
cost Rs. 2 million. How much should you save annually if
your savings earn a compound return of 12 % ?
The future value interest factor for a 5 year annuity, given an
interest rate of 12% is:
FVIFA n=5,r = 12 % = ( 1 + 0.12 )5-1
0.12
= 6.353
The annual savings should be :
Rs. 20,00,000
6.353
= Rs. 3,14,812
ANNUAL DEPOSIT IN A SINKING FUND:
Roy Ltd. has an obligation to redeem Rs. 500 million
bonds 6 years hence. How much should the
company deposit annually in a sinking fund account
wherein it earns 14% interest to cumulate Rs. 500
million in 6 years time ?
FVIFA n=6,r =14% = ( 1 + 0.14 )6 -1
0.14
= 8.536
The annual sinking fund deposit should be :
Rs. 500 million
8.536
= Rs. 58.575 million
 PRESENT VALUE OF A SINGLE FLOW
• Suppose someone promises to give you Rs. 1,000 three
years hence. What is the present value of this amount if the
interest rate is 10 % ? The present value can be calculated
by discounting Rs. 1,000, to the present point of time, as
follows:
value three years hence = Rs. 1,000
value two years hence = Rs. 1,000 {1/ 1.10}
value one year hence = Rs. 1,000{1/1.10}{1/1.10}
value now = Rs. 1,000{1/1.10}{1/1.10}{1/1.10} =
₹ 750
 PRESENT VALUE OF A SINGLE FLOW
• The present value formula can be readily obtained
by manipulating the compounding formula:
FVn = PV ( 1 + r )n
or, PV = FVn [ 1/ ( 1+ r )n ]
• The factor 1/ ( 1 + r )n is called the discounting factor
or the present interest factor ( PVIFr,n)
 PRESENT VALUE OF AN ANNUITY
The present value of an annuity may be expressed as
follows:
A A A A
PVAn = ------- + ------- + --- + ---------- + -------
( 1 + r ) ( 1 + r )2 ( 1 + r )n-1 ( 1 + r )n
which reduces to

PVAn = A x [ ( 1 +r ) -1 ] =n
A x PVIFA r%, nyrs
--------------------- ]

r ( 1 + r )n
 PRESENT VALUE OF AN ANNUITY
• Suppose you expect to receive Rs. 1,000 annually for 3
years, each receipt occurring at the end of the year. What is
the present value of this stream of benefits if the discount
rate is 10% ? The present value is this annuity is simply the
sum of the present values of all the inflows of this annuity:
Rs. 1,000 { 1/1.10 } + Rs. 1,000 { 1/1.10 }2
+ Rs. 1,000 { 1/1.10 }3
= Rs. 1,000 x 0.9091 + Rs. 1,000 x 0.8264 + Rs. 1,000 x
0.7513
= Rs. 2,478.8
 APPLICATIONS
HOW MUCH CAN YOU BORROW FOR A CAR:
After Reviewing your budget, you have determined that you
can afford to pay Rs. 12,000 per month for 3 years toward a
new car. You call a finance company and learn that the going
rate of interest on car finance is 1.5% per month for 35
months. How much can you borrow ?
The present value interest factor of annuity is :
1 1
1- --------- 1- ------------
( 1+ r )n ( 1.015 )36
PVIFAr,n= ----------------- = ------------------- = 27.70
r .015
Hence the present value of 36 payments of Rs 12,000 each is:
Present Value = Rs 12,000 x 27.70 = Rs 3,32,400
PERIOD OF LOAN AMORTISATION:
You want to borrow Rs. 10,80,000 to buy a flat. You
approach a housing finance which charges 12.5%
interest. You can pay Rs. 1,80,000 per year toward
loan amortisation. What should be the maturity
period of the loan ?
1,80,000 x PVIFAn,r = 10,80,000
1,80,000 x PVIFA n=?,r = 12.5% =10,80,000
1
1 - ---------
(1.125 )n
= 1,80,000 x --------------- = 10,80,000
0.125
Given this equality the value of n is calculated as follows:
1
1- ------------
( 1.125 )n 10,80,000
---------------- = --------------- = 6
0.125 1,80,000
1
------------- = 4 or, 1.125n = 4
( 1.125 )n
n log 1.125 = log 4 or, n x 0.0512 = .6021
0.6021
n = ---------- = 11.76 years or 12 years
0.0512
 DETERMINING THE LOAN AMORTISATION
SCHEDULE:
Suppose a firm borrows Rs. 10,00,000 at an interest
rate of 15% and the loan is to be repaid in 5 equal
installments payable at the end of the next 5 years.
The annual installment payment A is obtained by
solving the following equation.
Loan amount = A x PVIFA n=5,r = 15%
10,00,000 = A x 3.3522
Hence A = 2,98,312
 PRESENT VALUE OF A PERPETUITY
• A perpetuity is an annuity of infinite duration. Hence, the
present value of a perpetuity may be expressed as follows:
P∞ = A x PVIFA r, ∞ = A x 1/r
where P∞ = present value of a perpetuity
A = constant annual payment
PVIFA r, ∞ = present value interest factor for a
perpetuity.
n 1 1
PVIFA r, ∞ ∑ ----------- = ----------

t = 1 ( 1 + r )t r
 MINICASE STUDY
 As an investment advisor, you have been approached by a
client called Soumen, who wants some help in investment
related matters.
 Soumen is currently 45 years old and has Rs. 6,00,000 in the
bank. He plans to work for 15 more years and retire at the
age of 60. Soumen’s present salary is Rs. 5,00,000 per year.
He expects his salary to increase at the rate of 12 % per year
until his retirement.
• Soumen has decided to invest his bank balance and future
savings in a balanced mutual fund scheme that he believes
will provide a return of 9 percent per year. You agree with his
assessment.
• Soumen seeks your help in answering several questions given
below. In answering these questions, ignore the tax factor.
i. Once he retires at the age of 60, he would like to
withdraw Rs. 8,00,000 per year for his consumption needs
from his investments for the following 15 years (He
expects to live upto the age of 75 years). Each annual
withdrawal will be made at the beginning of the year.
How much should be the value of his investments when
Soumen turns 60, to meet this retirement need?
ii. How much should Soumen save each year for the next 20
years to be able to withdraw Rs.8,00,000 per year from
the beginning of the 21st year ? Assume that the savings
will occur at the end of each year.
iii. Suppose Soumen wants to donate Rs. 5,00,000 per year in
the last 5 years of his life to a charitable cause. Each
donation would be made at the beginning of the year.
Further, he wants to bequeath Rs. 10,00,000 to his daughter
at the end of his life. How much should he have in his
investment account when he reaches the age of 60 to meet
this need for donation and bequeathing?
iv. Soumen is curious to find out the present value of his
lifetime salary income. For the sake of simplicity, assume
that his current salary of Rs. 5,00,000 will be paid exactly
one year from now, and his salary is paid annually. What is
the present value of his life time salary income, if the
discount rate applicable to the same is 7 percent?
Remember that Soumen expects his salary to increase at
the rate of 12 percent per year until retirement.