Handout - Present Value Basics

September 15, 2020
The basics of present values

Examples of present value calculations
Ritesh Pandey
September 15, 2020
Ritesh Pandey The basics of present values 1 / 119

September 15, 2020
Future values and present values
Money has a time value.

It can be invested to earn interest.
Therefore, we have,
A basic principle of finance
A Rupee today is worth more than a Rupee tomorrow.

September 15, 2020
Example 1: A one year bank deposit

Question: Suppose that you invest |100 in a bank account that
pays an interest of r = 8% a year.
What will be the value of your investment after 1 year?

September 15, 2020

In the first year, we will earn an interest of 0.08 × |100 = |8.
At the end of the first year (i.e., at the beginning of the second
year) the account will have the principal (= amount deposited
initially) plus the interest of the principal i.e., | 100 + | 8 = |
108.

September 15, 2020
In general, if the bank deposit gives an interest rate of r % per

year, then The value of an investment or |P after 1 year will be
A = |P + |P × r = |P × (1 + r ).

September 15, 2020

By investing |100 in the bank deposit, we give up the opportu-
nity to spend the |100 today, but get to spend |108 after one
year.

September 15, 2020
Time 0 1
Cash Flow Notation C0 C1
Cash Flow Amount P (1 + r )P
Cash Flow Nature PV (1 + r )

FV

September 15, 2020
Example 2: A two year bank deposit

Question: Suppose that you keep the |100 invested in the bank
account for two years at the same interest rate.
What will be the value of your investment after 2 years?

September 15, 2020
Case 1: The bank pays simple interest (Unusual case)
The interest on |100 for year 1 = | 100 times .08 = | 8.

For the second year, interest rate is applied again on the
initial principal only. So, The interest on |100 for year 2
= | 100 × 0.08 = | 8.
Total amount at the end of year 2 in the accout =
principal + interest for year 1 + interest for year 2 = 100
+ 8+8 = |116.

September 15, 2020
Case 1: The bank pays simple interest (Unusual case)
A = | rP + | rP + | P (1)
= | P(1 + 2r ) (2)

September 15, 2020

Case 2: The bank pays compound interest (Usual case)
In compound interest, interest rate for an year is applied

to the new principal (principle + acumulated interest) for
that year.
In the second year, we will earn an interest of 0.08 × |108
= |8.64
So, the value of the investment after 2 years will be |108
+ |8.64 = |116.4
This can be directly computed as
|100 × (1 + r )2 = |100 × (1.08)2

September 15, 2020
Case 2: The bank pays compound interest (Usual case)
A = | rP + | r (P + rP) + | P (3)
2
= | 2rP + r P + P (4)
2
= | P(2r + r + 1) (5)
= | P(1 + r )2 (6)
(7)

September 15, 2020
Note that interest in the second year is applied on both the

original |100 investment and also on the |8 interest earned in
the first year.
This kind of interest earned is called compound interest and
we say that our money grows at a compound rate.
The final values, |108 or |16.4 of our investment after 1 and 2
years respectively are called future values of our |100
investment.

September 15, 2020
‘t’ year bank deposit

What will be the value of your |100 investment after ‘t’ years,
assuming the rate of interest is fixed at 8%?

September 15, 2020
Future value of |100 = |100 × (1 + r )t .

September 15, 2020

Longer the investment horizon ‘t’, greater will be the
future value.
Larger the interest rate ‘r’, greater will be the future value.

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September 15, 2020

Let us reverse the situation now.
How much will you have to invest in the above bank deposit so
that after one year you end up with |108?
In other words, what is the present value of |108 invested at

8% for one year?

September 15, 2020

Clearly, the present value invested at 8% for 1 year will grow to the
future value of |108
That is
Present value × (1 + r ) = Future value

= |108(given).
Therefore,
Future value
Present value =
(1 + r )
108
=
(1 + 0.08)
= |100.
September 15, 2020
A one year bank deposit
Time 0 1
Cash Flow Notation C0 C1
F
Cash Flow Amount 1+r
F
Cash Flow Nature PV 1 FV

1+r

September 15, 2020

Again we consider the reverse the situation.
How much will you have to invest in the above bank deposit so
that after two years you end up with |116.4?
In other words, what is the present value of |116.4 invested at

8% for two years?

