Time Value of Money

Coverage
• Understanding the basics about time value of money
• Calculating the future value and present value of different
type of cash flows
• Understanding the difference between effective annual
rate and annual percentage rate
• To be able to prepare a loan amortization schedule and
calculate the amount of outstanding loan at any point
during the period.
 Some Terminologies
• Time value of money
• Single Amount, Annuity and Perpetuity
• Time line of cash flows
• Future Value (FV) and Present Value (PV)
 Examples for Time line
1. 10 year insurance policy with an annual premium of ₹5000
0 1 2 3 4 5 6 7 8 9 10
I____I____I_____I____I____I____I____I____I____I_____I
-5 -5 -5 -5 -5 -5 -5 -5 -5 -5
2. 13 year insurance policy with an annual premium of ₹5000 for 10
years and cash back of ₹ 10000 every year at the end of 11th, 12th
and 13th year.
0 1 2 3 4 5 6 7 8 9 10 11 12 13
I____I____I_____I____I____I____I____I____I___I___I___I___I___I
-5 -5 -5 -5 -5 -5 -5 -5 -5 -5 10 10 10
• You want to borrow from the bank ₹10,00,000 for 3 years.
There are three possible options for repayment,
1. At the end of 3 years pay ₹12,00,000
2. Pay interest every year @ 10% and repay ₹ 10,00,000 at the
end of 3 years
3. Pay equal annual instalment of ₹3,75,000
 PV & FV of single cash flows
1. Suppose you have an option of buying a piece of land in
Sanquelim town for ₹ 10,00,000. The broker tells you that
after two years you will be able to sell it for ₹ 12,50,000.
The applicable interest rate is 8%. Should you invest in
this piece of land?
-10,00,000 12,50,000
I________ I _________I
time 0 1 2
• PV= 12,50,000/(1.08)^2 = ₹10,71,673.5 (discounting)
• FV= 10,00,000x(1.08)^2 = ₹11,66,400 (compounding)
 PV & FV of Multi-period
Cash Flows
2. Suppose you want to keep aside a certain amount to be
able to study further after 5 years. You expect you will need
Rs. 20,00,000. What is the amount that you should put
aside @ 8% interest rate.
20,00,000

I____ I ____ I ____ I _____I_____ I

0 1 2 3 4 5

• PV= 20,00,000/(1+8%)^5 = Rs. 13,61,166

 PV & FV of single cash flows
Formulae
• PV = FV/(1+ r)t
Present value can be calculated by discounting
the future value.
PVIF= PV Interest Factor = 1/ (1+ r)t

• FV = PV x (1+ r)t
Future value can be calculated by compounding
the present value.
FVIF = Future Value Interest Factor = (1+ r)t
 Practice
3. Wilkinson Co. has identified an investment project
with the following cash flows. If the discount rate is
10 percent, what is the present value of these cash
flows?

Year Cash Flow ($)

1 675
2 880
3 985
4 1530
 Practice- solution

I____ I ____ I ____ I _____I

0 1 2 3 4
675 880 985 1530

• 675/(1.10)

• 880/(1.1)^2
• 985/(1.1)^3

• 1530/(1.1)^4
• 613.63+727.27+740.05+1045.01 = 3125.96
 Increased Frequency of Compounding
• Interest is calculated more than once in a year.
• eg. For Semi-annual compounding interest is calculated
twice, for quarterly four times, for monthly 12 times.

• PV = FV/(1+ r/m)txm FV = PV x (1+ r/m)txm

• Where m= frequency of Compounding

 Increased frequency of Compounding

4. Suppose you want to keep aside a certain amount to be

able to study further after 5 years. You expect you will need
Rs. 20,00,000. What is the amount that you should put
aside @ 8% interest rate compounded semi-annually?

