CHA PTER

4
Time Value of Money
4.1 INTRODUCTION

The value/ purchasing power of money at a particular time is called time value of money. Arupee
roday is worth more than a rupee that will be received tomorrow. The income expected at a future
date will have lower value than the money held today. For example, suppose you have deposited
Rs. 200 in a bank with a 10 per cent rate of interest. After one year, the interest would be Rs. 20
and, consequently, the amount will become Rs. 220 at the end of the year. It follows that Rs. 220
expected one year hence is worth only Rs. 200 today.
The value of money is more today because
1. it gives liquidity, and an opportunity to invest and earn returns (interest);:
2. individuals, in general, prefer current consumption to future consumption because the future
is always uncertain and involves risk;
3. capital can be employed productivily to generate positive returns; and
4. in inflationary period, a rupee represents a greater real purchasing power than arupee a
year hence.
hus, as money has earning and purchasing power, it has time value.

2 TECHNIQUES FOR ADJUSTING TIME VALUE OF MONEY OR

INTEREST FORMULAS
While making investment decisions, computations are done in many ways. To simplify all these
Computations, it is extremely important to know how to use interest formulas more effectively. Before
discussing the effective application of interest formulas for making decisions on investments We
shall describe the various interest formulas.
Interest rate can be classified into simple interest rate and compound interest rate. In the simple
interest rate, the interest is calculated based on the initial deposit for every interest period. In the
Compound
plus interestinterest rate, the interest for the current period is computed| based on the amount (principal
up to the end of the previous period) at the beginning of the current period.

77
78 Time Value of Money
various interest formulas are as follows:
The notations used in
P= Principal amount
annually)
n= No. of interest periods compounded monthly, quarterly, semi-annually or
i= Interest rate (it may be
year n
F= Future amount at the end of interest period
at the end of every after periodto/from the amo
A= Equal amount deposited willbe added/subtracted, period
G= Uniform amount which 1
of deposit A, at the end of period
Amount/Future Value of an
4.2.1 Single-Payment Compound
Amount
find the single future sum (F)of the initial payment (P) made at
In this section the objective is to rate icompounded every period. See Figure 4.1.
time 0 after n periods, at an interest
F

P, 4
i%
Figure 4.1 Cash flow diagram for single-payment compound amount.
The formula to obtain the single-payment compound amount is
F=P(l+ iy
Or F=P(FIP, i, n)
where
(FIP, i, n) is called as single-payment compound amount factor.

EXAMPLE 41
A person deposits a sum of Rs. 20,000 at the interest rate 18%
Find the maturity value after 10year. compounded annually for 10 year
Solution
P= Rs. 20,000
i= 18% compounded annually
n= 10 years
F= PI+ iy = P(FIP, i, n)
= 20,000 (FIP, 18%, 10)
20,000 x 5.234 = Rs. 104,680
The maturity value of Rs. 20,000 invested now at 18 per cent compounded yearly is equalto
Rs. 104,680 after 10 years.

4.2.2 Single-Payment Present Worth Amount

Here the objective is to find the present
worth amount (P) of a single future (F) which willbe
received after n periods at an interest rate compound at the end of every interest
period.
 Techniques for Adjusting Time Value of Money or Interest Formulas 79

The corresponding cash flow diagram is shown in Figure 4.2.

F

P 1 2 3 4
i%
Figure 4..2 Cash flow diagram of single-payment present worth amount.
The formula to obtain the present worth is
F
P= =F(PIF, i,n)
(1+i)"

EXAMPLE4.2
Anerson wishes to have a future sum of Rs. 100,000 for his son's education after 10 years
from
now. What is the single-payment that he has to deposit now so that he gets the desired amount after
10years? The bank gives 15 per cent interest rate, compounded annually.
Solution
F= Rs. 100,000
i= 15%, compounded annually
n= 10 years
p= F(PIE, i, n)
= 100,000 (P/E, 15%, 10)
= 100,000 x 0.2472
= Rs. 24,720
The person has to invest Rs. 24,720 now so that he will get a sumn of Rs. 10,000 after 10 years at
15 per cent interest rate, compounded annually.
2.3 Equal-Payment Series Compound Amount/Future Value of an
Annuity
ne objective is to find the future worth of n equal payments which are made at the end of every
ierest period till the end of nth interest period at an interest rate compounded at the end of each
period. The corresponding cash flow diagram is shown in Figure 4.3.
1% F

1 2 4

A A A

Pigure 4.3 Cash flow diagram of equal-payment series compound amount.