September 15, 2020

Two year bank deposit
Clearly, the present value invested at 8% for 2 years will grow to the
future value of |16.4
That is
Present value × (1 + r )2 = Future value

= |116.4(given).
Therefore,
Future value
Present value =
(1 + r )2
116.4
=
(1 + 0.08)2
= |100.
September 15, 2020

That is, for a deposit at rate ‘r’ for ‘t’ years,
Future value
Present value =
(1 + r )t

September 15, 2020
‘t’ year discount factor

1
The value (1+r )t
is called the ‘t’ year discount factor at rate ‘r’
So, the 2 year discount factor at 8% rate of interest will equal

1
(1.08)2
= .8573
And then, Present value = .8573 × 116.4 = |100.

September 15, 2020

The longer the time ‘t’ for which we have to wait to get a
given sum of money, lower will be its present value.
Larger the interest rate ‘r’, lower will be the present value
of a given future sum of money.

September 15, 2020

September 15, 2020
Valuing an investment opportunity

Example 4 : A one period safe project
Suppose you work in a company that is deciding about whether
to construct a residential block of buildings on the outskirts of
the city or not. The cost of buying the land and constructing the
block is |7,00,00,000. Your company has enough funds to go
ahead with the project. Since the residential real estate market
is booming, you are confident that the block will be sold after
construction within one year at |8,00,00,000.
Question: What is the rate of return on this one-period invest-

ment?

September 15, 2020
Expected profit
Rate of return =
Investment required
(8, 00, 00, 000 − 7, 00, 00, 000)
=
7, 00, 00, 000
= 14.29%.

September 15, 2020

A safe investment
Instead of investing in the above project, your company
could have returned the amount of |7,00,00,000 (say, as
dividend) to the shareholders.
The shareholders could have, on their own, invested this
amount in a risk-free investment, say Treasury Bills, that
promise a return of 7% for one year.
Alternatively, they could have invested in the stock
market, which is a risky investment but, on average, offers
a return on investment of 13%.
Question: What is the opportunity cost of capital for the
firm: 7% or 13%?

September 15, 2020
Answer: The opportunity cost of capital for the firm is7%.

The shareholders could earn 14.29% from the residential
project at no risk.
The shareholders could also have, on their own, earned a
risk-free return of 7% for one year in T-Bills.
Clearly, since the project has no risk, the investors would
lose out on the 7% return from T-Bills if they invest in
the project.

September 15, 2020

Question: How much is the residential project worth today?

September 15, 2020

We need to find the present value of the project.
In other words, we need to find the Present value of the cash

flow that the project will generate at the end of one year.
Future value
Present value =
(1 + r )
8, 00, 00, 000
=
(1 + 0.07)
= |7, 47, 66, 355.

September 15, 2020

To find the present value of the project, we discount its expected
future cash flow by the opportunity cost of capital to the firm.

September 15, 2020

Question: Suppose, after the land has been purchased and the
construction costs paid, your firm decides to sell the project.
How much will your firm get for the (unstarted) project?

September 15, 2020

Answer: We will get just the present value of the project, i.e.,
|7,47,66,355 today.
In order to earn a sure-fire sum of |8,00,00,000 in one
year, investor will have to invest today, a sum of
|7,47,66,355 in T-Bills. So, to get the same sum in the
same time from the same-risk project, they will not pay
more than that.
Of course, they will be ready to pay less, but then we
would not sell for less since we could make the same 7%
return easily in the financial markets.
The value |7,47,66,355 is the only amount at which both
seller and buyer may agree.
September 15, 2020

The present value of the project is also its market price.

September 15, 2020

Question: So, will investors will ready to participate in your
residential project by investing their money in it? Why or why
not?

