01 Time Value of Money 07

Time Value of Money
Author: Dilip Thosar Slide no. 1

For BVUAmplify DITM Time Value Of Money
August2008 December 8, 2021
Time Value Of Money
• Present and Future Value of Money
– Uncertainty of Realization
– Opportunity cost of investment
• Risk Free Interest Rate
• Discounting
• Interest Rate (annual)
• Cost Of Money (Capital)
• Compounding
• USE OF SPREADSHEETS : MS-Excel
Future Value, Discounting Factor
• “FV0”= PV
• FV1 = PV + PV * R
= PV * (1+R)
• Discounting Factor D = PV/FV
D1 = 1/ (1+R)

Compounding
FV2 = FV1 *(1+R)
FV2 = PV*(1+R)2
= PV*(1 + 2*R + R2)
= PV*(1+2R) + (PV*R)*(1+R)
interest on principal + interest on interest
= PV*(1+2R) + (PV*R)*(1+R)
• Compound Interest & Simple Interest
• Ic2=(1+R)2-1 = 2R+R2 Is2= 2R
PV = FV2 / (1+R)2
D2 = 1/ (1+R)2
Compounding & Discounting Factors
Ci,R = 1 / (1+R)i
Di,R = 1 / (1+R)i
• Numerical Exercise : Generate your own

discounting and compunding factor tables for
various i and R values.

FV at end of N years
FVN = PV * (1+R)N
PV = FVN / (1+R)N
DN = 1/ (1+R)N

Periodic (Intra-year) Compounding
• R = Annual Interest Rate
• n=No. of periods in year
• r = Period Interest Rate = R/n
• Reff Effective Annual Interest Rate
= (1+r)n - 1= (1+R/n)n -1
• FVr=1 = PV*(1+r)n = PV*(1+R/n)n

R= 12%

Period n r=R/n Reff=(1+r)^n -1

Annual 1 12.00% 12.00%
Semi-Annual 2 6.00% 12.36%
Quarterly 4 3.00% 12.55%
Monthly 12 1.00% 12.68%
Weekly 52 0.23% 12.73%
Daily 365 0.03% 12.75%

Periodic (Multi-year) compounding
• Future value at end of N years (N*n periods)
FVN = PV * (1+Reff)N
= PV * (1+ (1+r)n -1 )N
= PV * ((1+r)n )N
= PV * (1+r)n*N
FVN = PV*(1+R/n)n*N

PV of a stream of returns
• Return Ci at the end of ith year has FVi = Ci

• PV of this return PVi = FVi * Di = Ci / (1+R)i
• PV of the stream = Σ PVi
C1 C2 C3 CN
PV = -------- + -------- + -------- + ... + --------
(1+R)1 (1+R)2 (1+R)3 (1+R)N
• PV = Σ N
i=1 Ci / (1+R)i
Annuity
• When all Ci are equal, Ci = C
• Annuity Present Value
PVn = Σ N
i=1 Ci / (1+R)i
• Annuity Factor PV/C
= AN,R = Σ N
i=1 (1 / (1+R)i)
AN,R = (1-1/(1+R)i)/R
• Annuity Factor Lookup Table
Perpetuity
• Stream of constant return every year for ever
• Annuity without termination
• PV = C *
∞ Σ ∞
i=1 (1 / (1+R)i)
Σ ∞
i=1 (1 / (1+R)i) = 1/R !!!
• PV ∞,R,C = C / R
• Perpetuity Factor = PV∞ / C = P = 1/R
• Perpetuity Factor Table
Growing Perpetuity
• Perpetual Stream of INCREASING annual
returns
• If the diminishing of value due to R has a

bigger than the increase in the annuity, the
PV works out to be finite
• For a growth rate of G for the annual return,
PV ∞,R,C,G = C / (R-G)
Net Present Value NPV
• NPV = PV(inflows) – PV(outflows)
• For an investment decision,
NPV = Investment (at t=0) – PV (returns)
• For an Annuity Purchase,
NPV = Price of Annuity – PV of returns

The lighter side
• A young attorney who had taken over his
father’s practice rushed home elated one
night.
• “Dad, listen,” he shouted, “I’ve finally settled
that old Birla lawsuit.”
• “Settled it!” cried his astonished father. “Why,
I gave that to you as an annuity for life.”

Numericals : A
1. Draw up a Table showing Discounting
factors (PV of a future Re. 1) for various
interest rates R and periods N (no. of years)
2. Draw up a Table showing Annuity factors
(PV of an annuity of Re. 1 p.a.for N years)
for various interest rates R and periods N
(no. of years)
3. Draw up a Table showing Perpetuity factors
(PV of a perpetuity of Re. 1 p.a.) for various
interest rates R and periods N (no. of years)
Numericals: B
1. On a contract, you have a choice of receiving Rs 25000 six years from
now or Rs 50000 twelve years from now. At what implied interest rate
would you be indifferent between the two contracts?
2. ABC Ltd’s last dividend was Rs 4 per share and these are expected to
grow forever at a rate of 5% per annum. Its share price is Rs 60. What
is the required rate of return? If the investor’s required rate of return is
12%, what price would he be willing to pay? If the growth rate falls to
3%, what will the new price be?
3. A zero coupon 1000 par value bond is currently selling for Rs 322. It
matures in exactly ten years. What is the discount rate on this bond?
4. You have just won the Maharashtra state lottery and have three
reward options to choose from. You can select a lump sum payment of
61 million now, 10 annual end of the year payments of 9.5 million or 30
annual end of the year payments 0f 5.5 million.. Which option would
you choose if the interest rate is (a) 7% (b) 8% (c) 9%
5. You have just been left an inheritance of $ I million, which is earning
an interest of 5% per annum. You plan to withdraw $ 100,000 per year.
How long will the inheritance last?
Microsoft Office
Excel Worksheet