20,00,000

I____ I ____ I ____ I ____ I_____ I

0 1 2 3 4 5

• PV= 20,00,000/(1+4%)10 = Rs. 13,51,128

 Increased Frequency of Compounding

5. Wilkinson Co. has identified an investment project with

the following cash flows. If the discount rate is 10 percent
and compounding is done semi-annually (or monthly), what
is the present value of these cash flows?
Year Cash Flow ($)
1 675
2 880
3 985
4 1530
 Practice- solution
I____ I ____ I ____ I _____I
0 1 2 3 4
675 880 985 1530

• 675/(1.05)2

• 880/(1.05)4
• 985/(1.05)6

• 1530/(1.05)8
• 612.245+723.98+735.02+1035.56 = 3106.805
 Practice- solution

I____ I ____ I ____ I _____I

0 1 2 3 4
675 880 985 1530

• 675/(1.0083)12

• 880/(1.0083)24
• 985/(1.0083)36

• 1530/(1.0083)48
• 611.26+721.65+731.48+1028.92 = 3093.31
 Effective Interest Rate
• Effective Interest Rate = (1+r/m)m - 1
where r = Annual Percentage Rate

Frequency Annual Effective

Percentage Rate Annual Rate
(APR) (EAR)
Annual 10% 10%
Semi-annual 10% 10.25%
Monthly 10% 10.47%
Daily 10% 10.5156%
 Calculating the APR & EAR
6. Fill in the blanks
APR Frequency of EAR
Compounding
6.2% Quarterly 6.346%
7.5% Semi-Annually 7.64%
8.7% Annually 8.7%
9.5% Daily 9.965%
12.22% Monthly 12.93%
 ANNUITY

An annuity is a constant cash flow that occurs at

regular intervals for a fixed period of time. Defining A
as the annuity amount, the time line for annuity will be
as follows:

0 1 2 3 4 n
I_____|_____|_____|_____|__...___I
A A A A A
 PV of end-of-the-period annuity
• PV(Annuity) = A x { (1- (1+r)-n)}
r
Where,
A = Annuity Amount
r = discount rate and
n = no. of years/periods

Note: Using this formula gives you value of the annuity at the end of the
year prior to the first annuity amount.
 PV of Annuity
7. Suppose you have an option of buying a piece of land in
Sanquelim town for ₹ 10,00,000. Or you can buy it by paying
6,00,000 after 1 year and another 6,00,000 at the end of two years.
The applicable interest rate is 8%. Which option should you select?
0 1 2
I______|_____|
-6 -6
0 1 2
I______|_____|
-10
PV = 6,00,000 x ((1-(1.08)-2)) = ₹ 10,69,958
0.08
 Annuity practice sums
8. Investment X offers to pay you $3,900 per year for nine
years, whereas Investment Y offers to pay you $6,100 per
year for five years. Which of these cash flow streams has
the higher present value if the discount rate is 5 percent? If
the discount rate is 22 percent?
0 1 2 3 4 5 6 7 8 9
• I___I___I___I___I___I___I___I___I___I
3900 3900 3900 3900
0 1 2 3 4 5
• I___I___I___I___I___I
6100 6100 6100 6100
X@5%: PVA = $3,900 x [1 – (1.05)-9 ] = $27,720.50
0.05
Y@5%: PVA = $6,100 x [1 – (1.05)-5 ] = $26,409.81
0.05
And at an interest rate of 22 percent:
X@22%: PVA = $3,900{[1 – (1.22)-9 ] = $14,766.51
0.05
Y@22%: PVA = $6,100{[1 – (1.22)-5 ] = $17,468.2
0.05
 PV of Multiple annuities
9. Suppose you are pension fund consultant to XYZ
company and are trying to estimate the present value of its
expected pension fund obligations, which are as follows:
Years Annual Cash Flow
1 to 5 200 mn $
6 to 10 300 mn $
11 to 20 400 mn $
• Assume a discount rate of 10%.
 0 1 2 3 4 5
• I____I____I____I____I____I
200 200 200 200 200
0 1 2 3 4 5 6 7 8 9 10
• I____I____I____I____I____I____I____I____I____I____I
300 300 300 300 300
0 1 10 11 12 13 14 15 16 17 20
• I____I_...__I____I____I____I____I____I____I____I_...___I
400 400 400 400 400 400 400 400
• PV of 1st cash flow = 200x(1-(1+10%)-5)/10% = 758.16

