Sessions 2, 3 and 4

Time Value of Money

Present Value and Future Value

FINANCIAL MANAGEMENT
MBA
2024

Dr. Kavitha Ranganathan

T. A. Pai Management Institute
Critical Concepts
 Cash flows and Assets

 The Time Value of Money

 The Present Value and Future Value

 Special Cashflows:

 Perpetuities and Annuities

 Nominal and Real Interest Rate

 Inflation

 References:

 Textbook: Brigham et al.

 Andrew Lo, MIT Lectures

 Aswath Damodaran Corporate Finance material

Cash Flows and Assets
Cash Flows and Assets
Key Insight: Manipulating Cashflows

 What is--

 ¥150 + £300 = ??
Key Insight: Cashflows At Different Dates
Are Different “Currencies”

Past and future CFs cannot be combined

without first converting them

 Need an exchange rate

How do you convert them?

How do you convert Cash Flows?
Future Value--Compounding

$1 today is worth more than $1 in the future

(why?)
Present Value--Discounting
Example
What Determines the discount or the compound rate?

 Supply and Demand

 more people want money today than tomorrow

 Inflation
 Inflation is how the price of goods generally increases, and can be
an appropriate substitute for figuring out the future value of money

 Opportunity Cost of Capital

 rate of return which can be earned from next best alternative
investment opportunity with similar risk profile
 Discount Rate and Opportunity Cost: Insights

 You have identified a house

that is available for purchase
for INR 280000. You are
absolutely certain that you
will be able to sell it for Rs.
320000 in one year’s time.
Should you purchase it?
Assume banks are paying an
annual interest of 5%.

 NPV?
 INR 24,761.90

 Opportunity cost?
Problem 1
Solution
The Time Value of Money

 Implicit Assumptions

 Cashflows are known (magnitudes, signs, timing)

 Discount rates are known and stable.
 No frictions in converting Present and Future Values.

 Do These Assumptions Hold in Practice?

 Which assumptions are most often violated?

 Which assumptions are most plausible?

 We take these assumptions as truth (for now!)

Time Value of Money
Perpetuities and Annuities
How to value them?

FINANCIAL MANAGEMENT
MBA
2024

Dr. Kavitha R anganathan

T. A. Pai Management Institute
 Annuities and Perpetuities
Perpetuities

A perpetuity is a stream of cash flows that

goes on forever
Examples of perpetuities in financial
markets includes:
 Preferred stock
 Consol bonds (bonds with no maturity date)


0 1 2 3

$100 $100 $100

Special Cashflows: Perpetuity
Special Cashflows: Perpetuity

C
PV0 
r

Where:
PV0 = Present value of the perpetuity
C = the periodic cash
r = the discount rate
Example: Valuing Perpetuity

 While acting as executor for a distant relative, you

discover a £1,000 Consol Bond issued by Great Britain
in 1814, issued to help fund the Napoleonic War. If the
bond pays annual interest of 3% and other U.K.
Government bonds are currently paying 5%, what would
each £1,000 Consol Bond sell for in the market?
Growing Perpetuity
Annuities

An annuity is a stream of payments that

continues for a finite period of time

 Annuity pays a fixed sum each year for a specified
number of years

If the payment occurs at the end of the period,

it is an ordinary annuity
If the payment occurs at the start of the time

period, it is an annuity due

Difference Between Annuity Types

Ordinary Annuity
0 1 2 3

$100 $100 $100

Annuity Due
0 1 2 3

$100 $100 $100 $100

Value an Ordinary Annuity
 Annuities
Ordinary Annuities

Present Value of n year Future Value of n year annuity

annuity

C 1   ( 1  r) n  1
PV0  1  n 
FVn C  
r  (1  r )   r 
 Problem 1
 You have just won a lottery. The Lottery Corporation gives
you two options. You can take 10,00,000 at the end of
each year for 25 years or a lump sum of 100,00,000 today.
If the appropriate discount rate is 10%, what should you
do?

C 1 
PV0  1  n 
r  (1  r ) 

( )
−𝑛
1 − ( 1+𝑟 )
𝑃 𝑉 ¿ 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 =𝐶
¿ 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑟
 Problem 2
 Assume that you want to save 2,000 at the end of each
year for the next 10 years. If you can earn 10% on
your investments, how much would you have saved?

 ( 1  r) n  1
FVn C  
 r 

𝐹 𝑉 ¿ 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 =𝐶
¿ 𝐴𝑛𝑛𝑢𝑖𝑡𝑦
(( 1+𝑟 )𝑛 − 1
𝑟 )
 Annuities
Annuities Due

 ( 1  r)n  1
FVn C   (1  r)
 r 

(1+r)
 Problem 3: PV or FV?
 Assume that we want to save 2,000 at the beginning of
each year for the next 10 years. If we can earn 10% on
our investments, how much will we have saved?

𝐹 𝑉 ¿ 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 =𝐶
¿ 𝐷𝑢𝑒
(
( 1+𝑟 )𝑛 − 1
𝑟 )( 1+𝑟 )
 Problem 4: PV or FV?