The equal amount deposited at the end of each interest period = A
No. of interest
periods = n
80 Time Value of Money

Rate of interest =i
Single future amount = F
The formula to obtain F is

F=A +=|-AEIA, i.n)

amount factor.
Where (FIA, i, n) is termed as equal-payment series compound
EXAMPLE 4.3
A person who is now 35 years is planning for his retired life. He plans to invest an equal sum of
Rs. 10,000 at the end of every year for the next 25 years starting from the end of the next year. The
bank gives 20per cent interest rate, compounded annually. Find the maturity value of his accoum
when he is 60 years.
Solution
A= Rs. 10,000
n= 25 years
i= 20%
F= ?
The corresponding cash flow diagram is shown in Figure E4.3.1.
i= 20%
F
0 1 3 4
25
10,000 10,000 10,000 10,000
10,000
Figure E4.3.1
F=

= A(FIA, i, n)
= 10,000 (FIA,
209%, 25)
= 10,000 ×
471.981
-Rs. 4,719,810
The future sum of the
annual equal payments after 25 years is
equal to Rs, 4.719.810.
4.2.4 Equal-Payment Series Sinking Fund
In this type of investment mode, the
deposited at the end of every interest objective
period
is to
for n find the equivalent amount (A) that should be
end of nth interest period at an interest periods to realize a the
interest rate of i. See Figure 44 future sum (F)at
 Techniques for Adjusting Time Value of Money or
Interest Formulas 81

2 4

4 A A A
A
Figure 4.4 Cash flow diagram of
1r Baual amount to be equal-payment series sinking fund.
deposited at the end of each interest period
n= No. of interest periods
i=Rate of interest
f= Single future amount at the end
of the nth period
The formula to get F is

A= F
L1+i" -1| =F(AF, i, n)
where (A/F, i, n) is called as
equal-payment series sinking fund factor.
EXAMPLE4.4
Acompany has to replace a
present facility after 15 years at an outlay of Rs.
deposit an equal anmount at the end of every
year for the next 15 years at an 500,000. It plans to
compounded annually. Find the equivalent amount that must be interest rate of 18 per cent,
for the next 15 years. deposited at the end of every year
Solution
F= Rs. 500,000
n= 15 years
i= 18%
A= ?
Ine corresponding cash flow diagram is
shown in Figure E4,4.1.
500,000
i=18%
F
A
1 2 3 4
15
A A A

Figure E4.4.1

A= F
La+iy" -1|= F(AF, i, n)
= 500,000(A/F, 18%, 15)
= 500,000 x 0.0164
= Rs. 8200
The
annual equal amount which must be deposited for 15 years is Rs. 8200.
82 Time Value of Money
Worth Amount
4.2.5 Equal-Payment Series Present
The objective of this mode of investment is to find the present worth of an equal payment made ;
the end of every interest period for ninterest periods at an interest rate i, compounded at the end oj
is shown in Figure 4.5.
every interest period. The corresponding cash flow diagram
P 1%

3 4

A A A A A

Figure 4.5 Cash flow diagram for equal-payment series present worth amount.
Here,
P= Present worth
A= Annual equivalent payment
i= Interest rate
n= No. of interest periods
The formula to compute P is

P=A = A(PIA, i, n)
i(1+ i)"
where (PiA, i, n) is called equal-payment series present worth
factor.
EXAMPLE 4.5
A company wants to set up a
reserve which will help it to have an annual
Rs. 1,000,000 for the next 20 years equivalent amount o1
to growat the rate of 15 per cent towards its employees welfare measures. The reserve is assumeu
reserve amount. annually. Find the single payment that must be
made now to tne
Solution
A= Rs. 1,000,000
i= 15%
n= 20 years
P= ?

