Financial Management I

6. Time Value of Money

Dr. Suresh
suresh.suralkar@gmail.com
Phone: 40434399, 25783850
 Course Content - Syllabus
Sr Title ICMR Ch. PC Ch. IMP Ch.
1 Introduction to Financial Management 1* 1 1
2 Overview of Financial Markets 2* 2 -
3 Sources of Long-Term Finance 10* 17 20, 21
4 Raising Long-term Finance - 18* 20, 21, 23
5 Introduction to Risk and Return 4* 8, 9 4, 5
6 Time Value of Money 3* 6 2
7 Valuation of Securities
8 Cost of Capital

9 Basics of Capital Expenditure

Decisions
10 Analysis of Project Cash Flows

11 Risk Analysis and Optimal Capital

Expenditure Decision
*Book preference 2 / 57
 Time Value of Money

Reference Books

1. Financial Management, ICMR Book, Chapter 3

2. Financial Management, Prasanna Chandra, 7th Edition,

Chapter 6

3. Financial Management, I. M. Pandey, 9th Edition,

Chapter 2

3 / 57
 Syllabus – Time Value of Money

1. Introduction

2. Types of Cash Flows

3. Future Value of a Single Cash Flow

4. Multiple Flows and Annuity

5. Present Value of a Single Cash Flow

6. Multiple Flows and Annuity

7. Growing Annuity

8. Perpetuity and Growing Perpetuity 4 / 57

 1. Introduction

Companies take up new projects, where they invest money

for the benefits expected over a period of time in future.

4 Cr 1 Cr 1 Cr 1 Cr 1 Cr 1 Cr
Investment

How to determine whether the project is financially viable

or not?
Answer to this question will be to sum up the benefits
accruing over the future period and compare the total
value of benefits with the initial investment.
If the total of benefits exceed the initial investment, then
the project is considered to be financially viable. 5 / 57
 1. Introduction

Concept of Time Value of Money

One rupee at present is worth more than one rupee next
year. Because one rupee at present can be invested to
earn an income. Value of money at present is more than
value of money in future time. Hence we can say money
has a value based on time. This concept is called as ‘time
value of money’ or an ‘interest’.

4 Cr 1 Cr 1 Cr 1 Cr 1 Cr 1 Cr
Investment
Present values 0.86Cr 0.74Cr 0.64Cr 0.55Cr 0.47Cr
total 3.26 Cr
6 / 57
 1. Introduction

How to determine the time value of money and use it into

cash flows of a project?
We are going to study these things in this chapter.
Nominal or market interest rate depends on real interest
rate, inflation and uncertainty about future.

Nominal or market interest rate = Real interest rate +

expected inflation rate + risk premium for uncertainty

Due to inflation, a rupee today has higher purchasing

power than rupee in future.
Future is characterized by uncertainty, which require
some risk premium. 7 / 57
 Compounding

0 1 2 3 4
-1000 250 500 750 750
+
FV(750)
+
FV(500)
+
FV(250)

compare with FV(1000)

Under the method of compounding, we find the future

values (FV) of all the cash flows at the end of the time
horizon, at a particular rate of interest.
8 / 57
 Discounting

0 1 2 3 4
-1000 250 500 750 750
compare with the
sums of PV(250)
+
PV(500)
+
PV(750)
+
PV(750)

Under the method of discounting, we calculate the time

value of money at present. So we will be comparing the
initial outflow with the sum of the present values (PV) of
the future inflows at a given rate of interest. 9 / 57
 2. Types of Cash Flows

Types of Cash Flows: Cash flows from

Operating Activities,

Investing Activities and

Financing Activities.

Cash flow is the difference between amount of cash

flowing in and out a company.

10 / 57
 3. Future Value of a Single Cash Flow

FVn  PV (1  k) n

Where FVn = future value in n years

PV = present value or initial value of cash flow
k = annual rate of interest
n = duration or the life of investment
(1+k)n = future value of unit investment, say Rs. 1
= FVIF(k, n)
= future value interest factor
Use Table 1 to get FVIF value for k & n
Multiply PV and FVIF to get the future value
11 / 57
 3. Future Value of a Single Cash Flow

Example
If the bank offers a compounded rate of interest of 11%
per annum on the deposit. An amount of Rs. 10,000
deposited today, will become how much after 3 years?

