A Rupee in hand today is worth more

than a Rupee receivable after a year

Why???
 Inflation
 Uncertainty
 Investment (in Fd, bonds, stock market or
other projects)
 Simple interest- earned or paid only on the
principal amount invested or borrowed.

 Compound interest- earned or paid on the

principal amount as well as any previous
interest earned.
 Mr X has Rs. 1,000 to invest in n FD giving
simple interest at the rate of 10%. Find out
the value amount he would get if he invests
the amount for the following time periods .
 1 year
 3 years
 4 years
-1000 100 100 100 100 100
+1000

 Draw a timeline

 Amount at the end of 1 year = 1000+100

= Rs. 1,100

Amount at the end of 3 years = 1000+300

= Rs. 1,300

Amount at the end of 5 years = Rs. 1,500

 In compounding, we get the value of all our
cash flows at a certain point of time in the
future. It helps us to find out the Future
Value.
 Eg. Mr. X has Rs. 1000 to invest in an FD
giving a rate of interest of 10%. Find out the
value amount he would get if he invests the
amount for the following time periods .
 1 year
 3 years
 4 years
1000 1,100 1,210 1,331 1,464

*(1.10) *(1.10) *(1.10) *(1.10)

 Draw a timeline

 Amount at the end of 1 year = 1,000*(1.10)

= Rs. 1,100

Amount at the end of 3 years = 1,000*(1.10)*(1.10)*(1.10)

= 1,000*(1.10)^3 = Rs. 1,331

Amount at the end of 4 years = 1,000*(1.10)^4 = Rs.1,464

End Compounded Interest Scheme Simplified Future
of Calculation Value
Year
1 1,000 *(1.10) 1,000*(1.10) 1,100

2 [1,000*(1.10)] *1.10 1,000*(1.10)^2 1,210

3 [1,000*(1.10)*(1.10)]*1.10 1,000*(1.10)^3 1,331

4 [1,000*(1.10)*(1.10)*(1.10)]*(1.10) 1,000*(1.10)^4 1,464

For the purpose of simplicity, let us assume the
following :-

Rate of interest (in decimal terms) =r

No. of years of investment =n
Cashflow that occurs today = PV
Cashflow that occurs in the future = FV

FV = PV * (1+r)^n
 Discounting involves finding out the value of
various cash future cash flows at time 0 on
the timeline. It helps us to find the Present
Value. It is the reverse of compounding.

 Eg. You need an amount of Rs. 60,000 at the

end of 5 years. How much should you invest
in a scheme now that invests your money at
7% per annum.
 Ans: -
FV =60,000
r =.07
N=5

Applying the FV formula, we know that

60,000 = PV *(1.07)^5

PV = FV/(1+r)^n
= 60,000/(1.07)^5
= Rs. 42,780
For the purpose of simplicity, let us assume the
following :-

Rate of interest (in decimal terms) =r

No. of years of investment =n
Cashflow that occurs today = PV
Cashflow that occurs in the future = FV

PV = FV / (1+r)^n
 An annuity means a series of equal payments
occurring over a particular period at equal
intervals.
 Examples:
 Insurance premiums
 Recurring deposit
 Retirement savings
 Loan repayments
 You invest Rs. 20,000 from your annual
salary in a recurring deposit at the end of
every year for 3 years. How much will you get
at the end of 3 years if the RD pays a
compounded interest of 9% every year.
 -20,000 -20,000 -20,000

*(1.09)^2 *(1.09)

Total cashflow
20,000
+
21,800
+
23,762
=
65,562

Amount at the end of 3 years = 20,000 * (1.09)^2

+20,000*(1.09)+20,000
=Rs. 65,562
Let us assume the following :-

Rate of interest (in decimal terms) =r

No. of years of investment =n
Annuity at the end of every period = A
Value of the annuity in the future = FVA

FVA = A *[(1+r)^n-1]
r
 You have taken a personal loan today, such
that you have to pay an annual installment of
Rs. 15,650 every year for the next 4 years. If
the rate of interest charged by the bank is
10%, can you find out the amount of loan
taken today?
 Draw a timeline
 Present value of the annuity=
15650/(1.0)
+ 15650/(1.10)^2
+ 15650/(1.10)^3
+ 15650/(1.10)^4

= Rs. 49,608
Let us assume the following :-

Rate of interest (in decimal terms) =r

No. of years of investment =n
Annuity at the end of every period = A
Value of the annuity at time 0= PVA

PVA = A *[1-(1+r)^(-n)]
r
A perpetuity is an annuity that goes on forever

PVP = A
r
Eg. Suppose a retirement fund gives you a
cashflow of Rs. 2,00,000 for the rest of your
life . Find out the amount to be invested today
if the rate of investment is 6% pa.
Ans : 2,00,000/.06
= Rs. 33,33,000
If an annuity occurs at the beginning of the
period rather than at the end of the period, it is
called an annuity due.

In such a case, we multiply the present

value/future of a regular annuity by (1+r) to
get the present value of an annuity due.
 Read the problem thoroughly
 Determine if it’s a PV or an FV problem
 Determine if it’s a single flow or a multiple
cashflow problem
 Create a timeline
 Put the cashflows on the timeline
 Solve the problem
 Check your calculations
 Eg. Suppose a project involves an initial
investment of Rs. 10 lakh and generates net
inflows as follows:-
End of Year Inflow (in Rs.)
1 2 lakh
2 4 lakh
3 6 lakh

 What is the present value of the above cashflows?

(Assume that the funds are discounted at a rate
of interest of 12% pa)
Ans :-

PV = 2 /(1.12) + 4/(1.12)^2 +
6/1.12)^3 = 9.25 lacs

Note: Since the initial investment is Rs. 10 lac and

the present value of cash inflows is Rs. 9.25 lacs,
the investment is not viable.
If m is the number of compounding periods in
a year, then the compounding period becomes
m*n and the interest rate becomes r/n.

The effective rate of interest = EIR

EIR = [(1+r/m)^m-1)
 Rita has a Rs. 1000 FD with Sahara
Investments. The interest rate is 7%
compounded on a monthly basis for 1 year.
What is the Effective Annual Interest Rate.
 What is the EIR if the interest is compounded
quarterly.
 What is the EIR if the interest is compounded
on a monthly basis.
EIR if the interest is compounded monthly=
[(1+ .07/12)^12 ] -1
= 7.23%
EIR if the interest is compounded quarterly =
7.19%

EIR if the interest is compounded semi annualy

= 7.12%
Solve yourself
You have invested in a fund that pays a compounded
interest every quarter at 10% per annum for 5 years.
Find out the amount you get at the end of 5 years.
*Here, the amount is compounded or discounted every quarter,
the number of periods of compounding becomes (5*4=20) and
the interest rate becomes (10%/4= 2.5%)

What will be the amount that you get if the interest is

compounded on a
a. monthly basis.
b. Semi annual basis
c. Daily basis
You take a loan for Rs.10,000 at an interest
rate of 7 percent per year. The bank wants you
to make a series of payments that will pay off
the loan and the interest over six years.
Determine the annual equal instalments that
you would have to pay to the bank.
 Determine the installment per period
 Make a loan table with the 5 headings

 Opening balance
 Installment
 Interest
 Repayment
 Closing balance

 Calculate the interest on the opening balance in the first period.

 Deduct the interest from the installment in the first period to
find out the repayment.
 Determine the closing balance at the end of the first period.
 Repeat the step for the rest of the periods.
PVA = Rs 10,000
N = 6 years
R = 7%
A = Rs. 2,098
Ref: Financial management by IM Pandey,
Financial management by Khan & Jain