The corresponding cash flow

diagram is illustrated in Figure E4.5..
/= 10%
1 2 3 4
20
1,000,000 1,000,000 1,000,000 1,000,000
1,000,000
Flgure E4.5.1
 Techniques for Adjusting Time Value of Money or Interest Formulas 83

P= A| (1+iy" -1 = A(PlA,i, n)
i(1+i)"
= 1,000,000 x (PlA, 15%, 20)
= 1,000,000 × 6.2593
= Rs. 6,259,300
The amount of reserve which must be set up now is equal to Rs. 6,259,300.

A26 Equal-Payment Series Capital Recovery Amount

The obiective of this mode of investment is tofind the annual equivalent amount (4) to be recovered
at the end of every interest period for n interest periods for a loan P which is
sanctioned now at an
interest rate of i, compounded at the end of every interest period. See Figure 4.6.
P 1%
n
2 3

A A A
A

Figure 4.6 Cash flow diagram for equal-payment series capital recovery amount.
P= Present worth (loan amount)
A= Annual equivalent payment (recovery amount)
i= Interest rate
n= No, of interest periods
The formula to compute P is

A= P i(+i)" = P(AP, i, n)
L1+i)" -1|
where (A/P, i, n) is called egqual-payent series capital recovery jactor.

EXAMPLE4.6
ADankgives a loan to a company to purchase an equipment worth Rs. 1,000,000 at an interest rate
0 18 per cent, compounded annually. This amount should be repaid in 15 yearly equal instalments.
Find the instalment amount that the company has to pay to the bank.

Solution
P= Rs. 1,000,000
i= 180%
n= 15 years
A= ?
The corresponding cash flow diagram is shown in Figure E4.6.1.
84 Time Value of Money

1,000,000 i 18%

3 4 15
2

A A

Figure E4.6.1

i(1+ iy"
A= =P(AP, i, n)
(1+i)" -1
=1,000,000 x (A/P, 18%, 15)
= 1,000,000 x (0.1964)
=Rs. 196,400
The annual equivalent instalment to be paid by the company to the bank is Rs. 196,400.

4.3 UNIFORM GRADIENT SERIES FACTOR (A/G, i, N)

There are cases, where the periodic payments do not occur at an equal series.
increase or decrease by a constant amount. For example, a series of paymentsThese payments may
increasing in Rs. 200, Rs. 250, Rs. 300 and Rs. 350 occurring at the end of thewould be uniformly
and fourth years respectively. Similarly, a uniformly first, second, third
Rs. 100, Rs. 50 occurring at the end of first, decreasing series will be Rs. 200, Rs. I30.
case, an equal-payment series provides the basesecond, athird and fourth years, respectively. In cau
end of second year. See Figure 4.7. with constant annual increase or decrease at he

350

300
250

200 G
2G 3G

Figure 4.7 Gradient series 4

Aseries of payments that

cash flow diagram.
increases at a rate of Rs. 50
per year can be
arithmetic gradient is, then, pattern of an
illustrated. The
A',A + G, A' +2G, ... A' t
(N - Ii
where Nis the duration of the series (Ns 4). A
for each individual payment, and the result uniform series can be For P
should be added. evaluated by calculating
In another
method, the calculationcan
 Annuity 85

be made simple by converting the series to an equivalent annuity of equal payments A. The formula
forthetranslationis developed by separating the series in two parts:
1, Base annually designated A
An arithmetic gradient series increasing by G each period. See Table 4.1
Table 4.1 Gradient Series and Equivalent Set of Series
Set of series
equivalent to
End of year Gradient series gradient series Annual series
(1) (2) (3) (4)

A
2 G G A
2G G+ G A
4 3G G+ G+ G

n-1 (n- 2) G G+ G +G... G A

(n- 1) G G+ G+ G... + G+ G A

F= G(ElA, i, n - 1) + (FlA, i, n - 2) + G(FIA, i, 2) + (FlA, i, 1)

=l1+iy +(1+iy-2 +..+(l+)² +(1+) -(n-D

nG
La+ iy"- +(1+ iy-2 +...+(1 +i)' +l +i) +1
series compound amount factor for n
Ve. SInside the parentheses constitute the equal-payment
years. Therefore,
nG

