Lecture - 02

THE TIME VALUE OF MONEY

Lecture 03 CF PGP 08-10 1

The Time Value of Money
Would you prefer to
have Rs.1 million now or
Rs.1 million 10 years
from now?

Of course, we would all prefer the money

now!

This illustrates that there is an inherent

monetary value attached to time.

Lecture 03 CF PGP 08-10 2
 What is The Time Value of
Money?
 A rupee received today is worth more than
a rupee received tomorrow
– This is because a rupee received today can be
invested to earn interest
– The amount of interest earned depends on the
rate of return that can be earned on the
investment
 Time value of money quantifies the value of
a rupee through time
Lecture 03 CF PGP 08-10 3
 WHY TIME VALUE
A rupee today is more valuable than a rupee a year hence.
Why ?
• Preference for current consumption over future
consumption
• Productivity of capital
• Inflation
Many financial problems involve cash flows occurring at
different points of time. For evaluating such cash flows, an
explicit consideration of time value of money is required
Lecture 03 CF PGP 08-10 4
 Centre for Financial Management , Bangalore
 TIME LINE
Part A

0 1 2 3 4 5
12% 12% 12% 12% 12%

10,000 10,000 10,000 10,000 10,000

 
Part B

  0 1 2 3 4 5
12% 12% 12% 12% 12%

10,000 10,000 10,000 10,000 10,000

Lecture 03 CF PGP 08-10 5

 NOTATION
PV : Present value
FVn : Future value n years hence

Ct : Cash flow occurring at the end of year t

A : A stream of constant periodic cash flow over a

given time
r : Interest rate or discount rate
g : Expected growth rate in cash flows
n : Number of periods over which the cash flows
occur.
FVIF: Future Value Interest Factor.
Lecture 03 CF PGP 08-10 6
 FUTURE VALUE OF A SINGLE AMOUNT
Rs
First year: Principal at the beginning 1,000
Interest for the year
(Rs.1,000 x 0.10) 100
Principal at the end 1,100
 

Second year: Principal at the beginning 1,100

Interest for the year
(Rs.1,100 x 0.10) 110
Principal at the end 1,210

Third year: Principal at the beginning 1,210

Interest for the year
(Rs.1,210 x 0.10) 121
Principal at the end 1,331

FORMULA
FUTURE VALUE = PRESENT VALUE (1+r)n
Lecture 03 CF PGP 08-10 7
 VALUE OF FVIFr,n FOR VARIOUS
COMBINATIONS OF r AND n

  n/r 6% 8% 10 % 12 % 14 %
2 1.124 1.166 1.210 1.254 1.300
4 1.262 1.361 1.464 1.574 1.689
6 1.419 1.587 1.772 1.974 2.195
8 1.594 1.851 2.144 2.476 2.853
10 1.791 2.518 2.594 3.106 3.707

Lecture 03 CF PGP 08-10 8

 DOUBLING PERIOD
Thumb Rule : Rule of 72
Doubling period = 72
Interest rate
Interest rate : 15 percent
Doubling period = 72 = 4.8 years
15
A more accurate thumb rule : Rule of 69

Doubling period = 0.35 + 69

Interest rate
Interest rate : 15 percent
Doubling period = 0.35 + 69 = 4.95 years
15
Lecture 03 CF PGP 08-10 9
 PRESENT VALUE OF A SINGLE AMOUNT

PV = FVn [1/ (1 + r)n]

n/r 6% 8% 10% 12% 14%

2 0.890 0.857 0.826 0.797 0.770
4 0.792 0.735 0.683 0.636 0.592
6 0.705 0.630 0.565 0.507 0.456
8 0.626 0.540 0.467 0.404 0.351
10 0.558 0.463 0.386 0.322 0.270
12 0.497 0.397 0.319 0.257 0.208

Lecture 03 CF PGP 08-10 10

 PRESENT VALUE OF AN UNEVEN SERIES
A1 A2 An
PVn = + + …… +
(1 + r) (1 + r)2 (1 + r)n
n At
= 
t =1 (1 + r)t

Year Cash Flow PVIF12%,n Present Value of

Rs. Individual Cash Flow
1 1,000 0.893 893
2 2,000 0.797 1,594
3 2,000 0.712 1,424
4 3,000 0.636 1,908
5 3,000 0.567 1,701
6 4,000 0.507 2,028
7 4,000 0.452 1,808
8 5,000 0.404 2,020

