CHAPTER - 2 LUE OF MONEY has purchase of fixed asets, er a long period. If a firm purchases ts in immediate cash outflow. But ceived in future, Say over 9 to 10 ‘al decisions, the firm will have to recash inflows and outflows. But cash flows occuring atdifferent e value even if they are equal. Obviously, Juble than Rs 5,000 receivable hould be recognised in TIME VAI Most of the financial decisions, suc affect the cash flows of a firm ov! d machinery today, it resu! fit from the plant will be re vyears.In order to make sound financi plantan the bene compa periods donot have the sam 55,000 receivable after 1 year is more val after 10 years. Therefore, time value of money s! making financial decisions. For example, consider the following proposals. Machine A MachineB Rs. Rs. Initial investment 5,00,000 5,00,000 Expected cash inflows: Iyear | 1,00,000 2,00,000 year | 1,00,000 2,00,000 Mlyear} —3,00,000 1,00,000 Total 5,00,000 5,00,000 otal cash inflows are ut Machine B equal for machine A ea and B. B i oe ra = more cash inflows earlier than Machine A mice urchase of machine B is better, based on the time value of mot : ney. Time Value of Money22 prefer toreceive the amount, today itself. This is called time preference for money. However, he may be ready to receive the money after one year if he is suitably rewarded for his waiting. The reward is called interest. Mr. Rajesh may agree to receive Rs 10,000 after 1 year if he is paid an interest of Rs 1200. So, time preference for money is expressed as interest rate. Hence, time value of money is tobe recognised in making financial decisions. This is done by making appropriate adjustments through discounting or compounding of cashflows Resons for Time Preference for Money People prefer to receive money, earlier than later. The reasons are: | 1. Uncertainty: Future is uncerain. There is a chance of not getting, the money at all. Hence, people like to receive the money today itself rather than waiting for the future. 2. Preference for Consumption: The money may be needed to meet urgent current needs. Therefore, people prefer to receive money as early as possible 3. Investment Opportunities: Money has time value. If Mr. Chandran receives Rs 50,000 today, he can invest the amount and earn interest. Suppose he gets an interest of 10%, he will have Rs 55,000 at the end of 1 year. Therefore, itis good for him to receive Rs 50,000 now as it will grow into Rs 55,000 after one year. TECHNIQUES OF TIME VALUE OF MONEY | Values of cashflows differ according to the time of occurence. They | have to be adjusted to reflect the time value of money. Compounding, and discounting are the techniques used for this purpose. Compounding Technique It has been explained that time preference for money makes a person receive money now rather than waiting for the future. But ifhe is duly rewarded for the waiting time, by an offer of more money in the future, he may prefer to wait. For example, an investor is willing to | deposit Rs 1,00,000 say for 2 or 3 years only because he is assured of | more money in the future. . es2.3 Compounding technique is used to find out the future value o¢ - say for instance, the maturity value of a deposit of Rs 10,099 Ps ‘ % wee aes years at 12% interest. The application of compounding techn; ae iq discussed hereunder. ne Compound Value of a Lumpsum Illustration 1: Mr. Ram deposits Rs 10,000 for 3 years at 199, What is the compound value of his deposit? 