CHAPTER

2
CHAPTER OUTLINE
2.1 Introduction
2.2 Time Value of Money
2.3 Techniques of Time Value of Money
2.4 Annuity
2.5 Perpetuity
2.6 Risk
2.7 Return
2.8 Risk-Return Relationship
2.9 Risk-Return Trade-off
2.10 Financial Environment
2.11 Summary

2.1 INTRODUCTION
Similar to other subjects of science, finance too has its own language and the two most
important concepts of finance are—Time Value of Money and risk.
Before taking any sort of financial decisions these two factors are given due importance. Since
money can be put to productive use, its value is different depending upon when it is received or
paid. The application of time value and measurement of risk are the invaluable tools in financial
analysis. If the timing and risk associated with Cash Flows is not considered, the firm may make
decisions which may allow it to miss its objective of maximising the owner’s welfare.

2.2 TIME VALUE OF MONEY

Money has a time value. A rupee today is more valuable than a rupee a year hence. The
value of money with reference to time is simply the Time Value of Money. For example, if
Mr. C earns `10,000 and from his earnings he spends `6,000 then the remaining amount of
`(10,000 – 6,000) = `4,000 is his savings. Suppose Mr. C sacrifices his present consumption by
2.2 Financial Management

`4,000 to raise the amount for his future consumption. So he would expect some additional
amount in lieu of his sacrifice. That additional amount is the interest factor. His amount of
savings along with an extra amount (interest) should be available for his future consumption.
If the rate of interest is 10% per annum, then the savings of `4,000 would earn him an interest
of (4,000 ¥ 10% ¥ 1 year) = `400 at the end of 1 year. The total amount Mr. C will get along with
the principal amount and interest = `4,000 (1 + 0.10) = `4,400. So an individual sacrificing his
present consumption by `4,000 would require an amount of `4,400 to get the same benefit. As
interest rate is greater than 0, the amount of money invested at present would earn something
more and the quantity of money, not the value, will increase in future.
In calculating the Present Value, the interest factor is termed as the discount factor. If we
consider the above example other way round, i.e. the Present Value of `4,400 which is to be
4,400
received in future is = = `4,000. If we consider in terms of `1, the different value of
(1 + 0.10)
`1 at different point of time is called Time Value of Money. Similarly, if discount rate is 10%
per annum, the Present Value of `1 to be received at future date, say after 1 year will be =
1 1
or = `0.91. The Time Value of Money concept states that the money received
(1 + 0.10) 1.1
today is worth more than the money to be received in future.
The value of money is decreasing due to the inflationary situation persisting in the economy.
The real purchasing power of `1 today is more than its purchasing power in future. This
concept is applicable to individuals as well as businesses for the purpose of decision making.
For an individual, the Investment Decision making depends on his/her perception. This
is true that value of money decreases with time due to inflation, so an amount invested at
present date would be of less value at future date. The value of money is depreciating with
time. So a rational investor prefers present/current consumption than future consumption as
well as receiving at present than at a future date. Purchasing power of money is decreasing
due to inflation. So before taking an Investment Decision an individual should consider the
importance of Time Value of Money factor.
From a business point of view, Cash Inflows are generated at a future date from the investment
made at a present date. So the point of time of Cash Inflow and outflow (investment) is different.
Hence, before arriving at any Investment Decision, the Time Value of Money should be taken
into consideration. The inflation factor is an important aspect of any Investment Decision.
Since the time of Cash Inflow and outflow is different, they cannot be compared unless they
are bought into same footings, i.e. the Present Value of the future Cash Inflows is calculated
considering the discount factor and is then compared with the Cash Outflow. For example, D
Ltd. considers purchasing a machinery worth `2,00,000 and the expected Cash Flow is `50,000
for 3 years at a discount rate of 10%. Let see whether it is a right decision to invest. If the Cash
Inflow is greater than Cash Outflow then only it is worth investing. So, Present Value of Cash
50,000 50,000 50,000
Inflows = 1
+ 2
+ = `1,24,300 as Present Value of the Cash Inflow
(1 + 0.10) (1 + 0.10) (1 + 0.10)3
greater than Cash Outflow, it is a worthy decision.
 Basic Concepts: Time Value of Money 2.3

2.2.1 Concept of Time Value of Money

Money has time value. Before stating the definition of Time Value of Money in technical terms
let us understand a basic idea. The value of a rupee received today is more than the value of
a rupee to be received in future or the other way round the value of a rupee in future will be
less than the value of a rupee at present. In finance, this is simply referred to as Time Value of
Money.
The different value of same amount of money or one rupee at different points or periods of
time is known as Time Value of Money.

2.2.2 Timeline and Notation

When Cash Flows occur at different points in time, it is very convenient to deal with Cash Flows
using a timeline. A timeline shows the timing and the amount of each Cash Flow in a Cash
Flow stream. Let us explain the concept of timeline with the help of the following example.
Consider a Cash Flow of `15,000 at the end of each year for consecutive 4 years. Discount
rate is 6%. Now this can be represented with the help of timeline as follows (Figure 2.1):

Period 1 Period 2 Period 3 Period 4

Figure 2.1 Time Line

The Cash Flow at the time 0 does not require any further adjustment because it is at its
Present Value. Period 1 which is the first year of Cash Flow as in Figure 2.1 is the time period
between Point 0 and Point 1. Similarly, the time between Point 1 and Point 2 is Period 2 and
so on. Cash Flow at Point 1 is the Cash Flow occurring at the end of Period 1 or beginning of
Period 2 (here in the example we assume that Cash Flow takes place at the end of each year).
Similarly, Cash Flow at the end of Point 2 is the Cash Flow at the end of Period 2 and so on.
The discount rate of 6% in the above example may vary from one period to another period.
Now, consider a Cash Flow of `15,000 at the beginning of each year for consecutive 4 years,
and a discount rate of 6%. Now this can be represented with the help of timeline as follows:

Since Cash Flow is at the beginning of each year, hence Cash Flow at Point 1 is the Cash
Flow occurring at the beginning of second year and so on. Here the end of Point 0 is the
beginning of Period 1, end of Point 1 is the beginning of Period 2 and end of Point 3 is the
beginning of Period 4. Likewise, it may continue till n number of years.
2.4 Financial Management

Timeline for Simple Interest

In Simple Interest, interest is earned on the principal amount only. This can be explained with
the following example. We assume that `2,000 is invested at the beginning of Period 1 for 3
years at the rate of 10% Simple Interest. With timeline it can be represented as follows:

The principal of `2,000 deposited at Point 0, earns interest throughout the year and at the
end of Period 1 it stands at `2,200, i.e. = `2,000 + 2,000 ¥ 10% ¥ 1, similarly at the end of period
2 as `2,400 and so on. Adding the Simple Interest, total amount will be = `2,000 + (200 + 200 +
200) = `2,000 + 600 = `2,600.

