Financial Management

Unit 3

Unit 3

Time Value of Money

Structure: 3.1 Introduction Learning objectives Rationale 3.2 Future Value Time preference rate or required rate of return Compounding technique Discounting technique Future value of a single flow Doubling period Increased frequency of compounding Effective vs. Nominal rate of interest Future value of series of cash flows Future value of annuity Sinking fund 3.3 Present Value Discounting or present value of a single flow Present values of a series of cash flows Present values of perpetuity Present value of an uneven periodic sum Capital recovery factor 3.4 Summary 3.5 Solved Problems 3.6 Terminal Questions 3.7 Answers to SAQs and TQs

3.1 Introduction
In the previous unit, you have learnt that wealth maximisation is far more superior to profit maximisation. Wealth maximisation considers time value of money, which translates cash flows occurring at different periods into a comparable value at zero period. For example, a firm investing in fixed assets will reap the benefits of such investments for a number of years. However, if such assets are procured
Sikkim Manipal University Page No. 41

Financial Management

Unit 3

through bank borrowings or term loans from financial institutions, there is an obligation to pay interest and return of principle. Decisions, therefore, are made by comparing the cash inflows (benefits/returns) and cash outflows (outlays). Since these two components occur at different time periods, there should be a comparison between the two. In order to have a logical and a meaningful comparison between cash flows occurring over different intervals of time, it is necessary to convert the amounts to a common point of time. This unit is devoted to a discussion of techniques of doing so. 3.1.1 Learning objectives After studying this unit, you should be able to: Explain the time value of money Understand the valuation concepts Calculate the present and the future values of lump sums and annuity flows 3.1.2 Rationale Time value of money is the value of a unit of money at different time intervals. The value of the money received today is more than its value received at a later date. In other words, the value of money changes over a period of time. Since a rupee received today has more value, rational investors would prefer current receipts over future receipts. That is why, this phenomena is also referred to as Time preference of money. Some important factors contributing to this are: Investment opportunities Preference for consumption Risk These factors remind us of the famous English saying, A bird in hand is worth two in the bush. The question now is: why should money have time value? Some of the reasons are: Production Money can be employed productively to generate real returns. For example, if we spend Rs. 500 on materials, Rs. 300 on labour and
Sikkim Manipal University Page No. 42

Financial Management

Unit 3

Rs. 200 on other expenses and the finished product is sold for Rs. 1100, we can say that the investment of Rs. 1000 has fetched us a return of 10%. Inflation During periods of inflation, a rupee has higher purchasing power than a rupee in the future. Risk and uncertainty We all live under conditions of risk and uncertainty. As the future is characterised by uncertainty, individuals prefer current consumption over future consumption. Most people have subjective preference for present consumption either because of their current preferences or because of inflationary pressures.

3.2 Future Value

3.2.1 Time preference rate or required rate of return The time preference for money is generally expressed by an interest rate, which remains positive even in the absence of any risk. It is called the risk free rate. For example, if an individuals time preference is 8%, it implies that he is willing to forego Rs. 100 today to receive Rs. 108 after a period of one year. Thus he considers Rs. 100 and Rs. 108 as equivalent in value. In reality though this is not the only factor he considers. He requires another rate for compensating him for the amount of risk involved in such an investment. This risk is called the risk premium. Required rate of return = Risk free rate + Risk premium There are two methods by which the time value of money can be calculated: Compounding technique Discounting technique 3.2.1.1 Compounding technique
In the compounding technique, the future values of all cash inflows at the end of the time horizon at a particular rate of interest are calculated. The amount earned on an initial deposit becomes part of the principal at the end of the first compounding period. Sikkim Manipal University Page No. 43

Financial Management

Unit 3

The compounding of interest can be calculated by the following equation:

Where, A = Amount at the end of the period P = Principle at the end of the year i = Rate of interest n = Number of years
Example Mr. A invests Rs. 1,000 in a bank which offers him 5% interest compounded annually. Substituting the actual figures for the investment or Rs. 1000 in the formula
n

, we arrive at the values shown in table 3.1.

