CHAPTER

Basic Concept of Time Value

1
of Money

INTRODUCTION

Moneyhastimevalue.Arupeetodayismorevaluablethanayearhence.It
isonthisconceptthetimevalueofmoneyisbased.Therecognitionofthe
timevalueofmoneyandriskisextremelyvitalinfinancialdecisionmaking.

Mostfinancialdecisionssuchasthepurchaseofassetsorprocurementof
funds,affectthefirmscashflowsindifferenttimeperiods.Forexample,if
afixedassetispurchased,itwillrequireanimmediatecashoutlayandwill
generatecashflowsduringmanyfutureperiods.Similarlyifthefirm
borrowsfundsfromabankorfromanyothersource,itreceivescashand
commitsanobligationtopayinterestandrepayprincipalinfutureperiods.
Thefirmmayalsoraisefundsbyissuingequityshares.Thefirmscash
balancewillincreaseatthetimesharesareissued,butasthefirmpays
dividendsinfuture,theoutflowofcashwilloccur.Sounddecisionmaking
requiresthatthecashflowswhichafirmisexpectedtogiveupoverperiod
shouldbelogicallycomparable.Infact,theabsolutecashflowswhichdiffer
intimingandriskarenotdirectlycomparable.Cashflowsbecomelogically
comparablewhentheyareappropriatelyadjustedfortheirdifferencesin
timingandrisk.Therecognitionofthetimevalueofmoneyandriskis
extremelyvitalinfinancialdecisionmaking.Ifthetimingandriskofcash
flowsisnotconsidered,thefirmmaymakedecisionswhichmayallowitto
missitsobjectiveofmaximisingtheownerswelfare.Thewelfareofowners
wouldbemaximisedwhenNetPresentValueiscreatedfrommakinga
financialdecision.Itisthus,timevalueconceptwhichisimportantfor
financialdecisions.

Thus,weconcludethattimevalueofmoneyiscentraltotheconceptof
finance.Itrecognizesthatthevalueofmoneyisdifferentatdifferentpoints
oftime.Sincemoneycanbeputtoproductiveuse,itsvalueisdifferent
dependinguponwhenitisreceivedorpaid.Insimplerterms,thevalueofa
certainamountofmoneytodayismorevaluablethanitsvaluetomorrow.It
isnotbecauseoftheuncertaintyinvolvedwithtimebutpurelyonaccount
1

FINANCIAL MATHEMATICS

oftiming.Thedifferenceinthevalueofmoneytodayandtomorrowis
referredastimevalueofmoney.

REASONS FOR TIME VALUE OF MONEY

Moneyhastimevaluebecauseofthefollowingreasons:

RiskandUncertainty:Futureisalwaysuncertainandrisky.Outflowof
cashisinourcontrolaspaymentstopartiesaremadebyus.Thereisno
certaintyforfuturecashinflows.Cashinflowsisdependentoutonour
Creditor,Banketc.Asanindividualorfirmisnotcertainaboutfuturecash
receipts,itprefersreceivingcashnow.

Inflation:Inaninflationaryeconomy,themoneyreceivedtoday,hasmore
purchasingpowerthanthemoneytobereceivedinfuture.Inotherwords,a
rupeetodayrepresentsagreaterrealpurchasingpowerthanarupeeayear
hence.

Consumption:Individualsgenerallyprefercurrentconsumptiontofuture
consumption.

Investmentopportunities:Aninvestorcanprofitablyemployarupee
receivedtoday,togivehimahighervaluetobereceivedtomorroworaftera
certainperiodoftime.

Thus,thefundamentalprinciplebehindtheconceptoftimevalueofmoney
isthat,asumofmoneyreceivedtoday,isworthmorethanifthesameis
receivedafteracertainperiodoftime.Forexample,ifanindividualisgiven

analternativeeithertoreceive`10,000noworafteroneyear,hewillprefer
`10,000now.Thisisbecause,today,hemaybeinapositiontopurchase
moregoodswiththismoneythanwhatheisgoingtogetforthesame
amountafteroneyear.