Solution
Formula FVn  PV (1  k) n

∴ FVn = PV x FVIF(k,n)
= PV x FVIF(11,3)
= 10,000 x 1.368
= Rs. 13,680 12 / 57
 3. Future Value of a Single Cash Flow

Doubling Period
Frequent question asked by the investors is ‘How many
years required to double an investment with a given rate
of interest?’
Solution
Above question can be answered by a rule known as ‘Rule
of 72.” It is an approximate method of calculating. As
per the rule, the period within which the amount will be
doubled is obtained by dividing 72 by the rate of interest.
13 / 57
 3. Future Value of a Single Cash Flow

For example, if the given rate of interest is 10%, then

doubling period is 72 / 10 = 7.2 years.

However, more accurate way of calculating doubling

period is the ‘Rule of 69’, according to which the
69
doubling period is 0.35 
Interest Rate

= 0.35 + 69/10
= 0.35 + 6.9
= 7.25 years
14 / 57
 3. Future Value of a Single Cash Flow

By calculator
Doubling Period Calculation
Formula FVn  PV (1  k) n
FVn
∴  (1  k) n
PV
By taking log on both sides
log (FVn/PV) = n log(1+k)
∴ n = log(FV n/PV)
log(1  k)
log 2
=  7.27 years
log 1.1 15 / 57
 3. Future Value of a Single Cash Flow

Growth Rate
Compounded Annual Growth Rate (CAGR) can be
calculated for a series of incomes by using Future Value
Interest Factor (FVIF) Table, (Table 1)

Example:
Years 1 2 3 4 5 6

Profits in lakh 95 105 140 160 165 170

Calculate the compound rate of growth.

16 / 57
 3. Future Value of a Single Cash Flow

Calculate the compound rate of growth.

Years 1 2 3 4 5 6

Profits in lakh 95 105 140 160 165 170

Solution:
Ratio of profits for last year to first year = 170 / 95 = 1.79
Refer FVIF(k,n-1) table (Table 1)
Look for the value close to 1.79 for 5 years
The value close to 1.79 is 1.762 and corresponding interest
rate is 12 %.
Therefore compound rate of growth (CAGR) is 12%. 17 / 57
 3. Future Value of a Single Cash Flow

By calculator
FV = PV (1+k)n
∴ 170 = 95 (1+k)5
∴ 1+k = (170/95)1/5
5
= 1.79

= 1.1235
∴ k = 0.1235 or 12.35%

18 / 57
 3. Future Value of a Single Cash Flow

Increased Frequency of Compounding

For example, half yearly compounding, quarterly
compounding etc.
Example
You have deposited Rs. 10, 000 in a bank, which offers
10% interest p.a. compounded semi-annually. Calculate
the amount at end of the year.
Formula
k mn
FVn  PV (1  )
m

Where, FVn = future value after n years 19 / 57

 3. Future Value of a Single Cash Flow

Example
An amount of Rs. 1000 is invested in a bank for 2 years.
Rate of interest is 12 % compounded quarterly.
Calculate the amount at the end.
Solution k
FVn  PV (1  ) mn
m
where m = 4, frequency of compounded in a year.
∴ FVn = 1000 (1+0.12/4)8
= 1000 (1.03)8
= 1000 x 1.267
= Rs. 1267 20 / 57
 3. Future Value of a Single Cash Flow

Effective vs. Nominal Rate of Interest

Rs. 100 with 10 % interest amounts to Rs. 110 at the end of
year.
However semi-annually 100(1.05)2 = 100 x 1.1025 = 110.25
∴ The principal amount grows 10.25% p.a.
This 10.25% is called effective rate of interest.
Hence the accumulation under semi-annual compounding
exceeds the accumulation under annual compounding.

