Time Value of Money

Dr. Vinodh Madhavan

The contents of this presentation are based on the book titled Financial Management:
Theory and Practice 7e by Prasanna Chandra

Why is Time Value of Money important?

A Rupee today is more valuable than a rupee one year hence.
Individuals generally prefer current consumption as opposed to

future consumption
One Rupee today could be invested in risk-free assets so as to

generate (1+rf) rupees one year down the line

In an inflationary environment, rupee today would possess

relatively higher purchasing power vis--vis a rupee one year

down the line.

Why is Time Value of Money important?

Many real-world financial projects/problems would involve multiple cash

flows of differing periodicity.

While evaluating such real-world projects on a standalone basis or while

comparing two or more projects, cash flows pertaining to different projects

need to be brought to the same point of time.
Hence compounding and discounting techniques serve as the foundation for

may things we do in finance

Valuing securities such as stock, bonds, and hybrid instruments
Valuing firms
Assessing viability of envisioned projects at firm level.
Setting up an loan amortization schedule
Determining lease rentals

Time Lines
Any financial exercise involving cash flows at different points of time

would be better served by representing such cash flows in a time line

0

CF1

CF2

CF3

I%

CF0

Tick marks occur at the end of periods, so Time 0 is today; Time 1 is the

end of the first period (year, month, etc.)

End of one time period is the beginning of the next one.
When it comes to valuation, it has to be noted that we all live in time
period zero.

Unequal Cash Flows

Consider the following case of unequal but finite number of cash flows.

0
-50

12%

1
100

12%

2
75

12%

3
50

Since, cash outflow at time period zero happens right now, it need not

be discounted, for present value of any cash flow happening at time

period zero is nothing but the cash flow itself.
The discount rate, (otherwise referred to as opportunity cost of capital

or interest rate or yield in some instances) can differ from one time
period to the other.

Future Value of a Lump Sum

Suppose you invest Rs. 10,000 in a savings account that yields

10% every year on an annual basis.

Value of investment after one year: Rs. 11,000.
Original principal of Rs. 10,000 + 1000 Rs. of interest

Value of Investment after three years: Rs. 13,310

Principal of 11,000 and an interest of Rs. 1100 at the end of year two
Principal of Rs. 12100 and an interest of Rs. 1210 at the end of year

three.
FVt = PV (1+r)t

The power of compounding

Suppose your initial investment of Rs. 10,000 had yielded a simple

interest of 10% per year (As opposed to compound interest)

Total Value of Investment after 3 full years = Principal + Accrued

Simple Interest = 10,000 + 3000 = 13,000

Total Value of Investment after 3 years of Compounding = Rs. 13,310.
The effect of compounding is small for a small number of periods, but

increases as the number of periods increases.

Doubling Period
How long it would take for an investment of Rs. 10,000 (lets say)

to double for a given rate of interest (lets say 12%)

Rule of thumb

Rule of 72
An approximate doubling period can be obtained by dividing

72 by rate of interest (72/12 = 6 years)

A more precise calculation
Doubling Time = 0.35 + 69/Interest Rate = 0.35 + 69/12

= 6.1 years

Present Value One Period Example

Suppose you need $10,000 in two years for the down payment on a

new car. If you can earn 7% annually, how much do you need to
invest today?
PV = 10,000 / (1.07)2 = 8,734.38
Put differently, Present Value calculation helps us answer as to how

much do I have to invest today to have some amount in the future.

When we talk about discounting, we mean finding the present value
of some future amount
When we talk about the value of something, we are talking about
the present value unless we specifically indicate that we want the
future value.

Points to be noted with respect to PV

For a given interest rate the longer the time period, the lower the

present value
What is the present value of $500 to be received in 5 years? 10 years?
The discount rate is 10%
5 years: PV = 500 / (1.1)5 = 310.46
10 years: PV = 500 / (1.1)10 = 192.77
For a given time period the higher the interest rate, the smaller the

present value
What is the present value of $500 received in 5 years if the interest
rate is 10%? 15%?
Rate = 10%: PV = 500 / (1.1)5 = 310.46
Rate = 15%; PV = 500 / (1.15)5 = 248.59

Implied rate of return

Often we will want to know what the implied interest rate is in an

investment
Suppose you are offered an investment that will allow you to

double your money in 6 years. What is the implied rate of

interest?
r = (20,000 / 10,000)1/6 1 = .122462 = 12.25%

Simplifications
Annuity
A stream of constant cash flows that lasts for a fixed number of

periods
Growing annuity
A stream of cash flows that grows at a constant rate for a fixed number

of periods
Perpetuity
A constant stream of cash flows that lasts forever
Growing perpetuity
A stream of cash flows that grows at a constant rate forever

Present Value of an Annuity

A stream of constant cash flows that lasts for a finite amount of

time.

C
C
C
C
PV

2
3
T
(1 r ) (1 r ) (1 r )
(1 r )
C
1
PV 1
T
r (1 r )

Annuity: Example
If you can afford to pay Rs.10,000 per month for the next 3 years towards

servicing a car loan, what is the loan amount that you would be eligible
for? Assume Interest Rate of 7% for the car loan.