• PV of 2nd cash flow at the end of the 5th year

= 300x(1-(1+10%)-5)= 1137.24
0.05
• PV of 2nd cash flow today = 1137.24 = 706.1
(1.10)5
• PV of 3rd Cash flow at the end of 10th year
= 400x(1-(1+10%)-10) = 2457.83
0.1
• PV of 3rd Cash flow today = 2457.83 = 947.6
(1.1)10
• Total Liability = 758.16+706.13+947.6 = 2411.89
 Loan repayment
10. Suppose you are planning to take a housing loan of
₹30,00,000 for 15 years. Calculate your equal annual
instalment assuming an annual interest rate of 8%. Prepare
a loan amortisation schedule.
0 1 2 3 4 5 6 7 8 14 15
• I____I____I____I____I____I____I____I____I_...___I____I
3000 -EAI –EAI -EAI -EAI -EAI
• EAI = PV x (r/(1-(1+r)-n ))
= 30,00,000 x (0.08/(1-(1.08)-15 )) = ₹ 350,467.3
Loan Amortization Schedule
Outstanding Outstanding
Loan Amount Loan Amount
Period (beg. Per) EMI Interest Principal (end Per)
0 3000000.00 0.00 0.00 0.00 3000000.00
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15 0.00
Loan Amortisation schedule
Outstanding Outstanding
Loan Amount Loan Amount
Period (beg. Per) EMI Interest Principal (end Per)
0 3000000.00 0.00 0.00 0.00 3000000.00
1 3000000.00 350488.63 240000.00 110488.63 2889511.37
2 2889511.37 350488.63 231160.91 119327.73 2770183.64
3 2770183.64 350488.63 221614.69 128873.94 2641309.70
4 2641309.70 350488.63 211304.78 139183.86 2502125.84
5 2502125.84 350488.63 200170.07 150318.57 2351807.27
6 2351807.27 350488.63 188144.58 162344.05 2189463.22
7 2189463.22 350488.63 175157.06 175331.58 2014131.64
8 2014131.64 350488.63 161130.53 189358.10 1824773.53
9 1824773.53 350488.63 145981.88 204506.75 1620266.78
10 1620266.78 350488.63 129621.34 220867.29 1399399.49
11 1399399.49 350488.63 111951.96 238536.68 1160862.81
12 1160862.81 350488.63 92869.03 257619.61 903243.20
13 903243.20 350488.63 72259.46 278229.18 625014.03
14 625014.03 350488.63 50001.12 300487.51 324526.51
15 324526.51 350488.63 25962.12 324526.51 0.00
 Changes in Interest rate
• 1% change in interest rate after
– 2 years results in the term of the loan increasing by 18 months.
– 10 years results in the term of the loan increasing by 2 months.
1% change in interest rate after 2 years 1% change in interest rate after 10 years
35,000.00 35,000.00
30,000.00 30,000.00
25,000.00 25,000.00
20,000.00 20,000.00
15,000.00 15,000.00
10,000.00 10,000.00
5,000.00 5,000.00
0.00 0.00
1