Timeline for Compound Interest

In Compound Interest, interest is earned on the principal amount as well as on the interest
earned previously. Let us explain it with the previous example (of Simple Interest)—`2,000
invested at the beginning of Period 1 for 3 years at the rate of 10% Compound Interest. With
timeline it can be represented as follows:

2,000 2,200 2,420 2,662

0 1 2 3

The principal of `2,000 deposited at Point 0, earns interest throughout the year and at the
end of Period 1 it stands at `2,200, i.e. = `2,000 + (2,000 ¥ 10% ¥ 1). Similarly, it will be `2,200 +
(2,200 ¥ 10% ¥ 1) = `2,200 + 220 = `2,420 and `2,420 + (2,420 ¥ 10% ¥ 1) = `2,420 + 242 = `2,662,
respectively, at the end of period 2 and 3.

Timeline for Annuity

Annuity starts after the last deposit and the time period for which interest is earned is number
of deposits minus 1. Say n number of deposits of N amount have been made at 1-year gap so
the number of period for which interest is earned is (n – 1).
For example, Cash Flow of `5,000 at the end of each year for 5 consecutive years is shown
as follows:
 Basic Concepts: Time Value of Money 2.5

Notations used in Time Value of Money

FV = Future Value
PV = Present Value
n = Number of years
r = Interest rate (in case of compounding) or discount rate (the interest rate in case
of discounting, i.e. in case of calculating Present Value is called discount rate)
A = Annuity, i.e. equal stream of Cash Flows or Sinking Fund
P = Perpetuity
g = growth rate
m = Number of times compounding/discounting is done
PVIFr, n = Present Value Interest Factor/multiplier used to calculate the Present Value of
an Annuity at a particular discount rate for a specified time period.
FVIFr, n = Future Value Interest Factor/multiplier factor used to calculate the Future Value
of an Annuity at a particular interest rate for a specified time period.
PVIFAr, n = Present Value Interest Factor of an Annuity/multiplier used to calculate the
Present Value of an Annuity at a particular discount rate for a specified time period
FVIFAr, n = Future Value Interest Factor of an Annuity/multiplier used to calculate the
Future Value of an Annuity at a particular interest rate for a specified time period.

2.2.3 Reasons for Time Preference of Money

The reasons why value of a rupee is worth more at present than in future are discussed below:
1. Preferring present consumption: Individuals always prefer current consumption than
future consumption. In order to induce them to forgo their current consumption and
invest for future they should be offered a very high rate of interest. So, the likings for
present consumption than at future, make the Future Value of money less worthy than
that at present.
2. Inflation: Inflation is a situation of rising price. In an inflationary situation, the value of
money depreciates over time, i.e. the real purchasing power of money decreases. Hence,
this factor increases or rather widens the gap between the value of money at present and
future.
3. Risk: Future is always uncertain. Nobody knows what would happen in future. There
can be different mishaps such as death of the investor, winding up of the company which
may lead to non-receipt of money, i.e. total loss. If uncertainty is more value of money
will be less in future.
4. Investment opportunities: An individual receiving an amount of money today can in-
vest it instantly than the same amount of money being received and invested in future.
2.6 Financial Management

2.2.4 Importance of Time Value of Money

Time Value of Money facilitates comparison for the purpose of taking any financial decision.
Through application of Compounding and Discounting Techniques, Cash Inflows and
Outflows at different time period can be compared.
Let us take an example from an individual point of view as well as from a business point
of view.

From individual point of view:

Suppose an individual Mr. B is given two options—to have `25,000 at present or to take `25,000
at a future date say after 1 year. He as a rational individual would like to go for the first option,
i.e. taking `25,000 at present because he can keep that amount in bank and can earn some
extra amount, i.e. interest. Suppose rate of interest is 10%, then Mr. B will receive = 25,000
(0.10 ¥ 1 year) = 27,500 after 1 year.
Similarly, if Mr. B is asked to pay a debt of `25,000 today or at a later date, i.e. after 1 year,
he would select the second option, i.e. would like to defer the payment. The reason is the same
he can keep the amount in bank and earn something extra. So it is apparent that the time gap
helps him to earn something extra and the rate of interest is an important aspect in deter-
mining Time Value of Money.

From business point of view:

Time Value of Money is an important consideration for a firm before making any Investment
Decision. Capital Budgeting techniques are applied to take a decision. Here Cash Inflows
and outflows are considered taking into account the Time Value of Money before taking any
financial (investment) decision.
Suppose a project requires an initial investment (Cash Outflow) of `2,00,000 with an
expected Cash Inflow of `20,000 at the end of every year for 10 years. Here the Present Value
of future Cash Inflows is calculated and compared with outflow before taking any decision.
So it is to be remembered that Cash Flows of different values at different points of time cannot
be compared unless they are in same balance, i.e. without adjusting for difference in values.

2.2.5 Concept of Rate of Interest

1. Simple Interest Rate: It is the rate of interest (percentage) on the actual principal amount.
Simple Interest in absolute terms = P ¥ r ¥ n
where, P = Principal, r = Rate of interest in decimal, n = Number of years

Illustration 2.1
Problem
Mr. X deposits `8,000 in bank at the rate of 8% Simple Interest per annum. How much he will
receive after 4 years?
 Basic Concepts: Time Value of Money 2.7

Solution
Future Value = Principal + Simple Interest
= P0 + P0 ¥ r ¥ n
= 8,000 + 8,000 ¥ 0.08 ¥ 4
= 8,000 + 2,560
= `10,560

Illustration 2.2
Problem
Mr. C will receive `10,000 after 5 years. Now he invested `8,000. Find the rate of interest annually.
Solution
Future Value = Principal + Simple Interest
Future Value = P0 + (P0 ¥ r ¥ n)
10,000 = 8,000 + (8,000 ¥ r ¥ 5)
10,000 = 8,000 + (40,000 ¥ r)
10,000 – 8,000 = (40,000 ¥ r)
2,000 = 40,000 ¥ r
2,000
or, r= so, r = 0.05 or 5%
40,000

2. Compound Interest Rate: The interest accrued on the previously earned interest is
basically Compound Interest. When interest is earned on the interest received previously
and the original principal amount, it is known as Compound Interest. Compound
Interest is the interest earned on the interest of previous year and the initial principal.
Compound Interest is calculated as follows:
Amount to be received after n years = P (1 + r)n

Illustration 2.3
Problem
Mr. D invested `6,000 in bank at the rate of 10% Compound Interest per annum. How much he
will receive after 3 years?
Solution
Amount to be received in future or Future Value = P0 + P0 ¥ r ¥ n
FV = 6,000 + 6,000 ¥ 0.10 ¥ 1
FV1 = 6,000 + 600 = `6,600
FV2 = 6,600 + 6,600 ¥ 0.10 ¥ 1
= 6,600 + 660 = `7,260
FV3 = 7,260 + 7,260 ¥ 0.10 ¥ 1
= 7,260 + 726 = `7,986
2.8 Financial Management

or
Amount to be received in future or Future Value = P (1 + r)n
or, FV = 6,000 (1 + 0.10)3
FV = 6,000 (1.10)3
FV= 6,000 ¥ 1.331
FV = `7,986
Generally compounding is done for the following number of times:
For 1 month = Compounded monthly
For 12 months = Compounded annually
At an interval of 3 months = Compounded quarterly
For 6 months = Compounded half yearly
For 1 day = Compounded daily
If compounding is done on any of the following basis (except annually), the formula for calculating
interest rate based on number of time compounding is done would be as follows:
r Rate of interest
i = , i.e.
k Number of times compounding is done

