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Basic Concept of Time Value of Money
Basic Concept of Time Value of Money
1.1
INTRODUCTION
Money has time value. A rupee today is more valuable than a year hence. It
is on this concept the time value of money is based. The recognition of the
time value of money and risk is extremely vital in financial decision making.
Most financial decisions such as the purchase of assets or procurement
of funds, affect the firms cash flows in different time periods. For example,
if a fixed asset is purchased, it will require an immediate cash outlay and
will generate cash flows during many future periods. Similarly if the firm
borrows funds from a bank or from any other source, it receives cash and
commits an obligation to pay interest and repay principal in future periods.
The firm may also raise funds by issuing equity shares. The firms cash
balance will increase at the time shares are issued, but as the firm pays
dividends in future, the outflow of cash will occur. Sound decision-making
requires that the cash flows which a firm is expected to give up over period
should be logically comparable. In fact, the absolute cash flows which differ
in timing and risk are not directly comparable. Cash flows become logically
comparable when they are appropriately adjusted for their differences in
timing and risk. The recognition of the time value of money and risk is
extremely vital in financial decision-making. If the timing and risk of cash
flows is not considered, the firm may make decisions which may allow it to
miss its objective of maximising the owners welfare. The welfare of owners
would be maximised when Net Present Value is created from making a
financial decision. It is thus, time value concept which is important for
financial decisions.
Thus, we conclude that time value of money is central to the concept of
finance. It recognizes that the value of money is different at different points
of time. Since money can be put to productive use, its value is different
depending upon when it is received or paid. In simpler terms, the value of a
certain amount of money today is more valuable than its value tomorrow. It
is not because of the uncertainty involved with time but purely on account
1
FINANCIAL MATHEMATICS
When cash flows occur at different points in time, it is easier to deal with
them using a timeline. A timeline shows the timing and the amount of each
cash flow in cash flow stream. Thus, a cash flow stream of ` 10,000 at the
end of each of the next five years can be depicted on a timeline like the one
shown below.
As shown above, 0 refers to the present time. A cash flow that occurs at
time 0 is already in present value terms and hence does not require any
adjustment for time value of money. You must distinguish between a period
1
of time and a point of time . Period 1 which is the first year is the portion of
timeline between point 0 and point 1. The cash flow occurring at point 1 is
the cash flow that occurs at the end of period 1. Finally, the discount rate,
which is 12 per cent in our example, is specified for each period on the
timeline and it may differ from period to period. If the cash flow occurs at
the beginning, rather than the end of each year, the timeline would be as
shown in Part B. Note that a cash flow occurring at the end of the year 1 is
equivalent to a cash flow occurring at the beginning of year 2. Cash flows
can be positive or negative. A positive cash flow is called a cash inflow; and
a negative cash flow, a cash outflow.
1.4
FINANCIAL MATHEMATICS
VALUATION CONCEPTS
There are two techniques for adjusting time value of money. They are:
1. Compounding Techniques/Future Value Techniques
2. Discounting/Present Value Techniques
The value of money at a future date with a given interest rate is called
future value. Similarly, the worth of money today that is receivable or
payable at a future date is called Present Value.
First year
FVn = PV(1 + r )
n
By taking into consideration, the above example, we get the same result.
n
FVn = PV (1 + r )
= 1,000 (1.10)
FVn = 1331
To solve future value problems, we consult a future value interest factor
(FVIF) table. The table shows the future value factor for certain
combinations of periods and interest rates. To simplify calculations, this
expression has been evaluated for various combination of r and n.
Exhibit 1.1 presents one such table showing the future value factor for
certain combinations of periods and interest rates.
FINANCIAL MATHEMATICS
n/r
2
4
6
8
10
12
6%
8%
10%
12%
14%
1.124
1.262
1.419
1.594
1.791
2.012
1.166
1.360
1.587
1.851
2.159
2.518
1.210
1.464
1.772
2.144
2.594
3.138
1.254
1.574
1.974
2.476
3.106
3.896
1.300
1.689
2.195
1.853
3.707
4.817
1.6
where,
mn
m
FVn = Future value after n years
PV = Cash flow today
r = Interest rate per annum
m = Number of times compounding is done during a year
n = Number of years for which compounding is done.
