Time Value of Money-

Introduction
 Introduction Time Value of
Money
A Dollar Today is worth more than a dollar in future. Why ?

We can invest the dollar elsewhere and earn interest / dividend /

price appreciation.

If you could earn 5% interest in a savings account in a year, the

dollar would be worth $1.05 a year from now.

The first is the presence of inflation means that the dollar today will
buy more in terms of real goods than the same dollar a year from
now.
 Time Value of Money
Consequently you would demand an interest
rate to compensate for the loss in purchasing
power that comes with inflation.

Secondly, individuals prefer present

consumption than to future consumption.

If there is no inflation, the dollar today and the

dollar a year from now would purchase the
same quantity of goods.
 1. Introduction

Concept of Time Value of Money

One rupee at present is worth more than one rupee next
year. Because one rupee at present can be invested to earn
an income. Value of money at present is more than value
of money in future time. Hence we can say money has a
value based on time. This concept is called as time value
of money or an interest.

4 Cr 1 Cr 1 Cr 1 Cr 1 Cr 1 Cr Investment
Present values 0.86Cr 0.74Cr 0.64Cr 0.55Cr 0.47Cr
total 3.26 Cr

6 / 57
 Interest Rates

Simple Interest Rate :

Simple interest rate is calculated on the
original principal only for the time during
the which money lent is used. Simple
interest is paid or earned on the principal
amount lent or borrowed.
Formula : Pnr
P Principal
n number of years
r rate of interest rate (r in decimal)
 Illustration 1
What is the simple interest on principal Rs
8000 for 4 years at 12% p.a.
Pnr = 8000*4*0.12=Rs 3,840.00
Amount (Principal + amount)
= P (1+nr) = 8000[1+(4*0.12)]= 8000
*(1+0.48)
=11,840
Interest = Amount Principal = 11,840
-8000= 3,840.00
Note : Amount = P (1+nr)
 Illustration 2
At what rate of interest (percent) will
Rs 26,435 will amount to Rs 31,722
in 4 years.
Amount = P (1+nr)
31,722 = 26,435 (1+4*r/100)
31,722 = 26,435 + 1,05,740 *r /100
Rate of Interest = 5%
 Compound Interest Rate
If interest for one period is added to the principal for
the next period, it is called compounded interest.
The time period for compound may be annual, half
yearly, quarterly, or any other regular period of time.
A = P(1+i)n
A Amount at the end of n period
P Principal amount at the beginning of the nperiod
i rate of interest per payment period (in decimal)
n- number of payment periods
 Compound Interest Contd.
When Interest is payable half-yearly
A = P (1+i/2)2n
When interest is payable Quarterly
A = P (1+i/4)4n
When interest is payable Monthly
A = P (1+i/12)12n
When interest is payable daily
A = P (1+i/365)365n
The Frequency of
Compounding
The frequency of compounding aects the
future and present values of cash flows. The
stated interest rate can deviate significantly
from the true interest rate
For instance, a 10% annual interest rate, if there

is semiannual
Frequency Rate compounding,
t Formula works outAnnual
Eective to-
Eective Interest Rate = 1.05Rate
2- 1 = .10125 or
Annual 10.25%10% 1 r 10.00%
Semi- 10% 2 (1+r/2)2-1 10.25%
Annual
Monthly 10% 12 (1+r/12)12-1 10.47%
Daily 10% 36 (1+r/365)365- 10.5156%
5 1
Continuous 10% expr-1 10.5171%
10
 Illustration 1
Find out the compounded interest
rate on Rs 6000 for 3 years at 9%
compounded annually.
A= P (1+i)n
=6000* (1+0.09)3
=6000* (1.29503)
=Rs 7,770
 Illustration 2
What sum will amount to Rs 5,000 in 6 years
time at 8.5% compounded annually.

A= P(1+i)n

=5000 * (1+0.085)6

=5000* 1.63147 = Rs 8,157

 Illustration 3
Find the compounded interest on Rs 2,500 for 15 months
at 8% compounded quarterly.