Illustration 2.4
Problem
An amount of `5,000 doubles after 7 years. Find the compound rate of interest compounded
1
annually. Given 2 7 = 1.104090
Solution
FV = P (1 + r)7
10,000 = 5,000 (1 + r) 7
10,000
= (1 + r)7
5,000
2 = (1 + r)7
1
27 = 1 + r
1.104090 = 1 + r
r = 1.104090 – 1 = 0.101090 = 10.11% (approximately)
3. Effective Rate of Interest: If interest is given more than once in a year (say x times) then
the effective rate of interest is calculated as follows:
x
Ê rˆ
EROI = Á 1 + ˜ -1
Ë x¯
Illustration 2.5
Problem
If the rate of interest is 15% per annum compounded (i) monthly, (ii) quarterly and (iii) semi-annually
calculate the effective rate of interest.
 Basic Concepts: Time Value of Money 2.9

Solution x
Ê rˆ
EROI = Á 1 + ˜ - 1
Ë x¯
12
(i) EROI = ÊÁ 1 +
0.15 ˆ
Ë ˜ -1
12 ¯
12
Ê 0.15 ˆ
EROI = Á 1 + ˜ -1
Ë 12 ¯
= (1 + 0.0125)12 – 1
= (1.0125)12 – 1
= 1.1607545 – 1
= 0.1607545 = 16.075%
4
Ê 0.15 ˆ
(ii) EROI = Á 1 + ˜ -1
Ë 4 ¯
= (1 + 0.0375)4 – 1
= (1.0375)4 – 1
= 1.15865 – 1
= 0.158650, i.e. 15.865%
2
Ê 0.15 ˆ
(iii) EROI = Á 1 + ˜ -1
Ë 2 ¯
= (1 + 0.075)2 – 1
= (1.075)2 – 1
= 1.15562 – 1
= 0.15562, i.e. 15.562%

2.2.6 Comparison of Simple and Compound Interest

Money is invested at Compound Interest means that each interest payment is reinvested to
earn further interest in future periods. But no interest is earned on interest, the investment
earns only Simple Interest. How an investment of `1,000 grows over time under Simple and
Compound Interest as to rate of interest is shown in Table 2.1.

Table 2.1 Comparison of Simple & Compound Interest on an investment of `1,000

Simple Interest Compound Interest
Year
Opening Balance Interest Closing Balance Opening Balance Interest Closing Balance
1 1,000 100 1,100 1,000 100 1,100
5 1,400 100 1,500 1,464 146 1,610
10 1,900 100 2,000 2,358 236 2,594
20 2,900 100 3,000 6,116 612 6,728
50 5,900 100 6,000 1,06,718 10,672 1,17,390
100 10,900 100 11,000 1,25,27,829 12,52,783 1,37,80,612
2.10 Financial Management

2.2.7 Doubling Period

Investors want to know 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. Is there any
thumb rule which dispenses with the use of the Future Value interest factor table? Yes, there
are thumb rules which are discussed below:
1. Rule of 72: This is a thumb rule for determining the number of years to be taken
for an amount to double if invested at a specified Compound Interest rate, which is
compounded annually.
72
Number of years =
annual rate of interest
Illustration 2.6
Problem
How long will it take for `20,000 to double at a compound rate of 8% per annum (approximately)?
Solution
72
Number of years =
annual rate of interest
72
Number of years =
8
Number of years = 9 years

2. Rule of 69: Rule 69 is similar to Rule 72 which states how long it takes for an amount of
money invested at R% per period to double.
69
Number of years = + 0.35 period
ROI(%) or 100k
Illustration 2.7
Problem
How long will it take for `40,000 to become `80,000 at a compound rate of 10% per annum
(approximately)?
Solution
69
Number of years = + 0.35 period
ROI(%) or 100 k
69
Number of years = + 0.35 period
10
Number of years = 6.9 + 0.35
Number of years = 7.25 years.

3. Rule of 70: This rule states that the approximate number of years (n) taken for an amount
growing at a constant growth rate of R%, to double is:
70
Number of years =
R
 Basic Concepts: Time Value of Money 2.11

Illustration 2.8
Problem
How long will it take for `60,000 to double, at a constant compound rate of 12% per annum
(approximately)?
Solution
70
Number of years =
R
70
Number of years = = 8 years
12

2.3 TECHNIQUES OF TIME VALUE OF MONEY

There are two methods of estimating Time Value
of Money which are shown in Figure 2.2 and
explained as follows:
1. Discounting Technique or the Present Value
Method
2. Compounding Technique or the Future
Value Method
Figure 2.2 Techniques of Time Value of Money
2.3.1 Discounting or Present Value Method
The current value of an expected amount of money to be received at a future date is known as
Present Value. If we expect a certain sum of money after some years at a specific interest rate,
then by discounting the Future Value we can calculate the amount to be invested today, i.e. the
current or Present Value. Hence, Discounting Technique is the method that converts Future
Value into Present Value. The amount calculated by Discounting Technique is the Present
Value and the rate of interest is the discount rate. Discounting can be done a number of times
and based on this, methods for calculating Present Values are listed as follows in Table 2.2:
Table 2.2 Discounting or Present Value Method for Single and Multiple Cash Flows
S. No. Single and Multiple Formula Notations Used
Cash Flows
1. Annually single Ï 1 ¸ PV = Present Value
Cash Flow PV = FV Ì n˝ FV = Future Value
Ó (1 + r ) ˛
r = Discount rate
or, PV = FV(1 + r)–n n = Number of years
or, PV = FV(PVIFr, n) PVIFr, n = Present Value Interest Factor
2. Multiple times, say Ï 1 ¸ PV = Present Value
m number of times Ô mn Ô FV = Future Value
PV = FV Ì Ê rˆ ˝
discounting is done Ô ÁË 1 + m ˜¯ Ô r = Discount rate
Ó ˛
n = Number of years
m = Number of times discounting is
done say quarterly then m = 4; half-
yearly, m = 6 and so on.
2.12 Financial Management

3. Cash Flows of FV1 FV2 FVn PV = Present Value

different amounts PV = + + + n
, FV = Future Value
(1 + r )1 (1 + r )2 (1 + r )
over the years r = Discount rate
n
At
i.e. Â A(1 + r )t n = Number of years
t =1

Illustration 2.9
Problem
Find the Present Value of `80,000 to be received after 10 years at the discount/interest rate of 12%.
Solution
Ï 1 ¸
PV = FV Ì n ˝ , where,
Ó (1 + r ) ˛
PV = Present Value
FV = Future Value, i.e. `80,000
r = Discount/interest rate, i.e. 12% or 0.12
n = Number of years, i.e. 10
Ï 1 ¸
PV = 80,000 Ì 10 ˝
Ó +
(1 0.12) ˛
Ï 1 ¸
PV = 80,000 Ì 10 ˝
Ó (1.12) ˛