PV 1 +
mn
m
=
1000
1 +
.10 2 3
2
= ` 1340
OR
The compound value of Re. 1 at 5% interest at the end of 6 years is `
1.340. Hence the value of ` 1000 using the table (FVIF r , n ) will be
PV 1 +
mn
m
= 10,000 1 +
.10 4 3
4
12
= 10,000 (1 + 0.025)
= ` 13,448.89
ILLUSTRATION 4: Mr. Ravi Prasad and Sons invests ` 500, ` 1,000, ` 1,500,
Rs 2,000 and ` 2,500 at the end of each year. Calculate the compound value
th
at the end of the 5 year, compounded annually, when the interest charged
is 5% per annum.
SOLUTION: Statement of the compound value
End of
the Year
Amount
Deposited
(1)
(2)
1
2
3
4
5
500
1,000
1,500
2,000
2,500
Futur e
Value
(4)
(2) (4)
1.216
1.158
1.103
1.050
1.000
608.00
1,158.00
1,654.50
2,100.00
2,500.00
8020.50
1.7
FINANCIAL MATHEMATICS
where
1.8
PV 1 +
r
m
Effective interest rate brings all the different bases of compounding such as
yearly, half-yearly, quarterly, and monthly on a single platform for
comparison to select the beneficial base. Now, the question is which works
out highest interest amount? When interest is compounded on half-yearly
basis, interest amount works out more than the interest calculated on yearly
basis. Quarterly compounding works out more than half-yearly basis.
Monthly compounding works out more than even quarterly compounding.
So, if compounding is more frequent, then the amount of interest per year
works out more. Now, we want to equate them for comparison.
Suppose, an option is given as the following:
Basis of Compounding
Yearly
Half-yearly
Quarterly
Monthly
10%
9.5%
9%
8.5%
m
1
m
where
Take nominal interest rate as the base and find-out the comparable rate
of interest for half-yearly, quarterly and monthly basis and select that which
is most attractive.
ILLUSTRATION 5:
(i) A company offers 12% rate of interest on deposits. What is the
effective rate of interest if the compounding is done on
(a ) Half-yearly
(b) Quarterly
(c) Monthly
(ii) As an alternative, the following rates of interest are offered for
choice. Which basis gives the highest rate of interest that is to be
accepted?
Basis of Compounding
Yearly
Half-yearly
Quarterly
Monthly
12%
11.75%
11.50%
11.25%
SOLUTION:
(i) The formula for calculation of effective interest is as below:
EIR =
m
(A) When the compounding is done on half-yearly basis:
+
EIR = 1
.12 2
2
= 1.1236 1
= 12.36%
(B) When the compounding is done on quarterly basis
EIR
.12
4
= 0.1255
= 12.55%
(C) When the compounding is done on monthly basis
EIR = 1 + .12
12
= 0.1268
= 12.68%
12
10
FINANCIAL MATHEMATICS
Basis of Compounding
EIR
12%
12%
12%
12%
12%
12.36%
12.55%
12.68%
Yearly
Half-yearly
Quarterly
Monthly
EIR = 1 + .1175
2
= 0.1209
= 12.09%
When the compounding is done on quarterly basis:
1
EIR =
0.1150
4
= .1200
= 12%
When the compounding is done on monthly basis
EIR =
0.1125 12
12
= 0.1184
= 11.84%
Thus, out of all interest rate, interest rate of 11.75% on half-yearly
compounding works out to be the highest effective interest rate i.e.,
12.09% so this option is to be accepted.
ILLUSTRATION 6: Find out the effective rate of interest, if nominal rate of
interest is 12% and is quarterly compounded.