September 15, 2020

Answer: Yes they will be willing to invest.
They will make only 7% risk-free from T-Bills.
The project, on the other hand, offers them, risk-free
14.29% return on investment.

September 15, 2020

Question: Can we say that taking up the project will make your
company better-off by |7,47,66,355?

September 15, 2020

Answer: No. It will be better-off by the net present value
(NPV) of the project and not by its present value.
Net present value = Present value (PV) − Investment

= |7, 47, 66, 355 − |7, 00, 00, 000
= |47, 66, 355.

September 15, 2020

If we denote initial investment by −C0 and next year’s cash
inflow by C1 , then
C1
NPV = −C0 +
(1 + r )
8, 00, 00, 000
= −7, 00, 00, 000 +
1.07
= |47, 66, 355.

September 15, 2020

Time 0 1
Cash Flows −C0 C1
Present values of cash flows:

−C0
DF : 1
C1
+ 1+r
1
DF : 1+r
NPV:
C1
−C0 + 1+r

September 15, 2020
Example 5 : A one-period risky project

Question: Suppose, that the construction project is not risk-free
but that the cash flow from the project is uncertain. Would the
investors still pay |7,47,66,355 for the project?

September 15, 2020

Answer: No. Investors can get a certain |8,00,00,000 from T-
Bills by investing |7,47,66,355 in them today.
So, they will be willing to pay an amount less than |7,47,66,355.

We will have to cut our asking price for the project.

September 15, 2020
A second basic principle of finance

A safe Rupee is worth more to the investors than a risky Rupee.
This is the assumption that most investors are risk-averse and would
take on risk only when they are compensated by a return greater than
the risk-free return.

September 15, 2020

Question: What will be the opportunity cost of capital for the
firm in case of the risky project?

September 15, 2020
Answer: The opportunity cost of capital will now be 13%
This is because 13% is what we are losing out on by not investing

in the stock market and investing in the residential project
This assumes that the risk of the project is equal to that of

the only risky investment opportunity available viz. the stock
market.

September 15, 2020

Question: If the company takes up this risky project, by how
much is it better-off today?

September 15, 2020

8, 00, 00, 000

Present value =
(1 + 0.13)
= |7, 07, 96, 460.
C1
NPV = −C0 +
(1 + r )
8, 00, 00, 000
= −7, 00, 00, 000 +
1.13
= |7, 96, 460.

September 15, 2020

There are two effects at play here.
1 Time effect: This reduces the value of |8,00,00,000 to
|7,47,66,355.
2 Time + Risk effects: These reduce the value of
|8,00,00,000 to |7,07,96,460.
3 It is difficult to disentangle the impact of the time delay
and the risk effect in most usual situations.

September 15, 2020
Two rules for decision making

1 Net present value rule: Accept investments that have a
positive NPV.
2 Rate of return rule: Accept investments that offer rates
of return greater than their opportunity costs of capital.
3 Usually, both rules give the same answer. In case there is
a conflict, we decide on the basis of the NPV rule.

September 15, 2020
Example 6: A two period risky project

Suppose that your company’s Finance Head finds out that once
completed, the residential space can be rented out for two years
at an annual rent of |20,00,000 and after two years the block
can be sold off at |8,50,00,000
Question: How much value will this course of action add to your
company’s value?

September 15, 2020

Example 6 : A two period risky project
Answer: As before, the net addition to the company’s value will
be the NPV of the project.
C1 C2
NPV = −C0 + +
(1 + r ) (1 + r )2
20, 00, 000 (20, 00, 000 + 8, 50, 00, 000)
= −7, 00, 00, 000 + +
1.13 (1.13)2
= −|96, 327.
Instead of adding to the company’s value, the option will reduce the
company’s value by |96,327. We should, by the NPV rule, not take
the option of renting out and then selling the space.