PV = 80,000
1
{
3.105848 }
PV = 80,000 ¥ 0.321973
PV = `25,757.86

Illustration 2.10
Problem
Calculate the Present Value of `40,000 to be received after 6 years at the discount rate of 10% if
discounting is done (i) semi-annually and (ii) quarterly.
Solution
Ï 1 ¸
Ô mn Ô , where,
PV = FV Ì Ê rˆ ˝
Ô ÁË 1 + m ˜¯ Ô
Ó ˛
PV = Present Value
FV = Future Value, i.e. `40,000
r = Discount rate, i.e. 10% or 0.10
n = Number of years, i.e. 6
m = Number of times discounting is done
 Basic Concepts: Time Value of Money 2.13

Ï 1 ¸
(i) Semi-annually PV = FV ÔÌ Ê rˆ ˝
mn Ô

Ô ÁË 1 + m ˜¯ Ô
Ó ˛

Ï 1 ¸
PV = 40,000 ÔÌ Ê 0.10 ˆ
2¥6 Ô
˝
Ô ÁË 1 + 2 ˜¯ Ô
Ó ˛
Ï 1 ¸
PV = 40,000 Ì 12 ˝
Ó (1 + 0.05) ˛
Ï 1 ¸
PV = 40,000 Ì 12 ˝
Ó (1.05) ˛

PV = 40,000 { 1
1.795856 }
PV = 40,000 ¥ 0.5568375
PV = `22,273.50
Ï 1 ¸
Ô mn Ô
(ii) Quarterly PV = FV Ì Ê rˆ ˝
Ô ÁË 1 + m ˜¯ Ô
Ó ˛
Ï 1 ¸
Ô 4¥6 Ô
PV = 40,000 Ì Ê 0.10 ˆ ˝
Ô ÁË 1 + 4 ˜¯ Ô
Ó ˛
Ï 1 ¸
Ô 4¥6 Ô
PV = 40,000 Ì Ê 0.10 ˆ ˝
Ô ÁË 1 + 4 ˜¯ Ô
Ó ˛
Ï 1 ¸
PV = 40,000 Ì 24 ˝
Ó (1 + 0.025) ˛
Ï 1 ¸
PV = 40,000 Ì 24 ˝
Ó (1.025) ˛

PV = 40,000 { 1
1.8087259 }
PV = 40,000 ¥ 0.5528754
PV = `22,115.01

Illustration 2.11
Problem
Mr. T expects to get `25,500 after 5 years from an investment made now. If the interest rate is 11%
per annum, how much he should invest now to get the required amount of `25,500?
2.14 Financial Management

Solution
FV = PV (1 + r)n,
where, PV = Present Value
FV = Future Value, i.e. 25,500
r = Interest rate, i.e. 11% or 0.11
n = Number of years, i.e. 5
FV = PV (1 + r)n
25,500 = PV (1 + 0.11)5
25,500
= PV
(1.11)5
25,500
PV =
1.685058
PV = `15,133.01

Illustration 2.12
Problem
The following are the Cash Inflows from an investment for 5 years. End of 1 year, `3,000; 2 year,
`3,500; 3 year, `4,500; 4 year, `5,500 and 5 year, `6,000. Calculate the Present Value of the series
taking the discount rate of 8%.
Solution
PV of the Series of Cash Inflows
Discounting Factor or Present Present Value
Year Cash Inflows (`)
Value Factor PV = FV ¥ (PVIFr, n)
1
1 3,000 = 0.9259259 3,000 ¥ 0.9259259 = 2,777.77
(1 + 0.08)1
1
2 3,500 = 0.8573388 3,500 ¥ 0.8573388 = 3,000.68
(1 + 0.08)2
1
3 4,500 = 0.7938322 4,500 ¥ 0.7938322 = 3,572.20
(1 + 0.08)3
1
4 5,500 = 0.73502985 5,500 ¥ 0.73502985 = 4,042.66
(1 + 0.08)4
1
5 6,000 = 0.6805832 6,000 ¥ 0.6805832 = 4,083.50
(1 + 0.08)5
Total `17,476.81

Illustration 2.13
Problem
Mr. B has two options: (i) to receive `80,000 after 6 years and (ii) to receive `1,00,000 after 8 years.
Which option he should choose when discount rate is (i) 8% and (ii) 12%.
 Basic Concepts: Time Value of Money 2.15

Solution
PV of Cash Flows is as follows
Option (i) Discount Rate 8% Option (ii) Discount Rate 8%

Ï 1 ¸ Ï 1 ¸
PV = FV Ì n˝ PV = FV Ì n˝
Ó (1 + r ) ˛ Ó (1 + r ) ˛
Ï 1 ¸ Ï 1 ¸
PV = 80,000 Ì 6˝ PV = 1,00,000 Ì 8˝
Ó (1 + 0.08) ˛ Ó (1 + 0.08) ˛
Ï 1 ¸ Ï 1 ¸
PV = 80,000 Ì 6˝ PV = 1,00,000 Ì 8˝
Ó (1.08) ˛ Ó (1.08) ˛
PV = 80,000 { 1
1.58687 } PV = 1,00,000 { 1
1.85093 }
PV = 80,000 ¥ 0.630169 PV = 1,00,000 ¥ 0.540268
PV = `50,413.57 PV = `54,026.84

When discount rate is 8%, option (ii) is better than option (i), so he should choose option (ii).

Option (i) Discount Rate 12% Option (ii) Discount Rate 12%

Ï 1 ¸ Ï 1 ¸
PV = FV Ì n˝ PV = FV Ì n˝
Ó (1 + r ) ˛ Ó (1 + r ) ˛
Ï 1 ¸ Ï 1 ¸
PV = 80,000 Ì 6˝ PV = 1,00,000 Ì 8˝
Ó (1 + 0.12) ˛ Ó (1 + 0.12) ˛
Ï 1 ¸ Ï 1 ¸
PV = 80,000 Ì 6˝ PV = 1,00,000 Ì 8˝
Ó (1.12) ˛ Ó (1.12) ˛

PV = 80,000 { 1
1.97382 } PV = 1,00,000 { 1
2.475963 }
PV = 80,000 ¥ 0.5066311 PV = 1,00,000 ¥ 0.4038832
PV = `40,530.49 PV = `40,388.32

When discount rate is 12%, option (i) is better than option (ii), so he should choose option (i).