19
28

46
55
64
73
82
91
10

37

100
109
118

136
145

163
172
127

154

1
9
17
25

41
49
57
65
73
81

97
33

89

105
113
121
129
137

153
161
169
177
145
 Loan Repayment - Practice
11. Audrey Sanborn has just arranged to purchase a
$650,000 vacation home in the Bahamas with a 20 percent
down payment. The mortgage has a 5.2 percent APR,
compounded monthly, and calls for equal monthly
payments over the next 30 years. Her first payment will be
due one month from now. However, the mortgage has an
eight-year balloon payment, meaning that the balance of
the loan must be paid off at the end of Year 8. There were
no other transaction costs or finance charges. How much
will Audrey's balloon payment be in eight years?
• The amount borrowed is the value of the home times one
minus the down payment, or:
Amount borrowed = $650,000(1 – .20)
Amount borrowed = $520,000
The time line is:
0 1 2 3 4 47 48 359 360
I____I____I____I____I__....__I____I_...__I____I
520,000 A A A A A A A A
• EMI = 520000 x ((.0043)/(1-(1.0043)-360 ))
= $ 2842.55

Balloon Payment at the end of 8 years = the present value

of the remaining EMI i.e 360 - 96 = 264
PV = 2842.55 x (1-(1.0043)-264 )
0.0043
= $ 448,104.28
 Future value of end-of-the period annuities

• FVA = A x ((1+r)n-1)
r
Where, A =Amount of Annuity, r = Annual Interest Rate
and n = number of years
0 1 2 3 4 n
I_____|_____|_____|_____|__...___I
A A A A A
Note: Using this formula gives you value of the annuity at the end of the year
of the last annuity amount.
 Individual Retirement accounts
12. Suppose under a pension plan, you have to invest ₹100,000 every
year till the age of 65, when you get a lump sum amount. The annual
interest rate under the plan is 8%. If you enter into this plan at the age
of 26 years and invest for 40 years till the age of 65. What will the lump
sum amount that you will get at the age of 65. Assume that the income
under this plan is exempted under the Income Tax Act.

• Assume that you do not want the lump sum amount but you are
looking at getting an annual amount for the rest of your life. Calculate
the annual amount. You expect to live for 30 years after your
retirement. Assuming no taxes and that the first annual amount
comes at the end of the 66th year.
 25 26 27 28 29 64 65
I____I____I____I____I__....__I____I
100 100 100 100 100 100

• FV= 100000 x ((1.0840)-1)

0.08

= 25,905,651.87
 65 66 67 68 69 94 95
I____I____I____I____I__....__I____I
A A A A A A

• A = 25,905,652 x (0.08)
(1-(1.08)-30 )

= 2,301,190.5
 Annuities at the beginning of the year
(Annuity Due)
0 1 2 3 4 5
I_____|_____|_____|_____|_____I
A A A A A

0 1 2 3 4 5
I_____|_____|_____|_____|_____I
A A A A A
PV(Annuity) = A + A x (1- (1+r)-(n-1) ) FVA = A(1+r) x ((1+r)n – 1)
r r
• Individual Retirement Account question assuming
beginning of the year investments: ₹ 27,978,104.02
 Credit Card debt
13. You decide to buy an iphone 13 pro and need ₹100,000
for the same. You do not have the money. However, you
have a credit card. You decide to take a loan on the credit
card. You feel that you will be able to pay ₹4000 per month
towards this debt. The interest charged by the credit card
company per month is 3%. In how much time will you be
able to repay this debt?
• 100000 = 4000 x (1- (1.03)-n )
0.03
-n x ln(1.03)=ln (0.25) Ans.: 47 months
Credit card debt repayment options

No. of Total Interest

months EMI paid

31 5000 54994.64

38 4500 67260.83

47 4000 87603.50

66 3500 130418.63
 Growing Annuity
A growing annuity is a cash flow that grows at a constant rate for a
specified period of time.
If A is the current cash flow, and g the expected growth rate, the time
line for growing annuity will be:
0 1 2 3 4 5
I________|________|________|________|________I
A A(1+g)1 A(1+g)2 A(1+g)3 A(1+g)4

PV (growing annuity) = A1 x (1-((1+g)n(1+r)-n ))