September 15, 2020

Example 6 : A two period risky project
Time 0 1 2
Cash Flows −C0 C1 C2

−C0
DF : 1
C1
+ 1+r
1
DF : 1+r
C2
+ (1+r )2
1
DF : (1+r )2
NPV:
C1 C1
−C0 + 1+r + (1+r )2

September 15, 2020

The DCF formula
The NPV of a multi-period project is simply the sum of all
the discounted cash flows, both positive (inflows) and negative
(outflows/investments).
n
X Ct
NPV =
t=0
(1 + r )t
As a special case, if the only investment occurs at t = 0, then,

n
X Ct
NPV = −C0 +
t=1
(1 + r )t
September 15, 2020

Suppose that your company’s banker approaches you and offers
to loan you the |7,00,00,000 required for the project at the risk-
free rate of 7%, based on her excellent past relationship with
your company and the safe, sound and profitable nature of your
current businesses, in her assessment
Question: What happens to the NPV of the project?

September 15, 2020

Answer: Nothing.
The riskiness of the project is different from the
risk-profile of the company promoting it.
Even if we get the money from the bank at the risk-free
rate of 7%, this does not change the opportunity cost of
the project to 7%. The company’s shareholders would still
miss out on the 13% return from the stock market by
investing in the construction project and so the
opportunity cost of the project would still remain 13%.

September 15, 2020
Valuing perpetuities
A stream of cash flows occurring at regular intervals in perpetuity such
that the cash flow in each period is the same is called a perpetuity.
Present value of a perpetuity
If the fixed cash flow per period is C and the interest rate is r , then
it can be shown that
C
PV(perpetuity) = (8)
r
Inverting this formula we have

Rate of return from a perpetuity
C
r= (9)
PV(perpetuity)
September 15, 2020

Example 7 : A normal perpetuity
Time 0 1 2 3 ...
Cash Flows 0 C C C ...
C
DF : 1
+ 1+r
1
+ C DF : 1+r
(1+r )2
1
+ C DF : (1+r )2
(1+r )3
1
+ C DF : (1+r )3
(1+r )i
1
NPV: DF : (1+r )i
C +
0 + 1+r C + C +
(1+r )2 (1+r )2
...+ = rC

September 15, 2020
Suppose that your company, as part of its Corporate Social
Responsibility (CSR) initiatives, decided to create a fund for
the education of tribal children.
Starting next year, the company will start paying |25,00,000

each year, in perpetuity, into the fund. The rate of interest is
9%.
Question: For what amount should your company sign a check

today to create this fund?

September 15, 2020
C
PV(perpetuity) =
r
25, 00, 000
=
.09
= |2, 77, 77, 778.
Answer: The company sign a check of |2,77,77,778 today to

create this fund.

September 15, 2020
Valuing perpetuities due
Example 8 : A perpetuity due

Suppose that your company now realizes that the CSR regula-
tions by the government kick in with immediate effect
The company wants immediate creation of the fund to meet

mandatory CSR expenditure requirements.
Question: For what amount should your company sign a check

today to create this fund?

September 15, 2020
Example 8 : A perpetuity due
The company will have to pay an upfront of |25,00,000 for the current year in addition
to the |2,77,77,778 calculated above. Total amount = |3,02,77,778
This is equivalent to moving the perpetuity starting next year forward by one year to the
current year. Perpetuities starting immediately are termed perpetuities due.
C
PV(perpetuity due) = C +
r
C (1 + r )
=
r
C
= (1 + r ) ×
r
= (1 + r ) × PV(Normal perpetuity)
= (1.09) × |2, 77, 77, 778
= |3, 02, 77, 778.
Answer: The company sign a check of |3,02,77,778 today to create this fund.

September 15, 2020
Valuing delayed perpetuities
Example 9 : A delayed perpetuity

Suppose that your company does not have enough cash to start
the fund immediately. It lobbies successfully with the govern-
ment and gets the mandatory CSR spending regulations to kick
in beginning the fourth year from now.
Question:What is the present worth of the education fund now?