Illustration 2.14
Problem
Years Cash Flows (`)
1 8,000
2–4 10,000
5 12,000

For the above data, discount rate is 12%. Calculate the Present Value of Cash Flows.
2.16 Financial Management

Solution
PV of the Series of Cash Flows
Cash Flows Discounting Factor or Present Present Value
Year
(`) Value Factor PV = FV ¥ (PVIFr, n)

1 8,000 ¥ 0.8928 = 7,142.4

1 8,000 = 0.8928
(1 + 0.12)1

1 1 1 10,000 ¥ 2.1445 = 21,445

+ +
2–4 10,000 (1 + 0.12)2 (1 + 0.12)3 (1 + 0.12)4
= 0.7972 + 0.7118 + 0.6355 = 2.1445

1 12,000 ¥ 0.5674 = 6,808.8

5 12,000 = 0.5674
(1 + 0.12)5
Total `35,396.2

2.3.2 Compounding or Future Value Method

Compounding is just the opposite of discounting. The process of converting Present Value into
Future Value is known as compounding. Future Value of a sum of money is the expected value
of that sum of money invested after n number of years at a specific compound rate of interest.
Methods for calculating Future Value are given as follows Table 2.3:

Table 2.3 Compounding or Future Value Method for Single and Multiple Cash Flows
Single and Multiple
S. No. Formula Notations Used
Cash Flows
1. Annually single FV = PV(1 + r)n PV = Present Value
Cash Flow Or, FV = PV (FVIFr, n) FV = Future Value
r = Interest rate
n = Number of years
FVIFr, n = Future Value Interest Factor
2. Multiple times say mn PV = Present Value
Ê rˆ
m Number of times FV = PV Á 1 + ˜ FV = Future Value
Ë m¯
compounding is r = Interest rate
done n = Number of years
m = Number of times compounding
done say quarterly then m = 4, half-
yearly m = 2 and so on.
3. Cash Flows of FV = PV1 ¥ (1 + r)1 + PV2 ¥ (1 + r)2 PV = Present Value
different amounts + … + PVn ¥ (1 + r)n, FV = Future Value
over the years n r = Interest rate
i.e. Â At (1 + r )t n = Number of years
t =1
t = 1, 2, 3, 4….
 Basic Concepts: Time Value of Money 2.17

Illustration 2.15
Problem
Mr. D invested `12,000 in bank at the rate of 5% Compound Interest per annum, compounded
(i) bi-annually, (ii) quarterly. How much he will receive after 4 years?
Solution mn
Ê rˆ
Amount to be received in future or Future Value = PV Á 1 + ˜
Ë m¯
PV = Present Value
FV = Future Value
r = Interest rate, i.e. 5% or, 0.05
n = Number of years, i.e. 4
m = Number of times compounding done
4¥2
Ê 0.10 ˆ
Or, FV = 12,000 ÁË 1 + ˜
2 ¯
FV = 12,000 (1.05)8
FV = 12,000 ¥ 1.477455
FV or Compounded Amount = `17,729.465
Compound Interest = `17,729.465 – 12,000 = `5,729.465
4¥4
Ê 0.10 ˆ
Or, FV = 12,000 ÁË 1 + ˜
4 ¯
FV = 12,000 (1.025)16
FV = 12,000 ¥ 1.484505
FV or Compounded Amount = `17,814.0674

Illustration 2.16
Problem
Mr. X invested `250, `500, `750, `1,000 and `1,250 at the end of each year. Compute the compounded
value at the end of last year, i.e. 5th year, compounded annually at the rate of 12% Compound
Interest per annum.
Solution n
FV = Â At (1 + r )t
t =1

Compounded Value at the end of 5th Year

End of Amount Number of Years Compounded Factor Future Value (`)
Year Invested (`) Compounded = PV(FVIF12%, 5)
1 250 4 (1 + 0.12)4 or (1.12)4 = 1.5735 250 ¥ 1.5735 = 393.37
2 500 3 3 3
(1 + 0.12) or (1.12) = 1.4049 500 ¥ 1.4049 = 702.45
(Contd.)
2.18 Financial Management

End of Amount Number of Years Compounded Factor Future Value (`)

Year Invested (`) Compounded = PV(FVIF12%, 5)
3 750 2 (1 + 0.12)2 or, (1.12)2 = 1.2544 750 ¥ 1.2544 = 940.8
4 1,000 1 1 1
(1 + 0.12) or, (1.12) = 1.12 1,000 ¥ 1.12 = 1,120
5 1,250 0 0 0
(1 + 0.12) or, (1.12) = 1.0000 1,250 ¥ 1.00 = 1,250
th `4,406.62
Compounded Value at the end of 5 Year =

Or, FV = 250 ¥ (1 + 0.12)4 + 500 ¥ (1 + 0.12)3 + 750 ¥ (1 + 0.12)2 + 1,000 ¥ (1 + 0.12)1 + 1,250 ¥
(1 + 0.12)0
FV = 250 ¥ 1.5735 + 500 ¥ 1.4049 + 750 ¥ 1.2544 + 1,000 ¥ 1.12 + 1,250 ¥ 1.00
FV = 393.37 + 702.45 + 940.8 + 1,120 + 1,250
FV = `4,406.62

Illustration 2.17
Problem
Mr. Y deposited `60,000 in a bank paying 8% Compound Interest per annum for 15 years, on time
deposits. What will be the value of the deposit at the end of 15 years? Given FVIF8%, 15 = 3.172169.
Solution
Initial Deposit = `60,000
r = 0.08, i.e. 8%
n = 15 years
FV = PV(1 + r)n
Or FV = PV (FVIFr, n)
FV = 60,000 ¥ 3.172169
FV = `1,90,330.15

Illustration 2.18
Problem
Mr. E deposited `50,000 in bank for a time period of 1 year. The bank gives two options: (i) to
receive interest at the rate of 11% per annum compounded monthly and (ii) to receive interest at
the rate of 11.75% per annum compounded semi-annually. Which option Mr. E would choose?
Solution mn
Ê rˆ
FV = PV Á 1 + ˜ , when compounding is done multiple times.
Ë m¯
PV = Present Value
FV = Future Value
r = Interest rate
n = Number of years
m = Number of times compounding is done.
 Basic Concepts: Time Value of Money 2.19

Option (i) Option (ii)

mn mn
Ê rˆ Ê rˆ
FV = PV Á 1 + ˜ FV = PV Á 1 + ˜
Ë m¯ Ë m¯
12 ¥ 1 2¥1
Ê 0.11ˆ Ê 0.1175 ˆ
FV = 50,000 Á 1 + ˜ FV = 50,000 Á 1 + ˜
Ë 12 ¯ Ë 2 ¯
12 ¥ 1 2¥1
Ê 0.11ˆ Ê 0.1175 ˆ
FV = 50,000 Á 1 + ˜ FV = 50,000 Á 1 + ˜
Ë 12 ¯ Ë 2 ¯
FV = 50,000(1 + 0.0091666)12 FV = 50,000(1 + 0.05875)2
FV = 50,000(1.0091666)12 FV = 50,000(1.05875)2
FV = 50,000 ¥ 1.1157188 FV = 50,000 ¥ 1.12095156
FV = `55,785.9418 FV = `56,047.5781

Effective Rate of Interest Calculation

Option (i) Option (ii)
x x
Ê rˆ Ê rˆ
EROI = Á 1 + ˜ - 1 EROI = Á 1 + ˜ - 1
Ë x¯ Ë x¯
12 2
Ê 0.11ˆ Ê 0.1175 ˆ
= Á1 + ˜ -1 = Á1 + ˜ -1
Ë 12 ¯ Ë 2 ¯
12 2
Ê 0.11ˆ Ê 0.1175 ˆ
= Á1 + ˜ -1 = Á1 + ˜ -1
Ë 12 ¯ Ë 2 ¯

= (1 + 0.0091666)12 – 1 = (1 + 0.05875)2 – 1
= (1.0091666)12 – 1 = (1.05875)2 – 1
= 1.1157188 – 1 = 1.12095156 – 1
= 0.1157188, i.e. 11.57188% = 0.1209515, i.e. 12.09515%

So Mr. E should choose option (ii) which has the highest Future Value and the effective rate of
interest as compared to option (i).