Numericals :B (contd.)
6. You have been offered share of a business. The business is expected
to generate cash flows of $ 1 million, growing at 5% forever. What is the
value of the business if the discount rate is 15%. How much should the
business grow annually to justify a valuation of 1,25,00,000.
7. Your uncle is quite impressed with your MBA degree. He wants you to
help him in his post retirement planning. Currently, he has Rs 10 lacs
with him. He will retire after 10 years. During these ten years, he will
save Rs 150,000 per annum. He expects to live for 15 years post
retirement. How much can he consume every year post retirement?
Assume interest rate of 10%. How much should he save over the next
ten years if he wants Rs 800,000 per annum post retirement?
8. You are the manager of a professional soccer team and are negotiating
a contract with your rival team’s star player. You can afford to pay $1.5
million over annually over the next three years. The player’s agent
believes that he will not accept anything below nominal value of 5
million. Can you meet the agent’s demand without relaxing your
financial constraint. Interest rate is 10%.

9. You have been hired to run a pension fund. The fund currently has 10 million and expects
to get 3 million per annum for the next 5 years and 2million annually for five years after
that. At 8%,
a. How much will the Fund have after ten years?
b. If the Fund is required to pay a perpetuity starting at the end of the 11th year, what would be the
annual cash flow of the perpetuity?
10. You are an investment advisor who has been approached by a client for help on his
financial strategy. He has savings of $250,000. He is 55 years old and expects to work for
ten years more. During these ten years he expects to earn 100,000 per annum. Assume
an interest rate of 5%.
a. Once he retires ten years from now, he would like to withdraw $80,000 per annum for the next 25
years. ( His actuary tells him he will live until 90 years.) How much would he need ten years from
now to be able to do this.
b. How much of his income would he need to save each year for the next ten years to be able to
afford these planned withdrawls ( $80,000 per year).
c. Assume interest rates decline to 4% ten years from now. How much, if any, would your client
have to lower his withdrawl every year assuming that he still plans to withdraw cash each year for
the next 25 years.
11. Early Bird has decided to start saving for his retirement. He plans to invest $2000 every
year beginning from his 21st birthday. He will continue this for 10 years and then stop. But,
his savings continue to earn interest until his retirement at 60 years. Late Bird also plans to
save $ 2000 every year. However, she will start her savings from her 31st birthday and
continue to save till he retires at 60 years. The interest rate for both is 7%. Who is better
off at retirement and by how much?

12. You borrow 10000 at 14% for four years for your car. The loan is repayable in
four equal annual instalments payable at the end of each year.
a. What is the annual payment that will completely amortise the loan over four years?
b. Of each equal payment, what is the amount of interest and the amount of principal
repayment?
Microsoft Office
Excel Worksheet
13. You wish to buy a photocopier and the supplier has quoted a price of 11,000
cash or 3000 per year for five years. If your cost of capital is 12%, which
alternative would you prefer? What if the cost of capital is 8%.
14. New York State has started a lottery scheme wherein it will give away 40 million
(2million per year for the next 20 years) to the winner. It plans to donate 50% of
the collections of 36 million to charities. If the discount rate is 10%, will it save
anything from the scheme or will it have to fund the charity donations from other
sources?
15. Savings in pension fund up to 2000 per annum are tax free. You are starting your
career at 25 years. You plan to retire at 65 years. Your investments are likely to
yield 8% per annum. How much money will you have at retirement? What
amount will you have if your annual returns are taxed at 25%.

Numericals C
1. An RBI bond 2002, of face value Rs. 10,000 yields Rs.
14,802.50 at the end of 5 years. All interest is taxable
@20% on realization. What are the pre-tax and effective
post-tax yield rates of the bond?
2. A 5-year fixed deposit scheme at the ICICI bank provides
an interest @8% p.a. compounded quarterly. Is it better to
invest in this scheme or an RBI bond 2002?
3. A secure scheme offers unit certificates which pay back
Rs.2,000/- every year starting from the end of the tenth
year from purchase of unit, till the death of the buyer.
Assuming a life of 80 years, a present age of 20 years,
and an risk-free interest rate of 6% for all those years,
would it be preferable, rather than investing for the risk-
free interest, to buy this certificate at a price of
a. Rs. 5,000/- ? c. Rs. 20,000/- ?
b. Rs. 10,000/- ? d. Rs, 50,000/- ?

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01 Time Value of Money 07

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Time Value of Money

Author: Dilip Thosar Slide no. 1

Author: Dilip Thosar Slide no. 3

• Numerical Exercise : Generate your own

Author: Dilip Thosar Slide no. 5

Author: Dilip Thosar Slide no. 6

• FVr=1 = PV(1+r)n = PV(1+R/n)n

Author: Dilip Thosar Slide no. 7

Author: Dilip Thosar Slide no. 8

• Return Ci at the end of ith year has FVi = Ci

• If the diminishing of value due to R has a

Author: Dilip Thosar Slide no. 13

Author: Dilip Thosar Slide no. 14

Author: Dilip Thosar Slide no. 16

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