Thus,timevalueofmoneyisavitalconsiderationinmakingfinancial
decision.Letustakesomeexamples:

EXAMPLE 1: Aprojectneedsaninitialinvestmentof ` 1,00,000.Itis expected

togiveareturnof`20,000perannumattheendofeachyear,forsixyears.
Theprojectthusinvolvesacashoutflowof`1,00,000inthezeroyearand
cashinflowsof`20,000peryear,forsixyears.Inordertodecide,whether
toacceptorrejecttheproject,itisnecessarythatthePresentValueofcash
inflowsreceivedannuallyforsixyearsisascertainedandcomparedwiththe
initialinvestmentof`1,00,000.

ThefirmwillaccepttheprojectonlywhenthePresentValueofcashinflows
atthedesiredrateofinterestexceedstheinitialinvestmentoratleastequals
theinitialinvestmentof`1,00,000.

EXAMPLE 2: Afirmhastochoosebetweentwoprojects.Oneinvolvesan
outlayof`10lakhswithareturnof12%fromthefirstyearonwards,for

BASIC CONCEPT OF TIME VALUE OF MONEY

3

tenyears.Theotherrequiresaninvestmentof`10lakhswithareturnof
14%perannumfor15yearscommencingwiththebeginningofthesixth
yearoftheproject.Inordertomakeachoicebetweenthesetwoprojects,it
isnecessarytocomparethecashoutflowsandthecashinflowsresulting
fromtheproject.Inordertomakeameaningfulcomparison,itisnecessary
thatthetwovariablesarestrictlycomparable.Itispossibleonlywhenthe
timeelementisincorporatedintherelevantcalculations.Thisreflectsthe
needforcomparingthecashflowsarisingatdifferentpointsoftimein
decisionmaking.

TIMELINES AND NOTATION

Whencashflowsoccuratdifferentpointsintime,itiseasiertodealwith
themusingatimeline.Atimelineshowsthetimingandtheamountofeach
cashflowincashflowstream.Thus,acashflowstreamof`10,000atthe
endofeachofthenextfiveyearscanbedepictedonatimelineliketheone
shownbelow.

Asshownabove,0referstothepresenttime.Acashflowthatoccursattime
0isalreadyinpresentvaluetermsandhencedoesnotrequireany
adjustmentfortimevalueofmoney.Youmustdistinguishbetweenaperiod
1

oftimeandapointoftime .Period1whichisthefirstyearistheportionof
timelinebetweenpoint0andpoint1.Thecashflowoccurringatpoint1is
thecashflowthatoccursattheendofperiod1.Finally,thediscountrate,
whichis12percentinourexample,isspecifiedforeachperiodonthe
timelineanditmaydifferfromperiodtoperiod.Ifthecashflowoccursat
thebeginning,ratherthantheendofeachyear,thetimelinewouldbeas
showninPartB.Notethatacashflowoccurringattheendoftheyear1is
equivalenttoacashflowoccurringatthebeginningofyear2.Cashflows
canbepositiveornegative.Apositivecashflowiscalledacashinflow;and
anegativecashflow,acashoutflow.

Chandra,Prasanna,FinancialManagementTheoryandPractice,Fifthedition,TMH
PublishingCompanyLtd.,NewDelhi,p.72.

FINANCIAL MATHEMATICS

VALUATION CONCEPTS

Thetimevalueofmoneyestablishesthatthereisapreferenceofhaving
moneyatpresentthanafuturepointoftime.Itmeans

(a)Thatapersonwillhavetopayinfuturemore,forarupeereceivedtoday.
Forexample:Supposeyourfathergaveyou`100onyourtenthbirthday.
Youdepositedthisamountinabankat10%rateofinterestforoneyear.
Howmuchfuturesumwouldyoureceiveafteroneyear?Youwouldreceive
`110

Futuresum=Principal+Interest

100+0.10100

` 110

Whatwouldbethefuturesumifyoudeposited`100fortwoyears?You
wouldnowreceiveinterestoninterestearnedafteroneyear.

Futuresum=1001.10

=`121

WeexpressthisprocedureofcalculatingasCompoundValueorFuture
Valueofasum.

