Financial Market

Time Value of Money

Future Value Present Value

Value of Money is a function of interest rates, time period, and inflation.

Simple vs Compound Interest
Bank A pays 8.0% p.a. simple interest on its deposits for 3 years. Bank B pays 8% interest
compounded quarterly for the same tenure. How much extra interest would an investor earn by
placing the deposit with Bank B if the deposit amount is ₹10,000 for 3 years?

Simple Interest : 10000 ∗ 0.08 ∗ 3 = 2400

0.08 3∗4
Quarterly Compound Interest: 10000 ∗ 1 + − 10000 = 2682.42
4

Dfference = 2682.42 − 2400 = 282.42

If the interest was being compounded monthly, How much extra interest would be paid by Bank B?

Ans: 302.37
What is the difference between Simple and Compounding Interest?

Simple Interest is computed Only on the Principal or Original Amount deposited or received. On the
other hand, under the Compounding Interest method, Interest is also earned on the Accumulated
Interest from Prior Periods.

Effectively, Compounding assumes Reinvestment of Interest Earned in Prior Periods at the Same
Rate of Return.

100 @10% 100 +10

for 2 Years (100+10)+(10+1)=121

Years 0 1 2
Annual Percentage Rate (Nominal / Quoted Rate) vs Effective Annual Rate
The Quoted interest rate is usually for One Year or Annual.

Ex. SBI offers a 12% personal loan with monthly compounding. Is the borrower actually paying
interest @ 12% per annum?
𝒓 𝒏
𝑬𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝒂𝒏𝒏𝒖𝒂𝒍 𝒓𝒂𝒕𝒆 (𝑬𝑨𝑹) = (𝟏 + ) −𝟏
𝒏

𝟎.𝟏𝟐 𝟏𝟐
Or 𝑬𝑨𝑹 = (𝟏 + ) −𝟏 = 𝟎. 𝟏𝟐𝟔𝟖 𝒐𝒓 𝟏𝟐. 𝟔𝟖%
𝟏𝟐

Where r is the Annual Percentage Rate of Interest specified by the Bank – 12% in the above question.
n is the periodicity of interest within a year – monthly or 12 periods in the question above.

The Effective Annual Rate of interest or Effective Cost of Borrowings is independent of the amount
borrowed. It depends on the periodicity of compounding of the rate of interest.
If we calculate EAR in previous example….
Bank A pays 8.0% p.a. simple interest on its deposits for 3 years. Bank B pays 8% interest
compounded quarterly for the same tenure. How much extra interest would an investor earn by
placing the deposit with Bank B if the deposit amount is ₹10,000 for a period of 3 years?
𝟎. 𝟎𝟖 𝟒
𝐄𝐟𝐟𝐞𝐜𝐭𝐢𝐯𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐑𝐚𝐭𝐞 = (𝟏 + ) −𝟏 = 𝟏. 𝟎𝟖𝟐𝟒 − 𝟏 = 𝟎. 𝟎𝟖𝟐𝟒
𝟒
𝟑
𝐀𝐦𝐨𝐮𝐧𝐭 𝐨𝐟 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐄𝐚𝐫𝐧𝐞𝐫𝐝 𝐢𝐧 𝟑 𝐲𝐞𝐚𝐫𝐬 = 𝟏𝟎𝟎𝟎𝟎 ∗ 𝟏 + 𝟎. 𝟎𝟖𝟐𝟒 − 𝟏𝟎𝟎𝟎𝟎 = 𝟐𝟔𝟖𝟏. 𝟐𝟗

Simple Interest = 2400

𝐃𝐟𝐟𝐞𝐫𝐞𝐧𝐜𝐞 = 𝟐𝟔𝟖𝟏. 𝟐𝟗 − 𝟐𝟒𝟎𝟎 = 𝟐𝟖𝟏. 𝟐𝟗 ≈ 282.42

The principal amount is not considered when computing the Effective Annual Rate (EAR)!
Calculate the EAR for the quoted interest of 9% p.a. under following situations:
1. Compounded semiannually
2. Compounded quarterly
3. Compounded monthly

Ans:
1. 9.20%
2. 9.31%
3. 9.38%
Future Value of Money

Ex. If you plan to double your investment in 5 years, what is the rate of interest,
compounded annually, that you must earn on it?

