Chapter- 2

Time Value Analysis

Dr.M.Mariappan
Centre for Hospital Management, SHSS

1
After studying Chapter 2, you should be able to:
– Explain why time value analysis is so
important to healthcare financial
management
– Find the present and future values for lump
sums, annuities, and uneven cash flow
streams.
– Solve for interest rate and number of periods
– Explain and apply the opportunity cost
principle
– Describe and apply stated, periodic, and
effective annual interest rates.
2
 Introduction
• Financial value of asset
– Financial assets: Stocks, Bonds, Securities
– Real Assets: Diagnostic equipments, Medical and
Surgical equipments, General equipments, and other
assets - All are based on future cash flows
• The current value of the money is higher than the
future value. However investment in the bank can
yield interest, and hence can be worth more than
invested money in the future. All these effect due
to the timing differences.
3
 Introduction
• The process of assigning proper values to cash
flows that occur at different points in time is
called time value analysis.
• Please note that many financial decisions in
healthcare involve the valuation of future cash
flows so time value analysis is so important for
financial decision making.

4
 Time Lines
Time lines (TL) is a tool used in time value analysis. It makes
it easier to visualise when the cash flows in a particular
analysis occur. The three period time line is as follows

0 1 2 3

I0%

CF0 CF1 CF2 CF3

Time O is any starting point

Time 1 is one period from the starting point or end of period 1
Time 2 is two periods from the starting point, or the end of period
2, and so on
The time period intervals can be years, quarters, months or days
depending on the cash flow evaluated 5
 Time Lines
• If the time periods are years, the interval from
0 to 1 would be year 1, and the tick mark
labeled 1 would represent both the end of
year and the beginning of year 2.
• Also in many time value analysis, Time O (the
starting point) is considered to be today.

6
 Time Line Illustration 1

0 1 2

5%
-Rs.100
? What does this time line show?

In this case, the interest rate for each of the two periods is 5
percent; a lump sum (single amount) investment of the Rs.100
is made at time 0 and time 2 value is unknown.
The Rs.100 is an outflow because it is shown as a negative
cash flow. (out flows are often designated by parenthesis
rather than by minus signs) 7
 Time Line Illustration 2

0 1 2 3

10%

Rs.100 Rs.100 Rs.100

? What does this time line show?

8
 Time Line Illustration 3

0 1 2 3

6%

-50 100 75 50

? What does this time line show?

9
 Illustrations
• Draw time lines that illustrates the following situation.
• 4. An investment of Rs.50000 at time O for five years time
line. Inflows of Rs.12000 at end of years 3, 4 and 5 and
interest rate during the entire five years of 10 percent
• 5. An investment of Rs.30000 at time O for three years time
line. Inflows of Rs.20000 at the end of year 3 and interest rate
during the first year 5 percent and 2 and 3 year 10 percent.
• 6. An investment of Rs.10000 at time 0 for five year time line.
The interest rate during the entire five years of 9 percent.

10
Future Value of Lump sum (Compounding)

• The process of going from today’s values, or

present values, to future values is called
compounding.
• For example: a hospital invest Rs.100 in a bank
account that pays 5 percent interest each year.
How much would be in the account at the end
of one year (N=1)?

11
Future Value of Lump sum (Compounding) contd…

• PV = Rs.100 = present value, or beginning amount

of account
• I = 5 percent = interest rate the bank pays on the
account per year. The interest amount, which is
paid at the end of the year, is based on the balance
at the beginning of each year. Expressed as a
decimal, I = 0.05
• INT = amount of interest earned during each year,
which equals the beginning amount multiplied by
the interest rate. Thus INT= PV x I
12
 Future Value of Lump sum (Compounding)
contd…
• FVN = Future value, ending amount, of the
amount at the end of N years. Whereas PV is
the value now or present value, FVN is the
value N years into the future added to the
account
• N = number of years involved in the analysis
• In the given example, N=1, so FVN can be
calculated as follows.