21 / 57
 3. Future Value of a Single Cash Flow

Effective vs. Nominal Rate of Interest

Formula for effective rate of interest
k m
r  (1  )  1
m

Where r = effective rate of interest

k = nominal rate of interest
m = frequency of compounding per year

22 / 57
 3. Future Value of a Single Cash Flow

Example
Calculate the effective rate of interest, for the 12%
nominal rate of interest quarterly compounded.
Solution
Effective rate of interest
k m
r  (1  )  1
m
0.12 4
 (1  ) 1
4
= 1.034 -1 …Refer FVIA(3,4) table
= 1.126 -1
= 0.126 or 12.6% 23 / 57
4. Future Value of Multiple Flows and Annuity

0 1 2 3
1000 2000 3000 Accumulation

FV(3000)
+
FV(2000)
+
FV(1000)

Suppose we invest Rs. 1000 now i.e. at the beginning of

year 1, Rs. 2000 at the beginning of year 2 and Rs. 3000
at the beginning of year 3. How much will these cash
flows accumulate at the end of year 3 at the rate of 12%
p. a.
24 / 57
4. Future Value of Multiple Flows and Annuity

0 1 2 3
1000 2000 3000 Accumulation

FV(3000)
+
FV(2000)
+
FV(1000)

∴ Future value at the end of 3 years, at 12% interest p.a.

= FV(Rs. 1000) + FV (Rs. 2000) + FV(Rs. 3000)
=1000 x FVIF(12,3) +2000 x FVIF(12,2)+3000 x FVIF(12,1)
= 1000 x 1.405 + 2000 x 1.254 + 3000 x 1.12
= Rs. 7273 25 / 57
4. Future Value of Multiple Flows and Annuity

By calculator
Future value at the end of 3 years
= 1000 x 1.123 + 2000 x 1.122 + 3000 x 1.12
= Rs. 7273.73

26 / 57
4. Future Value of Multiple Flows and Annuity

Annuity
Annuity is a stream or series of periodic flows of equal
amounts. For example life insurance premium.
Regular Annuity or Deferred Annuity: When the equal
amounts of cash flows occur at the end of each period,
over the specified time horizon.
Annuity Due: When cash flows occur at the beginning of
each period, over the specified time horizon.
0 1 2 3 4 5 6

Future value of regular annuity

FVA6  A(1  k)61  A(1  k)6-2  A(1  k)6-3  ...  A(1  k)6-6
27 / 57
4. Future Value of Multiple Flows and Annuity

Future value of regular annuity

FVAn  A(1  k) n 1  A(1  k) n -2  A(1  k) n -3  ...  A
Which reduces to  (1  k) n  1
FVAn  A  
 k 
Where, A = amount deposited /invested at the end of every
year for n years
k = rate of interest, expressed in decimals
n = time horizon
FVAn = Accumulation at the end of n years.
The expression  (1  k)  1 is called the Future Value
n

 k 
Interest Factor for Annuity (FVIFA) and it accumulates
Rs. 1 invested or paid at the end of every year for a
period of n years at the rate of interest k.
FVIFA values are given in Table 2. 28 / 57
4. Future Value of Multiple Flows and Annuity

Example
Calculate the ‘Annuity regular’ for yearly annuity of Rs.
1000 invested with a 12 % interest for a period of 10
years.
Solution
 (1  k) n  1
FVAn  A  
 k 
∴ FVAn = A x FVIFA(k,n)
= 1000 x FVIF(12,10)
= 1000 x 17.549
= Rs. 17549 29 / 57
4. Future Value of Multiple Flows and Annuity

By calculator
 (1  k) n  1
FVAn  A  
 k 

 (1  0.12)10  1
∴ FVAn  1000 
 0.12 

= 1000 x 17.54874
= Rs. 17548.74

30 / 57
4. Future Value of Multiple Flows and Annuity

Example
Under a recurring deposit scheme of the bank, a fixed
amount is deposited every month. The rate of interest is
9% compounded quarterly. Calculate the maturity value
for a monthly installment of Rs. 500 for 12 months.
Solution
Amount of deposit = Rs. 500 per month
Rate of interest = 9% compounded quarterly
k m
Effective rate of interest r  (1  ) 1
m
0.09 4
 (1  )  1  0.0931 or 9.31%
4
31 / 57
4. Future Value of Multiple Flows and Annuity