Present Value of the Cash Flow Stream 13,376

Lecture 03 CF PGP 08-10 11
 FUTURE VALUE OF AN ANNUITY
 An annuity is a series of periodic cash flows (payments and

receipts ) of equal amounts

 

1 2 3 4 5
1,000 1,000 1,000 1,000 1,000
+
1,100

+
1,210
+
1,331
+
1,464
Rs.6,105
 Future value of an annuity =Lecture
A 03[(1+r)
CF PGP-1]
n 08-10 12
 WHAT LIES IN STORE FOR YOU
Suppose you have decided to deposit Rs.30,000 per year in your
Public Provident Fund Account for 30 years. What will be the
accumulated amount in your Public Provident Fund Account
at the end of 30 years if the interest rate is 11 percent ?
The accumulated sum will be :
Rs.30,000 (FVIFA11%,30yrs)

  = Rs.30,000 (1.11)30 - 1
.11
  = Rs.30,000 [ 199.02]
= Rs.5,970,600
Lecture 03 CF PGP 08-10 13
 HOW MUCH SHOULD YOU SAVE ANNUALLY
You want to buy a house after 5 years when it is expected to cost
Rs.2 million. How much should you save annually if your savings
earn a compound return of 12 percent ?

The future value interest factor for a 5 year annuity, given

an interest rate of 12 percent, is :

(1+0.12)5 - 1
FVIFA n=5, r =12% = = 6.353
0.12
  The annual savings should be :
Rs.2000,000 = Rs.314,812
6.353
Lecture 03 CF PGP 08-10 14
 ANNUAL DEPOSIT IN A SINKING FUND
Futura Limited has an obligation to redeem Rs.500 million
bonds 6 years hence. How much should the company deposit
annually in a sinking fund account wherein it earns 14 percent
interest to cumulate Rs.500 million in 6 years time ?
The future value interest factor for a 5 year annuity,
given an interest rate of 14 percent is :
FVIFAn=6, r=14% = (1+0.14)6 – 1 = 8.536

0.14  
The annual sinking fund deposit should be :
Rs.500 million = Rs.58.575 million
8.536 Lecture 03 CF PGP 08-10 15
 FINDING THE INTEREST RATE
A finance company advertises that it will pay a lump sum of Rs.8,000 at the
end of 6 years to investors who deposit annually Rs.1,000 for 6 years. What
interest rate is implicit in this offer?
The interest rate may be calculated in two steps :
1.  Find the FVIFAr,6 for this contract as follows :

Rs.8,000 = Rs.1,000 x FVIFAr,6

FVIFAr,6 = Rs.8,000 = 8.000

Rs.1,000
2.  Look at the FVIFAr,n table and read the row corresponding to 6 years

until you find a value close to 8.000. Doing so, we find that
FVIFA12%,6 is 8.115 . So, we conclude that the interest rate is slightly below
12 percent. Lecture 03 CF PGP 08-10 16
 HOW LONG SHOULD YOU WAIT
You want to take up a trip to the moon which costs Rs.1,000,000 the cost
is expected to remain unchanged in nominal terms. You can save annually
Rs.50,000 to fulfill your desire. How long will you have to wait if your savings
earn an interest of 12 percent ? The future value of an annuity of Rs.50,000
that earns 12 percent is equated to Rs.1,000,000.
50,000 x FVIFAn=?,12% = 1,000,000
50,000 x 1.12n – 1 = 1,000,000
0.12
  1.12n - 1 = 1,000,000 x 0.12 = 2.4
50,000
  1.12n = 2.4 + 1 = 3.4
n log 1.12 = log 3.4
  n x 0.0492 = 0.5315
  n = 0.5315 = 10.8 years
0.0492
You will have to wait for about 11 years.
Lecture 03 CF PGP 08-10 17
 PRESENT VALUE OF AN ANNUITY
1- 1
Present value of an annuity = A (1+r)n
r
Value of PVIFAr,n for Various Combinations of r and n

n/r 6 % 8% 10 % 12 % 14 %
2 1.833 1.783 1.737 1.690 1.647
4 3.465 3.312 3.170 3.037 2.914
6 4.917 4.623 4.355 4.111 3.889
8 6.210 5.747 5.335 4.968 4.639
10 7.360 6.710 6.145 5.650 5.216
12 8.384 7.536 6.814 6.194 5.660
Lecture 03 CF PGP 08-10 18
Exercise:

(i) Calculate the present value of Rs. 600

(a) received one year from now;
(b) received at the end of five years;
(c) received at the end of fifteen years.
Assume a 5 percent time preference rate

(i) Determine the present value of Rs. 700 each paid at the end of each of the
next six years. Assume an 8 percent of interest rate.