(r-g)
 Perpetuity And growing perpetuity
Perpetuity is a constant cash flow at a regular interval forever.
0 1 2 3 4 ∞
I________|________|________|________|___......_____I
A A A A A
PV∞ = A/r
A growing perpetuity is a cash flow expected to grow at a constant rate
forever.
0 1 2 3 4 ∞
I________|________|________|________|___......_____I
A A(1+g)1 A(1+g)2 A(1+g)3 A(1+g)∞
PV of growing perpetuity = A1/(r-g)
 Growing Annuity
14. Your current basic annual salary is ₹ 10,00,000 which is
expected to go up by 7% per annum averagely. The first increment
is due in year 1. You expect to continue working with the
organisation for the next 5 years. The employer’s contribution to
PF is 12% of the basic. Find the present value of the employer’s PF
contribution assuming a discounting rate of 8%.
0 1 2 3 4 5
I_____|_____|_____|_____|_____I
120(1.07) 120(1.07)3 120(1.07)5
PV =120 x1.07x (1-((1.07)5 x (1.08)-5) ) = ₹ 583537.67
(0.08-0.07)
 Valuing a stock with stable growth in dividends
15. Company XYZ Ltd. has paid a dividend of ₹ 20 per share for the
year ending March 2021. It plans to maintain a constant dividend
payout. The company has been growing at a rate of 6% for the last
five years and is expected to continue to do so in the long term. The
rate of return required by the investors on the stocks of similar risk is
15%. Calculate the value of the stock as of April 2021.

0 1 2 3 4 ∞
I________|________|________|________|___......_____I
A A(1+g)1 A(1+g)2 A(1+g)3 A(1+g)∞
PV of growing perpetuity = A1/(r-g) = 21.2 /(0.15-0.06)
Ans.: ₹ 235.56
 Sinking fund provisions on the bond
XYZ ltd. has bonds with a face value of $100 mn coming due in
10 years. Assuming an interest rate of 8%, calculate the
amount that the company needs to keep aside every year so
that there are enough funds to retire the bonds at maturity.
0 1 2 3 4 5 6 7 8 9 10
I____I____I____I____I____I____I____I____I____I____I
100
100 = A x ((1.08)10-1)
0.08
Sinking Fund Provision each year = $ 6,902,950
 PV= FV/(1+r)n

PV = A x { (1- (1+r)-n)} PV FV = PV x (1+r)n

r
FV

Increased frequency
FVA = A x ((1+r)n-1) SINGLE of Compounding.
r PV AMOUNT EAR>APR
EAR &
Time Value APR
EAR=(1+APR/m)m-1
FV of Money

PV = A + A{(1- (1+r)-(n-1))} PV
Annuity
r
FVA = A(1+r) ((1+r)n – 1) Perpetuity PV= A/r
r
Growing Growing
Beginning annuity Perpetuity
Period
PV= A1/(r-g)
PV = A1 x (1-((1+g)nx(1+r)-n ))
(r-g)
 Some Cases: Job Worth
16. Tom Adams has received a job offer from a large
investment bank as a clerk to an associate banker. His base
salary will be $63,000. He will receive his first annual salary
payment one year from the day he begins to work. In addition,
he will get an immediate $10,000 bonus for joining the
company. His salary will grow at 3.8 percent each year. Each
year he will receive a bonus equal to 10 percent of his salary.
Mr. Adams is expected to work for 25 years. What is the
present value of the offer if the discount rate is 8.5 percent?
 0 1 2 3 4 25
I________|________|________|________|___......_____I
63000 63000(1.038)1 63000(1.038)3 63000(1.038)24
0 1 2 3 4 25
I________|________|________|________|___......_____I
6300 6300(1.038)1 6300(1.038)3 6300(1.038)24

PV of the job= 10000 + 63000 x1.1x (1-((1.038)25/(1.085)25 ))