Rate of interest per month  (1  r)1/12  1

 (1  0.0931)1/12  1

 0.0074 or 0.74%

Maturity value of an annuity

 (1  k) n  1
FVAn  A  
 k 
 (1  0.0074) 12 1
 500  
 0.0074 

 500 x 12.50  Rs. 6250

32 / 57
4. Future Value of Multiple Flows and Annuity

If the payments are made at the beginning of every year,

then the value of such an ‘annuity due’ is calculated by
modifying the formula of ‘annuity regular’ as follows

FVAn(due) = A (1+k) FVIFA(k,n)

33 / 57
4. Future Value of Multiple Flows and Annuity

Example
A person aged 20 is insured for a policy of Rs. 10,000. The
term of policy is 25 years and the annual premium is Rs.
41.65. Calculate the rate of return the person gets.
Solution
Premium = Rs. 41.65 per annum
Term of policy = 25 years
Value at the maturity = P (1+K) FVIFA(k,n), since the
premium is paid at the beginning of the year.
∴ 10,000 = 41.65 (1+k) FVIFA (k,25)
∴ (1+k) FVIFA(k,25) = 240.1 34 / 57
4. Future Value of Multiple Flows and Annuity

From Table 2, we get

(1+0.14) FVIFA(14,25) = 1.14 x 181.871 = 207.33
and
(1+0.15) FVIFA(15,25) = 1.15 x 212.793 = 244.71
By interpolation
240.1  207.33
k = 14% + (15% - 14%) x
244.71  207.33
= 14 + 1 x 32.77 /37.38
= 14 + 0.87 %
= 14.87 %
35 / 57
 5. Present Value of a Single Cash Flow

Discounting: Using this approach we can find present

value of a future cash flow or a stream of future cash
flows. Present value approach is commonly followed for
evaluating financial viability of projects.
FVn = PV(1+k)n
= PV x FVIF(k,n)
FVn FVn
∴ PV  or PV 
FVIF(k, n) (1  k) n
The inverse of FVIF(k,n) is defined as PVIF(k,n)
∴ The Present Value Interest Factor for k and n
PV = FVn x PVIF(k,n)
36 / 57
 5. Present Value of a Single Cash Flow

To determine the present value of a future sum, we have to

just multiply future value by PVIF factor for the values
of k and n. PVIF values are provided in Table 3.
Example: Calculate the issue price of a zero coupon bond
with a face value of Rs. 1000, redeemable after 5 years
with 12% interest p.a.
Solution: PV = FV x PVIF(k,n)
= 1000 x PVIF(12,5)
= 1000 x 0.567 = Rs. 567 37 / 57
 5. Present Value of a Single Cash Flow

By calculator
FVn
PV 
(1  k) n
1000

(1  0.12) 5

 Rs. 567.43

38 / 57
 5. Present Value of a Single Cash Flow

Example: A bank certificate having value of Rs. 100 after a

year is to be issued with a 12% interest p.a. quarterly
compounded. Calculate the issue price of a certificate.
Solution
k m
Effective rate of interest r  (1  )  1
m
0.12 4
 (1  )  1  0.1255 or 12.55%
4
Issue price of the certificate is FVn
PV 
(1  k) n
100
  Rs. 88.85
(1  0.1255)
39 / 57
 5. Present Value of a Single Cash Flow

Example: A bank wishes to issue a cash certificate of Rs.

1,00,000 to be received after 10 years, at the rate of 10%
interest p.a. compounded quarterly. Calculate the issue
price of this certificate.
Solution
k m
Effective rate of interest r  (1  ) 1
m
0.10 4
 (1  )  1  0.1038 or 10.38%
4

Issue price of the certificate is FVn

PV 
(1  k) n
100000
  Rs. 37247.41
(1  0.1038) 10
40 / 57
 6. Present Value of
Multiple Flows and Annuity

0 1 2 3
Accumulation 1000 2000 3000

PV(1000)
+
PV(2000)
+
PV(3000)

∴ Present value at the end of 3 years, at 12% interest p.a.