Table 3.1: Interest compounded annually Year Beginning amount Interest rate Amount of interest Beginning principal Ending principal 1 Rs.1000 5% 50 Rs.1000 Rs.1050 2 Rs.1050 5% 52.50 Rs.1050 Rs.1102.50 3 Rs.1102.50 5% 55.13 Rs.1102.50 Rs.1157.63

As seen from table 3.1, Mr. A has Rs. 1050 in his account at the end of the first year. The total of the interest and principal amount Rs. 1050 constitutes the principal for the next year. He thus earns Rs. 1102.50 for the second year. This becomes the principal for the third year. This compounding procedure will continue for an indefinite number of years. Let us now see how the values in table 3.1 are arrived at. Amount at the end of year 1 = Rs. 1000 (1+0.05) == Rs. 1050 Amount at the end of year 2 = Rs. 1050 (1+0.05) == Rs. 1102.50 Amount at the end of year 3 = Rs. 1102.50 (1+0.05) == Rs. 1157.63 The amount at the end of the second year can be ascertained by substituting Rs.1000 (1+0.05) for Rs.1050, that is, Rs.1000 (1+0.05) (1+0.05)=Rs.1102.50 Similarly, the amount at the end of the third year can be ascertained by substituting Rs.1000 (1+0.05) for Rs.1102.50, that is, Rs.1000 (1+0.05) (1+0.05) (1+0.05)=Rs.1157.63 Sikkim Manipal University Page No. 44

Financial Management

Unit 3

3.2.1.2 Discounting technique In the discounting technique, the present value of the future amount is determined. Time value of the money at time 0 on the time line is calculated. This technique is in contrast to the compounding approach where we convert the present amounts into future amounts. Solved Problem Mr.A requires Rs.1050 at the end of the first year. Given the rate of interest as 5%,find out how much Mr. A would invest today to earn this amount. Solution If P is the unknown amount, then P (1+0.05) =1050 P=1050/ (1+0.05) =Rs.1000 Thus Rs. 1000 would be the required principal investment to have Rs. 1050 at the end of the first year at 5% interest rate. The present value of the money is the reciprocal of the compounding value. Mathematically, we have

Where P is the present value for the future sum to be received, A is the sum to be received in future, i is the interest rate and n is the number of years.

3.2.2 Future value of a single flow (lump sum) The process of calculating future value will become very cumbersome if they have to be calculated over long maturity periods of 10 or 20 years. A generalised procedure of calculating the future value of a single cash flow compounded annually is as follows:

Sikkim Manipal University

Page No. 45

Financial Management

Unit 3

Where, FVn = future value of the initial flow in n years hence PV = initial cash flow i = annual rate of interest n = life of investment The expression ( 1 i)n represents the future value of the initial investment of Re. 1 at the end of n number of years. The interest rate i is referred to as the Future Value Interest Factor (FVIF). To help ease the calculations, the various combinations of i and n can be referred to in the table 3.1. To calculate the future value of any investment, the corresponding value of
(1 i)n from the table 3.1 is multiplied with the initial investment.

Solved Problem The fixed deposit scheme of a bank offers the interest rates, as shown in the table 3.2:
Table 3.2: Fixed deposit scheme of a bank Period of deposit <45 days 46 days to 179 days 180 days to 365 days 365 days and above Rate per annum 9% 10% 10.5% 11%

What will be the status of Rs. 10, 000 after three years, if it is invested at this point of time? Solution FVn = PV (1+i)n or PV*FVIF (11%, 3y) = 10000*1.368 (from the tables) = Rs.13, 680 The status of Rs. 10, 000 after three years, if it is invested at this point of time, would be Rs.13, 680. 3.2.2.1 Doubling period A very common question arising in the minds of an investor is how long will it take for the amount invested to double for a given rate of interest. There are 2 ways of answering this question.
Sikkim Manipal University Page No. 46

Financial Management

Unit 3

1. One is called rule of 72. This rule states that the period within which the amount doubles is obtained by dividing 72 by the rate of interest. For instance, if the given rate of interest is 10%, the doubling period is 72/10, that is, 7.2 years. 2. A much accurate way of calculating doubling period is the rule of 69, which is expressed as 0.35+69/interest rate. Going by the same example given above, we get the number of years as 7.25 years {0.35 + 69/10 (0.35 +6.9)}.
3.2.2.2 Increased frequency of compounding

