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Finance - An Introduction: Basic Concept in Finance
Finance - An Introduction: Basic Concept in Finance
Prof. R.Madumathi
An important principle in financial management is that the value of money depends on when the cash flow occurs which implies Rs.100 now is worth more than Rs.100 at some future time.
Management Science-II
Prof. R.Madumathi
Management Science-II
Prof. R.Madumathi
Inflation: Under inflationary conditions, the value of money, expressed in terms of its purchasing power over goods and services, declines. Hence Rs.100 possessed now is not equivalent to Rs.100 to be received in the future.
Personal consumption preference: Most of us have a strong preference for immediate rather than delayed consumption. As a result we tend to value the Rs.100 to be received now more than Rs.100 to be received latter.
Management Science-II
Prof. R.Madumathi
Let us assume x amount is invested now and the investor expects r% to accrue on the investment one year ahead. This is translated into present and future values as follows: PV = Rs. x FV = Rs. x + (r * x)
This relationship leads to the following concept of discounting the future value to arrive at the present value i.e., PV = FV / (1 + r)
This is the formula for equating the future value that is associated at the end of 1st year. Now the concept of time over a longer duration can be easily brought into the above equation, where 'n' defines the time duration after which the cash flows are expected.
Management Science-II
Prof. R.Madumathi
Interest with annual compounding adds the interest received earlier to the principle amount and increases the final amount that is received from the investment. Hence, the FV of an investment for a two year duration with annual compounding would be: FV = PV * (1+r)* (1+r) = PV * (1+r)^2.
Management Science-II
Prof. R.Madumathi
Compound Value
In compounding, it is assumed that a certain sum accrues at the end of a time duration, which is again reinvested. In short, when a sum is invested in a year, it will yield interest and the interest is reinvested for the next year and so on till the time when withdrawal is made. The 3 year or 4 year bank deposit is a typical example of this annual interest compounding. Here:
Management Science-II
Prof. R.Madumathi
The term (1+r)^n is the compound value factor (CVF) of a lump sum of Re.1, and it always has a value greater than 1 for positive r, indicating that CVF increases as r and n increase.
For instance, let us take an illustration of a banker declaring a 10% p.a. interest payable semiannually. This implies that at the end of the year the amount received for every one rupee will be 1 * (1+[10%/2]) * (1+[10%/2]) i.e., (1.05) * (1.05) = (1.05)^2 = 1.1025.
Management Science-II
Prof. R.Madumathi
Continuous Compounding
Sometimes compounding may be done continuously. For example, banks may pay interest continuously; they call it continuous compounding. It can be mathematically proved that the continuous compounding function will reduce to the following: FV = PV x {e^x} When x = (r * n) and e is mathematically defined as equal to 2.7183.
Management Science-II
Prof. R.Madumathi
Similarly, the present value of a future flow of Rs.100 at 10% p.a. interest rate to be received 5 years hence with continuous compounding will be PV = FV / {e^.5} = 100 / {e^.5} = Rs.60.65.
Annuity
There can be a uniform cash flow accrual every year over a period of 'n' years. This uniform flow is called "Annuity". An annuity is a fixed payment (or receipt) each year for a specified number of years. The future compound value of an annuity as follows:
FV = A {[(1+r)^n - 1]/ r}
The term within the curly brackets {} is the compound value factor for an annuity of Re.1, and A is the annuity. The present value of an annuity hence will be
PV = A {[1 - 1/(1+r)^n]/r}
Annuity Example
The Future value of Rs.10 received every year for a period of 5 years at an assumed interest rate of 10% per annum will be
The Present value of Rs.100 to be received every year in the next five years at an assumed interest rate of 10% per annum will be
Management Science-II
Prof. R.Madumathi
PV =100{[1 - 1/(1+0.1)^5]/0.1}=Rs.379.08
PV = A/r
where A is the annuity amount occurring indefinitely and r is the interest rate.
Management Science-II
Prof. R.Madumathi
Annuity Due
The formula for computing value of an annuity due is: FV = A[(1 + r) + (1+r)^2+ (1+r)^3 +....+ (1+r)^n-1] FV = A {[(1+r)^(n-1) -1] / r} Hence, PV = A {[1 - 1/(1+r)^n]/r } * (1+r) PV = A(PVRA,r)*(1+r) Where PVAR is present value of regular annuity and r is the interest rate.
Management Science-II
Prof. R.Madumathi
Management Science-II
Prof. R.Madumathi
Management Science-II
Prof. R.Madumathi