(ii) Assuming a 10 percent discount rate, compute the present value of Rs. 1100,
Rs. 900, Rs. 1500 and Rs. 700 received at the end of one through four years.

Lecture 03 CF PGP 08-10 19

Solution:
(i) Present value of Rs. 600:
(a) The present value factor at 5 % for one year is 0.952.
Rs. 600 x 0.952 = Rs. 571.20
(b) The PVF at 5% for 5 years is 0.784
Rs. 600 x 0.784 = Rs. 470.40
(c) The PVF at 5% for 15 years is 0.481
Rs. 600 x 0.481 = Rs. 288.60

(ii) The PVFA at 8% for 6 years is 4.623

Rs. 700 x 4.623 = Rs. 3236.10

(iii) P= Rs. 1100 x 0.909 + Rs. 900 x 0.826 + Rs. 1500 x 0.751
+ Rs. 700 x 0.683
= Rs. 999.90 + Rs. 743.40 + Rs. 1126.50 + Rs. 478.10
= Rs. 3347.90

Lecture 03 CF PGP 08-10 20

 LOAN AMORTISATION SCHEDULE
Loan : 10,00,000 r = 15%, n = 5 years
10,00,000 = A x PVAn =5, r =15%
= A x 3.3522
A = 298,312

Year Beginning Annual Interest Principal Remaining

Amount Instalment Repayment Balance
(1) (2) (3) (2)-(3) = (4) (1)-(4) = (5)
1 10,00,000 298,312 150,000 148,312 851,688
2 851,688 298,312 127,753 170,559 681,129
3 681,129 298,312 102,169 196,143 484,986
4 484,986 298,312 727,482 225,564 259,422
5 259,422 298,312 38,913 259,399 23*

  a     Interest is calculated by multiplying the beginning loan balance by the interest rate.
b.   Principal repayment is equal to annual instalment minus interest.
* Due to rounding off errorLecture
a small03balance
CF PGPis08-10
shown 21
 EQUATED MONTHLY INSTALMENT

Loan = 10,00,000, Interest = 1% p.m, Repayment period

= 180 months

A x [1-1/(1+0.01)180]
10,00,000 =
0.01
A = Rs.12,002

Lecture 03 CF PGP 08-10 22

 PRESENT VALUE OF A GROWING ANNUITY
A cash flow that grows at a constant rate for a specified period of time is a
growing annuity. The time line of a growing annuity is shown below:
A(1 + g) A(1 + g)2 A(1 + g)n
0 1 2 3 n
The present value of a growing annuity can be determined using the
following formula :
(1 + g)n
1–
(1 + r)n
PV of a Growing Annuity = A (1 + g)
r–g

The above formula can be used when the growth rate is less than the
discount rate (g < r) as well as when the growth rate is more than the
discount rate (g > r). However, it does not work when the growth rate is
equal to the discount rate (g = r) – in this case, the present value is
simply equal to n A. Lecture 03 CF PGP 08-10 23
 PRESENT VALUE OF A GROWING ANNUITY
For example, suppose you have the right to harvest a teak
plantation for the next 20 years over which you expect to get
100,000 cubic feet of teak per year. The current price per cubic
foot of teak is Rs 500, but it is expected to increase at a rate of 8
percent per year. The discount rate is 15 percent. The present
value of the teak that you can harvest from the teak forest can
be determined as follows:

1.0820
1–
1.1520
PV of teak = Rs 500 x 100,000 (1.08)
0.15 – 0.08
= Rs.551,736,683
Lecture 03 CF PGP 08-10 24
 ANNUITY DUE

A A … A A
Ordinary
annuity
0 1 2 n–1 n

A A A … A
Annuity
due
0 1 2 n–1 n

Thus,
Annuity due value = Ordinary annuity value (1 + r)
This applies to both present and future values