(b)Apersonmayacceptlesstoday,forarupeetobereceivedinthefuture.
Thus,theinverseofcompoundingprocessistermedasdiscounting.Herewe
canfindthevalueoffuturecashflowasontoday.

TECHNIQUES OF TIME VALUE OF MONEY

Therearetwotechniquesforadjustingtimevalueofmoney.Theyare:

CompoundingTechniques/FutureValueTechniques

Discounting/PresentValueTechniques

Thevalueofmoneyatafuturedatewithagiveninterestrateiscalledfuture
value.Similarly,theworthofmoneytodaythatisreceivableorpayableata
futuredateiscalledPresentValue.

Compounding Techniques/Future Value Technique

Inthisconcept,theinterestearnedontheinitialprincipalamountbecomesa
partoftheprincipalattheendofthecompoundingperiod.

FOR EXAMPLE: Supposeyouinvest ` 1000forthreeyearsinasaving account

thatpays10percentinterestperyear.Ifyouletyourinterestincomebe
reinvested,yourinvestmentwillgrowasfollows:

BASIC CONCEPT OF TIME VALUE OF MONEY

5

Firstyear
:
Principalatthebeginning
1,000

Interestfortheyear(`1,0000.10)
100

Principalattheend
1,100
Secondyear
:
Principalatthebeginning
1,100

Interestfortheyear(`1,1000.10)
110

Principalattheend
1210
Thirdyear
:
Principalatthebeginning
1210

Interestfortheyear(`12100.10)
121

Principalattheend
1331

Thisprocessofcompoundingwillcontinueforanindefinitetimeperiod.

Theprocessofinvestingmoneyaswellasreinvestinginterestearnedthere
oniscalledCompounding.Butthewayithasgoneaboutcalculatingthe
futurevaluewillprovetobecumbersomeifthefuturevalueoverlong
maturityperiodsof20yearsto30yearsistobecalculated.

Ageneralisedprocedureforcalculatingthefuturevalueofasingleamount
compoundedannuallyisasfollows:

Formula:
FVn=PV(1+r)

Inthisequation(1+r) iscalledthefuturevalueinterestfactor(FVIF).
where, FVn=Futurevalueoftheinitialflownyearhence

PV=Initialcashflow

r=AnnualrateofInterest

n=numberofyears

Bytakingintoconsideration,theaboveexample,wegetthesameresult.

FVn=PV(1+r)
=1,000(1.10)

FVn=1331

Tosolvefuturevalueproblems,weconsultafuturevalueinterestfactor
(FVIF)table.Thetableshowsthefuturevaluefactorforcertain
combinationsofperiodsandinterestrates.Tosimplifycalculations,this
expressionhasbeenevaluatedforvariouscombinationofrandn.
Exhibit1.1presentsonesuchtableshowingthefuturevaluefactorfor
certaincombinationsofperiodsandinterestrates.

FINANCIAL MATHEMATICS

Continued of Time Value of Money

Exhibit 1.1 Value of FVIFr, n for various combinations of r and n

n/r
6%
8%
10%
12%
14%

2
1.124
1.166
1.210
1.254
1.300

4
1.262
1.360
1.464
1.574
1.689
6
1.419
1.587
1.772
1.974
2.195
8
1.594
1.851
2.144
2.476
1.853
10
1.791
2.159
2.594
3.106
3.707
12
2.012
2.518
3.138

3.896
4.817

Future Value of A Single Amount (Lumpsum)

TheformulaforcalculatingtheFutureValueofasingleamountisasfollows:

FVn=PV(1+r)

ILLUSTRATION 1: Ifyoudeposit ` 55,650inabankwhichispayinga12 per

centrateofinterestonatenyeartimedeposit,howmuchwouldthedeposit
growattheendoftenyears?

SOLUTION:
FVn
=
n

PV(1+r) orFVn=PV(FVIF12%,10yrs)

FV
n

=
` 55,650(1.12)

10

` 55,6503.106= ` 1,72,848.90

MULTIPLE COMPOUNDING PERIODS

Interestcanbecompoundedmonthly,quarterlyandhalfyearly.If
compoundingisquarterly,annualinterestrateistobedividedby4andthe
numberofyearsistobemultipliedby4.Similarly,ifmonthlycompounding
istobemade,annualinterestrateistobedividedby12andnumberofyears
istobemultipliedby12.

