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Time
Time Value
Value
Of
Of
Money
Money
Which would you prefer -- Rs10,000 today or
Rs10,000 in 5 years?
years
Future Value is the value at some future time of a present amount of money.
Compounding is the process of finding the future value of the present stream of cash
flows
Discounting is the process of finding out the present value of the future stream of cash
flows.
Interest is the compensation for the opportunity cost of funds and the uncertainty of
repayment of the amount borrowed; that is, it represents both the price of time and the
price of risk. The price of time is compensation for the opportunity cost of funds and the
price of risk is compensation for bearing risk.
Future value
Types
Types of
of Interest
Interest
Simple Interest
Interest paid (earned) on only the original amount, or
principal, borrowed (lent).
Compound Interest
Interest paid (earned) on any previous interest earned,
as well as on the principal borrowed (lent).
Simple
Simple Interest
Interest Formula
Formula
Formula SI = P0(i)(n)
SI = P0(i)(n)
= 1,000(.07)(2)
= 140
Simple
Simple Interest
Interest (FV)
(FV)
FV = P0 + SI
= Rs1,000 + Rs140
= Rs1,140
Compound Interest
A= P(1+i)n
A = amount at the end of ‘n’ period
i= rate of interest per payment period
n = no. of payment periods
Valuation
Valuation Using
Using Table
Table II
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
Using
Using Future
Future Value
Value Tables
Tables
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
Double
Double Your
Your Money!!!
Money!!!
72 / 12% = 6 Years
[Actual Time is 6.12 Years]
Frequency
Frequency of
of Compounding
Compounding
General Formula:
FVn = PV0(1 + [i/m])mn
n: Number of Years m:
Compounding Periods per Year
i: Annual Interest Rate FVn,m:
FV at the end of Year n
PV0: PV of the Cash Flow today
Impact
Impact of
of Frequency
Frequency
= 1,271.20
Sinking Fund
Fn = A * CVIFA n,i
A = Fn * 1/CVIFAn,i
A = Fn * SFFn,i
SFF n,i = sinking fund factor
Present Value
Translating a value to the present is referred to as discounting.
Present value = PV = FV / (1 + i) n
Where:
PV = present value (today's value),
FV = future value (a value or cash flow sometime in the future),
i = interest rate per period, and
n = number of compounding periods
And [(1 + i) n] is the compound factor.
Annuity
An Annuity represents a series of equal payments (or receipts)
occurring over a specified number of equidistant periods.
Ordinary Annuity:
Annuity Payments or receipts occur at
the end of each period.
Annuity Due:
Due Payments or receipts occur at the
beginning of each period.
Examples of Annuities
(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3
0 1 2 3
Today
Parts
Parts of
of an
an Annuity
Annuity
(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3
0 1 2 3
FVADn = R (FVIFAi%,n)(1+i)
FVAD3 = Rs1,000 (FVIFA7%,3)(1.07)
= Rs1,000 (3.215)(1.07) = Rs3,440
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
Hint on Annuity Valuation
PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = Rs1,000 (PVIFA7%,3)(1.07)
= Rs1,000 (2.624)(1.07) = Rs2,808
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
Effective
Effective Annual
Annual
Interest
Interest Rate
Rate
(1 + [ i / m ] )m - 1
Effective
Effective Annual
Annual Interest
Interest Rate
Rate
EAR = ( 1 + 6% / 4 )4 - 1 =
1.0614 - 1 = .0614 or 6.14%!
Steps
Steps to
to Amortizing
Amortizing aa Loan
Loan
Step 1: Payment
PV0 = R (PVIFA i%,n)
$10,000 = R (PVIFA 12%,5)
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774
Amortizing
Amortizing aa Loan
Loan Example
Example
R
C = cash payment
R = interest rate
Example
If someone were promised a cash flow of Rs 400 per year until they died and they
could earn 6% on other investments of similar quality, in present value terms
the perpetuity would be worth Rs 6,666.67. (Rs 400 / .06 = Rs 6,666.67)