10000

10000

10000

10000

Eligible Loan Amount = 3,25,056.55

36

Deferred (Ordinary) Annuity vs. Annuity Due

Ordinary Annuity
0

I%

PMT

PMT

PMT

PMT

PMT

Annuity Due
0
PMT

I%

Annuity: Example
If you can afford to pay Rs.10,000 per month at the beginning of each

month for the next 3 years towards servicing a car loan, what is the loan
amount that you would be eligible for? Assume Interest Rate of 7% for
the car loan.
10000

10000

10000

10000

Eligible Loan Amount = 3,25,056.55 * 1.07 = Rs. 3,47,810.51

36

Future Value of an Annuity

Suppose there is an annuity outflow. Then the future value of such

an annuity at the end of its life could be calculated as follows.

-C

-C

-C

-C

= (1 + )1 +(1 + )2 ++ 1 + +

(1 + ) 1

Future Value of an Annuity

Suppose you deposit Rs. 5000 every month in a bank for the

next 5 years. What will be the future value of this investment

five years hence? Assume an annual interest rate of 10%
Monthly Interest rate happens to be .10/12 = .0083 = .83%
Future Value = 5000

1.008360 1
.0083

= 3,86,776.32

Growing Annuity
A growing stream of cash flows with a fixed maturity

C(1+g)

C (1+g)2

C(1+g)T-1

C
C (1 g )
C (1 g )
PV

2
T
(1 r )
(1 r )
(1 r )
T

1 g
C

PV
1
r g (1 r )

T 1

Growing Annuity
A defined-benefit retirement plan offers to pay Rs. 20,000 per year for

the next 40 years and the payout increases at the rate of 3% each year.
What is the present value at retirement if the discount rate is 10%?

Rs. 20,000

Rs. 20,000(1.03)

Value of Retirement Plan = 20000

$20,000(1.03)39

40
1

1.03 40
1.10

.10.03

= Rs. 2,65,121.5741

Perpetuity
A constant stream of cash flows that lasts forever

C
C
C
PV

2
3
(1 r ) (1 r ) (1 r )
C
PV
r

Growing Perpetuity
A growing stream of cash flows that lasts forever

C(1+g)

C (1+g)2

C
C (1 g ) C (1 g )
PV

2
3
(1 r )
(1 r )
(1 r )
2

C
PV
rg

Classifications of Interest Rates

Nominal rate (INOM) also called the quoted or stated rate. A quoted

annual rate is one that ignores compounding effects.

INOM is stated in contracts. Periodicity of Compounding must also

be given, e.g. 8% interest paid on a quarterly basis or an 8%

interest payable on a daily basis

Periodic rate (IPER) amount of interest charged each period, e.g.

monthly or quarterly.

IPER = INOM/M, where M is the number of compounding periods

per year. M = 4 for quarterly and M = 12 for monthly

compounding.

Classifications of Interest Rates

Effective (or equivalent) annual rate (EAR = EFF%) the annual rate

of interest actually being earned, accounting for compounding.

What is the EFF% for an investment that pays 10% interest on a

semiannual basis?
EFF% = ( 1 + INOM/M )M 1 = ( 1 + 0.10/2 )2 1 = 10.25%
An investor should be indifferent between receiving 10.25% interest

on an annual basis and receiving 10% interest on a semi annual basis

Similarly, if compounding happens every day of the year, the annual
rate of interest that an investor should earn for him/her to be
indifferent to periodicity of compounding? (Ans: 10.52%)

Please Note
Investments with different compounding intervals provide different

effective returns.
To compare investments with different compounding intervals, you

must look at their effective returns (EFF% or EAR).

Problems on TVM
1.

After five years, Ramesh will receive a pension of Rs. 6000

per month for 15 years. How much can Ramesh borrow
now at 12% interest so that borrowed amount can be paid
with 30% of pension amount? The interest will be
accumulated till the first pension amount becomes
receivable.

2.

Mr. Longman receives a provident fund amount of Rs.

1,00,000. He deposits it in a bank which pays 10%
interest. If he withdraws annually Rs. 20,000, how long can
he do so?

Problems on TVM
3.

As a winner of a competition, you can choose one of the following

prizes. If the interest rate is 10%, which one would you prefer?
a. Rs. 500,000 now
b. Rs. 1,000,000 at the end of 6 years
c. Rs. 60,000 a year forever
d. Rs. 100,000 per year for 10 years
e. Rs. 35,000 next year and rising thereafter by 5% per year forever.

4.

An oil well presently produces 80,000 barrels per year. It will last for
20 years more, but the production will fall by 6% per year. Oil prices
are expected to increase by 4% per year. Currently, the price of oil is
Rs. 60 per barrel. What is the present value of wells production if the
discount rate is 12%.

Problems on TVM
5.

Pipe India owns an oil pipeline which will generate Rs. 120
million of cash income in the coming year. It has a very long life
with virtually negligible operating costs. The volume of oil
shipped however will decline over time and hence cash flows will
decrease by 3% per year. Assume a discount rate of 12%
a.