Theformulatocalculatethecompoundvalueis

rmn

FVn=PV1

where,
FVn

=
Futurevalueafternyears

PV=
Cashflowtoday

r
=
Interestrateperannum

=Numberoftimescompoundingisdoneduringayear

=Numberofyearsforwhichcompoundingisdone.

ILLUSTRATION 2: Calculatethecompoundvaluewhen ` 1000isinvested for3

yearsandtheinterestonitiscompoundedat10%p.a.semiannually.

BASIC CONCEPT OF TIME VALUE OF MONEY

SOLUTION: Theformulaeis

r
mn

FVn=

PV1

.10
23

=
1000

=
` 1340

OR

ThecompoundvalueofRe.1at5%interestattheendof6yearsis` 1.340.
Hencethevalueof ` 1000usingthetable(FVIFr, n)willbe

FVn=10001.340=`1,340

ILLUSTRATION 3: Calculatethecompoundvaluewhen ` 10,000isinvested for

3yearsandinterest10%perannumiscompoundedonquarterlybasis.

SOLUTION: Theformulaeis

rmn

FVn=

PV1

.10

43

=
10,0001

=
10,000(1+0.025)

12

=
` 13,448.89

ILLUSTRATION 4: Mr.RaviPrasadandSonsinvests ` 500, ` 1,000, ` 1,500,Rs

2,000and ` 2,500attheendofeachyear.Calculatethecompound valueat
th

theendofthe5 year,compoundedannually,whentheinterestchargedis
5%perannum.

SOLUTION: Statementofthecompoundvalue

Endof
Amount
NumberofYears
CompoundedInterest
Future
theYear
Deposited
Compounded
Factor(FVIFr,n)

Value

fromAppendix

(1)
(2)
(3)
(4)
(2)(4)
1
500
4
1.216
608.00
2
1,000
3
1.158
1,158.00
3

1,500
2
1.103
1,654.50
4
2,000
1
1.050
2,100.00
5
2,500
0
1.000
2,500.00

th

Amountattheendof5 yearisFutureValue=
8020.50

FINANCIAL MATHEMATICS

FUTURE VALUE OF MULTIPLE CASH FLOWS

Theaboveillustrationisanexampleofmultiplecashflows.

Thetransactionsinreallifearenotlimitedtoone.Aninvestorinvesting
moneyininstalmentsmaywishtoknowthevalueofhissavingsaftern
years.Theformulaeis

FVn=

PV

where
FVn=Futurevalueafternyears

PV=Presentvalueofmoneytoday

r=Interestrate

=Numberoftimescompoundingisdoneinayear.

EFFECTIVE RATE OF INTEREST IN CASE OF MULTI-PERIOD

COMPOUNDING

Effectiveinterestratebringsallthedifferentbasesofcompoundingsuchas
yearly,halfyearly,quarterly,andmonthlyonasingleplatformfor
comparisontoselectthebeneficialbase.Now,thequestioniswhichworks
outhighestinterestamount?Wheninterestiscompoundedonhalfyearly
basis,interestamountworksoutmorethantheinterestcalculatedonyearly
basis.Quarterlycompoundingworksoutmorethanhalfyearlybasis.
Monthlycompoundingworksoutmorethanevenquarterlycompounding.
So,ifcompoundingismorefrequent,thentheamountofinterestperyear
worksoutmore.Now,wewanttoequatethemforcomparison.

Suppose,anoptionisgivenasthefollowing:

BasisofCompounding
InterestRate

Yearly
10%
Halfyearly
9.5%
Quarterly
9%
Monthly
8.5%

Now,thequestioniswhichbasisofcompoundingistobeacceptedtogetthe
highestinterestrate.TheansweristocalculateEffectiveInterestRate.