A = P (1+i/4)4n

= 2500 * (1+0.08/4)4*1.25

= 2500*1.04 = 2,760

Compound interest = 2760-2500= 260

 Compounding

0 1 2 3 4
-1000 250 500 750 750
+
FV(750)
+
FV(500)
+
FV(250)

compare with FV(1000)

Under the method of compounding, we find the future values

(FV) of all the cash flows at the end of the time horizon, at a
particular rate of interest.
8 / 57
 Discounting

0 1 2 3 4
-1000 250 500 750 750
compare with the
sums of PV(250)
+
PV(500)
+
PV(750)
+
PV(750)

Under the method of discounting, we calculate the time value

of money at present. So we will be comparing the initial
outflow with the sum of the present values (PV) of the future
inflows at a given rate of interest.
9 / 57
Discounting and
Compounding
The mechanism for factoring in these elements is
the discount rate. The discount rate is a rate at
which present and future cash flows are traded o.
It incorporates
(1)Preference for current consumption (Greater ....Higher
Discount Rate)
(2)Expected inflation(Higher inflation .... Higher
Discount Rate)
(3)Uncertainty in the future cash flows (Higher Risk....Higher
Discount Rate)
A higher discount rate will lead to a lower value for
cash flows in the future.
The discount rate is also an opportunity cost, since
it captures the returns that an individual would have
made on the next best opportunity.
Discounting future cash flows converts them into cash
flows in present value dollars. Just a discounting converts
future cash flows into present cash flows,
Compounding converts present cash flows into future
 Future Value of a Single Cash Flow

FVn PV (1 k) n

Where FVn = future value in n years

PV = present value or initial value of cash flow
k = annual rate of interest
n = duration or the life of investment
(1+k)n = future value of unit investment, say Rs. 1
= FVIF(k, n)
= future value interest factor
Use Table 1 to get FVIF value for k & n
Multiply PV and FVIF to get the future value
11 / 57
 Illustration 1
(i) Calculate Future value of an investment
$50,000 with interest earning 6% p.a. for 10 years.
Calculate Future value of the investment if the
interest is paid semi-annually.
FV = PV(1+k)n
FV = 50,000* (1+0.06)10
= 50,000* 1.7908 = 89,542
FV = 50000 * (1+0.06/2)2*10
= 50000 * (1+0.06/2)20
= 90,306
 3. Future Value of a Single Cash Flow (using the
table values)

Example
If the bank offers a compounded rate of interest of 11% per annum
on the deposit. An amount of Rs. 10,000 deposited today, will
become how much after 3 years?

Solution FVn PV (1 k) n

Formula
FVn = PV x FVIF(k,n)
= PV x FVIF(11,3)
= 10,000 x 1.368
= Rs. 13,680
12 / 57
 Future Value of a Single Cash Flow

Increased Frequency of Compounding

For example, half yearly compounding, quarterly
compounding etc.
Example
You have deposited Rs. 10, 000 in a bank, which offers 10%
interest p.a. compounded semi-annually. Calculate the
amount at end of the year.
Formula
k mn
FVn PV (1 )
m

Where, FVn = future value after n years

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 3. Future Value of a Single Cash Flow

Example
An amount of Rs. 1000 is invested in a bank for 2 years. Rate of interest
is 12 % compounded quarterly. Calculate the amount at the end.
Solution k mn
FVn PV (1 )
m
where m = 4, frequency of compounded in a year.
FVn = 1000 (1+0.12/4)8
= 1000 (1.03)8
= 1000 x 1.267
= Rs. 1267

20 / 57
 Future Value of a Single Cash Flow

Effective vs. Nominal Rate of Interest

Rs. 100 with 10 % interest amounts to Rs. 110 at the end of
year.
However semi-annually 100(1.05)2 = 100 x 1.1025 = 110.25
The principal amount grows 10.25% p.a.
This 10.25% is called effective rate of interest.
Hence the accumulation under semi-annual compounding
exceeds the accumulation under annual compounding.

