Time Value of Money

Topics to be Covered.. • • • • • • • • What is the “Time Value of Money”? Simple & Compound Interest Future Value Present Value Annuities NPV IRR PAYBACK .

1.000 today or Rs. Everyone knows that money deposited in a savings account will earn interest. Because of this universal fact.1. we would prefer to receive money today rather than the same amount in the future .000 in 5 years? Obviously.Time Value of Money Which would you rather have – Rs. Rs.000 today. 1.

110 = Rs.110 Rs.120 = Rs.100 = Rs.5 + Rs.5 + Rs.5 + Rs.105 = Rs.100 = Rs.105 • Year 2: 5% of Rs.125 .5 + Rs.115 = Rs.100 = Rs. you don’t earn interest on interest • Year 1: 5% of Rs.115 • Year 4: 5% of Rs.Simple Interest • With Simple Interest.120 Rs.5 + Rs.100 = Rs.100 = • Year 5: 5% of Rs.100 = • Year 3: 5% of Rs.

08 + Rs.6.5.79 + Rs.5.115.63 .105.110.121.55 • Year 5: 5% of Rs.76 = Rs.51+ Rs.100. a depositor earns interest on interest! • Year 1: 5% of Rs.110.25 • Year 3: 5% of Rs.00 = Rs.55 = Rs.121.76 • Year 4: 5% of Rs.100.76 = Rs.5.25 = Rs.105.Compound Interest • With compound interest.25 + Rs.00 + Rs.55 = Rs.115.5 .00 = Rs.121.110.00 = Rs.115.127.25 = Rs.105.00 • Year 2: 5% of Rs.00 = Rs.

4. how much will be in the account at the end of two years if there are no withdrawals? 0 8% 1 2 Rs.Future Value If you invested Rs. with interest compounded annually. 4.000 FV .000 today in an account that pays 8% interest.

6 P.4665.V – Future Value = 4000(1+0.V – Present Value i – Interest Rate n – Number of Compounding Period .08)^2 = Rs.Future Value (Formula) FV = PV (1 + i)^n F.

How much money must you deposit today in an account that pays 8% interest.000 PV0 .10.10.000? 0 8% 5 10 Rs. compounded annually.10.000 saved 10 years from now. so that you reach your goal of Rs.Present Value Assume that you need to have exactly Rs.

08)10 = Rs.4631.000 PV0 .000 / (1.93 0 8% 5 10 Rs.Present Value (Formula) PV0 = FV / (1+i)n = Rs.10.10.

[1/(1+i)n] i .Annuities • An Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods • FVA = A (1+i)n – 1 i • PVA = A 1 .

1.1.000 2 Rs.1.215 If one saves Rs.145 4 FVA3 = Rs.1.07)1 + Rs.07)0 = Rs.000 a year at the end of every year for three years in an account earning 7% interest.070 Rs.215 = FVA3 .1.1.Example of an Ordinary Annuity -FVA End of Year 0 7% 1 Rs.000(1.3.000(1.1.1.1.000 Rs. compounded annually.07)2 + Rs. how much will one have at the end of the third year? Rs.000 3 Rs.000 (1.3.

000 4 Rs.873.44 Rs.07)1 + Rs.Example of an Ordinary Annuity -PVA End of Year 0 7% 1 Rs.1.07)2 + Rs.1.000/(1.32 If one agrees to repay a loan by paying Rs.000/(1.07)3 = Rs.816.934.1.1.000 a year at the end of every year for three years and the discount rate is 7%.000 3 Rs.1.32 = PVA3 PVA3 = Rs.000 2 Rs.30 Rs.624.000/(1.1.1.58 Rs.624.2. how much could one borrow today? .2.

Net Present Value • NPV = the total PV of the annual net cash flows .the initial outlay FORMULA: Ct=cash inflow in the period t C0=cash outflow of today K=required rate of return T=time period .

000 each for years 1–6.000 per year. Other cash outflows for years 1–6 are expected to be 5.000. The required rate of return is 10%. Cash inflows are expected to be 30. And there are no cash flows expected after year 6.Example: • This project will have an immediate cash outflow of 100. .

08.10)5 30.523 30.00.10)1 30.Year T=0 T=1 T=2 T=3 T=4 T=5 Cash flow -1.10)2 30.10)6 T=6 14.783 17.000-5000/(1.000/(1.000-5000/(1.000-5000/(1.00.10)3 30.000-5000/(1.10)0 30.000 22.10)4 Present value -1.727 20.000-5000/(1.112 TOTAL 1.661 18.075 15.881 .000-5000/(1.

The Internal Rate of Return (IRR) of a Capital Budgeting project is the discount rate at which the Net Present Value (NPV) of a project equals zero.Internal Rate of Return (IRR) IRR: the return on the firm’s invested capital. IRR: CFt t (1 + IRR) = IO .

1000 .1000 500 100 400 200 200 200 200 400 100 700 . YEAR • 0 • 1 • 2 • 3 • 4 • 5 Cost of capital is 10% PROJECT A PROJECT B .

Project A Project B Accept if greater than or equal to the required rate of return Reject if less than required rate of return .

5 years .Payback Period • • • • • • • Year 0 1 2 3 4 5 Cash flow -1000 500 400 200 200 200 Net Cash Flow -1000 .500 -100 100 300 400 Payback Period Payback Period = 2 + (100)/(200) = 2.

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