2𝑋 = 𝑋 1 + 𝑟 5

21/5 − 1 = 𝑟

𝑟 is the Effective Annual Rate of Interest

Ans. 14.87%
Future Value of Money
Ex. Aman recently won a lottery of ₹10 lacs. He plans to buy a car in five years and expects the
value of the choice of his car to be ₹18 lacs by that time. What is the min interest rate that he
must earn to purchase the car?

Timing of Cash Flow

₹18lacs

₹10 lacs
3 4 5
0 1 2

18,00,000 = 10,00,000 1 + 𝑟 5 𝒓 is the EAR

Ans. 12.475%
Future Value of Money
Mr. Raman deposits with BOI the following series of money at the at the end of each year for 3 years
at 6% p.a. How much does he get at the end of 4th year if the bank compound interest annually.

End of year Amount in ₹

1 1000
2 2000
3 3000
Future Value of Money
Timing of Cash Flow 2000 3000
1000

Years 0 1 2 3 4

𝑭𝑽 = 𝟏𝟎𝟎𝟎 ∗ 𝟏. 𝟎𝟔𝟑 + 𝟐𝟎𝟎𝟎 ∗ 𝟏. 𝟎𝟔𝟐 + 𝟑𝟎𝟎𝟎 ∗ 𝟏. 𝟎𝟔𝟏 = 𝟔𝟔𝟏𝟖. 𝟐𝟐

How much will be the final value if the deposits were made at the beginning of the year?

1000 2000 3000

Years 0 1 2 3 4

𝑭𝑽 = 𝟏𝟎𝟎𝟎 ∗ 𝟏. 𝟎𝟔𝟒 + 𝟐𝟎𝟎𝟎 ∗ 𝟏. 𝟎𝟔𝟑 + 𝟑𝟎𝟎𝟎 ∗ 𝟏. 𝟎𝟔𝟐 = 𝟕𝟎𝟏𝟓. 𝟑𝟏

A Case of Series of Deposits of Different Amount!!

Future Value of Money
Ex. You want to buy a Harley Davidson in 5 years, currently available in the range of ₹20 – 25 lacs. The
expected price in 5 years is ₹30 lacs . You plan to save ₹1lac per year for the next 5 years and the balance
amount to be funded by bank borrowing. If the bank offers interest at 9% p.a. on a 5 year Recurring
Deposit, how much money will you borrow at the end 5th year if the bank compounds interest annually?

What does the cash flow look like?

End of year Amount in ₹
1 100,000
2 100,000
3 100,000
4 100,000
5 100,000

Ans
Future Value of Money
X lac
Timing of Cash Flow 1 lac
1 lac 1 lac 1 lac

1 lac
Years 0 1 2 3 4 5
FV = 1 ∗ 1.094 + 1 lac ∗ 1.093 + 1 lac ∗ 1.092 + 1 lac ∗ 1.091 + 1 lac ∗ 1.090 = 5.985 lac
Or multiply each component by respective 𝑭𝑽𝑰𝑭𝒏,𝒓

𝐹𝑉 = 1 ∗ 1.4116 + 1 ∗ 1.295 + 1 ∗ 1.188 + 1 ∗ 1.09 + 1 ∗ 1 = 5.9846

Is there an easier way to calculate? What type of Cash Flow is this?

Stream of Constant Cash Flow (payment or receipt) occurring at Regular Intervals of time.
ANNUITY

𝐹𝑉 = 1 ∗ FVIFA𝑛,𝑟 = 1 ∗ 5.985 = 5.985 𝑙𝑎𝑐𝑠