Time Value of money

Future cash flows are less valuable because of investment opportunities of the present cash flow Logical and meaningful comparison Interest rate /Rate of return / discount rate

Time line Notation

Express the question on time line Techniques
1. Compounding : Single Amount, Annuity, uneven 2. Discounting : Single Amount, Annuity, uneven

Compounding for a single a Amount

Fn = P(1+ i)n
Fn : Future Value P : Principal amount in present n : no. of years compounding is done i : interest rate per annum (1+ i)n : CVF, Compound value factor

General Formula Fn = P{1+ i/m}mn

m : no. of times per year compounding is done n : no. of years i: nominal interest rate

Compounding for Annuity

Annual compounding of a series of payment For simplicity, the compounding period is one year and payment is made at the end of year

Compound sum of an Annuity

Fn = A* CVFA Or Fn = A[(1+i) n -1] / i Ordinary Annuity Annuity due Annuity due = ordinary Annuity * (1 + i)

Discounting for single Amount

PV = Fn /(1+ i)n = Fn * PVF 1/(1+ i)n : PVF, Present value factor Present value of a series of uneven cash flows PV = C1 /(1+ i) + C2 /(1+ i)2 + . Cn /(1+ i)n

Present value of an Annuity

PV = A * PVFA Or PV = A[{1-(1/1+i)n}/i]

Present value of growing annuity

PV = A (1+g)/(1+ i) + A(1+g)2 /(1+ i)2 + PV = A (1+g)[1-{(1+g)n/(1+i)n}]/(i-g)

Present value of perpetuity

PV = A /(1+ i) + A /(1+ i)2 + PV = A / i

Effective Interest rate Effective ={1+(Stated annual interest rate)/m}m 1 Interest rate

Doubling Period
Thumb Rule : Rule of 72 Doubling Period = 72 / interest rate
A more accurate thumb rule : Rule of 69 Doubling period = 0.35 + 69 / interest rate

Summary
Technique Amount Single Annuity Formula Fn = P(1+ i)n = P * CVF Fn = A* CVFA Or Fn = A[(1+i) n -1] / I General formula Tables CVF CVFA

Compounding

Uneven Question

Single
Annuity

PV = Fn /(1+ i)n = Fn * PVF

PV = A * PVFA Or PV = A[{1-(1/1+i)n}/i] General formula

PVF
PVFA

Discounting

Uneven