So far we have seen the calculation of the time value of money. It has been assumed that the compounding is done annually. Let us now see the effect on interest earned when compounding is done more frequently - half-yearly or quarterly Example If we have deposited Rs.10, 000 in a bank which offers 10% interest per annum compounded semi-annually, the interest earned is as shown in table 3.3.
Table 3.3: Interest earned Amount invested Interest earned for first 6 months 10000*10%*1/2 (for 6 months) Amount at the end of 6 months Interest earned for second 6 months 105000*10%*1/2 Amount at the end of the year Rs.10,000 Rs.500 Rs.10,500 Rs.525 Rs.11,025

If in the above case, compounding is done only once in a year the interest earned will be 10000*10% which is equal to Rs. 1000 and we will have Rs. 11000 at the end of first year.
Going by the calculations, we see that one gets more interest if compounding is done on a more frequent basis. The generalised formula for shorter compounding periods is:

Sikkim Manipal University

Page No. 47

Financial Management

Unit 3

Where, FVn = future value after n years PV = cash flow today i = nominal interest rate per annum m = number of times compounding is done during a year n = number of years for which compounding is done

Solved Problem Under the ABC Banks Cash Multiplier Scheme, deposits can be made for periods ranging from 3 months to 5 years. Every quarter, interest is added to the principal. The applicable rate of interest is 9% for deposits less than 23 months and 10% for periods more than 24 months. What will the amount of Rs. 1000 today be after 2 years? Solution

m = 12/3 = 4 (quarterly compounding) 1000 (1+0.10/4)4*2 1000 (1+0.10/4)8 Rs. 1218 The amount of Rs. 1000 after years would be Rs. 1218 3.2.2.3 Effective vs. Nominal rate of interest We have just learnt that interest accumulation by frequent compounding is much more than the annual compounding. This means that the rate of interest given to us, that is 10% is the nominal rate of interest per annum. If the compounding is done more frequently, say semi-annually, the principal amount grows at 10.25% per annum. 0.25% is known as the Effective Rate of Interest. The general relationship between the effective and nominal rates of interest is as follows: Where, r = Effective rate of interest i = Nominal rate of interest m= number of time compounding is done during the year m = Frequency of compounding per year.
Sikkim Manipal University Page No. 48

Financial Management

Unit 3

Solved Problem

Calculate the effective rate of interest if the nominal rate of interest is 12% and interest is compounded quarterly.
Solution:

m= 12/3 =4 (quarterly compounding) r = {(1+0.12/4)4}-1 r=0.126 or 12.6% p.a. The effective rate of interest is 12.6% p.a. 3.2.3 Future value of series of cash flows An investor may be interested in investing money in instalments and wish to know the value of his savings after n years. Let us understand the calculation of the same with the help of a solved problem.
Solved Problem Mr. Madan invests Rs. 500, Rs. 1000, Rs. 1500, Rs.2000 and Rs. 2500 at the end of each year for 5 years. Calculate the value at the end of 5 years compounded annually if the rate of interest is 5% p.a. Solution The value at the end of 5 years, compounded annually at a rate of interest of 5% per annum, is calculated in the table 3.4 Table 3.4: Future value of series of cash flows
End of year Amount invested (Rs) Number of years compounded Compounded interest factors from tables FV in Rs.

1 2 3 4 5

500 1000 1500 2000

4 3 2 1

1.216 1.158 1.103 1.050

608 1158 1654 2100 2500 Rs.8020

2500 0 1.000 Amount at the end of the fifth year

The value at the end of the fifth year is Rs. 8020

Sikkim Manipal University

Page No. 49

Financial Management

Unit 3

3.2.4 Future value of an annuity Annuity refers to the periodic flows of equal amounts. These flows can be either termed as receipts or payments. Example If you have subscribed to the Recurring Deposit Scheme of a bank requiring you to pay Rs. 5000 annually for 10 years, this stream of payouts can be called Annuities. Annuities require calculations based on regular periodic contribution of a fixed sum of money. The future value of a regular annuity for a period of n years at i rate of interest can be summed up as under:

Where, FVAn = Accumulation at the end of n years i = Rate of interest n = Time horizon or no. of years A = Amount invested at the end of every year for n years The expression (1 i)n 1) / i) is called the Future Value Interest Factor for Annuity (FVIFA). This represents the accumulation of Re.1 invested at the end of every year for n number of years at i rate of interest. From the tables 3.4 and 3.5, different combinations of i and n can be calculated. We just have to multiply the relevant value with A and get the accumulation in the formula given above.