2 Solution: Compound Value Rs Principal or Investment 10,000 Interest for the I year at 10% 1000 71000 Interest for the II year-10% on 11,000 1100 12100 Interest for the III year-10% on 12,100 1210 Compound value or future value after 3 years 13310 (OR) Formula Method FV =P(1+i)" Where, FV=Future value; P=Principal; i=Rate of interest; n=No. of years In the above example, P=10,000 i=10% n=3years FV = 10,000(1+.10) = 10,000(1.331) = Rs 13,310. Compound Value through Tables difficult when the period Calculation of compound value becomes: factor tables are (n)is long, say 15 0r20 years. Hence, compound value used to calculate the compound values easily.24 The Compound Value Factor table gives compound values of Re.1 for different periods at different rates of interest. Example : Rajkumar deposits Rs 20,000 at 12% for 10 years. The maturity value of the deposit can be found with the help of compound value factor tables. As per the table, Compound value of Re 1 after 10 years at 12% = Rs 3.106. So, the compound value of Rs. 20,000 = 3.106 x 20,000 = Rs 62,120. Multiple Compounding Periods In the previous section, the compounding of interest annually has been explained. However, in practice, compounding of interest may be done half-yearly, quarterly or even monthly. In such cases, future value can be calculated as follows. Futurevalie (FV) = P(e where P= Principal i Rate of interest m = ___ Frequency ofcompounding ina year n= __ Numberof years Illustration 2 : Manohar deposits Rs. 20,000 for 2 years at 10%. Calculate the maturity value of the deposit (FV) if interest is compounded half- yearly. Solution: P = Rs20,000 i=10% = 10/100 =.10 m= (half-yearly) = 2 times n=2years #8 20,000 (1 + 05)! 20,000 (1.2155) = Rs. 24, 310. ny, i (0 4 7 /Example : Half-yearly Compounding Rs. Principal Interest for 1 year @ 10% Interest for 6 months at 10%, Interest for 6 months at 10% on 105 Compound value It may be noted that the effective rate of interest in half-yearly compounding is 10.25% though the nominal rate is only 10% The ettective rate of interest can be found through the following formula _\m i | Effective Rate of Interest (ERD) = (+4) =u where i = Nominal rate of interest m= Frequency of compounding In the above exmaple, interest of 10% is compounded half-yearly, two times ina year. (1+ .05)7-4 1.1025 — 1 = .1025 or 10.25% Doubling Period Often investors and financial decision makers are interested in knowing the doubling period, thatis the time taken for doubling of an investment, When interest rates ruled high in the nineties, investment in Indra Vikas Patra doubled in 5 years, An investment of Rs 10,000 became Rs 20,000 in 5 years. |27 The doubling period canbe found approximately by following: rule of thumb methods, popularly known as rule of 72 and rule aay Rule of 72 According to this rule, R Ree «7 oubling period = Rate of interest n If the rate of interest is 12%, doubling period is sea 6 years If the rate of interest is 18%, doubling period is, 2 = 4 years. Itcan also be used to find out the rate of interest If the doubling period is 6 years the rate of interest = 2 ae Rule of 69 Rule of 69 isa refinement over rule of 72. It gives a more accurate result 69 Interest rate Doubling period Doubling period = 035+ Example _ Interest Rate 9 035+ 9% =7.25years 69 0.35+ 17 =6.10years 10% 12% Compound Value of Series of Payments fferent points of time, such as at the third year and soon. The compound | od, say 3 years. Insuch | Payments may be made at di end of the first year, second year, value may be received after the specified peri cases, first payment remains locked up for2 years (n- 1) second payment remains locked up for 1 year (n-2) and soon. \ Miustration 3: Calculate the compoun payments: d value of the following28 Solution: Compound Value = FV = P(1+i)" Ipayment of Rs 1000 is invested for 2 years Rs Value after 2 years = 1000 (1 + .12)? = 1000 (1.254) 1254 T payment of Rs 2000 is invested for 1 year Value after 1 year = 2000 (1 + .12)! = 2000 (1.12) 2240 TI payment of Rs 3000 invested for 0 year Value of 3000 at the end of the III year = 3000 (1) 3000 Compound value at the end of the III year 6494 (OR) Formula Method FV=P, (1 +i)" +P,(1+i)"*+... Where FV = Future value or compound value P,,P,,P,. n=Number of years. FV = 1000(1 + .12)?