September 15, 2020

There are no payments to be made for t = 0, 1, 2, and3. The first payment starts at
t=4
This means that the value of this perpetuity starting at t = 4 will be the usual
|2,77,77,778 but at t = 3.
Its value today will be
PV(Normal perpetuity)
PV( Delayed perpetuity) =
(1 + r )3
C /r
=
(1 + r )3
2, 77, 77, 778
=
(1.09)3
= |2, 14, 49, 541.
Answer: The delay lowers the company’s obligation today to |2,14,49,541.

September 15, 2020

Time 0 1 2 3 ...
Cash Flows 0 0 0 C
r
0
DF : 1
0
1
0 DF : 1+r
1
C (1 + r )3
DF : (1+r )2
r
1
NPV: DF : (1+r )3
0 +
0 + 1+r 0 + Cr (1 + r )3
(1+r )2
= C
r (1+r )3

September 15, 2020

C
Value of a perpetuity delayed by ‘n’ years = r (1+r )n

September 15, 2020
Valuing annuities
A stream of, say, n cash flows occurring at regular intervals from t = 1 to
t = n + 1 such that the cash flow in each period is the same is called an
annuity.
Present value of an annuity
If the fixed cash flow per period is C and the interest rate is r , then
it is obvious that
PV(annuity) = PV(Perpetuity) − PV(Perpetuity delayed by n years )

(10)
C C /r
− = (11)
r (1 + r )n

C 1
= 1− (12)
r (1 + r )n
h i
1 Pandey 1
The quantity Ritesh1− is called the annuity
The factor for values
basics of present n periods
68 /and
119
September 15, 2020
Valuing annuities
Time 0 1 2 3 4 ...
Normal perpetuity 0 C C C C ...
(-)Delayed perpetuity 0 0 0 0 C ...
Annuity 0 C C C 0 ...

September 15, 2020
Valuing annuities
Example 10 : Effect of a car loan
You wish to buy a car that has a net price of |4,00,000. Since you
can’t pay upfront in full, you approach a bank for a 5 year car loan.
The bank asks for a payment of |10,000 per month beginning next
month at an annual interest rate of 10%.
Question: How much extra will you have to pay for the car under
this scheme?

September 15, 2020
Valuing annuities
Example 10 : Effect of a car loan
Here, C = |10, 000.
n = 12 × 5 = 60.
r ≈ 10%/12 = .92%.
So,
PV (Car loan) = |10, 000 × Annuity factor (.92%, 60)

= 10, 000 × 45.99
= |4, 59, 930.
Answer: An extra |59,930 has to be paid under this scheme.

September 15, 2020
Valuing annuities
Example 11 : Home Loan EMIs
You have purchased a house on home loan. The amount of loan

taken is |50,00,000. The loan has to be paid in EMIs for 20 years
beginning next month at an annual interest rate of 12%.
Question: How much EMI do you have to pay?

September 15, 2020
Valuing annuities
Example 11 : Home Loan EMIs
Here, C =?.
n = 12 × 20 = 240 months
r ≈ 12%/12 = 1% per month.
So,
PV (Home loan) = |50, 00, 000 = C × Annuity factor (1%, 240)
This gives
|50, 00, 000

C=
90.82
= |55, 054.31
Answer: The EMI

Ritesh comes out to be |55,054.31.
Pandey The basics of present values 73 / 119
September 15, 2020
Valuing annuities
Example 12 : Education Loan Amortization
You have taken out a loan to meet expenditure on your post graduate
studies. The amount of loan taken is |16,00,000. The loan has to
be paid in equal amounts one a year for 8 years beginning next year
at an annual interest rate of 8%.
Question: Draw up a loan amortization schedule and show in a figure

the split of the annual payment between principal repayment and
interest payment.

September 15, 2020
Valuing annuities

September 15, 2020
Valuing annuities

September 15, 2020
Valuing annuities
Example 13 : Saving to buy a luxury car
You wish to purchase a luxury car worth |25,00,000 with the next 5
years of savings. You estimate that you will be able to save |5,00,000
per year beginning next year
You also estimate that you will be able to earn an interest of 8% per
year on these savings.
Question: Would you be able to buy the car as you desire?What if

the car was worth |30,00,000?