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 3. Future Value of a Single Cash Flow

Effective vs. Nominal Rate of Interest

k m
r (1 ) 1
Formula for effectivem
rate of interest

Where r = effective rate of interest

k = nominal rate of interest
m = frequency of compounding per year

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 Effective rate of int =
[1+ Stated Annual Int. Rate / t]t - 1
Continuous Compounding int rate
Effective rate of int.
= [1+ Stated Annual Int. Rate / ] - 1
= expr-1
 3. Future Value of a Single Cash Flow

Example
Calculate the effective rate of interest, for the 12% nominal
rate of interest quarterly compounded.
Solution
Effective rate of interest k m 0.12 4
r (1 ) 1 (1 ) 1
m 4

= 1.034 -1 Refer FVIA(3,4) table

= 1.126 -1
= 0.126 or 12.6%
23 / 57
 4. Future Value of Multiple Flows and Annuity

0 1 2 3
1000 2000 3000 Accumulation

FV(3000)
+
FV(2000)
+
FV(1000)

Suppose we invest Rs. 1000 now i.e. at the beginning of year

1, Rs. 2000 at the beginning of year 2 and Rs. 3000 at the
beginning of year 3. How much will these cash flows
accumulate at the end of year 3 at the rate of 12% p. a.

24 / 57
 4. Future Value of Multiple Flows and Annuity

0 1 2 3
1000 2000 3000 Accumulation

FV(3000)
+
FV(2000)
+
FV(1000)

Future value at the end of 3 years, at 12% interest p.a.

= FV(Rs. 1000) + FV (Rs. 2000) + FV(Rs. 3000)
=1000 x FVIF(12,3) +2000 x FVIF(12,2)+3000 x FVIF(12,1)
= 1000 x 1.405 + 2000 x 1.254 + 3000 x 1.12
= Rs. 7273
25 / 57
4. Future Value of Multiple Flows and Annuity

By calculator
Future value at the end of 3 years
= 1000 x 1.123 + 2000 x 1.122 + 3000 x 1.12
= Rs. 7273.73

26 / 57
4. Future Value of Multiple Flows and Annuity

Annuity
Annuity is a stream or series of periodic flows of equal
amounts. For example life insurance premium.
Regular Annuity or Deferred Annuity: When the equal
amounts of cash flows occur at the end of each period,
over the specified time horizon.
Annuity Due: When cash flows occur at the beginning of
each period, over the specified time horizon.
0 1 2 3 4 5 6

Future value of regular annuity

FVA 6 A(1 k) 61 A(1 k) 6-2 A(1 k) 6-3 ... A(1 k) 6-6
27 / 57
4. Future Value of Multiple Flows and Annuity

Future value of regular annuity

FVA n A(1 k) n 1 A(1 k) n - 2 A(1 k) n -3 ... A
Which reduces to (1 k) n 1
FVA n A
k
Where, A = amount deposited /invested at the end of every year
for n years
k = rate of interest, expressed in decimals
n = time horizon
FVAn = Accumulation at the end of n years.
(1 k) 1
n

The expression k

is called the Future Value Interest
Factor for Annuity (FVIFA) and it accumulates Rs. 1 invested
or paid at the end of every year for a period of n years at the
rate of interest k.
FVIFA values are given in Table 2.
28 / 57
 4. Future Value of Multiple Flows and Annuity

Example
Calculate the Annuity regular for yearly annuity of Rs.
1000 invested with a 12 % interest for a period of 10 years.
Solution
(1 k) n 1
FVA n A
k
FVAn = A x FVIFA(k,n)
= 1000 x FVIF(12,10)
= 1000 x 17.549
= Rs. 17549