Lecture 03 CF PGP 08-10 25

PRESENT VALUE OF PERPETUITY

A
Present value of perpetuity =
r

Lecture 03 CF PGP 08-10 26

 SHORTER COMPOUNDING PERIOD

Future value = Present value 1+ r mxn

m
Where r = nominal annual interest rate
m = number of times compounding is done in a
year
n = number of years over which compounding is
done
Example : Rs.5000, 12 percent, 4 times a year, 6 years
5000(1+ 0.12/4)4x6 = 5000 (1.03)24
= Rs.10,164
Lecture 03 CF PGP 08-10 27
 EFFECTIVE VERSUS NOMINAL RATE

r = (1+k/m)m –1
r = effective rate of interest
k = nominal rate of interest
m = frequency of compounding per year
Example : k = 8 percent, m=4
r = (1+.08/4)4 – 1 = 0.0824
= 8.24 percent
Nominal and Effective Rates of Interest
Effective Rate %
  Nominal Annual Semi-annual Quarterly Monthly
Rate % Compounding Compounding Compounding Compounding
8 8.00 8.16 8.24 8.30
12 12.00 12.36 12.55 12.68
Exercise 1: XYZ Bank pays 12 percent and compounds interest quarterly. If Rs.
1000 is deposited initially, how much shall it grow at the end of 5 years?

Exercise 2: How long will it take to double your money if it grows at 12%
annually.

Exercise 3: Mohan bought a share 15 years ago for Rs. 10. It is now selling for
Rs. 27.60. What is the compound growth rate in the price of the share?

Lecture 03 CF PGP 08-10 29

Solution 1: The quarterly interest rate will be 3 percent and the number of periods
for which it will be compounded will be 20. Thus,
F = P x CVF (20, 3%)
= 1000 x 1.806 = Rs. 1806

Solution 2: F = P x CVF (n, i)

2 = 1 x CVF (n, 0.12)
From the present value tables the factor nearest to 2.00 is
CVF (6, 0.12) = 1.974. Therefore, n = 6 years

Solution 3: F = P x CVF (n, i)

27.60 = 10 x CVF (15, i)
CVF (15, i) = 2.760
From the present value tables, i = 7%

Lecture 03 CF PGP 08-10 30

Exercise 4: Sadhulal Bhai is borrowing Rs. 50000 to buy a low-income group
house. If he pays equal instalments for 25 years and 4 percent interest on
outstanding balance, what is the amount of instalment? What shall be the
amount of instalment if quarterly payments are required to be made?

Exercise 5: A company has issued debentures of RS. 50 lakhs to be repaid after 7

years. How much should the company invest in a sinking fund earning 12
percent in order to be able to repay debentures?

Exercise 6: A bank has offered to you an annuity of Rs. 1800 for 10 years if you
invest Rs. 12000 today. What rate of return would you earn?

Lecture 03 CF PGP 08-10 31

Solution 4: Annual payment
P = A x PVFA (n,i)
Rs. 50000 = A x PVFA (25, 0.04)
Rs. 50000 = A (15.622)
A = Rs. 50000 / 15.622
= Rs. 3200.61

Quarterly payment
P = A x PVFA (100, 0.01)
Rs. 50000 = A (63.029)
A = Rs. 50000 / 63.029
= Rs. 793.28

Lecture 03 CF PGP 08-10 32

Solution 5: A x PVFA (7, 0.12) = Rs. 50 lakhs
A (10.089) = Rs. 50 lakhs
A = 50 / (10.089)
= Rs. 4.96 lakhs

Solution 6: 12000 = 1800 PVFA (10, r)

PVFA (10, r) = 12000 / 1800 = 6.667

PVFA (10, 8%) = 6.710 PVFA (10, 9%) = 6.418

Rate of return = 8% + [6.710 – 6.667] = 8% + 0.043

[6.710 - 6.418] 0.292
= 8% + 0.15% = 8.15%

Lecture 03 CF PGP 08-10 33

Exercise 7: A firm purchases a machinery for Rs. 800,000 by making a down
payment of Rs. 150000 and remainder in equal instalments of Rs. 150000 for
six years. What is the rate of interest to the firm?

Exercise 8: AB Limited is creating a sinking fund to redeem its preference

capital of Rs. 5 lakh issued on 6 April 2004 and maturing on 5 April 2015.
The first annual payment will be made on 6 April 2004. The company will
make equal annual payments and expects that the fund will earn 12 percent
per year. How much will be the amount of sinking fund payment?