TheformulaetocalculatetheEffectiveInterestRateis

rm

EIR=1

where
EIR=EffectiveRateofInterest

r=NominalRateofInterest(YearlyInterestRate)

m=Frequencyofcompoundingperyear

BASIC CONCEPT OF TIME VALUE OF MONEY

9

Takenominalinterestrateasthebaseandfindoutthecomparablerateof
interestforhalfyearly,quarterlyandmonthlybasisandselectthatwhichis
mostattractive.

ILLUSTRATION 5:

(i)Acompanyoffers12%rateofinterestondeposits.Whatistheeffective
rateofinterestifthecompoundingisdoneon

(a)Halfyearly

(b)Quarterly

(c)Monthly

(ii)Asanalternative,thefollowingratesofinterestareofferedforchoice.
Whichbasisgivesthehighestrateofinterestthatistobeaccepted?

BasisofCompounding
InterestRate

Yearly
12%
Halfyearly
11.75%
Quarterly
11.50%
Monthly
11.25%

SOLUTION:

(i)Theformulaforcalculationofeffectiveinterestisasbelow:

r
1

EIR=

(A)Whenthecompoundingisdoneonhalfyearlybasis:

.12
2

EIR=
1

1.12361

12.36%

(B)
Whenthecompoundingisdoneonquarterlybasis

.12

EIR
=
1

=
0.1255

=
12.55%

(C)
Whenthecompoundingisdoneonmonthlybasis

.12

12

EIR
=
1

12

=
0.1268

=
12.68%

10

FINANCIAL MATHEMATICS

BasisofCompounding
InterestRate

EIR

Yearly
12%

12%

Halfyearly
12%

12.36%

Quarterly
12%

12.55%

Monthly
12%

12.68%

(ii)Whenthecompoundingisdoneonhalfyearlybasis

.1175
2

EIR=
1

=
0.1209

=
12.09%

Whenthecompoundingisdoneonquarterlybasis:

0.1150

EIR=
1

.1200

12%

Whenthecompoundingisdoneonmonthlybasis

0.1125
12

EIR=

12

0.1184

11.84%

Thus,outofallinterestrate,interestrateof11.75%onhalfyearly
compoundingworksouttobethehighesteffectiveinterestratei.e.,12.09%
sothisoptionistobeaccepted.

ILLUSTRATION 6: Findouttheeffectiverateofinterest,ifnominalrateof
interestis12%andisquarterlycompounded.

SOLUTION:
EIR=
1

.12

=
[(1+0.03)
1]

=
1.1261

=
0.126

=
12.6%p.a.

BASIC CONCEPT OF TIME VALUE OF MONEY

11

Growth Rate

Thecompoundrateofgrowthforagivenseriesforaperiodoftimecanbe
calculatedbyemployingthefuturevalueinterestfactortable(FVIF)

EXAMPLE:

Years
Profit(inLakhs)

1
95
2
105
3
140
4
160
5
165

6
170

Howisthecompoundrateofgrowthfortheaboveseriesdetermined?This
canbedoneintwosteps:

(i)Theratioofprofitsforyear6toyear1istobedeterminedi.e.,
95
170

=1.79

(ii)TheFVIFr,ntableistobelookedat.Lookatavaluewhichiscloseto
1.79fortherowfor5years.Thevaluecloseto1.79is1.762and

theinterestratecorrespondingtothisis12%.Therefore,thecompoundrate
ofgrowthis12percent.

DISCOUNTING OR PRESENT VALUE CONCEPT

Presentvalueistheexactoppositeoffuturevalue.Thepresentvalueofa
futurecashinfloworoutflowistheamountofcurrentcashthatisof
equivalentvaluetothedecisionmaker.Theprocessofdeterminingpresent
valueofafuturepaymentorreceiptsoraseriesoffuturepaymentsor
receiptsiscalleddiscounting.Thecompoundinterestrateusedfor
discountingcashflowsisalsocalledthediscountrate.Inthenextchapter,
wewilldiscussthenetpresentvaluecalculations.

