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Time Value of Money

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Explain the methods of calculating present and future values.

Highlight the use of present value technique (discounting) in

Investment decisions.

EMI Calculations

11/7/2010

Chapter Objectives

risk

preference for consumption

investment opportunities

possession of a given amount of money now, rather than the

same amount at some future time.

Three reasons may be attributed to the individuals time

preference for money:

11/7/2010

rate. This rate will be positive even in the absence of any risk. It may

be therefore called the risk-free rate.

An investor requires compensation for assuming risk, which is called

risk premium.

The investors required rate of return is:

Risk-free rate + Risk premium.

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flows and

Discountingthe process of calculating present values of cash

flows.

value of money:

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Time Value

Adjustment

cash flows by applying the concept of compound interest.

Compound interest is the interest that is received on the

original amount (principal) as well as on any interest

earned but not withdrawn during earlier periods.

Simple interest is the interest that is calculated only on the

original amount (principal), and thus, no compounding of

interest takes place.

11/7/2010

Future Value

Fn P (1 i ) n

The term (1 + i)n is the compound value factor (CVF) of a lump

sum of Re 1, and it always has a value greater than 1 for positive

i, indicating that CVF increases as i and n increase.

a lump sum after n periods may, therefore, be written as

follows:

11/7/2010

Future Value

Fn =P CVFn,i

7

Rule of 72

The Rule of 72 is a simplified way to determine

how long an investment will take to double,

given a fixed annual rate of interest. By dividing

72 by the annual rate of return, investor can get

a rough estimate of how many year it ill take for

the initial investment to duplicate itself.

For example, the rule of 72 states that Rs.1

invested @ 8% would take 9 years (72 / 8) to

turn into Rs.2. In reality a 8 %, investment will

take 9.0064 years to double.

8

Rules of 115

The Rules of 115 is used to determine how

long an investment will take to triple, given a

fixed annual rate of interest. By dividing 115

by the expected annual rate of return,

investors can get a rough estimate of how

many years it will take for the investment will

take to triple the initial investment.

take 11.5 years (115 / 10 = 11.5) to turn into

Rs.3.

We will first find out the compound value factor at 15 per cent

for 10 years which is 4.046. Multiplying 4.046 by Rs 55,650, we

get Rs 225,159.90 as the compound value:

cent rate of interest on a ten-year time deposit, how much

would the deposit grow at the end of ten years?

11/7/2010

Example

10

(1 i ) n 1

Fn A

annuity of Re 1, which we shall refer as CVFA.

number of years. If you rent a flat and promise to make a series of

payments over an agreed period, you have created an annuity.

11/7/2010

Fn =A CVFA n, i

11

for four years at 6 per cent rate of interest. How much would

this annuity accumulate at the end of the fourth year? We first

find CVFA which is 4.3746. If we multiply 4.375 by Rs 5,000, we

obtain a compound value of Rs 21,875:

11/7/2010

Example

12

amount of current cash that is of equivalent value to the

decision-maker.

Discounting is the process of determining present value of a

series of future cash flows.

The interest rate used for discounting cash flows is also called

the discount rate.

11/7/2010

Present Value

13

Fn

n

F

(1

i

)

n

n

(1 i )

value factor (PVF), and it is always less than 1.0 for

positive i, indicating that a future amount has a smaller

present value.

PV Fn PVFn ,i

calculate the present value of a lump sum to be received

after some future periods:

11/7/2010

Flow

14

of Rs 50,000 to be received after 15 years. Her interest rate is

9 per cent. First, we will find out the present value factor,

which is 0.275. Multiplying 0.275 by Rs 50,000, we obtain Rs

13,750 as the present value:

11/7/2010

Example

15

annuity of Re 1, which we would call PVFA, and it is a sum of

single-payment present value factors.

written in the following general form:

1

1

P A

n

i i 1 i

11/7/2010

P = A PVAFn, i

16

periodic cash flows (annuity). In most instances the firm

receives a stream of uneven cash flows. Thus the present value

factors for an annuity cannot be used. The procedure is to

calculate the present value of each cash flow and aggregate all

present values.

11/7/2010

Periodic Sum

17

Perpetuity

Interest rate

are not very common in financial decision-making:

11/7/2010

18

EMI Calculation

(P*R/12) * [(1+R/12)^N] / [(1+R/12)^N -1]

P= Loan Amount

R= Rate of Interest

N= No. of Monthly Installments

Excel Function:

PMT

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20

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