Lecture 03 CF PGP 08-10 34

Solution 7: 800000 - 150000= 150000 x PVFA (6, r)
PVFA (6,r) = 650000 / 150000 = 4.333

Solution 8: A x CVFA (n,i) (1 + i) = 500000

A x CVFA (12, 0.12) (1.12) = 500000
A (24.133) (1.12) = 500000
27.029 A = 500000
A = 500000 / 27.029
= Rs. 18498.65

Lecture 03 CF PGP 08-10 35

Exercise 9: ABC Ltd. has borrowed Rs. 1000 to be repaid in equal instalments at
the end of each of the next 3 years. The interest rate is 15 percent. Prepare a
amortisation schedule.

Exercise 10: The earnings of Fairgrowth Ltd. were Rs. 3 per share in year 1.
They increased over a 10-year period to Rs. 4.02. Compute the rate of growth
or compound annual rate of growth of the earnings per share.

Exercise 11: ABC Ltd. has borrowed Rs. 1000 to be repaid in 12 monthly
instalments of Rs. 94.56. Compute the annual interest.

Lecture 03 CF PGP 08-10 36

Solution 9: Amount of equal instalment, A = Pn / PVIFA (i,n)
= Rs. 1000 / 2.2832= Rs. 437.98

Amortisation schedule
Year PaymentInterest Principal paid Bal. outstanding
1 437.98 150.00 287.98 712.02
2 437.98 106.80 331.18 380.84
3 437.98 57.13 380.85 0.00

= Loan balance at the beginning of the year x interest rate

e.g. year 1 = (Rs. 1000 x 0.15) = Rs. 150

Lecture 03 CF PGP 08-10 37

Solution 10: F(n) = P x FVIF (i,n)
4.02 = 3 x FVIF (i, 10)
FVIF (i, 10) = 4.02 / 3
FVIF (i, 10) = 1.340

According to the present value table, an FVIF of 1.340 at 10 years is at 3 percent

interest. The compound annual rate of growth in earnings per share is,
therefore, 3 percent.

Solution 11: P (n) = A x PVIFA (i, n)

1000 = 94.56 x PVIFA (i, n)
PVIFA (i, n) = 1000 / 94.56 = 10.5753

According to present value table, a PVIFA of 10.5753 for 12 periods at interest (i)
= 2 percent. The annual interest rate is therefore
0.02 x 12 = 24 percent

Lecture 03 CF PGP 08-10 38

Exercise: An investor wishes to choose the better of the two equally costly
cashflow streams, namely, Annuity X (AX) and Annuity Y (AY). While AX is
an annuity due (i.e. cash flows occur at the beginning of the year) with a cash
inflow of Rs. 90000 for each of 6 years, AY is an ordinary annuity (i.e. cash
flows occur at the end of the year) with a cash inflow of Rs. 1,00,000 for each
of 6 years.

Assuming 15 per cent return on investment (a) find the future value at the end of
year 6 (FVA 6) for both AX and AY and (b) which annuity is more attractive?

Lecture 03 CF PGP 08-10 39

 SUMMING UP
• Money has time value. A rupee today is more valuable than a
rupee a year hence.
• The general formula for the future value of a single amount
is :
Future value = Present value (1+r)n
• The value of the compounding factor, (1+r)n, depends on the
interest rate (r) and the life of the investment (n).
• According to the rule of 72, the doubling period is obtained
by dividing 72 by the interest rate.
• The general formula for the future value of a single cash
amount when compounding is done more frequently than
annually is:
Future value = Present value [1+r/m]m*n
Lecture 03 CF PGP 08-10 40
• An annuity is a series of periodic cash flows (payments and
receipts) of equal amounts. The future value of an annuity
is:
Future value of an annuity
= Constant periodic flow [(1+r)n – 1)/r]
• The process of discounting, used for calculating the present
value, is simply the inverse of compounding. The present
value of a single amount is:
Present value = Future value x 1/(1+r)n
• The present value of an annuity is:
Present value of an annuity
= Constant periodic flow [1 – 1/ (1+r)n] /r
• A perpetuity is an annuity of infinite duration. In general
terms:
Present value of a perpetuity = Constant periodic flow [1/r]
Lecture 03 CF PGP 08-10 41