4.4 ANNUITY
4.4.1 What is an Annuity? between payments N, and
Annui ty is ()
payment occurring
equal payments (4) (ii) equal periods
(i) the first characterized by: at the end of the first period.
86 Time Value of Money

4.5 ANNUITY DUE

A series of payments made at the beginning instead at the end of each period is referred
annuity due. In this case, calculation will be slightly different from general annuity It will difey
the following ways:
1. The series should be divided into two equal parts.
2. The first payment should be treated separately. annuity calculation.
3. The remaining payments should follow the rule of general
annuity, and the seríes of re
The present worth is the sum of first payment plus the product of =4.
worth factor. N will be the number of payments minus 1. The formula for annuity due
(Pi4, i, N).

EXAMPLE 4.7
What is the present worth of a series of 10 year-end payments of Rs. 1000 each, when the in
payment is due today and the interest rate is 5 per cent.
Solution
See Figure E4.7.1.
A= Rs. 1000
P=A+ A(P/A, 5, 9)
=1000+ 1000(7.1078)
= 1000 + 7107.8
= Rs. 8107.8

1 2 3 4 6 9

A= Rs. 1000
Figure E4.7.1

4.6 CALCULATION OF DEFERRED ANNUITY

Inthe case of deferredannuity, the first payment does not begin until some date later than the end
the first period. Deferred annuity can be calculated by dividing the series into two equal parts
" The first part is the number of payments paid, which follows the general annuity calcuatt
 Review Questions 87
is the number of periods.
The second part
" Finddout the present worth of annuity, then discount this value through the pre-annuity period.
Hence, we get the deferred annuity.

REVIEW QUESTIONS
money.
L Eplain the time value of
.Give practical applications of various interest formulas.
Anerson deposits a sum of Rs. 2,00,000 in abank for the education of his son who will be
admitted to a professional course after eight years. The bank pays 15 per cent interest rate,
compounded annuaily. Find the future amount of the deposited noney at the time of admitting
his son in the professional course.
Anerson needs asum of Rs. 5,00,000 for his daughter's marriage which will take place
25 vears from now. Find the amount of money that the person should deposit now in abank
if the bank gives 18 per cent interest, compounded annually.
6 Aperson who is 20 years old is planning for his retired life. He plans to invest an equal sum
of Rs. 20,000 at the end of every year for the next 20 years starting from the end of next year.
The bank gives 15 per cent interest rate, compounded annually. Find the maturity value of his
account when he is 50 years old.
Acompany is planning to expand its business after four years from now. The¿ expected money
required for the expansion programme is Rs. 150,000,000. The company can invest
Rs. 60,00,000 at the end of every year for the next five years. If the assured rate of return of
investment is 18 per cent for the company, check whether the accumulated sum in the account
would be sufficient to meet the fund for the expansion programme. If not, find the difference
In amounts for which the company should make some other arrangement after four years.
A financial institution introduces a plan to pay a sum of Rs. 2,500,000 after 20 years at the
Tae of 18 per cent, compounded annually. Find the annual equivalent amount that a person
Should invest at the end of every year for the next 20 years to receive Rs. 2,500,000 after
20 years from the institution.
OA Company is planning to expand its business after eight years from now. The money required
1or the expansion programme is Rs. 90,000,000. What annual equivalent amount should the
Company deposit at the end of every year at an interest rate of 15 per cent compounded
annually to get Rs. 90,000,000 after eight years from now?
h Company wants to set up a reserve which will help it to have an annual equivalent amount
O Rs. 2,500,000 for the next 20 years towards its employees welfare measures. The reserve
S assumed to growat the rate of 15 per cent annually. Find the single payment that must be
made as the reserve amount now.
An automobile company recently advertised its car for a down payment of Rs. 350,000.
Alternativelythe car can be taken home by customers without making any payment, but they
have to pay an equal yearly amount of Rs. 25,000 for 15 years at an interest rate of 18 per cent,

11. compounded annually.

ACompany takes Suggest the best alternative tothe customers.
a loan of Rs. 4000,000 to modernize its boiler section. The loan is to be
repaid in annually. Find the
30 equal instalments at 12 per cent interest rate, compounded
equal instalment amount that should be paid for the next 30 years.