13
 Answer

FVN = FV1 = PV + INT

1 = PV + (PV x I)
= PV x (1 + I)

FV1 = PV + (PV x I)
= Rs.100 x (1+0.05)
= Rs.100 x1.05 = Rs.105.

14
 7. What would be the value of the Rs.100 if the hospital
left its money in the account for five years?.

0 1 2 3 4 5
5%

Beginning amount -Rs.100

Interest earned 5 5.25 5.51 5.79 6.08

End of year amount 105 110.25 115.76 121.55 127.63

The account is opened with a deposit of Rs.100. This is shown as an outflow

at the year 0
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• The hospital earns Rs.100 x0.05 = Rs.5 of interest
during the year, so the amount in the account at
the end of year 1 is Rs.100 + Rs.5 = Rs.105.
• At the start of second year, the account balance
is Rs.105. Interest of Rs.105 x 0.05 = 5.25 is
earned on the now larger amount, the amount
balance at the end of second year is Rs.105
+5.25 =110.25. The year 2 interest Rs.5.25, is
higher than the first year’s interest, Rs.5,
because Rs.5 x0.05 = 0.25 in interest was earned
on the first year’s interest.

16
• This process continues, and because the
beginning balance is higher in each succeeding
year, the interest earned increases in each year.
• The total interest earned, Rs.27.63, is reflected
in the final balance at the end of year 5,
Rs.127.63.

17
 8.What is the FV after 3 years of
a Rs.100 lump sum invested at 10%?

0 1 2 3

10%
-Rs.100 FV = ?

Finding future values (moving to the right along

the time line) is called compounding.
For now, assume interest is paid annually.
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After 1 year:
FV1 = PV + INT1 = PV + (PV x I)
= PV x (1 + I)
= Rs.100 x 1.10 = Rs.110.00.

After 2 years:
FV2 = FV1 + INT2
= FV1 + (FV1 x I) = FV1 x (1 + I)
= PV x (1 + I) x (1 + I) = PV x (1 + I) 2
= Rs.100 x (1.10)2 = Rs.121.00.
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After 3 years:
FV3 = FV2 + I3
= PV x (1 + I)3
= 100 x (1.10)3
= Rs.133.10.
In general,

FVN = PV x (1 + I)N .

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Three Primary Methods to Find FVs

• Solve the FV equation using a regular (non-

financial) calculator.
• Use a financial calculator; that is, one with
financial functions.
• Use a computer with a spreadsheet program such
as Excel, Lotus 1-2-3, or Quattro Pro.

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 Non-Financial Calculator Solution
Use a regular calculator , either by multiplying the PV by (1+I)
for N times or by using the exponential function to raise (1+I)
to the Nth Power, and then multiplying the result by the PV.

0 1 2 3

10%
-Rs.100 Rs.110.00 Rs.121.00 Rs.133.10

(100 x 1.10) X1.10 X1.10

Rs.100 x 1.10 x 1.10 x 1.10 = Rs.133.10.

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 Financial Calculator Solution

 Financial calculators are pre-

programmed to solve the FV equation:
FVN = PV x (1 + I)N.
 There are four variables in the equation:
FV, PV, I and N. If any three are known,
the calculator can solve for the fourth
(unknown).
N= number of years, I = interest rate per period, PV = present value,
PMT= payment (This key is used only if the cash flows involve a
series of equal payments – an annuity.) and FV = future value
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Using a calculator to find FV (lump sum):

INPUTS
3 10 -100 0
N I/YR PV PMT FV
OUTPUT 133.10

Notes: (1) For lump sums, the PMT key is not used.
Either clear before the calculation or enter
PMT = 0.
(2) Set your calculator on P/YR = 1, END.
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 Use of spreadsheet
• Personal computer spreadsheet programs
such as Excel, Lotus 1-2-3, and Quattro Pro
are frequently used to solve time value
problems. With help of software the users can
create own formulas to perform tasks that
have not been preprogrammed.
• The time value formulas that are
preprogrammed in spreadsheets are called
functions
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 Present Value of a Lump sum (Discounting)
• Suppose the hospital has income reserves, has been
offered the chance to purchase a low risk security from
a local broker that will pay Rs.127.63 at the end of five
years.
• At the same time the local bank offers 5 percent interest
on five year certificate deposit (CD).
• It is necessary to find out how much local broker be
willing to pay for the security that promises to pay
Rs.127.63 in five years.