SOLUTION:
EIR = 1
m
1
m
= 1
.12
4
1
4
4
= [(1 + 0.03) 1]
= 1.126 1
= 0.126
= 12.6% p.a.
11
Growth Rate
The compound rate of growth for a given series for a period of time can
be calculated by employing the future value interest factor table (FVIF )
EXAMPLE:
Year s
1
2
3
4
5
6
95
105
140
160
165
170
How is the compound rate of growth for the above series determined?
This can be done in two steps:
(i) The ratio of profits for year 6 to year 1 is to be determined i.e.,
170
= 1.79
95
(ii) The FVIF r,n table is to be looked at. Look at a value which is close
to 1.79 for the row for 5 years. The value close to 1.79 is 1.762 and
the interest rate corresponding to this is 12%. Therefore, the
compound rate of growth is 12 per cent.
1.9
Present value is the exact opposite of future value. The present value of a
future cash inflow or outflow is the amount of current cash that is of
equivalent value to the decision maker. The process of determining present
value of a future payment or receipts or a series of future payments or
receipts is called discounting. The compound interest rate used for
discounting cash flows is also called the discount rate. In the next chapter,
we will discuss the net present value calculations.
1.10 SIMPLE AND COMPOUND INTEREST
12
FINANCIAL MATHEMATICS
1
5
10
20
50
100
S1 = P 0 (I) (n)
SOLUTION:
where
S1 = Simple interest
P 0 = Initial amount invested
I = Interest rate
n = Number of years
S1 = ` 1,00,000 0.06 5 years
S1 = ` 30,000
If the investor wants to know his total future value at the end of n years.
Future value is the sum of accumulated interest and the principal amount.
Symbolically
S1 + P 0
ILLUSTRATION 8: Mr. Krishnas annual savings is ` 1,000 which is
invested in a bank saving fund account that pays a 5 per cent simple interest.
Krishna wants to know his total future value or the terminal value at the end
of a 8 years time period.
13
SOLUTION:
Compound Interest
ILLUSTRATION 9: Suppose Mr. Jai Singh Yadav deposited ` 10,00,000 in a
financial institute which pays him 8 percent compound interest annually for
a period of 5 years. Show how the deposit would grow.
8
FV = P (1 + I)
SOLUTION:
5
FV5 = ` 14,69,000
Note: See compound value of one rupee Table for 5 years at 8% interest.
FV10 =
P 1
0
24
2
1
= Rs. 40,000
0.06 2 10
2
= ` 40,000 (1.806)
= Rs. 72,240
Alternatively, see the compound value for one rupee table for year 20
and 3% interest rate.
ILLUSTRATION 11: (Quarterly compounding): Suppose a firm deposits ` 50
lakhs at the end of each year, for 4 years at the rate of 6 per cent interest and
compounding is done on a quarterly basis. What is the compound value at
th
the end of the 4 year?
SOLUTION:
P0 1 +
FV4 =
4n
4
=
Rs. 50,00,000 1
644
4
= ` 50,00,000 1.267
= ` 63,35,000
14
FINANCIAL MATHEMATICS
Formula: g r = V0 (1 + r ) = Vn where, g r =
Growth rate in percentages
V0 = Variable for which the growth rate is needed
Vn = Variable value (amount) at the end of year n (1
n
+ r ) = Growth rate.
ILLUSTRATION 12: From the following dividend data of a company,
calculate compound rate of growth for 20032008.
SOLUTION:
Year
2003
2004
2005
2006
2007
2008
21
22
25
26
28
31
g r = V (1 + r )
0
= 21 (1 + r )
5
= (1 + r ) =
31
=V
n
= 31
= 1.476 21
Alternatively, the compound value one Rupee table for 5 years should
be seen till closed value to the compound factor is found. After finding the
closest value, first above it is seen to get the growth rate.
15
9. A rational human being has a time preference for money. Give reasons.
10. Explain the discounting and compounding technique of time value of money?