CF Session 2 - Time Value of Money

Avijit Bansal
Indian Institute of Management Calcutta

January 8, 2023

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 Maximizing value of the firm

Investing Decisions Financing Decisions Payout Decisions

Equity/Debt Reinvestment/
Cash Flows
Mix Payout

Maturity of Dividend/ Buy-

Hurdle Rate
Debt back

Return Gener- Currency of

ated Debt

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 Different stakeholders that cor-
porate managers have to cater to

Shareholders Bank/bond holders Employees Customers

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Exchange rate between currencies

$ 100 + | 100 = ?

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Exchange rate - cashflows in different time periods

| 100 today + | 100 after 1 year = ?

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Time Value of Money

What is more desirable? | 100 today or | 100 one year from now?

Why?

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Time Value of Money

Preference for consuming today

Uncertainty about the cash flow in future

Inflation concerns

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Timeline of cash flows

| 100 | 100
0 1 2

Year

100
PV at t = 0 is
(1 + r )1

100
PV at t = 0 is
(1 + r )2

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Timeline of cash flows

...
0 C1 C2 C3 C4 C5 C6 C7 C8 CT

Year 1 2 3 4 5 6 7 8 T

C1 C2 C3 CT
PV of all cash flows = + + + ··· +
(1 + r )1 (1 + r )2 (1 + r )3 (1 + r )T
T (1)
X Ct
=
(1 + r )t
t=1

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Perpetuity

A security that pays a fixed amount to the holder each year till perpetuity.

...
0 C C C C C C C C

Year 1 2 3 4 5 6 7 8

C C C
PV of a Perpetuity = + + + ...
(1 + r )1 (1 + r )2 (1 + r )3
∞
X C
= (2)
(1 + r )t
t=1
C
=
r

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Annuities

An annuity pays fixed amount every year for a limited number of years

0 C C C

Year 1 2 3

Can we derive a neat expression to value an annuity?

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Annuity as difference of two perpetuities

Three year annuity

0 C C C

Year 1 2 3

Perpetuity A: Starting from year 1

...
0 C C C C C C C C

Year 1 2 3 4 5 6 7 8 9

Perpetuity B: Starting from year 4

...
0 C C C C C

Year 1 2 3 4 5 6 7 8 9

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Value of Perpetuity A and B

Perpetuity A: Starting from year 1

...
0 C C C C C C C C

Year 1 2 3 4 5 6 7 8 9
C
Value of Perpetuity A at t = 0 is
r

Perpetuity B: Starting from year 4

...
0 C C C C C

Year 1 2 3 4 5 6 7 8 9
C
Value of Perpetuity B at t = 3 is
r
C 1
Value of Perpetuity B at t = 0 is ×
r (1 + r )3

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Value of a three year annuity

Three year annuity

0 C C C

Year 1 2 3

At t = 0, Value of 3-year annuity = Value of Perpetuity A - Value of Perpetuity B At

C C 1 C 1
h i
t = 0, Value of 3-year annuity = − × = × 1−
r r (1 + r )3 r (1 + r )3

Value of 3-year annuity = Payoff × Three year annuity factor

1 1
h i
Three year annuity factor = × 1−
r (1 + r )3

1 1
h i
T year annuity factor = × 1−
r (1 + r )T

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Valuing a T year annuity

...
0 C C C C C C C C C

Year 1 2 3 4 5 6 7 8 T

At t = 0, value of a T-year annuity is C × T year annuity factor

1 1
h i
At t = 0, value of a T-year annuity is C × 1−
r (1 + r )T

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Numerical Example

Suppose you buy a house by taking a loan of 50 lakhs for 30 years. The interest rate
charged by the bank is 10%. What would be your annual installments towards the
loan?

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Growing perpetuity

...
0 C C × (1 + g) C × (1 + g)2 C × (1 + g)3

Year 1 2 3 4

C C (1 + g) C (1 + g)2
PV of a Growing Perpetuity = + + + ...
(1 + r )1 (1 + r )2 (1 + r )3
∞
X C (1 + g)t−1
= (3)
(1 + r )t
t=1
C
=
r −g

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Growing annuity

0 C C × (1 + g) C × (1 + g)2 C × (1 + g)3 C × (1 + g)4

Year 1 2 3 4 T

C C (1 + g) C (1 + g)T −1
PV of a Growing Annuity = 1
+ 2
+ ··· +
(1 + r ) (1 + r ) (1 + r )T
T
X C (1 + g)t−1
= (4)
(1 + r )t
t=1
C (1 + g)T
h i
= 1−
r −g (1 + r )T

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Compounding

What is will be value of 100 compounded annually at 10% after 1 year?

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Frequency of compounding

Frequency Rate t Formula Effective Annual Rate

1
r

Annual 10% 1 1+ −1 10%
1
r 2

Semi-Annual 10% 2 1+ −1 10.25%
2 

r 12
Monthly 10% 12 1+ −1 10.47%
12 

r 365
Daily 10% 365 1+ −1 10.5156%
365n
r

n 10% n 1+ −1
n
Continuous 10% er − 1 10.5171%

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Numerical Example

SBI Credit card charges an interest of 3.5% per month on the outstanding balance.
Typically interest on a credit card is compounded at a daily frequency. What is the
effective annual interest rate on SBI credit card debt?

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Basic Terms used in Bond Pricing

Face Value/Par Value

Price

Coupon Rate and the payment frequency

Yield to maturity

Maturity

Note: We would be using the NPV and IRR formulas in excel extensively

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Size of Debt Market in India

Indian Treasury - 79 Lakh Crore

Corporate Bonds - 40 Lakh Crore

Indian Stock Markets - 300 Lakh Crore

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Factors impact bond prices

Time

Face Value and Coupons

Inflation

Credit

Liquidity

Currency

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References I

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