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• As per our previous calculations Rs.127.63 is
achieved from Rs.100 lump sum. The
solution is
0 1 2 3 4 5

Rs.127.63
To develop the discounting equation, solve the compounding equation for PV:
Compounding: FVN = PV x (1 + I)
Discounting PV = FVN ÷ (1 + I)N

0 1 2 3 4 5

100 = 1.05÷ 1.05÷ 1.05÷ 1.05÷ 1.05 ÷ 127.63

As shown by the arrows, discounting is moving to the left along a time lime27
 Discounting
• As the discounting, Rs.127.63 is yielding 5
percent rate of interest in compounding factor.
• In this case the local broker and bank likely to
offer the same
• Keeping the safety as parameter, it is quiet
possible that bank deposit could more safer
than local broker.

28
 What is the PV of Rs.100 due
in 3 years if I = 10%?

0 1 2 3

10%

PV = ? Rs.100

Finding present values (moving to the left

along the time line) is called discounting.

29
Solve FVN = PV x (1 + I )N for PV:

PV = FVN / (1 + I )N.

PV = Rs.100 / (1.10)3
= Rs.100(0.7513) = Rs.75.13.

30
 Financial Calculator Solution

INPUTS
3 10 0 100
N I/YR PV PMT FV
OUTPUT -75.13

Either PV or FV must be negative on most

calculators. Here, PV = -75.13. Put in
Rs.75.13 today, take out Rs.100 after 3 years.
31
 Opportunity Costs
• In the previous example we have seen opportunity costs
• While investing amount regardless of its sources of funds would
examine all the possible options that the cash flows expected to
be earned from any investment must be discounted at a rate
that reflects the return that could be earned.
• The problem is that the number of forgone opportunities cost
rate?
• The opportunity cost rate to be applied in time value analysis is
the rate that could be earned on alternative investments of
similar risk.

32
 Opportunity Costs
• The opportunity cost rate (i.e. the discount rate) applied to
investment cash flows is the rate that could be earned on
alternative investments of similar risk regardless of the source
of the investment funds.
• Generally opportunity cost rates are obtained by looking at
rates that could be earned on securities, stocks or bonds.
• Securities are usually chosen to set opportunity cost rates
because their expected returns are more easily estimated
than rates of return on real assets such as hospital beds, MRI
Machines, and the like.

33
 Opportunity Costs
• On the last illustration we needed to apply a discount
rate. Where did it come from?
– The discount rate is the opportunity cost rate.
– It is the rate that could be earned on alternative investments
of similar risk.
– It does not depend on the source of the investment funds.
• We will apply this concept over and over in this course.

34
 Solving for Interest
Assume that a bank offers an account
that will pay Rs.100 after 5 years on
each Rs.78.35 invested. What is the
implied interest rate?
Regular calculator FVN = PV x (1+I)N Rs.100= Rs.78.35 x (1+I)5

Rs.78.38 Rs.100
Financial Calculator

INPUTS
5 -78.35 0 100
N I/YR PV PMT FV
OUTPUT 5% 35
 Solving for N
Assume an investment earns 20
percent per year. How long will it take
for the investment to double?
Regular calculator 0
5%
Time line
-Rs.78.35 Rs.100

Financial Calculator

INPUTS 20 -1 0 2
N I/YR PV PMT FV
OUTPUT 3.8

36
 Annuities
• Lump sum is a single values, an annuity is a series of equal
payments at fixed intervals for a specified of periods.
• Annuity cash flows, which are given the symbol PMT, can
occur at the beginning or end of each period.
• If the payments occur at the end of each period as they
typically do, the annuity is an ordinary, or deferred,
annuity due.
• Because ordinary annuities are far more common in time
value problems when the term annuity is used, assume
that payments occur at the end of each period.