= PV(Rs. 1000) + PV (Rs. 2000) + PV(Rs. 3000)
=1000 x PVIF(12,3) +2000 x PVIF(12,2)+3000 x PVIF(12,1)
= 1000 x 0.893 + 2000 x 0.797 + 3000 x 0.712 = Rs. 4623
41 / 57
 6. Present Value of
Multiple Flows and Annuity

Project is said to be financially viable if the present value

of the cash flows exceeds the present value of the cash
outflows.

42 / 57
 6. Present Value of an Annuity

When an annuity is receivable at the end of every year for

a period of n years at the interest rate of k, then the
present value is equal to
A A A A
PVAn     ... 
(1  k) (1  k) 2 (1  k)3 (1  k) n

 (1  k) n  1
This reduces to PVAn  A  n 
 k(1  k) 
 (1  k) n  1
The expression  n 
is called the PVIFA, Present
 k(1  k) 
Value Interest Factor for Annuity and it represents the
present value of a regular annuity of Rs. 1 for a given
value of k and n. 43 / 57
 6. Present Value of an Annuity

PVIFA values are given in Table 4 for various values of k

and n.

These values are used with following conditions

• The cash flows are equal
• The cash flows occur at the end of every year

44 / 57
 6. Present Value of an Annuity

Example: Calculate the investment to receive a yearly

regular income of Rs. 10,000 for 10 years at the rate of
12 % p.a.
Solution: PVAn = 10,000 x PVIFA(12,10)
= 10,000 x 5.65 = Rs. 5650

 (1  k) n  1
By calculator PVAn  A  n 
 k(1  k) 
 (1  0.12)10  1 
 10,000 10 
 0.12(1  0 .12) 
 2.10585 
 10,000   Rs. 5650.23
 0.3727  45 / 57
 6. Present Value of an Annuity

Example: Calculate the initial deposit amount to receive a

monthly payment of Rs. 1000 for 12 month. The rate of
interest is 12% p.a. quarterly compounded.
k m
Solution: Effective rate of interest r  (1  m )  1
0.12 4
 (1  )  1  0.1255 or 12.55%
4
Effective rate of interest per month = (1.1255)1/12-1
= 0.0099
 (1  k) n  1  (1  0.0099) 12 1 
PVAn  A  n 
 1000  12 
 k(1  k)   0.0099(1  0.0099) 
 0.1255 
 1000   1000 x 11.26336  Rs. 11,263.36
 0.01114  46 / 57
 6. Present Value of an Annuity

Example: If an initial deposit of Rs. 4610 is done in a bank

for an annuity period of 60 months. Rate of interest is
11% p. a. quarterly compounded. Calculate the value of
monthly annuity income a person can receive.
k m
Solution: Effective rate of interest r  (1  )  1
m
0.11 4
 (1  )  1  0.1146 or 11.46%
4
Effective rate of interest per month = (1.1146)1/12-1.
= 0.00908
 (1  k) n  1
Monthly annuity can be calculated as PVAn  A n 
 k(1  k) 
 (1  0.00908) 60 1 
∴ 4610  A  60  ∴ A = Rs. 99.8833
 0.00908(1  0.00908)  47 / 57
 Capital Recovery Factor

Rearranging the equation for present value of an annuity,

we get
 (1  k)  1
n
PVAn  A  n 
 k(1  k) 
1
 (1  k) n  1
∴ A  PVAn  n 
 k(1  k) 

 k(1  k) n 
 PVAn  
 (1  k) n
 1 

 k(1  k) n 
The term   is known as a capital recovery
 (1  k) n
 1 
factor.
48 / 57
 Capital Recovery Factor

Example: A loan of Rs. 10,000 is repaid in 5 equal

installments. The loan carries a interest rate of 14% p. a.
Calculate the amount of each installment.
Solution
PVAn = A x PVIFA(k,n)
∴ 10,000 = A x 3433
∴ A = 10,000 / 3,433
= Rs. 29,129