If the pipeline is used forever, what is the present value of its

cash flows?

b.

If the pipeline is scrapped after 25 years, what is the present

value of its cash flows?

Problems on TVM
6.

You are considering whether your savings will be enough

to meet your retirement needs. You saved Rs. 100,000 last
year and you expect your annual savings to increase by 8%
per year for the next 20 years. If your savings can be
invested at 9%, how much would you have at the end of 20
years?

7.

A bank offers an interest rate of 8% on deposits made with

it. If the compounding happens on a weekly basis, what is
the effective interest arte offered by the bank?

Problems on TVM
8.

Ravi wants to save for the college education of his son, Deepak.
Ravi estimates that the college education expenses will be Rs. 10
lacs per year for four years once his son reaches college in 16
years the expenses would be paid at the beginning of the
years. He expects the annual interest rate of 8% over the next
two decades. How much money should he deposit in the bank
each year for the next 15 years (assuming that the deposit is
made at the end of each year) to take care of his sons college
education expenses?

9.

Phoenix company borrows Rs. 500,000 at an interest rate of

14%. The loan is to be repaid in 4 equal annual installments
payable at the end of each of the next 4 years. Prepare the loan
amortisation schedule.

Problems on TVM
10. It is now January 1. You plan to make 5 deposits of $100 each,

one every six months, with the first payment being made today.
If the bank pays a nominal interest rate of 12% but uses
semiannual compounding, how much will you have in account
after 10 years?
11. You must make a payment of $ 1432.02 ten years from today. To

prepare for this payment, you will have to make 5 equal deposits,
beginning today and for the next 4 quarters, in a bank that pays a
nominal interest rate of 12%, quarterly compounding. How
large must each of the five payments be?

Problems on TVM
12. Anne Lockwood, manager of Oaks Mall Jewelry, wants to sell on credit,

giving customers 3 months in which to pay. However Anne will have to

borrow from her bank to meet her firms accounts payable for the
interim period. The bank will charge a nominal interest rate of 15%, but
with monthly compounding. Anne wants to quote a nominal rate to her
customers (All of whom are expected to pay on time) that will exactly
cover her financing costs. What nominal annual rate should she quote to
her credit customers?
13. Suppose someone offered to sell you a note calling for the payment of
$1000 fifteen months from today, for $850. You have $850 in your bank
for which you are paid 6.76649% nominal rate with daily compounding.
If you decide not to buy the note, you plan to leave the money in the
bank as it is. The note is not risky. You are sure it will be paid on
schedule. Should you buy the note?

Problems on TVM
14. Assume that Rakesh is now 50 years old, that he plans to retire

in 10 years and that he expects to live for 25 years after he

retires, that is until, he is 85. Rakesh wants a fixed retirement
income that has the same purchasing power at the time he
retires as Rs. 40,000 has today (he realizes that the real value of
his retirement income will decline year by year after he retires).
His retirement income will begin the day he retires, 10 years
from today, and he will then get 24 additional annual payments.
Inflation is expected to be 5% from today forward. Rakesh
currently has a savings of Rs. 1 lac in his bank account for which
expects a return of 8% per year (annual compounding). How
much more should Rakesh save each year for the next 10 years
(with deposits made at the end of each year) to meet his
retirement goal?

Problems on TVM
15. Your company is planning to borrow Rs. 10 lacs on a 5 year

15% annual payment, fully-amortized term loan. What

fraction of the payment made at the end of second year will
represent repayment of principal?

J Smythe Inc.
J Smythe Inc. manufactures fine furniture and is contemplating on

introducing a new mahogany dining room table set. The set will sell for
5600$, including a set of eight chairs.
The company feels that the sales will be 1300, 1325, 1375, 1450 and
1320 sets per year for the next five years, respectively.
Variable cost will be 45% of sales and fixed costs will be $ 1.7 million.
The new tables will require inventory amounting to 10% of sales,
produced and stockpiled in the year prior to the sales.
It is believed that the introduction of mahogany table set will cause a
loss of 200 tables per year of the oak table that the company currently
produces.
The oak tables sell for $ 4500 and have a variable costs of 40% of sales.
The inventory for this oak table is also 10% of sales.

J Smythe Inc.
J Smythe currently has excess production capacity. If the company buys

necessary production equipment today, it will cost the company $10.5

million.
However availability of excess capacity implies that the company can go
ahead and produce the mahogany tables for the time being without
investing in a new equipment.
The comptroller of the company has pointed out that the current
excess capacity of company will end in two years should the company
choose to utilize excess capacity for production of mahogany tables.
Two years hence, the company would be forced to spend $ 10.5 million
to accommodate for increased sale of the companys products.
Five years from now, the new equipment will have a market value of
$2.8 million if purchased today, and a market value of $ 6.1 million if
purchased two years hence.

J Smythe Inc.
The depreciation rates for the new equipment is as follows

Year 1: 14.3%
Year 2: 24.5%
Year 3: 17.5%
Year 4: 12.5%
Year 5: 8.9%

The company has a tax rate of 40% and the required return for the

project is 14%.

All things considered, should the company get into the business of

selling mahogany table sets?