September 15, 2020
Valuing annuities
Example 13 : Saving to buy a luxury car
Here, C = |5, 00, 000.
n = 5 years
r = 8%/ per year.
The present worth of our savings for 5 years will be
PV (Savings) = |5, 00, 000 × Annuity factor (8%, 5)

= |5, 00, 000 × 3.99
= |19, 96, 355.
This will grow at 8% in 5 years to a future value of
5
FV = |19, 96, 355 × (1 + .08)
= |29, 33, 300.
Answer: Yes, we will be able to buy the car with 5 years worth of savings..

September 15, 2020
Valuing annuities
Future value of annuity
In general, the future value of an annuity at the end of year t,
FV(annuity) = PV(Annuity) × (1 + r )t (13)

C
(1 + r )t − 1

= (14)
r

September 15, 2020
Valuing growing perpetuities

Example 14 : A growing perpetuity
Let us go back to the fund your company wanted to start for edu-
cating tribal children.
Just before executing the fund documents, you realized that the costs
of educating a child would be subject to inflation and you had not
provided for such a rise in costs.
A rough estimate is that the costs would grow at the rate of 4% per
year beginning the next year.
Question: What should be the amount for which your company

should make an upfront commitment?

September 15, 2020
Valuing growing perpetuities

In order to keep pace with the growing costs, the per-year contribution of |25,00,000 should also grow at the rate of 4%
annually.
Present value of a growing perpetuity
If the fixed cash flow per period is C , it grows at the rate g , and the interest rate is r , then it can be shown that
C
PV(growing perpetuity) = (15)
r −g
So, in our example,
Example 14 : A growing perpetuity
25, 00, 000

PV(growing perpetuity) = (16)
.09 − .04
= |5, 00, 00, 000. (17)
Answer: The company should make an upfront commitment of |5,00,00,000.

September 15, 2020
Valuing growing annuities
Example 15: A growing annuity
Let us again go back to the fund your company wanted to start for
educating tribal children.
Due to a sudden demand for capital expenditure in a new factory

upcoming in the same tribal region, your company decides that it
would be able to provide for the growing annuity only for 3 years
beginning the next year
Question: What should be the new amount for which your company
should make an upfront commitment?

September 15, 2020
Consider the following table.
Year 1 2 3 4 5 6 ...
A 1 (1 + g ) (1 + g )2 (1 + g )3 (1 + g )4 (1 + g )5 etc.
B (1 + g )3 (1 + g )4 (1 + g )5 etc.
C 1 (1 + g ) (1 + g )2
1
PV (A) = r −g
(1+g )3 1
PV (B) = r −g (1+r )3
1 (1+g )3
So,PV (C ) = PV (A) − PV (B) = r −g
[1 − (1+r )3
]

September 15, 2020

For a growing annuity starting next year for n total years
Valuing a growing annuity
1 h (1 + g )n i
PV(growing annuity) = 1− (18)
r −g (1 + r )n
So, for our example,

Example 15 : PV of growing annuity
25, 00, 000 h (1 + .04)3 i

PV(growing annuity) = 1− (19)
.09 − .04 (1 + .09)3
= | 65, 69, 930. (20)

September 15, 2020
Example 16 : A growing annuity

Question: What should be happen if the costs were growing at
the same rate as the interest rate?

September 15, 2020
A growing annuity
If we put r = g in the above formulas, the PV value would blow
up to ∞.
(1+g ) i
However, we also realize that each term is of the form C (1+r )i+1
,
C
and so for r = g , each term has a PV of (1+r ) and therefore for
an annuity of n terms, the PV will be
C
PV(growing annuity, r=g ) = n × (21)
1+r
The formula remains valid for r < g .

September 15, 2020
Example 16 : A growing annuity
C
PV(growing annuity, r=g ) = n ×
1+r
25, 00, 000
=3×
(1 + .09)
= |68, 80, 734.