Illustration 2.19
Problem
Mr. R deposited `85,000 in bank at the rate of 12% Compound Interest per annum. How much he
would receive after 20 years? Given, FVIF12, 20 = 9.646.
Solution
FV = PV (1 + r)n
or FV = PV (FVIFr, n), where,
PV = Present Value or sum invested `85,00,000
FV = Future Value
r = Interest rate, i.e. 12% or 0.12
n = Number of years, i.e. 20
2.20 Financial Management

FV = PV (FVIFr, n)
FV = 85,00,000 ¥ 9.646
FV = `819,91,000

Illustration 2.20
Problem
Mr. Oman deposited `10,560 in bank for 20 years. Bank gives an interest at the rate of 10% p. a.
Find the Future Value of the present deposit.
Solution
Amount to be received in future or Future Value = Principal (1 + Simple Interest)n
r = 0.10,
n = 20
PV = 10,560
FV = 10,560 (1 + 0.10)20
FV = 10,560 (1.10)20
FV = 10,560 ¥ 0.62749
FV = `71,042.40

2.3.3 Distinction between Compounding and Discounting Methods

The points of distinction between compounding and discounting are as follows in Table 2.4.

Table 2.4 Contrast between Compounding and Discounting

Compounding Discounting
The process of converting the Present Value into The process of converting Future Value in Present
Future Value is known as compounding. Value terms is known as discounting.
Interest rate is used to calculate the Future Value or Discount rate is used to calculate the Present Value.
the compounded value.
Higher the interest rate greater will be the future or Higher the discount rate lower will be the Present
the compounded value. Value.
Future Value is always greater than the Present Value Present Value is always less than the Future Value.
provided the interest rate is positive.
FV = PV(1 + r)n Ï 1 ¸
PV = FV Ì n˝
Ó (1 + r ) ˛

Every finance manager has to take three important Financial Management decisions such
as the Investment Decision, Financing decision and the Dividend decision. Finance manager
has to take all these decisions keeping in mind the value maximisation or the wealth maximi-
sation objective of Financial Management. So a finance manager before taking a financial
decision should keep in mind the objective of value maximisation. In case of an Investment
 Basic Concepts: Time Value of Money 2.21

Decision, where return is fixed and assured it is said to be risk-free investment, for example,
10% Reserve Bank of India Bonds, government bonds, keeping money in deposit accounts
offered by public sector banks, etc. In this case, the probability of the return is 1 and hence
no risk is associated with it. Again for taking Investment Decision for investing in shares of
a company, the risk associated with mutual funds needs to be considered as in this type of
investment the return varies which is neither fixed nor assured. Share market is volatile and
the return varies depending on certain macro level factors and company-specific factors such
as capital depreciation, fluctuating dividend rate due to profit fluctuation, fund crisis, etc. So,
two aspects are involved in any financial decision—one the risk and another return. Both these
two factors vary from one decision to another. A proper balance or trade-off between risk and
return is required to maximise the return by minimising the risk and, thereby, achieving the
goal of maximising the market value to shares.

2.4 ANNUITY
Equal series of Cash Flow either receipt or payment for definite time period at regular intervals
is known as an Annuity. Generally, Cash Flows relating to financial decision are not equal, but
when the Cash Flows are equal and constant over time it is termed as Annuity. An Annuity
is a contract whereby financial product is sold by a financial institution which in turn accepts
and promises to grow the product with an objective to make a series of equal payments to the
individual upon annuitisation, at a later date. Annuity is a fixed and equal amount of money
receivable or payable (Cash Flows) at periodic intervals evenly spaced over time, usually, a
year is referred to as Annuity.
Some of the common examples of Annuity products are insurance premium payments,
retirement savings, mortgage payments, etc. The prime sellers of Annuity products are life
insurance companies and investment companies. The most commonly used Annuity product
is the insurance product. Usually four parties are involved in an Annuity contract, which are
annuitant, contract owner, beneficiary and insurance carrier. The person who will receive
the periodic payment is known as the annuitant. The person who enters into the contract is
the contract owner. The annuitant and the contract owner is usually the one and the same
person. Beneficiary is the person who is entitled to receive the fund on account of death of the
annuitant, and lastly, the insurance company is the insurance carrier who sold the product.
The process of conversion of an investment into equal series of payments is known as annui-
tisation. Annuities are of different types depending on different parameters such as starting
time of Annuity, types of pension scheme, types of pension amount and liquidity.
The most commonly used parameters are starting time of Annuity and types of pension
amount. The different types of Annuity based on these two are as follows:
1. Deferred Annuity and Annuity Due: Deferred Annuity is the type of Annuity that begins
only after the expiry of a certain period of time after the final and the last premium
or instalment has been paid by the purchaser of the Annuity contract. In this type of
Annuity Cash Flows occur at the end of each period. In case of Annuity Due, Cash Flows
2.22 Financial Management

occur at the beginning of each period. The Annuity where the Cash Flows occur at the
end of each period is called an ordinary or a deferred Annuity whereas the Annuity
where Cash Flows occur at the beginning of each period is called an Annuity Due.
2. Immediate Annuity: In immediate Annuity, the Cash Flow commences immediately
after the payment of final purchase premium.
3. Fixed Annuity: Fixed Annuity is the type of Annuity where the Cash Flow is fixed over
time despite market fluctuations. This type of Annuity is preferred by those investors
who like to take minimum risk.
4. Variable Annuity: Variable Annuity is the Annuity where the return is not fixed and
constant over time. It varies with market fluctuations. Usually it is preferred by those
investors who like to take high risk in expectation of high return.
5. Indexed Annuity: Indexed Annuity is almost similar to variable Annuity but the only
difference is that the rate of return here depends on stock market index such as Sensex,
Nifty, S&P 500, etc. It is not available in India.
The two main advantages of Annuity products are tax saving and assured return. Unlike
advantages there are some disadvantages also such as costly investment, penalty for early
withdrawal and often the complexity to understand.