+2000(1 +12)! + 3000 = 1000 (1.254) +2000 (1.12) + 3000 = 1254+2240+3000 = Rs, 6494 Alternatively, the future value can be found by using the compound value factor tables (CVF) also: Payment No.ofyears Amount(Rs) CVF @12% FV .. periodic payments 1 2 1000 1.254 1254 2 1 2000 1.120 2240 3 0 3000 1.000 3000 6494 Compound Value of an Annuity Annuity refers to a series of equal annual payments made at the end of each year fora particular period (e.g., annuity of Rs 7000 for 15 en |29 years). Where such annual payments are made for a certain number o years the compound value can be found as shown below. Illustration 4: Rajiv deposits Rs 1000 at the end of every year for five years. The rate of interest is 12%. What is the maturity value of the deposit ? Solution: Maturity Value = FV =P (1 +i)" Ipaymentis invested for 4 years Rs Value at the end of 4 years = 1000 (1 + .12)= 1000 (1.573) 1573 II payment is invested for 3 years Value at the end of 3 years = 1000 (1 + .12)°= 1000(1.404) 1404 Ill payments invested for 2 years Value at the end of 2 years = 1000 (1 +12)? = 1000(1.254) (1254 IV Payment is invested for 1 year Value at the end of 1 year = 1000 (1 + 12) ! = 1000 (1.120) 1120 V payment is invested for 0 year Value at the end of the fifth year 1000 (1) 1000 Maturity Value 6351 (OR) Formula Method FV=A(1+i)"™1+ A (1+i)"? +... Where A=Annuity i=Rateofinterest n=Numberof years. FV = 1000(1 + 12)*+1000(1 + .12)°+ 1000 (1 + 12)? +1000 (1 + 12)! +1000 = 1000 (1.573) + 1000 (1.404) + 1000 (1.254) + 1000 (1.12) + 1000 = 1573 + 1404 + 1254+ 1120+ 1000 = Rs. 6351 Compound Value through Annuity Table The compound Value of an annuity can be found with the aid of Compound Value Annuity Factor tables Compound value of an annuity of Re. 1 for 5 years at 12% = 6.353 Compound value of an annuity of Rs 1000 = 6.353 x 1000 = Rs. 635321 Discounting or Present Value Technique Discounting technique is quite important in making financia, decisions. It is the opposite of compounding. Through the process o compounding we find out the future value of money -say the compoung value of Rs. 5000 after 10 years at 10% interest. On the other hang through discounting, we find out the present value of a future cashflow - say the present value of Rs 10,000 receivable after 5 years. The discounting or present value technique facilitates meaningful comparison of cashflows occuring at different periods of time. For example, Rs. 5000 receivable after 2 years is converted into present value through discounting. Similarly Rs. 5000 receivable after 5 years is converted into present value. So, comparsion of present values enables sound financial decision making. In compounding, interest is added to the principal. Hence future value is greater than the present value. Rs 1000 of today invested at 10% grows into Rs 1610 in 5 years. On the other hand, present value of asum tobe received in future is less, as canbe seen from the following: wal Example: PV= (si" Present value of Rs 1000 received to day = (0 year) = Rs. 1000 * 1000 Present value of Rs 1000 receivable after 1 year= 79)! = Rs. 909 1000 Present value of Rs 1000 receivable after 2years= (qq)? = Rs S| : 1000 if Present value of Rs 1000 receivableafter 3years= 77, yp = BS | It could be seen that Rs 1000 had been discounted to get its prea value. Further present value declines with increase in the numbet e years. Longer the period, lower is the present value.212 Present Value of a Lumpsum Present value of a lumpsum is calculated by the following fournula: FV Present Value (PV) = dei” where FV = The future sum or cashflow tobe received i = Rateofinterest n= No.ofyears Illustration 6: Arun expects to receive Rs 1,00,000 after 5 years. Find the present value of the future receipt, if his time preference rate is 10%. Solution: 1,00,000_1,00,000 (1+.10) = 1.6105 The present value of Rs 1,00,000 receivable after 5 years = Rs. 62,092 PV = Rs.62,092 Present Value through Tables PV Table shows the present value of Re. 1 received at the end of different years (n) at different rates of interest (r). As per the