Let’s continue with the previous example, but now the Lottery
Corporation gives you the option of taking 1,000,000 at the
beginning of each year for 25 years or a lump sum of
10,000,000 today. If the appropriate discount rate is 10%, what
should you do?
Problem 5: Relationship Between
Annuity Due and Ordinary Annuity
 The future value of the ordinary annuity is $ 31,874.85
 The FV of the annuity due is $ 35,062.33
 The interest rate is 10%
 Now calculate how much larger (in percent terms) the
annuity due is compared to the ordinary annuity

P1  P0
% 
P0
35, 062.33  31,874.85

31,874.85
10%
Interest Rates
 Compounding Conventions

Interest May Be Credited/Charged More Often Than

Annually
• Bank Accounts?
• Daily
• Mortgages and Leases
• Monthly
• Bonds
• Semi-annually
• Effective Interest rate may differ from Quoted Interest
rate
 Nominal Versus Effective Interest Rates

When rates are compounded annually, the

quoted rate (nominal) and the effective rate

are equal
As the number of compounding periods per

year increases, the effective rate will become

larger than the quoted rate
Calculating the Effective Rate

( ) −1
𝑚
𝑄𝑅
𝑟 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 = 1+
𝑚

Where:
rEffective = Effective annual interest rate
QR = the quoted interest rate
m = the number of compounding periods per year
Problem 6: Effective Rate Calculation

 A bank is offering loans at 6%, compounded monthly.

What is the effective annual interest rate on its loans?

( )
𝑚
𝑄𝑅
𝑟 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒= 1 + −1
𝑚
Example

( )
𝒎
𝑸𝑹
𝒓 𝑬𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 = 𝟏+ −𝟏
𝒎
 Continuous Compounding

When compounding occurs continuously, we

calculate the effective annual rate using e,
the base of the natural logarithms
(approximately 2.7183)

𝑄𝑅
𝑟 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 =𝑒 − 1
10% Compounded At Various
Frequencies

Compounding Effective Annual

Frequency Interest Rate
2 10.25%
4 10.3813%
12 10.4713%
52 10.5065%
365 10.5156%
Continuous 10.5171%

5 - 40
 Loan Amortization

A “blended” payment loan is repaid in equal

periodic payments
However, the amount of principal and
interest varies each period

Suppose we want to calculate an

amortization table showing the amount of
principal and interest paid each period for a
Rs. 5,000 loan at 10% repaid in three equal
annual instalments.
 Problem 7: Loan Amortization

 Rs. 5,000 loan at 10% repaid in three equal annual instalments.

 First calculate the interest payments

 Second calculate the annual payments

𝑃𝑉 𝐴𝑛𝑛𝑢𝑖𝑡𝑦
𝐶=

( )
−𝑛
1 − ( 1 +𝑟 )
𝑟

5 - 42
 Example: Amortization Table

Period Principal: Paymen Interest Principal Principal:

Start of t End of
Period Period
1 5,000.00 2010.5 500.00 1,510.57 3,489.43
7
2 3,489.43 2010.5 348.94 1,661.63 1,827.80
7
3 1,827.80 2010.5 182.78 1,827.78 0
7

5 - 43
 Problem 8: Amortized Loan with Fixed Payment
44

Consider a 4-year loan with annual payments.

The interest rate is 8% and the principal

amount is $5,000. What is the annual payment?
 Format for Amortisation Schedule

Year Begining Annual Interest Principal End

Balance Payment Paid Paid Balance
1
2
3
4
Total
Problem 8: Amortization Table

Year Beg. Total Interest Principal End.

Balance Payment Paid Paid Balance
1 5,000.00 1,509.60 400.00 1,109.60 3,890.40

2 3,890.40 1,509.60 311.23 1,198.37 2,692.03

3 2,692.03 1,509.60 215.36 1,294.24 1,397.79

4 1,397.79 1,509.60 111.82 1,397.78 .01

Totals 6,038.40 1,038.41 4,999.99

46
 Practice Problems
1. What is the balance in an account at the end of 10 years
if $2500 is deposited today and the account earns 4%
interest, compounded annually? Quarterly?

2. If you deposit $10 in an account that pays 5% interest,

compounded annually, how much will you have at the end
of 10 years? 50 years? 100 years?

3. How much interest on interest is earned in an account by

the end of 5 years if $100,000 is deposited and interest is
4% per year, compounded continuously?

Note: Interest on interest is the difference between the

future value calculated using compounded interest and the
future value calculated using simple interest, because
simple interest includes only interest on the principal
 Practice Problems

3. How much will be in an account at the end

of five years the amount deposited today is
$10,000 and interest is 8% per year,
compounded semi-annually?

4. How much would I have to deposit in

an account today that pays 12% interest,
compounded quarterly, so that I have a balance
of $20,000 in the account at the end of 10
years?
 Practice Problems

5. Suppose I want to be able to withdraw

$5,000 at the end of five years and withdraw
$6,000 at the end of six years, leaving a zero
balance in the account after the last
withdrawal. If I can earn 5% on my balances,
how much must I deposit today to satisfy my
withdrawals needs?
Given: Hint -- There are two different future
values. Treat as two separate present values,
then combine.
 Practice Problems

6. The Lucky Loan Company will lend you $10,000

today with terms that require you to pay off the loan
in thirty-six monthly instalments of $500 each. What
is the effective annual rate of interest that the Lucky
Loan Company is charging you?

7. Under what conditions does the effective annual

rate of interest (EAR) differ from the annual or
quoted percentage rate (APR)?

8. As the frequency of compounding increases

within the annual period, what happens to the
relation between the EAR and the APR?