29 / 57
4. Future Value of Multiple Flows and Annuity

By calculator
(1 k) n 1
FVA n A
k

(1 0.12)10 1
FVA n 1000
0.12

= 1000 x 17.54874
= Rs. 17548.74

30 / 57
4. Future Value of Multiple Flows and Annuity

Example
Under a recurring deposit scheme of the bank, a fixed
amount is deposited every month. The rate of interest is
9% compounded quarterly. Calculate the maturity value
for a monthly installment of Rs. 500 for 12 months.
Solution
Amount of deposit = Rs. 500 per month
Rate of interest = 9% compounded quarterly
k
r (1 ) m 1
Effective rate of interest m
0.09 4
(1 ) 1 0.0931 or 9.31%
4
31 / 57
4. Future Value of Multiple Flows and Annuity

Rate of interest per month (1 r)1/12

1
(1 0.0931)1/12 1

0.0074 or 0.74%

Maturity value of an annuity

(1 k) n 1
FVA n A
k
(1 0.0074) 12 1
500
0.0074

500 x 12.50 Rs. 6250

32 / 57
4. Future Value of Multiple Flows and Annuity

If the payments are made at the beginning of every year,

then the value of such an annuity due is calculated by
modifying the formula of annuity regular as follows

FVAn(due) = A (1+k) FVIFA(k,n)

33 / 57
 4. Future Value of Multiple Flows and Annuity

Example
A person aged 20 is insured for a policy of Rs. 10,000. The term of
policy is 25 years and the annual premium is Rs. 41.65. Calculate
the rate of return the person gets.
Solution
Premium = Rs. 41.65 per annum
Term of policy = 25 years
Value at the maturity = P (1+K) FVIFA(k,n), since the premium is
paid at the beginning of the year.
10,000 = 41.65 (1+k) FVIFA (k,25)
(1+k) FVIFA(k,25) = 240.1

34 / 57
4. Future Value of Multiple Flows and Annuity

From Table 2, we get

(1+0.14) FVIFA(14,25) = 1.14 x 181.871 = 207.33
and
(1+0.15) FVIFA(15,25) = 1.15 x 212.793 = 244.71
By interpolation
240.1 207.33
k = 14% + (15% - 14%) x 244.71 207.33
= 14 + 1 x 32.77 /37.38
= 14 + 0.87 %
= 14.87 %
35 / 57
 5. Present Value of a Single Cash Flow

Discounting: Using this approach we can find present value of a future

cash flow or a stream of future cash flows. Present value approach is
commonly followed for evaluating financial viability of projects.
FVn = PV(1+k)n
= PV x FVIF(k,n)
or FVn
PV
FVIF(k, n)
The inverse of FVIF(k,n) is defined as PVIF(k,n) FVn
PV
(1 k) n
The Present Value Interest Factor for k and n
PV = FVn x PVIF(k,n)

36 / 57
 5. Present Value of a Single Cash Flow

To determine the present value of a future sum, we have to just

multiply future value by PVIF factor for the values of k and n.
PVIF values are provided in Table 3.
Example: Calculate the issue price of a zero coupon bond with a
face value of Rs. 1000, redeemable after 5 years with 12%
interest p.a.
Solution: PV = FV x PVIF(k,n)
= 1000 x PVIF(12,5)
= 1000 x 0.567 = Rs. 567
37 / 57
 5. Present Value of a Single Cash Flow

By calculator
FVn
PV
(1 k) n
1000

(1 0.12)5

Rs. 567.43

38 / 57
 5. Present Value of a Single Cash Flow

Example: A bank certificate having value of Rs. 100 after a

year is to be issued with a 12% interest p.a. quarterly
compounded. Calculate the issue price of a certificate.
Solution
k m
r (1 ) 1
Effective rate of interest m
0.12 4
(1 ) 1 0.1255 or 12.55%
4
FVn
Issue price of the certificate is PV
(1 k) n
100
Rs. 88.85
(1 0.1255)
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 5. Present Value of a Single Cash Flow

Example: A bank wishes to issue a cash certificate of Rs.