1.10 SIMPLE AND COMPOUND INTEREST

Incompoundinterest,eachinterestpaymentisreinvestedtoearnfurther
interestinfutureperiods.However,ifnointerestisearnedoninterest,the
investmentearnsonlysimpleinterest.Insuchacase,theinvestmentgrows
asfollows:

Futurevalue=Presentvalue[1+NumberofyearsInterestrate]For
example,if`1,000isinvested@12%simpleinterest,in5years
itwillbecome

1,000[1+50.12]=`1,600

12

FINANCIAL MATHEMATICS

Thefollowingtablerevealshowaninvestmentof`1,200growsovertime
undersimpleinterestaswellascompoundinterestwhentheinterestrateis
12percent.Fromthistable,wecanfeelthepowerofcompoundinterest.As
AlbertEinsteinonceremarked,Idontknowwhatthesevenwondersof
theworldare,butIknowtheeighththecompoundinterest.Youmaybe
wonderingwhyyourancestorsdidnotdisplayforesight.Hopefully,youwill
showconcernforyourposterity.

Valueof`1,000investedat10%simpleandcompoundinterest

Year

SimpleInterest

CompoundInterest

StartingBalance+Interest
StartingBalance+Interest

=EndingBalance

=EndingBalance

1
1,000
+100=1,100
1,000
+100
=1,100
5
1,400
+100
=1,500
1,464
+146
=1,610
10
1,900
+100
=2,000
2,358
+236
=2,594
20

2,900
+100
=3,000
6,116+612=6,728
50
5,900
+100
=6,000
1,06,718+10672=11,7,390
100
10,900+100=11,000
1,25,27,829+12,52,783=1,37,80,612

ILLUSTRATION 7: Mr.Rahulhasdeposited ` 1,00,000inasavingbank account

at6percentsimpleinterestandwishestokeepthesame,foraperiodof5
years.CalculatetheaccumulatedInterest.

SOLUTION:

S1=P0(I)(n)

where
S1=Simpleinterest

P0=Initialamountinvested

I
=
Interestrate

n=Numberofyears

S1
=
` 1,00,0000.065years

S1
=
` 30,000
Iftheinvestorwantstoknowhistotalfuturevalueattheendofnyears.Future
valueisthesumofaccumulatedinterestandtheprincipalamount.

Symbolically
FVn=P0+P0(I)(n)

OR

S1+P0

ILLUSTRATION 8: Mr.Krishnasannualsavingsis ` 1,000whichisinvested in

abanksavingfundaccountthatpaysa5percentsimpleinterest.Krishna
wantstoknowhistotalfuturevalueortheterminalvalueattheendofa8
yearstimeperiod.

BASIC CONCEPT OF TIME VALUE OF MONEY

13

SOLUTION:
FVn=
P0+P0(I)(n)

=
`
1000+`1000(0.05)(8)

=
`
14,000

Compound Interest

ILLUSTRATION 9: SupposeMr.JaiSinghYadavdeposited ` 10,00,000in a

financialinstitutewhichpayshim8percentcompoundinterestannuallyfor
aperiodof5years.Showhowthedepositwouldgrow.
SOLUTION:
FV

=
8

P(1+I)

(1+0.08)

FV5
=
10,00,000

=
10,00,000
(1.469)

FV5

=
` 14,69,000

Note:SeecompoundvalueofonerupeeTablefor5yearsat8%interest.

VariableCompoundingPeriods/SemiannualCompounding

ILLUSTRATION 10: Howmuchdoesadepositof ` 40,000growin 10yearsat

therateof6%interestandcompoundingisdonesemiannually.Determine
theamountattheendof10years.

FV10
=

I24

SOLUTION:

P 1
0


0.06
210

=Rs.40,000

` 40,000(1.806)

Rs.72,240

Alternatively,seethecompoundvalueforonerupeetableforyear20and
3%interestrate.

ILLUSTRATION 11: (Quarterlycompounding):Supposeafirmdeposits ` 50

lakhsattheendofeachyear,for4yearsattherateof6percent interestand

compoundingisdoneonaquarterlybasis.Whatisthecompoundvalueat
th

theendofthe4 year?