49 / 57
 Capital Recovery Factor

By Calculator
 (1  k) n  1
PVAn  A  n 
 k(1  k) 

 k(1  k) n 
∴ A  PVAn  
 (1  k) n
 1 

 0.11(1  0.11)5 
 10,000   Rs. 29,129
 (1  0.11)  1 
5

This method is very useful for deciding an equal amount of

installments for a loan repayment scheme.
50 / 57
 7. Present Value of Growing Annuity

0 1 2 3 n
A(1+g) A(1+g)2 A(1+g)3 A(1+g)n
A cash flow that grows at a constant rate for a specified
period of time is a growing annuity.
Formula for the present value of growing annuity
 (1  g) n 
1 - (1  k) n 
PV of Growing Annuity  A(1  g)  
 k -g 
 
 
where g is a growth rate and k is a discount rate.
Above formula is used when g<k or g>k. However it does
not work when g=k. In this case the present value is
equal to nA. 51 / 57
 7. Present Value of Growing Annuity

Example: Suppose you have a right to harvest a teak

plantation for the next 20 years over which you expect to
get 1,00,000 cubic feet of teak per year. The current price
of teak per cubic feet is Rs. 500 and it is expected to
increase at a rate of 8% p.a. The discount rate is 15%.
Calculate the present value of the teak that you can
harvest.  (1  g) n

1 - (1  k) n 
Solution: PV of Growing Annuity  A(1  g)  k - g 
 
 
 (1  0.08) 20 
1 - (1  0.15) 20 
∴ PV of teak  Rs. 500 x 1,00,000 x (1  0.08)    Rs.55,17,3 6,683
 0.15 - 0.08 
 
  52 / 57
 8. Present Value of
Perpetuity and Growing Perpetuity

An annuity of an infinite duration is known as perpetuity.

The present value of such perpetuity is expressed as
P∞ = A x PVIFA(k,∞)
Where PVIFA(k,∞) is a present value interest factor for a

perpetuity. Value of PVIFA(k,∞) is   1 t  1
t 1 (1  k) k

A
∴ P 
r
Present value interest factor of a perpetuity is one divided
by interest rate (expressed in decimal form).
Present value of a perpetuity is equal to the constant
annuity divided by the interest rate. 53 / 57
 8. Present Value of
Perpetuity and Growing Perpetuity

Example: How much I should invest in a bank to offer a

scholarship of Rs. 10,000 per annum perpetually
(forever) to a bright student with 10% p.a.
Solution
A
P 
r

10,000
  Rs.1,00,00 0
0.10

54 / 57
 8. Present Value of
Perpetuity and Growing Perpetuity

Example: How much I should invest in a bank to offer a

scholarship of Rs. 1000 per month perpetually (forever)
to a bright student with 10% p.a.
Solution:
Effective rate of interest per month = (1.10)1/12-1
= 0.007974 or 0.7974%
A
P 
r
1000
  Rs.1,25,40 8
0.007974 55 / 57
 8. Present Value of a Growing Perpetuity

0 1 2 3
A(1+g) A(1+g)2 A(1+g)3
A perpetuity growing at a constant rate is called growing
perpetuity. We assume that the increase will continue
indefinitely. For example, rent is a growing perpetuity.
PV of Growing Perpetuity
A A(1  g) A(1  g)
2 n -1
A(1  g)
    ...   ...
(1  k) (1  k) 2
(1  k) 3
(1  k) n

This reduces to
A
PV of growing Perpetuity 
k -g

Where g is a growth rate and k is a discount rate. 56 / 57

 8. Present Value of a Growing Perpetuity

Example: An office is expected to have rent of Rs. 30,000

next year. It is expected to increase by 5% every year.
We assume that the increase will continue indefinitely. If
the discount rate is 10%, calculate the present value of
the rental stream.
Solution
This is a growing perpetuity with g= 5% and k=10%.

A
∴ PV of Growing Perpetuity 
k -g
30,000
  Rs. 6,00,000
0.10 - 0.05
57 / 57