Sikkim Manipal University

Page No. 50

Financial Management

Unit 3

Solved Problem Mr. Ram Kumar deposits Rs. 3000 at the end of every year for five years into his account. Interest is being compounded annually at a rate of 5%. Determine the amount of money he will have at the end of the fifth year. Solution The amount of money Mr. Ram Kumar will have at the end of the fifth year is calculated from the table 3.5.
Table 3.5: Computation of future value of annuity
End of year 1 2 3 4 5 Amount invested (Rs) 2000 2000 2000 2000 2000 Number of years compounded 4 3 2 1 0 Compounded interest factors from tables 1.216 1.158 1.103 1.050 1.000 FV in Rs.

2432 2316 2206 2100 2000 11054

Amount at the end of the fifth year

OR Refer FVIFA table to compute the value at the end of 5th year: = 2000 * FVIFA (5%, 5y) = 2000 * 5.526 = Rs. 11052

We notice that we can get the accumulations at the end of n period using the tables. Calculations for a long time horizon are easily done with the help of reference tables. Annuity tables are widely used in the field of investment banking as ready beckoners.

Sikkim Manipal University

Page No. 51

Financial Management

Unit 3

Solved Problem Calculate the value of an annuity flow of Rs.5000 done on a yearly basis of five years, yielding at an interest of 8% p.a. Solution

= 5000 FVIFA (8%, 5y) = 5000* 5.867 = Rs. 29335 The value of annuity flow is Rs. 29,335.

3.2.5 Sinking fund

Sinking fund is a fund which is created out of fixed payments each period, to accumulate for a future sum after a specified period.
The sinking fund factor is useful in determining the annual amount to be put in a fund, to repay bonds or debentures or to purchase a fixed asset or a property at the end of a specified period.

is called the Sinking Fund Factor. Example: Manas Limited has an obligation to redeem Rs.50,00,000 debentures 6 years hence. How much should the company deposit annually in the sinking fund account yielding 14 percent interest to cumulate Rs.50,00,000 six years from now? Solution: n=6 years, r= 14%, Accumulated sum = 50,00,000 Annual sinking fund deposit should be: A= 50,00,000 FVIFA (14%, 6yrs) Referring FVIFA table the factor is 8.536 = 50,00,000 8.536 = Rs.5,85,754

Sikkim Manipal University

Page No. 52

Financial Management

Unit 3

Self Assessment Questions Fill in the blanks 1. The important factors contributing to time value of money are __________, ________________ and _______. 2. During periods of inflation, a rupee has a ___than a rupee in future. 3. As future is characterised by uncertainty, individuals prefer _________ consumption to __________ consumption. 4. There are two methods by which time value of money can be calculated by _________ and _________ techniques.

3.3 Present Value

Given the interest rate, compounding technique can be used to compare the cash flows separated by more than one time period. With this technique, the amount of present cash can be converted into an amount of cash of equivalent value in future. Likewise, we may be interested in converting the future cash flows into their present values. The Present Value (PV) of a future cash flow is the amount of the current cash that is equivalent to the investor. The process of determining present value of a future payment or a series of future payments is known as discounting. 3.3.1 Discounting or present value of a single flow
We can determine the PV of a future cash flow or a stream of future cash flows using the formula:

Where, PV = Present Value FVn = Amount i = Interest rate n = Number of years

Sikkim Manipal University

Page No. 53

Financial Management

Unit 3

Solved Problem If Ms. Sapna expects to have an amount of Rs. 1000 after one year what should be the amount she has to invest today, if the bank is offering 10% interest rate? Solution = 1000/(1+0.10)1 = Rs. 909.09
The same can be calculated with the help of tables.

= 1000*PVIF (10%, 1y) = 1000*0.909 = Rs. 909 The amount to be invested today to have an amount of Rs, 1000 after one year is Rs. 909.

Solved Problem An investor wants to find out the value of an amount of Rs. 10,000 to be received after 15 years. The interest offered by bank is 9%. Calculate the PV of this amount. Solution or 100000 PVIF (9%, 15y) = 100000*0.275 = Rs. 27500 The PV of Rs. 10, 000 is Rs. 27,500.