I4n

SOLUTION:
FV4=
P01

44

=
Rs.50,00,000
1

=
` 50,00,0001.267

=
` 63,35,000

14

FINANCIAL MATHEMATICS

Compound Growth Rate

Formula:gr=V0(1+r) =Vnwhere,gr=Growthrateinpercentages
V0=Variableforwhichthegrowthrateisneeded

Vn=Variablevalue(amount)attheendofyearn(1+r) =Growthrate.

ILLUSTRATION 12: Fromthefollowingdividenddataofacompany,calculate

compoundrateofgrowthfor20032008.

Year
DividendperShare(`)

2003
21
2004
22
2005
25
2006
26

2007
28
2008
31

SOLUTION:
g
r

=
V(1+r)

=
V

=
21(1+r)

=
31

31

=(1+r) =

=1.47621

Alternatively,thecompoundvalueoneRupeetablefor5yearsshouldbe
seentillclosedvaluetothecompoundfactorisfound.Afterfindingthe
closestvalue,firstaboveitisseentogetthegrowthrate.

Whatdoyoumeanbytimevalueofmoney?

Whatisthedifferencebetweencompoundandsimpleinterest?

Whyistheconsiderationoftimeimportantinfinancialdecisionmaking?Howcan
timebeadjusted?Illustrateyouranswer.

Explainthemeaningandimportanceofvaluationconcept.Howdoesvaluation
concepthelpindecisionmaking?

Distinguishbetween

(a)CompoundingandDiscountingtechnique

(b)EffectiveandNominalrateofinterest

Abirdinhandismorepreferablethantwobirdsinthebush.Explain.

Statetherelationshipbetweeneffectiverateofinterestandthenominalrateof
interest.

Whatismultiperiodcompounding?Howdoesitaffecttheannualrateofinterest?
Giveanexample.

BASIC CONCEPT OF TIME VALUE OF MONEY

15

Arationalhumanbeinghasatimepreferenceformoney.Givereasons.

Explainthediscountingandcompoundingtechniqueoftimevalueofmoney?

1.
Mr.Jitendradeposited`1,00,000inasavingbankaccounttoday,at

5percentsimpleinterestforaperiodof5years.Whatishisaccumulated

interest?
[Ans.`2500]
2.
Determinethefuturevalueof
` 1,00,000ifyouinvestinabankfor

5yearsat6%rateofinterest.
[Ans.`1,33,800]

Mr.Abhisekhdeposits`5,00,000foraperiodof10yearsat10%rateofinterest.
Whatwouldbethevalueofhissumafter10years?

[Ans.`12,97,000]

Mr.Dhirajdeposits`1,00,000attheendofeachyearfor10years.Whatwillbethe
valueofhismoneyattheendof10yearsat(a)9%,(b)10%and(c)12%?

[Ans.(a)`15,19,300;(b)`15,93,700;(c)`17,54,900]

5.Ifyoudeposit`1,00,000inabankwhichprovidesaninterestof

12%
quarterlycompoundingisdone.Howmuchwilltheinvestmentbe
after
5years?
[Ans.`1,80,611]

Mr.Rajdeposits`10,00,000andhereceives`1,00,000everyyearforthenext20
years.Findouttherateofinterestbeingofferedtotheinvestor.

[Ans.7.6%approx.]
7.
Supposeyoudeposit`1,00,000withaninvestmentcompany,whichpays

10percentinterestwithsemiannualcompounding.Whatisthetotaldeposit

amountattheendofthe5years?
[Ans.`1,21,900]
8.
Mr.Singhaniadepositsattheendofeachyear
` 2,000, ` 3,000,

` 4,000, ` 5,000and ` 6,000fortheconsequent5yearsrespectively.He

wantstoknowhisseriesofdepositsvalueattheendof5yearswith6per

centrateofcompoundinterest.
[Ans.`21,893]
9.
Aborroweroffers16percentrateofinterestwithquarterlycompounding.

Determinetheeffectiverateofinterest.
[Ans.17%]
10.
Mr.Gyandeposits`5,000attheendofeachyear,at8%peryear.What

amountwillhereceiveattheendof6years?
[Ans.`36,680]