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UNIT II

LESSON 7:
CHAPTER 5: FINANCIAL SECURITIES,
TIME VALUE OF MONEY
MARKETS AND VALUATION MODELS

Learning Objectives Future Value at Simple Interest

INTRODUCTION TO CORPORATE FINANCE


• To learn to compute future and present value at simple and Future Value = Principal + Interest
compound interest for single amount and series of FV n = PV + SI
payments.
FV n = PV+ PV (r) (n)
• To find out future and present value of annuities and value
FV n = PV [1 + (r) (n)]
of perpetuities
Translating a value to the future is referred to as compounding.
• To know what is Net Present Value (NPV) and Internal Rate
of Return (IRR) Present Value
Present Value i.e. Principal or Original amount (PV) can be
Introduction
ascertained if the future value, interest rate and the number of
Students, time periods are known.
Given a chance, any rationally thinking individual would prefer FV n
to have an amount of money now, as compared to having the PV = ————
same at a later date. Why do you think we do this ? This is [1 + (r) (n)]
because we give due weightage for ‘Time Preference for Money’ Translating a value to the present is referred to as discounting.
since we may otherwise lose the opportunity to earn additional
income / interest. Compound Interest
Hence ‘Time Preference for money’ is considered very valuable For Single Amount
due to the following reasons: Future Value
• Investment opportunities / opportunities cost and the The term Compound Interest merely implies that interest paid
element of cost (earned) on a loan (an investment) is periodically added to the
• Preference for current consumption to future consumption principal. Consequently, interest is earned on the interest as well
as the Principal or Original Amount. This interest-on-interest is
• Inflationary trend
compounding.
• Uncertainty
FV 1 = PV (1 + r)
Due to the above reasons money loses value with time and
FV 2 = FV 1 (1 + r) = PV (1 + r) (1 + r) = PV (1 + r) 2
hence a rupee on hand presently has a more value compared to a
rupee receivable at a later date. Considering the interest and FV n = PV (1 + r) n
futuristic risk, the preference will be to have the even future For the compounding factor (1 + r) n for Re.1, compound
value now itself, discounting the same at the rate of return. For interest tables or Future Value Interest Factor (FVIFn or
instance, one may prefer Rs.100/- instead of Rs.105/- after one terminal value interest factor) tables are designed.
year. This means that the value of the higher amount of FV n = PV (FVIFrn )
future is equivalent to a lesser present amount. In the example
future Rs.105/- after one year is treated as equal to present Present (or Discounted) Value
Rs.100/-. Present Value of future cash flows allows us to place all cash
flows on a current footing and enables to compare them in
Financial decisions are to be made comparing the cash outlays /
terms of present rupees
outflows and the benefits / cash inflows. A financial decision –
FV n
financing or investment – taken today has implications for
PV = ———— or FV n [ 1 / (1 + r) n ]
number of years in terms of cash flows. For a meaningful
(1 + r) n
comparison, the variables – cash outflows and cash inflows at
various points of time periods – shall be converted to a The component [ 1 / (1 + r) n ] is the Present Value Interest
common period of time. Factor (PVIFrn ) and the reciprocal of the Future Value Interest
Factor (FVIFrn )
Simple Interest
PV = FV n (PVIFrn )
Simple interest is a function of three variables: Original amount
borrowed or Principal, Interest Rate, Number of time period. For Series of Payments
SI = PV (r) (n) We may be interested in the future value of a series of pay-
Where, SI = Simple Interest ments made at different periods. Translating a series of
PV = Principal or Original Value payments into future or present value is similar to translating a
single amount.
r = rate of interest per time period
n = number of time periods

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Future or Compound Value PV = A [1 / (1 + r) 1] + A[ 1 / (1 + r) 2] + …………
INTRODUCTION TO CORPORATE FINANCE