September 15, 2020
Quoting interest rates
Semiannual compounding
Suppose that you invest |100 in a bank that pays you an interest
rate of 8% compounded semi-annually.
Question: What will your investment grow to in six months?

September 15, 2020
FV after 6 months = 100 × (1 + .08/2)

= |104.
Answer: The investment grow to in |104 in six months?

September 15, 2020
Question: What will your investment grow to in one year?

September 15, 2020
FV after 6 months = 104 × (1 + .08/2)

= |108.16.
Answer: The investment grow to in |108.16 in one year?

September 15, 2020
Question: What is the effective annual interest rate on your
deposit?

September 15, 2020

(1 + r effective annual ) × 100 = 108.16

= (1 + r semiannual )2 × 100
This means that

108.16
r effective annual = −1
100
= 8.16%
Answer: The effective annual interest rate is 8.16%.

September 15, 2020
The 8% interest rate in the previous example is termed as the

quoted rate or annual percentage rate

September 15, 2020
Quarterly compounding
Question: If the quoted annual percentage rate is 7% com-

pounded each quarter, what will |100 invested grow to in one
year?

September 15, 2020
FV after 1 year = 100 × (1 + .07/4)4

= |107.1859.
Answer: The |100 invested will grow to | 107.1859 in one year.

September 15, 2020
Question: What is the effective annual rate in the above situa-
tion?

September 15, 2020
107.1859
100
= 7.1859%

September 15, 2020
High frequency compounding
If the quoted rate of r % is compounded m times in a year, the

effective annual rate is
r effective annual = (1 + r /m)m − 1 (23)

September 15, 2020
Weekly compounding
Question: If the quoted annual percentage rate is 7% com-

pounded each week, what will |100 invested grow to in one
year, given there are 52 weeks in an year?

September 15, 2020
Weekly compounding
FV after 1 year = 100 × (1 + .07/52)52

= |107.2458.
Answer: The |100 invested will grow to | 107.2458 in one year.

September 15, 2020
Weekly compounding
tion?

September 15, 2020
Weekly compounding
107.2458
100
= 7.2458%

September 15, 2020
Continuous compounding
Question: If the |100 is invested at 7% continuously com-

pounded, what will it end up as after one year?

September 15, 2020

x
From elementary calculus, we know that lim (1 + x1 ) = e with
x→∞
e = 2.71828 . . .
So, if compounding is done m times per year with an annual interest rate
of r percent, then as m → ∞,
m
r m 1 r .r
lim (1 + ) = lim (1 + m ) (24)
m→∞ m m→∞
r
= er (25)
Answer: The |100 invested at 7% continuously compounded will end up

as e .07 = |107.25 in one year.

September 15, 2020
Answer: The |100 invested at 7% continuously compounded

will end up as e .07 = |107.25 in one year.

September 15, 2020
tion?

September 15, 2020
107.25
100
= 7.25%

September 15, 2020
Question: If the |100 is invested at 7% continuously com-

pounded, what will it end up as after three years?

September 15, 2020
FV = e .07×3
= |123.3651.
Answer: The |100 invested at 7% continuously compounded

will end up as |123.3651 in three years.

September 15, 2020
The value of |1 invested at r% annual rate continuously com-

pounded for t years is
FV = e rt (26)

September 15, 2020

You estimate that you will live for 20 years after retirement at
the age of 60 years.
You also estimate that you will be spending |1,00,000 per month
during your post-retirement life.
Your expenditure will be spread evenly during any year. The

interest rate continuously compounded is 9%.
Question: How much should you have saved by retirement to

support this level of expenditure in your retired life?