2.4.1 Present Value of an Annuity

An investor may be interested in knowing the Present Value of the Annuity of his investment.
The method for calculating the Present Value of Annuity is shown in Table 2.5.
Table 2.5 Method for Calculating the Present Value of an Annuity
S. No. Annuity Formula Notations Used
1. Deferred PVA = Present Value of Annuity
ÔÏ (1 + r ) - 1 Ô¸
n
Annuity PVA = A Ì n ˝ A = Future Value of Expected Equal Cash Flows
ÓÔ r(1 + r ) ˛Ô r = Discount rate
AÏ 1 ¸ n = Number of years
Or, PVA = Ì1 -
r Ó (1 + r )n ˝˛ Present Value Interest Factor of an Annuity
PVA ÏÔ (1 + r )n - 1 ¸Ô
Or, = Capital (PVIFA r, n) = Ì n ˝
(1 + r )n - 1 ÓÔ r(1 + r ) ˛Ô
recovery
r(1 + r )n factor (A)
PVIFAr, n is the interest factor used to calculate
the Present Value of an Annuity at a particular
discount rate for a specified time period.
Capital Recovery Factor = To repay the borrowings in
total taken at a given interest rate, payment of equal
annual instalments is known as capital recovery.
2. Deferred ÏÊ mn ¸ PV = Present Value
rˆ
Annuity when Ô ÁË 1 + ˜¯ - 1 Ô A = Annuity
Ô m Ô
discounting PVA = A Ì mn ˝ r = Discount rate
done m Ô r Ê1 + r ˆ Ô n = Number of years
ÔÓ ÁË m
˜¯ Ô˛
number of m = Number of times discounting is done say
times quarterly then m = 4, half-yearly m = 2 and so on.
 Basic Concepts: Time Value of Money 2.23

Illustration 2.21
Problem
Mr. J expects to get a fixed sum of `12,000 at the end of each year from an investment for 12 years.
If the discount rate is 6%, calculate the Present Value of the future Cash Flows?
Solution
Ï (1 + r )n - 1 Ô¸
Present Value of Annuity, PVA = A ÔÌ n ˝
ÓÔ r(1 + r ) ˛Ô

ÔÏ (1 + 0.06) - 1 Ô¸
12
PVA = 12,000 Ì 12 ˝
ÓÔ 0.06(1 + 0.06) ˛Ô
ÔÏ (1.06)12 - 1 Ô¸
PVA = 12,000 Ì 12 ˝
ÓÔ 0.06(1.06) ˛Ô
Ï 2.01219647 - 1 ¸
PVA = 12,000 Ì ˝
Ó 0.06 ¥ 2.01219647 ˛

PVA = 12,000 { 1.01219647

0.120731 }
PVA = 12,000 × 8.383844
PVA = `1,00,606.13

Illustration 2.22
Problem
Mr. I has taken loan of `7,50,000 from bank for 1 year. The bank charges interest at the rate of 12%
p. a. Find the amount of monthly instalment. Given PVIFA 12,1 = 11.255.
Solution
Present Value of Annuity, PVA = A ¥ PVIFA12,1
PVA
or A=
PVIF12,1
7,50,000
or A=
11.255
or A = `66,637.05

Illustration 2.23
Problem
Mr. U takes loan of `45,50,000 from bank for purchasing house. He decides to repay the loan in 15
years in 15 equal annual instalments. The bank charges an interest at the rate of 9% p. a. What will
be the amount of instalment if payments are to be made bi-annually?
2.24 Financial Management

Solution
ÏÊ rˆ
mn ¸
Ô ÁË 1 + ˜¯ - 1 Ô
Ô
PVA = A Ì m Ô , where,
mn ˝
Ô rÊ1 + r ˆ Ô
Á ˜
ÓÔ Ë m¯ ˛Ô
PVA = Present Value of Annuity, i.e. 45,00,000
A = Future Value of Expected Equal Cash Flows
r = Discount rate, i.e. 9% or 0.09
n = Number of years, i.e. 15
ÏÊ rˆ
mn ¸
Ô ÁË 1 + ˜¯ - 1 Ô
Ô m Ô
PVA = A Ì mn ˝
,
Ô r Ê1 + r ˆ Ô
Á ˜
ÓÔ m Ë m ¯ ˛Ô

Ï Ê 2 ¥ 15 ¸
0.09 ˆ
Ô ÁË 1 + ˜ -1 Ô
45,00,000 = A Ì
Ô 2 ¯ Ô
2 ¥ 15 ˝
Ô 0.09 Ê 0.09 ˆ Ô
Á1 + ˜
ÓÔ 2 Ë 2 ¯ ˛Ô
ÔÏ (1 + 0.045) - 1 Ô¸
30
45,00,000 = A Ì 30 ˝
ÓÔ 0.045(1 + 0.045) ˛Ô
ÏÔ (1.045)30 - 1 ¸Ô
45,00,000 = A Ì 30 ˝
ÔÓ 0.045(1.045) Ô˛
ÏÔ (1.045)30 - 1 ¸Ô
45,00,000 = A Ì 30 ˝
ÓÔ 0.045(1.045) ˛Ô
Ï 3.745318 - 1 ¸
45,00,000 = A Ì ˝
Ó 0.045 ¥ 3.745318 ˛

45,00,000 = A { 2.745318
0.1685393 }
45,00,000 = A ¥ 16.28888
45,00,000
A=
16.28888
A = `2,76,261.95 (approximately)

2.4.2 Future Value of an Annuity

If an investor makes an investment in an Annuity product for a specified period of time at a
certain rate of interest, he may be interested in knowing the future or compounded value of
an Annuity. The method for calculating the future or compounded value of Annuity is given
in Table 2.6.
 Basic Concepts: Time Value of Money 2.25

Table 2.6 Method for Calculating Future or Compounded Value of an Annuity

S. No. Annuity Formula Notations Used
1. Deferred Ï (1 + r )n - 1 ¸ FVA = Compounded sum of Annuity/Future Value
Annuity (Cash FVA = A Ì ˝ of Annuity
Ó r ˛
Flow at the A = Equal Cash Flows
end of each r = Interest rate
period) n = Number of years
Future Value Interest Factor of an Annuity
Ï (1 + r )n - 1 ¸
(FVIFAr, n) = Ì ˝
Ó r ˛
FVIFAr, n is the interest factor used to calculate the
Future Value of an Annuity at a particular interest
rate for a specified time period.
2. Annuity Due FVA = FVA = Compounded sum of Annuity/Future Value
(Cash Flow at Ï (1 + r )n - 1 ¸ of Annuity
the beginning A Ì ˝ (1 + r ) A = Equal Cash Flows
Ó r ˛
of each period) r = Interest rate
n = Number of years
The amount to be invested for certain number of years at a specified rate of interest to generate `1 at the end of the year
is known as Sinking Fund.
3. Sinking Fund Ï Sn ¸ A = annual fixed amount or Sinking Fund
Factor A=Ô Ô r = Rate of interest
Ì (1 + r )n - 1 ˝
ÔÓ r Ô˛ n = Number of years
Sn = Compounded sum of Annuity or Future Value
of an Annuity

Illustration 2.24
Problem
Mr. T invested fixed amount of `15,000 at an interest rate of 8% per annum at the end of each year
for 10 consecutive years. Compute the Future Value of the Annuity.
Solution
Ï (1 + r )n - 1 ¸
FVA = A Ì ˝
Ó r ˛
where,
FVA = Compounded sum of Annuity/Future Value of Annuity
A = Equal Cash Flows or Annuity, i.e. `15,000
r = Interest rate, i.e. 8% or 0.08
n = Number of years, i.e. 10
2.26 Financial Management

Ï (1 + r )n - 1 ¸
FVA = A Ì ˝
Ó r ˛
Ï (1 + 0.08)10 - 1 ¸
FVA = 15,000 Ì ˝
Ó 0.08 ˛
Ï (1.08) - 1 ¸
10
FVA = 15,000 Ì ˝
Ó 0.08 ˛