For finding future value of each cash flow in case of series of ....................................................…….+ A[1 / (1 + r) n ]
cash flows, we can use the formula FV n = PV(1+r) n or FV n = Since the future cash flow of annuity is same for every period,
PV(FVIFrn ) and add up to ascertain the Future Value. the formula is,
Annuities PVAn = A{ [1 / (1 + r) 1] + [ 1 / (1 + r) 2] + ………
An annuity is a series of equal cash flows occurring over a ...............................................……….+ [1 / (1+r) n ] }
specified number of periods. When cash flows occur at the end = A {[ (1 + r) n – 1] / [(1+r) n X r]} * mathematical derivation
of each period, it is called an Ordinary Annuity. is given at the end of the chapter
Future or Compound Value of Annuity It will be more clear for you looking at Graphically the Present
FVAn = A (1 + r) n-1 + A (1 + r) n-2 +…..................................... Value of an annuity of FV, say, of Re. 1 with discounting rate
...........................................…+ A (1 + r) 1 + A (1 + r) 0 of 10%
= A {[ (1 + r) n – 1] / r} *mathematical derivation is given at
the end of the chapter
The term [ (1 + r) n – 1] / r is referred to as the Future Value
0 1 2 3 4 5
Interest Factor for an Annuity,
Receipt at the end of
FVAn = A (FVIFA rn ) the year Re.1 Re.1 Re.1 Re.1 Re.1

Where FVIFA stands for the Future Value Interest Factor of an 0.909
0.826
Annuity at i% for n periods.
Time Line: The series of cash flows can be represented on a 0.751
time line as below, PV of Re.1 at 5% interest: 0.683

0 1 2 3 4 5 0.621
--------
Deposit at the end of 3.790
the year Re.1 Re.1 Re.1 Re.1 Re.1

1.050 In the above time line discounting is done individually using


1.102 the formula PV = FV n / (1 + r) n . Alternatively, table for
1.158 Present Value Discounting Factor of an Annuity (PVDFA) may
be referred to replace the term [ (1 + r) n – 1] / [(1+r) n X r] and
1.216 calculate.
--------
5.526
Perpetuities
===== A Perpetuity is an Ordinary annuity whose cash flows continue
In the above Time Line, the future value for each cash flow is indefinitely.
ascertained either by manual calculation of individual item with This special type of annuity will have to be determined in case
formula FV = PV (1+r) or by using the Future Value Interest of irredeemable preference shares with out maturity where
Factor table. Similarly when the cash flows are of equal value at preference dividend is expected to be paid perpetually. Looking
the end of each period as in the at the formula for PVA n i.e. A {[ (1 + r) n – 1] / [(1+r) n X r],
above example i.e. Ordinary Annuity, we can ascertain Future / this can be rewritten as
Compound Value Interest Factor of the Annuity (FVIFA)
using the table with the interest rate and the number of years. 1
1- --------
Present (or Discounted) Value n
(1+r)
For finding out the present value of a series of cash flows in PVA = A --------------------
r
future, we may ascertain the present value of each cash flow in
future with the formula PV = FV n / (1+r) n or FV n [1/
(1+r) n ]and add up.
In case of perpetuity since the time period is taken as infinite,
Alternatively the formula PV = FV n (PVIFrn ) may be used for
each cash flow and added to ascertain the future value.
1
As we know, the present value of a single cash flow in future is
1- --------
PV = FV n [1 / (1+r) n ] (1+r)
n

PVA = A --------------------
For a series of cash flows the formula to be expanded as
r
PV = FV 1 [1 / (1 + r) 1] + FV 2[ 1 / (1 + r) 2] + …………
..............................................…….+ FV n [1 / (1 + r) n ]
In case of Annuity, Since any denominator of infinite nature, including any term
raised to the power infinity, is zero,

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INTRODUCTION TO CORPORATE FINANCE


FV n
PVA = A ———— = ————— PV = -------------------
r r mn
Annuity Due 1+r
----
A series of equal cash flows starting at the beginning of each
period is called an Annuity Due.
m
While calculating future value, Annuity due is simply equal to Net Present Value
the future value of a comparable three year ordinary annuity
While Financial Objective is concluded as Wealth Maximization
compounded for one more period. This is because last cash
/ Shareholders’ Wealth, Wealth is defined as Net Present Value.
flow also accrues interest i.e. for one year., since the cash flow is
in the beginning of the year. NPV of a Financial decision is the difference between the
Present Value of Cash Inflows and the Present Value of Cash
Using the formula for future value and providing interest for
Outflows:
last cash flow the formula for Annuity Due for future value is
A {[ (1 +r) n – 1] / r} (1+r)
FV 1 FV 2 FV n
Alternatively, the Future / Compound Value of Annuity Due NPV = ---------- + ------------- + ………+ --------- - C0
may be ascertained by using the Future Value Interest Factor (1 + r) (1 + r)
2
(1 + r)
n