table, Present value of Re 1 receivable after 5 years at 10% = .621 (PV Factor) Present value of Rs 1,00,000 receivable after 5 years Present Value of a series of payments When payments are made in a series, overa period of time, present value is calculated as follows. Each payment or cashflow is discounted with reference to the period, at the specified rate of interest, to find out the present value. Then, the present values are added. The working is illustrated by the following example. Illustration 7: Calculate the present value of cashflows: Year 2 2 3 Expected cashflow (Rs) 1000 2000 3000 Interest Rate = 10% = .102.13 Solution: Present value of future cash flows: FV a. = Saud Gale Rs PV. of cw - of Rs 1000 receivable after 1 year = = T10 = %9 Pekin 2000 _ 2000 vV. receivable after 2 years = (jg)? 121 = 1653 3000 _ 3000 P.V. of Rs 3000 receivable after 3years = (jy yg)3 1.331 ~ 2254 Total present value of cashflows 4816 (OR) Formula Method a ee Fo EVD > CPL Lae dei" Where, F = Future cashflow i= Rate of interest n= No.of. years ooo, 2000, 3000 PV = Gy10)! (+10)? (1.10) 100, 2000 , 3000 Fe 1 sn aaihtldnvhlal | PV = 909 +1653 + 2254 = Rs.4816. Present Value through Table Present value table shows the present value of Re 1 ev received at the end of different years (n) at different rates of intel Facto!) rest (f)2.14 Year Gshflow PV. Factorati0% — Present Value RB Bs 1 1000 909 909 2 2000 826 1652 3 3000 751 2253 4814 Total Present Value Present Value of an Annuity Annuity refers to a series of equal annual payments, for a particular period of time say, 5 years or 10 years. The present of value of a series of such cashflows can be found as shown in the following example. Illustration 8: Mr. Krishnan expects to receive an annuity of Rs 5,000 for three years. His time preference rate is 10%. Calculate the present value of annuity. Solution: Present valueof Annuity = yn Where A = Annuity, i=Rate of interest, n=No.ofyears Rs 5000 _ $000 P.V. of Rs 5000 receivable after 1 year = (+ 10)! i = 445 5000 _ 5000 PV. of Rs 5000 receivableafter2 years = (yy)? ~ 1.21 = 4132 5000 _ 5000 P.V. of Rs5000 receivable after 3 years = (14.10) om 1331 = 3757 Total Present Value of Annuity 12,434 (OR) Formula Method PV.re y 215 Where A= Annuity i= Rate of interest; = No. of. years 5000 5000 5000 P= Gy ao eto?” Ur109 5000 5000 5000 —_—F peace et 121 1.331 = 4545 +4132 +3757 = Rs. 12,434 Present Value of Annuity - through Table Present Value Annuity table shows the present value of Re 1 received annually at the end of a number of years (n) at different rates of interest (r). As per the table, P.V. ofan annuity of Re 1 for 3 years at 10% = Rs. 2.486 (PVAF) PV. ofanannuity of Rs 5000 for 3 years at 10% =2.486 x 5000= Rs 12,430 Present value of an Annuity Due Annuity due refers to equal annual payments made at the beginning of every year. Present value of such payments is calculated as shown in the following illustration Illustration 9: Kalpana expects to receive Rs 6000 at the beginning of every year, for4 years. Find out the present value of the future receipts if the rate of interest is 10% Solution: A | PY ee (laa) ee | Present Value of Annuity Due Rs PV. of Rs 6000 received at the beginning of I year 6000 P.V. of Rs 6000 received at the beginning of Il year 6000 =) 5455 (end of I year) (+10)! = 102.16 PV. of Rs 6000 received at the beginning II year 6000 _ 6000 (end off year) (jg? 7 121 4959 P.V. of Rs 6000 received at the beginning IV year 6000 _ 6000 aya 4508 (end of Mlyear) (7 1o3 ~ 1.331 ta Ol et cn Total present value 20,922 (OR) Formula Method A A A py. = @Ashymenat ame) enn nye) (+i) 6000, 6000, 6000 = 6000+ 410)! +.10)? +10)? 000, 6000 6000 ee TAT nD ee = 6000 + 5455 + 4959 + 4508 = Rs. 20,922 Present Value of Annuity Due - through Table P.V. of Annuity of Re 1 for 4 years at 10% = 3.170 P.V.ofanannuity due ofRel = 3.170(1 +i) = 3.170(1.1)=3.487 P.V. of anannuity due of Rs6000 = 3.487x6000 =Rs. 20,922