FVA = 15,000 {
2.15892499 - 1
0.08 }
FVA = 15,000 {
1.158924997
0.08 }
FVA = 15,000 ¥ 14.48656
FVA = `2,17,298.437

Illustration 2.25
Problem
Mr. H deposits `12,000 at the beginning of each year for 8 consecutive years in bank. The deposit
earns Compound Interest of 12% p.a. Compute how much he will receive at the end of 8 years.
Solution
Future Value of Annuity Due-
Ï (1 + r )n - 1 ¸
FVA = A Ì ˝ (1 + r )
Ó r ˛
FVA = Compounded sum of Annuity/Future Value of Annuity
A = Equal Cash Flows, i.e. `12,000
r = Interest rate i.e. 12% or, 0.12
n = Number of years i.e. 8
Ï (1 + r )n - 1 ¸
FVA = A Ì ˝ (1 + r )
Ó r ˛
Ï (1 + 0.12)8 - 1 ¸
FVA = 12,000 Ì ˝ (1 + 0.12)
Ó 0.12 ˛
Ï (1.12) - 1 ¸
8
FVA = 12,000 Ì ˝ (1.12)
Ó 0.12 ˛

FVA = 12,000 {
2.47596317 - 1
0.12
(1.12) }
FVA = 12,000 {
1.475963176
0.12
(1.12) }
FVA = 12,000 ¥ 12.299693 ¥ 1.12
FVA = `1,65,307.8757
 Basic Concepts: Time Value of Money 2.27

Illustration 2.26
Problem
Mr. G wants to buy plot of land in Kolkata costing `65,00,000. The payment has to be made 15
years from now. With this plan, he wants to save fixed amount annually in the form of bank
deposit. The bank pays interest at the rate of 14% p.a. How much Mr. G should save per year if the
amount of deposit with interest would be sufficient to buy the plot of land after 15 years?
Solution
Fixed amount of savings required
Ï Sn ¸
Ô Ô
A = Ì (1 + r )n - 1 ˝
ÔÓ r Ô˛
where,
A = Annual fixed amount or Sinking Fund
r = Rate of interest i.e. 14% or, 0.14
n = Number of years i.e. 15
Sn = Compounded sum of Annuity or Future Value of an Annuity
Ï Sn ¸
Ô Ô
A = Ì (1 + r )n - 1 ˝
ÔÓ r Ô˛
Ï 65,00,000 ¸
Ô Ô
A = Ì (1 + 0.14)15 - 1 ˝
ÔÓ 0.14 Ô˛
Ï 65,00,000 ¸
Ô Ô
A = Ì (1.14)15 - 1 ˝
ÔÓ 0.14 Ô˛

Ï 65,00,000 ¸
A=Ô Ô
Ì 7.13793797 - 1 ˝
ÓÔ 0.14 ˛Ô
Ï 65,00,000 ¸
A=Ô Ô
Ì 6.1379379 ˝
ÔÓ 0.14 Ô˛

A= {
65,00,000
43.842414 }
A = `1,48,258.26 (approximately)

2.5 PERPETUITY
Perpetuity is an Annuity that occurs indefinitely. Annuity forever is known as Perpetuity.
Although it sounds illogical but still the Annuity where Cash Flows continue for an infinite
period of time is called Perpetuity. Examples of Perpetuity are real estate investments and
2.28 Financial Management

preferred stock investments. Perpetuities are not in vogue in all the countries. It is popular
in the United Kingdom (UK) where it is known as consols. An example of Perpetuity is
irredeemable preference shares although not in vogue in India at present.
Perpetuity where Cash Flows for infinite period, but grows at a constant rate is termed as
growing Perpetuity method for calculating Perpetuity is shown in Table 2.7.

Table 2.7 Method for Calculating Perpetuity

S. No. Perpetuity Formula Notations Used
P = Perpetuity
A
1. Perpetuity P= r = discount rate
r
A = expected Cash Flow
P = Perpetuity
A r = discount rate
2. Growing Perpetuity P=
(r - g ) A = expected Cash Flow
g = growth rate

Illustration 2.27
Problem
Compute the Present Value of a Perpetuity of `1,50,000 per year at a discount rate of 14%.
Solution
A
Present Value of a Perpetuity, P =
r
where,
P = Perpetuity
r = discount rate, i.e. 14% or 0.14
A = expected Cash Flow, i.e. `1,50,000
1,50,000
P=
0.14
P = `10,71,428.57 (approximately)

Illustration 2.28
Problem
Compute the Present Value of Perpetuity of `80,000 per year at a discount rate of 12% where
growth rate is 8%.
Solution
A
Growing Perpetuity, P =
(r - g )
where,
P = Perpetuity
r = Discount rate, i.e. 12% or 0.12
A = Expected Cash Flow, i.e. 8%, i.e. 0.08
 Basic Concepts: Time Value of Money 2.29

g = Growth rate, i.e. 8%, i.e. 0.08

A
P=
(r - g )
80,000
P=
(0.12 - 0.08)
80,000
P=
0.04
P = `20,00,000

2.6 RISK
The business dictionary defines risk as exposure to the possibility of loss, injury, or other
adverse or unwelcome circumstance, i.e. a chance or situation involving such a possibility.
Risk is the probability or possibility of having negative outcome due to certain sudden events.
The variation of the actual outcome from the expected outcome is defined as risk. In simple
terms, risk is the volatility in actual outcome. It is a sudden occurrence of some unexpected or
unplanned events resulting in reduction of earnings or huge financial losses.
Although used synonymously, risk is bit different from uncertainty. In case of risk, proba-
bilities of the occurrence of an event can be predicted based on the past available facts, figures
and information for the purpose of decision making, but in case of uncertainty the occurrence
of an event cannot be predicted, due to unavailability of facts, figures and information. Uncer-
tainty varies from zero (0) to infinity ( ). Risk is better than uncertainty. Risk lies somewhere
between certainty and uncertainty. If uncertainty is equal to 0, it indicates certainty.

2.6.1 Types of Risk

Risk can be categorised into three broad categories—Business Risk, non-Business Risk, and
Financial Risk. Business Risk is the risk associated with the day-to-day activities of business
or the operational activities of the business. It depends on certain factors such as changes in
demand, input prices and obsolescence due to technological advances. Non-Business Risk
refers to all forms of risk that are beyond the control of any business. Political risk and all
sorts of risk associated with variation in macroeconomic factors fall under this category of
risk. Financial Risk is the most common form of risk. This form of risk is associated with
the financing decision of a firm. It is a major area of concern for all the firms. Financial Risk
is associated with host of factors such as the uncertainty in the movement of market due to
factors such as fluctuation in interest rate, currencies and stock/share prices caused by certain
macro and micro factors. Financial Risk can be further classified into following types—market
risk, credit risk, liquidity risk, operational risk and legal risk. Market Risk is associated with
uncertain movement of stock prices, credit risk refers to the risk when one party generally
the customer-taken credit fails to fulfil the commitment, liquidity risk refers to risk that an
asset may not be sold in the market quickly for realisation of cash in time of financial crunch,
operational risk is associated with the possibility of failure of business due to mismanagement,