3.3.2 Present value of a series of cash flows

In a business scenario, the businessman will receive periodic amounts (annuity) for a certain number of years. An investment done today will fetch him returns spread over a period of time. He would like to know if it is worthwhile to invest a certain sum now in anticipation of returns he expects after a certain number of years. He should therefore equate the anticipated future returns to the present sum he is willing to

Sikkim Manipal University

Page No. 54

Financial Management

Unit 3

forego. The PV of a series of cash flows can be represented by the following formula:

The above formula or the equation reduces to:

The expression {(1 i)n 1/ i (1 i)n }

is known as Present Value Interest

Factor Annuity (PVIFA). It represents the PVIFA of Re. 1 for the given values of i and n. The values of PVIFA (i, n) can be found out from the Table 3.6. It should be noted that these values are true only if the cash flows are equal and the flows occur at the end of every year.

Solved Problem Calculate the PV of an annuity of Rs. 500 received annually for four years, when discounting factor is 10%. Solution The present value of annuity can be calculated from the table 3.6 as shown under:
Table 3.6: Computation of PV of annuity End of year 1 2 3 4 Cash inflows Rs.500 Rs.500 Rs.500 Rs.500 PV factor 0.909 0.827 0.751 0.683 3.170 PV in Rs. 454.5 413.5 375.5 341.5 1585.0

Present value of an annuity is Rs.1585. OR By directly looking at the table we can calculate:
Sikkim Manipal University Page No. 55

Financial Management

Unit 3

= 500*PVIFA (10%, 4y) = 500*3.170 = Rs. 1585 The present value of annuity is Rs. 1585.

Solved Problem Find out the present value of an annuity of Rs. 10000 over 3 years when discounted at 5%. Solution Present value of annuity = 10000*PVIFA (5%, 3y) = 10000*2.773 = Rs. 27730 Hence, the present value of annuity is Rs. 27,730.

3.3.3 Present value of perpetuity An annuity for an infinite time period is perpetuity. It occurs indefinitely. A person may like to find out the present value of his investment assuming he will receive a constant return year after year. The PV of perpetuity is calculated as:

Solved Problem The principal of a college wants to institute a scholarship of Rs. 5000 for a meritorious student every year. Find out the PV of investment which would yield Rs. 5000 in perpetuity, discounted at 10%. Solution = 5000/0.10 = Rs. 50000 This means he should invest Rs. 50000 to get an annual return of Rs. 5000.
Sikkim Manipal University Page No. 56

Financial Management

Unit 3

3.3.4 Present value of an uneven periodic sum In some investment decisions of a firm, the returns may not be constant. In such cases, the PV is calculated as follows.

Or PV= A1 PVIF (i, 1) + A2 PVIF (i, 2) + A3 PVIF (i, 3) + A4 PVIF (i, 4) +... + An PVIF (i, n) Solved Problem An investor will receive Rs. 10000, Rs. 15000, Rs. 8000, Rs. 11000 and Rs. 4000 respectively at the end of each of five years. Find out the present value of this stream of uneven cash flows, if the investors interest rate is 8%. Solution PV= 10000/ (1+0.08) +15000/ (1+0.08)2+8000/ (1+0.08)3+11000/ (1+0.08)4+4000/ (1+0.08)5 =Rs.39276 Or by referring table we can compute PV =10000 PVIF(8%,1yr)+15000 PVIF(8%,2yrs)+ 8000 PVIF(8%,3yrs)+ 11000 PVIF(8%,4yrs)+4000 PVIF(8%,5yrs) = 10000*0.926+15000*0.857+8000*0.794+11000*0.735+4000*0.681 = 9260+ 12855 + 6352 +8085 + 2724 = Rs.39,276 The present value of this stream of uneven cash flows is Rs. 39,276

3.3.5 Capital Recovery Factor Capital recovery factor is the annuity of an investment for a specified time at a given rate of interest. The reciprocal of the present value annuity factor is called capital recovery factor.