1,00,000 to be received after 10 years, at the rate of 10%
interest p.a. compounded quarterly. Calculate the issue
price of this certificate.
Solution
k
r (1 ) m 1
Effective rate of interest m
0.10 4
(1 ) 1 0.1038 or 10.38%
4
FVn
Issue price of the certificate is PV
(1 k) n
100000
Rs. 37247.41
(1 0.1038) 10
40 / 57
 6. Present Value of
Multiple Flows and Annuity

0 1 2 3
Accumulation 1000 2000 3000

PV(1000)
+
PV(2000)
+
PV(3000)

Present value at the end of 3 years, at 12% interest p.a.

= PV(Rs. 1000) + PV (Rs. 2000) + PV(Rs. 3000)
=1000 x PVIF(12,3) +2000 x PVIF(12,2)+3000 x PVIF(12,1)
= 1000 x 0.893 + 2000 x 0.797 + 3000 x 0.712 = Rs. 4623
41 / 57
 6. Present Value of
Multiple Flows and Annuity

Project is said to be financially viable if the present value

of the cash flows exceeds the present value of the cash
outflows.

42 / 57
 6. Present Value of an Annuity

When an annuity is receivable at the end of every year for a

period of n years at the interest rate of k, then the present
value is equal to
A A A A
PVA n ...
(1 k) (1 k) 2 (1 k) 3 (1 k) n

This reduces to (1 k) n 1
PVA n A n
k(1 k)

The expression (1is k) n

1 the PVIFA, Present Value Interest
called
n
k(1 k)
Factor for Annuity and it represents the present value of a
regular annuity of Rs. 1 for a given value of k and n.

43 / 57
 6. Present Value of an Annuity

PVIFA values are given in Table 4 for various values of k

and n.

These values are used with following conditions

The cash flows are equal
The cash flows occur at the end of every year

44 / 57
 6. Present Value of an Annuity

Example: Calculate the investment to receive a yearly

regular income of Rs. 10,000 for 10 years at the rate of 12
% p.a.
Solution: PVAn = 10,000 x PVIFA(12,10)
= 10,000 x 5.65 = Rs. 5650
(1 k) n 1
PVA n A n
By calculator k(1 k)
(1 0.12)10 1
10,000 10
0.12(1 0 .12 )
2.10585
10,000 Rs. 5650.23
0.3727 45 / 57
 6. Present Value of an Annuity

Example: Calculate the initial deposit amount to receive a

monthly payment of Rs. 1000 for 12 month. The rate of
interest is 12% p.a. quarterly compounded. k
r (1 ) m 1
Solution: Effective rate of interest m
0.12 4
(1 ) 1 0.1255 or 12.55%
4
Effective rate of interest per month = (1.1255)1/12-1
= 0.0099
(1 k) n 1 (1 0.0099) 12 1
PVA n A n
1000 12
k(1 k) 0.0099(1 0.0099)
0.1255
1000 1000 x 11.26336 Rs. 11,263.36
0.01114 46 / 57
 6. Present Value of an Annuity

Example: If an initial deposit of Rs. 4610 is done in a bank

for an annuity period of 60 months. Rate of interest is 11%
p. a. quarterly compounded. Calculate the value of
monthly annuity income a person can receive.
k
Solution: Effective rate of interest r (1 ) m 1
m
0.11 4
(1 ) 1 0.1146 or 11.46%
4
Effective rate of interest per month = (1.1146)1/12-1.
= 0.00908
Monthly annuity can be calculated as PVA n A (1 k) n
1
n
k(1 k)
4610 A (1 0.00908)
A = Rs. 99.8833
60
1
60
0.00908(1 0.00908) 47 / 57
 Capital Recovery Factor

Rearranging the equation for present value of an annuity, we

get
(1 k) 1
n
PVA n A n
k(1 k)
1
(1 k) n 1
A PVA n n
k(1 k)

k(1 k) n
PVA n
(1 k) n
1

The term isk(1 k) n as a capital recovery factor.