37
 Types of Annuities

Ordinary Annuity
0 1 2 3
I%

PMT PMT PMT

Annuity Due
0 1 2 3
I%

PMT PMT PMT

38
 Types of Annuity - Ordinary annuity

• Ordinary annuity: a series of equal payments at

the end of each period constitute an ordinary
annuity.
• Suppose a hospital invest Rs.100 at the end of
each year for three years in an account that paid
5 percent interest per year, how much would
the hospital accumulate at the end of three
years?
• To answer this question is the future value of
annuity
39
What is the FV of a 3-year ordinary annuity of
Rs.100 invested at 10%?

0 1 2 3

10%
Rs.100 Rs.100 Rs.100

110
121
FV = Rs.331

40
 Financial Calculator Solution

INPUTS
3 10 0 -100
N I/YR PV PMT FV
OUTPUT 331.00

Have payments but no lump sum,

so enter 0 for present value.

41
 What is the PV of this ordinary annuity?

0 1 2 3

10%

Rs.100 Rs.100 Rs.100

Rs.90.91

82.64

75.13

Rs.248.68 = PV

42
As per financial calculator

INPUTS
3 10 100 0
N I/YR PV PMT FV
OUTPUT -248.69

This problem has payments but no lump

sum, so enter 0 for future value.

43
 Types annuity – Annuities due

• If the three Rs.100 payments in an previous

example had been made at the beginning of
each year, the annuity have been an annuity
due.
• Each payment would be shifted to the left one
year, so each payment would be discounted for
one last year.
• Because its payments come in faster, an annuity
is more valuable than an ordinary annuity.
44
 What is the FV and PV if the
annuity were an annuity due?
The future value of our example, assuming
an annuity due, is found as follows:
0 1 2 3

10%

Rs.100 Rs.100 Rs.100 ?

The future value of an annuity due occurs one period after

the final payment, while the future value of a regular
annuity coincides with the final payment.
45
Annuity Due
0 1 2 3
5%
Rs.100 Rs.100 Rs.100
Rs.105
Rs.105.25
Rs.115.76
Rs.331.01

FV (Annuity due) = FV of a regular annuity x (1+I)

= Rs.315.25 x 1.05 =331.01

46
 Perpetuities
• Most annuities call for payments to be made over some finite period of time – for example Rs.100 per year for three
years. However, some annuities go on indefinitely, or perpetually. Such annuities are called perpetuities.
• A perpetuity is an annuity that lasts forever.
• What is the present value of a perpetuity?

PV (Perpetuity) =

PMT Payment
or
Interest Rate
I
Each security promises to pay Rs.100 annuity in perpetuity (forever). What
would each security be worth if the opportunity cost rate, or discount rate, was
10 percent? The answer is Rs.1000
PV (Perpetuity) = Rs.100/0.10 = Rs.1000
Suppose interest rates, and hence the opportunity cost rate, rose to 15
percent. What would happen to the security’s value? The interest rate
increase would lower its value to Rs.666.67
PV (Perpetuity) = Rs.100/0.15 = Rs.666.67 47
 Perpetuities
• Assume that interest rates fell to 5 percent.
The rate decrease would increase
perpetuity’s to Rs.2000
PV (Perpetuity) = Rs.100/0.05 = Rs.2000

The value of perpetuity changes dramatically

when interest rates change.
All securities’ value are affected by interest
rate changes, but some, like perpetuities, are
more sensitive to interest rate changes than
others, such as short-term Government bonds.
48
 Uneven Cash Flow Streams: Setup
• Annuity means a constant amount investment in regular interval
where as uneven cash flow means there is no constant cash
flow for example the financial evaluation of a proposed out
patient clinic or MRI facility rarely involves constant cash flows.
• Present value: the present value of an uneven cash flow stream
is found as the sum of the present values of individual cash
flows of the stream. For example a hospital is proposed to invest
as per the following schedule