September 15, 2020

Your total expenditure during the retired life will be an annuity with
continuous compounding during the 20 years of retired life.
Its value at the point of retirement will be

C 1
PV at retirement = 1 − rt
r e
C
1 − e −rt

=
r
12, 00, 000
1 − e .09×20

=
.09
= |1, 11, 28, 937.
Answer: You must have saved by retirement | 1,11,28,937 to support

this level of expenditure in your retired life.
September 15, 2020
Present Value of Annuities
Syntax: = PV(rate, nper, pmt, [fv], [type])

rate The discount rate
nper The number of periods
pmt The (constant) amount of the annuity payment
outflow per period
fv (optional; defaults to zero) Any value at the end of
payments
type (optional; defaults to 0) 1 if payments go out at the
start of each period and zero if they go out at the end

September 15, 2020
Present Value of Annuities
The discount rate and the number of periods should be

compatible
For payments coming in i.e., cash inflows, use a minus sign
before pmt

September 15, 2020
Present Value of General Cash Flows
Syntax: = NPV(rate, value1, [value2],...)

September 15, 2020
NPV vs PV functions in Excel
The NPV calculation is based on future cash flows. If your first

cash flow occurs at the beginning of the first period, the first
value must be added to the NPV result, not included in the
values arguments.
NPV is similar to the PV function (present value). The primary
difference between PV and NPV is that PV allows cash flows to
begin either at the end or at the beginning of the period. Unlike
the variable NPV cash flow values, PV cash flows must be
constant throughout the investment.

September 15, 2020
Future Value of Annuities
Syntax: = FV(rate, nper, pmt, [pv], [type])

rate The discount rate
nper The number of periods
pmt The (constant) amount of the annuity payment
outflow per period; should be with a minus sign
pv (optional; defaults to zero) The present value of the
annuity
type (optional; defaults to 0) 1 if payments go out at the
start of each period and zero if they go out at the end

September 15, 2020
Thank you.

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September 15, 2020

The basics of present values

September 15, 2020

Ritesh Pandey The basics of present values 1 / 119

Future values and present values

Money has a time value.

Ritesh Pandey The basics of present values 2 / 119

Future values and present values

Example 1: A one year bank deposit

What will be the value of your investment after 1 year?

Ritesh Pandey The basics of present values 3 / 119

Future values and present values

Example 1: A one year bank deposit

Ritesh Pandey The basics of present values 4 / 119

Future values and present values

Example 1: A one year bank deposit

In general, if the bank deposit gives an interest rate of r % per

Ritesh Pandey The basics of present values 5 / 119

Future values and present values

Example 1: A one year bank deposit

Ritesh Pandey The basics of present values 6 / 119

Future values and present values

Example 1: A one year bank deposit

Cash Flow Notation C0 C1

Cash Flow Amount P (1 + r )P

Cash Flow Nature PV (1 + r )

Ritesh Pandey The basics of present values 7 / 119

Future values and present values

Example 2: A two year bank deposit

What will be the value of your investment after 2 years?

Ritesh Pandey The basics of present values 8 / 119

Future values and present values

Example 2: A two year bank deposit

Case 1: The bank pays simple interest (Unusual case)

The interest on |100 for year 1 = | 100 times .08 = | 8.

Ritesh Pandey The basics of present values 9 / 119

Future values and present values

Example 2: A two year bank deposit

Case 1: The bank pays simple interest (Unusual case)

Ritesh Pandey The basics of present values 10 / 119

Future values and present values

Case 2: The bank pays compound interest (Usual case)

In compound interest, interest rate for an year is applied

|100 × (1 + r )2 = |100 × (1.08)2

Future values and present values

Example 2: A two year bank deposit

Case 2: The bank pays compound interest (Usual case)

Ritesh Pandey The basics of present values 12 / 119

Future values and present values

Note that interest in the second year is applied on both the

Ritesh Pandey The basics of present values 13 / 119

Future values and present values

‘t’ year bank deposit

Ritesh Pandey The basics of present values 14 / 119

Future values and present values

‘t’ year bank deposit

Future value of |100 = |100 × (1 + r )t .

Ritesh Pandey The basics of present values 15 / 119

Future values and present values

‘t’ year bank deposit

Ritesh Pandey The basics of present values 16 / 119

Future values and present values