Sikkim Manipal University

Page No. 57

Financial Management

Unit 3

is known as the Capital Recovery Factor. Solved Problem A loan of Rs. 100000 is to be repaid in 5 equal annual instalments. If the loan carries a rate of 14% p.a, what is the amount of each instalment? Solution Instalment*PVIFA (14%, 5) = 100000 Instalment=100000/3.433 = Rs. 29128. The amount of each instalment has been calculated.

Self Assessment Questions Fill in the blanks 5. _________________ is created out of fixed payments each period to accumulate for a future sum after a specified period. 6. The ________________ of a future cash flow is the amount of the current cash that is equivalent to the investor. 7. An annuity for an infinite time period is called ______________. 8. The reciprocal of the present value annuity factor is called __________.

3.4 Summary
Money has time preference. A rupee in hand today is more valuable than a rupee a year later. Individuals prefer possession of cash now rather than at a future point of time. Therefore cash flows occurring at different points in time cannot be compared. Interest rate gives money its value and facilitates comparison of cash flows occurring at different periods of time. Compounding and discounting are two methods used to calculate the time value of money.

Sikkim Manipal University

Page No. 58

Financial Management

Unit 3

3.5 Solved Problems

1. What is the future value of a regular annuity of Re. 1.00 earning a rate of 12% interest p.a. for 5 years?

Solution:

FVAn = A * FVIFA (12%,5yrs) = 1*FVIFA (12%, 5y) = 1*6.353 = Rs. 6.353

2. If a borrower promises to pay Rs.20000 eight years from now in return for a loan of Rs.12550 today, what is the annual interest being offered?

Solution: PV = A * PVIF(r%,8 yrs) 12550 = 20000*PVIF (r%, 8yrs) 12550/20000 = PVIF (r%,8yrs) 0.627 = PVIF (r%,8yrs) Refer PVIF table and search for 0.627 in the 8th year row. You can identify this number under 6% column. Hence the annual interest (r) = 6%

3. A loan of Rs. 500000 is to be repaid in 10 equal instalments. If the loan carries 12% interest p.a. what is the value of one instalment?

Solution: PV = A*PVIFA (12%, 10y) 500000 = A *5.650 500000/5.650 = A Rs. 88492 = A (instalment amount)

Sikkim Manipal University

Page No. 59

Financial Management

Unit 3

4. A person deposits Rs. 25000 in a bank that pays 6% interest half-yearly. Calculate the amount at the end of 3 years

Solution : I /m= 6% ; m= 2 ; n=3 yrs 25000*(1+0.06)3*2 = 25000*1.194 = Rs. 29850

5. Find the present value of Rs. 100000 receivable after 10 years if 10% is the time preference for money

Solution: Refer PVIF table (10%,10yrs) PV =100000*(0.386) = Rs. 38600

3.6 Terminal Questions

1. If you deposit Rs.10000 today in a bank that offers 8% interest, how many years will the amount take to double? 2. An employee of a bank deposits Rs. 30000 into his PF A/c at the end of each year for 20 years. What is the amount he will accumulate in his PF at the end of 20 years, if the rate of interest given by PF authorities is 9%? 3. A person can save _____________ annually to accumulate Rs. 400000 by the end of 10 years, if the saving earns 12% 4. Mr. Vinod has to receive Rs. 20000 per year for 5 years. Calculate the present value of the annuity assuming he can earn interest on his investment at 10% per annum
Sikkim Manipal University Page No. 60

Financial Management

Unit 3

5. Aparna invests Rs. 5000 at the end of each year at 10% interest p.a. What is the amount she will receive after 4 years?

3.7 Answers to SAQs and TQs

Answers to Self Assessment Questions

1. 2. 3. 4. 5. 6. 7. 8.

Investment opportunities, preference for consumption, risk Higher purchasing power Current and future Compounding and discounting Sinking fund Present Value Perpetuity Capital Recovery Factor

Answers to Terminal Questions 1. 2. 3. 4. 5. 9 years (using rule of 72); 8.975 years (using rule of 69) 30000*FVIFA (9%, 20Y) = 30000*51.160 = Rs. 1534800 A*FVIFA (12%, 10y) = 400000 which is 400000/17.549 = Rs. 22795 20000*PVIFA (105, 5y)=20000*3.791 = Rs. 75820 5000*FVIFA (10%, 4y) = 5000*6.105 = Rs. 23205

Sikkim Manipal University

Page No. 61