What is the present value of the hospital investment if the appropriate discount
rate (i.e. the opportunity cost rate) is 10 percent
1 2 3 4 5 6 7
10%
Rs.0 Rs.100 Rs.200 Rs.200 Rs.200 Rs.300 Rs.400
49
 Uneven Cash Flow Streams: Setup
The PV of each individual cash flow can be found using a regular calculator, and
then these values are summed to find the present value of the stream, Rs.868.28

0
1 2 3 4 5 6 7
10%
Rs.0 Rs.100 Rs.200 Rs.200 Rs.200 Rs.300 Rs.400
0.00

82.64
150.26

136.60

124.18

169.34

205.26
868.28 50
 Uneven Cash Flow Streams: Setup
The future value of each individual cash flow can be found using a regular
calculator, and then summing these values to find the future value of the stream,
Rs.1692.07
0 1 2 3 4 5 6 7
10%
Rs.0 Rs.100 Rs.200 Rs.200 Rs.200 Rs.300 Rs.400
400.00
330.00

242.00

266.20
292.82

161.05

0.00

1692.07

51
 Semiannual and other compounding periods: earlier all assumptions were
under annual compounding, suppose a bank account for 6 percent interest rate
under semiannual compounding basis what could be the earnings.
0 1 2 3
6%

-100 119.10
Annual: FV3 = 100 x (1.06)3 =119.10

0 1 2 3
0 1 2 3 4 5 6
3%

-100 119.41
Semiannual: FV6 = 100 x (1.03)6 = 119.41.

52
 Effective Annual Rate (EAR)
• EAR is the annual rate which causes any PV to grow to
the same FV as under intra-year compounding.
• What is the EAR for 10%, semiannual compounding?
–Consider the FV of Rs.1 invested for one
year. FV = Rs.1 x (1.05)2 = Rs.1.1025.
–EAR = 10.25%, because this rate would
produce the same ending amount
(Rs.1.1025) under annual compounding.

53
 What’s the value at the end of Year 3
of the following CF stream if the stated interest rate
is 10%, compounded semiannually?

0 1 2 3 4 5 6 6-month
5% periods

Rs.100 Rs.100 Rs.100

 Note that payments occur annually, but

compounding occurs semiannually, so we can not
use normal annuity valuation techniques.

54
 Amortization

Construct an amortization schedule

for a Rs.1,000, 10% annual rate
loan with 3 equal payments.

55
 Step 1: Find the required payments.

0 1 2 3

10%

-Rs.1,000 PMT PMT PMT

3
INPUTS 10 -1000 0
N I/YR PV PMT FV
OUTPUT 402.11

56
 Step 2: Find interest charge for Year 1.

INTt = Beginning balance x I.

INT1 = Rs.1,000 x 0.10 = Rs.100.

Step 3: Find repayment of principal in

Year 1.
Repmt = PMT - INT
= Rs.402.11 - Rs.100
= Rs.302.11.
57
 Step 4: Find ending balance at end of year
1.

End bal = Beg balance - Repayment

= Rs.1,000 - Rs.302.11 = Rs.697.89.

Repeat these steps for Years 2 and 3

to complete the amortization table.

58
 BEG RP END
YR BAL P I BAL

1 Rs.1,000 Rs.402 Rs.100 Rs.302 Rs.698

2 698 402 70 332 366
3 366 402 37 366 0
TOT Rs.1,206.34 Rs.206.34 Rs.1,000

Note that annual interest declines over time while the principal payment increases.

59
 Rs.
402.11
Interest

302.11

Principal Payments

0 1 2 3
Level payments. Interest declines because
outstanding balance declines. Lender earns
10% on loan outstanding, which is falling.
60