table as below
FVADn = A (FVIFA rn ) (1+r) Where C0 is Cash Outflow and r may represent the Opportunity
Similarly Present Value of Annuity Due can be calculated. Since Cost of Capital.
the first cash flow is immediate at the beginning, the Present
Internal Rate of Return
Value is equal to absolute value and hence the cash flow series
The Internal Rate of Return is the rate which equates the
will be as below:
Present Value of Cash Inflows with the Present Value of Cash
PVADn = A {1+[1 / (1 + r) 1] + [1 / (1 + r) 2] + Outflows of an investment. It is the rate at which the Present
……………….+ [1 / (1+r) n-1] } Value of the proceeds and the outlays are equal. In other
A {[(1 + r) n – 1] / [(1+r) n X r]} (1+r) * mathematical words, it is the rate at which the Net Present Value is (PV of
derivation is given at the end of the chapter Cash Outflows – PV of Cash Inflows) is zero.
Multi-period or Semi-annual and other compounding As you know we use the following formula to find the Present
Normally interest rate is expressed for a year. In case, com- Value of Cash inflows:
pounding is done semi-annually or quarterly or monthly or FV 1 [1 / (1 + r) 1] + FV 2[ 1 / (1 + r) 2] + …………
weekly, interest rate & compounding to be adjusted accordingly ...................................................…….+ FV n [1 / (1 + r) n ]
to alter the number of time periods. The formula FV n = (1+r) n Since PV of Cash Outflows (Co) is also known, we may use the
will get altered as below: following equation to find out r:
mn {FV 1 [1 / (1 + r) 1] + FV 2[ 1 / (1 + r) 2] + ………
r ..........................................……….+ FV n [1 / (1 + r) n ]} – Co = 0
FVn = PV 1 + ------
Mathematical Derivation of Formula for Future/Compound
m
Value of Annuity

where m is the number of compounding per year. FVAn = A (1 + r) n-1 + A (1 + r) n-2 +…………
………......................................……+ A (1 + r) 1 + A (1 + r) 0
When we take out A in every item, the series is as below:
The interest rate specified on annual basis is known as the
Nominal Interest Rate. If compounding done in a year is more (1 + r) n-1 + (1 + r) n-2 +……………
than once, the actual rate of interest is called the ............................................…………+ (1 + r) 1 + (1 + r) 0
Effective Interest Rate (EIR) /Annual Percentage Rate (APR), We may rewrite the series as below also:
which can be ascertained as below: (1 + r) 0 + (1 + r) 1 + …………………
.......................................................….+ (1 + r) n-2 + (1 + r) n-1
mn
r This series of n terms is in Geometric Progression with a
FVn = PV 1 + ------ - 1 common ratio. The Common Ratio is arrived at by dividing
m the following term by the preceding term in the series.
Let us take the first term (1 + r) 0 which is 1 (anything raised to
Similar to Future Value, Present Value of cash flows more than the power of 0 is equal to 1). Dividing the second term by the
once a year can be discounted with the following formula: first term 1, we get (1 + r) i.e. (1 + r) 1 / 1. Next we shall divide
the third item (1 + r) 2 by (1 + r) 1 which is again (1 + r). Hence
the Common Ratio in our series is (1 + r).

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We get Sn by adding the above n number of terms in the series
INTRODUCTION TO CORPORATE FINANCE

1 1+ r – 1 r
Sn = (1 + r) 0 + (1 + r) 1 +.….+ (1 + r) n-2 + (1 + r) n-1 …….Eqn.1 1- (1+r) -1 = 1 - ------ = ----------- = ------------
Multiplying both sides by ‘(1 + r)’ we have, 1+r 1+r 1+r
(1+r)Sn = (1+r) (1 + r) 0 + (1+r) (1 + r) 1 + ……………...... Simplifying the numerator,
.............................................. + (1+r) (1 + r) n-2 + (1+r) (1 + r) n-1
1 1 (1+r)n - 1
(1+r)Sn = (1+r) + (1 + r) 2 + …. ............................. (1 + r)-1 - (1 + r)-n-1 = -------------- - ------------ = ----------------
+ (1 + r) n-1 + (1 + r) n ..............................................…Eqn. 2 (1 + r) (1 + r)n+1 (1 + r)n+1
Now Subtracting Equation 2 from Equation 1, we have Using the simplified numerator and denominator,
n
Sn – (1 + r)S n = 1 - (1 + r)
(1 + r)n -1
Sn [1- (1+r)] = 1 - (1 + r)n -------------
(1 + r)n+1 [(1+r)n – 1] (1 + r)
Sn = ------------------------ = -------------- X -----------
1 - (1 + r) n -[(1+r)n –1] (1+r) n –1 r (1+r)n+1 r
Sn = -------------------- = --------------- = -------------- -----------
[1- (1+r)] 1-1-r r 1+r