(0.085-0.038)
=10,000 + 897395.59 + 89739.56
= $ 997135.15
 Case 2: Financial Planning
17. Bilbo Baggins wants to save money to meet three objectives.
First, he would like to be able to retire 30 years from now with a
retirement income of $20,000 per month for 20 years, with the first
payment received 30 years and 1 month from now. Second, he
would like to purchase a cabin in Rivendell in 10 years at an
estimated cost of $350,000. Third, after he passes on at the end of
20 years of withdrawals, he would like to leave an inheritance of
$1,500,000 to his nephew Frodo. He can afford to save $2,100 per
month for the next 10 years. If he can earn an EAR of 11 percent
before he retires and an EAR of 8 percent after he retires, how
much will he have to save each month in Years 11 through 30?
 0 1 2 3 120 121 122 360
I________|_____|_____|__...____|_____I____I____......_____I
-2100 -2100 -2100+350000

361 362 363 364 365 600

I______|______|______|______|___.....___I
20000 20000 20000 20000 20000 15,00,000
Amount needed at the time of retirement at point 360 to be
able to take care of the post retirement benefits.
PV of monthly amount = 20000 x (1-(1+0.0772/12) -240)
(0.0772/12)
=$ 24,41,708.21
PV of lumpsum amount = 1500000
(1+ 0.0772/12)240
= $ 3,21,888.41
Total = $ 27,63,530.52
Amount saved at the end of the 10th year
= 2100 x (1+0.1048/12)120 -1 = $ 442,197
(0.1048/12)

Amount remaining after investment = $ 92,197

Amount needed at the end of 30 years = Future value of
the annuity amount from the 11th year to end of 30th year +
the future value of the savings remaining

FV of annuity = 27,63,530.52 – 92197 x (1+11%)20

= 27,63,530.52 – 7,43,320.94
= 20,20,209.58
2020209.58 = A x ((1+ .1048/12)240 -1) = A x 808.385
(0.1048/12)
A = $ 2499.07
 Case 3: Calculating the compensation
18. You are serving on a jury. A plaintiff is suing the city for injuries
sustained after a freak street sweeper accident. In the trial, doctors
testified that it will be five years before the plaintiff is able to return to
work. The jury has already decided in favor of the plaintiff. You are the
foreperson of the jury and propose that the jury give the plaintiff an award
to cover the following: (1) the present value of two years back pay. The
plaintiff’s annual salary for the last two years would have been $ 37000
and $ 39000, (2) the present value offive years' future salary. You assume
the salary will be $ 43,000 per year. (3) $ 150,000 for pain and suffering.
(4) $25,000 for court costs. Assume that the salary payments are equal
amounts paid at the end of each month. If the interest rate you choose
is an EAR of 7.8 percent, what is the size of the settlement? If you were
the plaintiff, would you like to see a higher or lower interest rate?
Here, we have cash flows that would have occurred in the
past and cash flows that would occur in the future. We need
to bring both cash flows to today. Before we calculate the
value of the cash flows today, we must adjust the interest
rate, so we have the effective monthly interest rate. Finding
the APR with monthly compounding and dividing by 12 will
give us the effective monthly rate. The APR with monthly
compounding is:
APR = 12[(1.078)1/12 – 1]
APR = .0753, or 7.53%
To find the value today of the back pay from two years ago,
we will find the FV of the annuity (salary), and then find the
FV of the lump sum value of the salary. Doing so gives us:

FV = ($37,000 / 12) [{[ 1 + (.0753 / 12)]12 – 1} / (.0753 / 12)] (1 + .078)

FV = $41,292.59
Now, we need to find the value today of last year’s back pay:

FVA = ($39,000 / 12) [{[ 1 + (.0753 / 12)]12 – 1} / (.0753 / 12)]

FVA = $40,375.34
Next, we find the value today of the five year’s future salary:

PVA = ($43,000 / 12){[{1 – {1 / [1 + (.0753 / 12)]12(5)}] / (.0753 / 12)}

PVA = $178,681.97
The value today of the jury award is the sum of salaries, plus the
compensation for pain and suffering, and court costs. The award
should be for the amount of:

Award = $41,292.59 + 40,375.34 + 178,681.97 + 150,000 + 25,000

Award = $435,349.90
Thank you!!!