known

(1 k) n
1
48 / 57
 Capital Recovery Factor

Example: A loan of Rs. 10,000 is repaid in 5 equal

installments. The loan carries a interest rate of 14% p. a.
Calculate the amount of each installment.
Solution
PVAn = A x PVIFA(k,n)
10,000 = A x 3433
A = 10,000 / 3,433
= Rs. 29,129
49 / 57
 Capital Recovery Factor

By Calculator
(1 k) n 1
PVA n A n
k(1 k)

k(1 k) n
A PVA n
(1 k) n
1

0.11(1 0.11) 5
10,000 Rs. 29,129
(1 0.11) 1
5

This method is very useful for deciding an equal amount of

installments for a loan repayment scheme.
50 / 57
 7. Present Value of Growing Annuity

0 1 2 3 n
A(1+g) A(1+g)2 A(1+g)3 A(1+g)n
A cash flow that grows at a constant rate for a specified period
of time is a growing annuity.
Formula for the present value of growing annuity
(1 g) n
1-
PV of Growing Annuity A(1 g)
(1 k) n
k -g


where g is a growth rate and k is a discount rate.
Above formula is used when g<k or g>k. However it does not
work when g=k. In this case the present value is equal to nA.

51 / 57
 7. Present Value of Growing Annuity

Example: Suppose you have a right to harvest a teak

plantation for the next 20 years over which you expect to
get 1,00,000 cubic feet of teak per year. The current price
of teak per cubic feet is Rs. 500 and it is expected to
increase at a rate of 8% p.a. The discount rate is 15%.
Calculate the present value of the teak that you cann
(1 g)
harvest. 1 - (1 k) n
A(1 g)
Solution: PV of Growing Annuity k -g


(1 0.08) 20
1-
(1 0.15) 20
PV of teak Rs. 500 x 1,00,000 x (1 0.08) 0.15 - 0.08
Rs.55,17,3 6,683

52 / 57
 8. Present Value of
Perpetuity and Growing Perpetuity

An annuity of an infinite duration is known as perpetuity. The

present value of such perpetuity is expressed as
P = A x PVIFA(k,)
Where PVIFA(k,) is a present value interest factor for a

perpetuity. Value of PVIFA(k,) is 1 1

t 1 (1 k) t k

A
P
r
Present value interest factor of a perpetuity is one divided by
interest rate (expressed in decimal form).
Present value of a perpetuity is equal to the constant annuity
divided by the interest rate.
53 / 57
 8. Present Value of
Perpetuity and Growing Perpetuity

Example: How much I should invest in a bank to offer a

scholarship of Rs. 10,000 per annum perpetually
(forever) to a bright student with 10% p.a.
Solution A
P
r

10,000
Rs.1,00,00 0
0.10

54 / 57
 8. Present Value of
Perpetuity and Growing Perpetuity

Example: How much I should invest in a bank to offer a

scholarship of Rs. 1000 per month perpetually (forever)
to a bright student with 10% p.a.
Solution:
Effective rate of interest per month = (1.10)1/12-1
= 0.007974 or 0.7974%
A
P
r
1000
Rs.1,25,40 8
0.007974 55 / 57
 8. Present Value of a Growing Perpetuity

0 1 2 3
A(1+g) A(1+g)2 A(1+g)3
A perpetuity growing at a constant rate is called growing
perpetuity. We assume that the increase will continue
indefinitely. For example, rent is a growing perpetuity.
PV of Growing Perpetuity
A A(1 g) A(1 g) 2 A(1 g) n -1
... ...
(1 k) (1 k) 2
(1 k) 3
(1 k) n

This reduces to
A
PV of growing Perpetuity
k -g

Where g is a growth rate and k is a discount rate.

56 / 57
 8. Present Value of a Growing Perpetuity

Example: An office is expected to have rent of Rs. 30,000 next

year. It is expected to increase by 5% every year. We assume
that the increase will continue indefinitely. If the discount
rate is 10%, calculate the present value of the rental stream.
Solution
This is a growing perpetuity with g= 5% and k=10%.

PV of Growing Perpetuity
A

k -g
***** 30,000
Rs. 6,00,000
0.10 - 0.05
57 / 57