Multiplying with A which was removed in the beginning, the [(1+r)n – 1] (1 + r)


= --------------- X ---------
formula is (1+r)n (1+r)1 r
A {[ (1 + r) n – 1] / r}
Mathematical Derivation of formula for Present Value of an [(1+r)n – 1]
= ---------------
Annuity (1+r)n X r
PVAn = A [1 / (1 + r) ] + A[ 1 / (1 + r) ] + ……………
1 2

..........................................................….+ A[1 / (1 + r) n ] Multiplying with A, which was removed in the beginning, the
We may rewrite the equation as follows: formula is
PVAn = A [ (1 + r) -1] + A[ (1 + r) -2] + …………… A {[ (1 + r) n – 1] / [(1+r) n X r]}
.......................................................….+ A[(1 + r) -n ]
Mathematical Derivation of formula for Present Value of an
When we take out A in every item, the series is as below: Annuity Due
(1 + r) -1 + (1 + r) -2 + ……………….+ (1 + r) -n PVADn = A {1+[1 / (1 + r) 1] + [1 / (1 + r) 2] +
This series of n terms is in Geometric Progression with a ……………….+ [1 / (1+r) n-1] }
common ratio. The Common Ratio is arrived at by dividing Multiplying and dividing the whole expression by (1+r), we get
the following term by the preceding term in the series.
A (1+r) {1+[1 / (1 + r)1 ] + [1 / (1 + r)2 ] + ……………….+ [1 / (1+r)n-1 ] }
Dividing the second term by the first term, we get (1 + r) -1. -------
(1+r)
Next we shall divide the third item (1 + r) -3 by (1 + r) -2 which is
again (1 + r) -1. Hence the Common Ratio in our series is (1 + r) - A (1+r) {1+[1 / (1 + r)1 ] + [1 / (1 + r)2] + ……………….+ [1 / (1+r)n-1] } x [1/(1+r)]
1
. A (1+r) {[1 / (1 + r)] + [1 / (1 + r)2 ] + ……………….+ [1 / (1+r)n] }

We get Sn by adding the above n number of terms in the series Keeping the term A(1+r), the other term is in geometric
Sn = (1 + r) -1 + (1 + r) -2 + ………….+ (1 + r) -n …......Eqn.1 progression with common ratio as 1/(1+r). Hence applying the
Multiplying both sides by ‘(1 + r) -1’ we have, formula for sum of geometric progression i.e. Sn = a(rn – 1) / r
–1 where a is the first term and r is the common ratio, we get
(1+r) -1Sn = (1 + r) -1(1 + r) -1 + (1 + r) -2 (1 + r) -1 + ……………
........................................................….+ (1 + r) -n (1 + r) -1 (1 + r) n – 1 / [(1+r) n X r
Using the concept of am X an = am+n, we get Adding the term already removed we have A (1+r) [(1 + r) n – 1
/ [(1+r) n X r]
(1+r) -1Sn = (1 + r) -2 + (1 + r) -3 + ……………….+ (1 + r) -n-1
…………Eqn. 2 Points to Ponder
Now Subtracting Equation 2 from Equation 1, we have • Capital budgeting methods includes NPV and IRR which
are said to be the discounted methods as annual cash flows
-1 -1
S n – (1 + r) Sn = (1 + r) - (1 + r)
-n-1
are discounted using time value of money.
-1 -1 -n-1 • Project Appraisal and Selection is made considering present
S n [1- (1+r) ] = (1 + r) - (1 + r)
value of future cash flows.
-1 -n-1
(1 + r) - (1 + r) Review Questions
Sn = ------------------------
[1- (1+r)-1] 1. If you invest Rs.3000 today at a compound interest of 9%,
what will be its future value after 50 years?
Simplifying the denominator, 2. What is the present value of Rs.80,000 receivable 15 years
from now, if the discount rate is 10%?

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