Corporate Finance

Time Value of Money

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Topics Covered
* Overview of Time value of Money
* Future value of a Single cash flow
* Present value of a Single cash flow
* Doubling Period
* Shorter Compounding Period
* Effective Vs. Nominal rate
* Concept of Annuity
* Future value of Annuity
* Sinking Fund Factor
* Present value of Annuity
* Capital Recovery Factor
* Present value of an uneven series
* Present value of Perpetuity
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Overview : Time value of Money

Money has a time value

i.e. the value a rupee today is not the same
what it is at a year hence.

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Why Time Value
A rupee today is more valuable than a rupee a year
hence. Why ?
* Preference for current consumption over
future consumption
* Productivity of capital
* Inflation
Many financial projects involve cash flows occurring
at different points of time. For evaluating such cash
flows, an explicit consideration of time value of
money is required.

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Future value of a Single Cash Flow

We have,
FVn = A × (1+K)n

FVIF(k, n) = (1+K)n

 FVn = A × FVIF(k, n)

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Value of FVIF(k,n) for various Combinations of r
and n

  n/k 6% 8% 10 % 12 % 14 %

2 1.124 1.166 1.210 1.254 1.300

4 1.262 1.361 1.464 1.574 1.689

6 1.419 1.587 1.772 1.974 2.195

8 1.594 1.851 2.144 2.476 2.853

10 1.791 2.518 2.594 3.106 3.707

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e.g.: Mr. X deposits Rs. 1000 in a bank.
Compute the value of the deposit after 6
years. Assume a rate of interest @ 10% p.a.

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e.g.: Mr. X deposits Rs. 1000 in a bank.
Compute the value of the deposit after 6
years. Assume a rate of interest @ 10% p.a.

Solution:
Value of the Deposit
= A × FVIF(10%, 6)
= 1000 × 1.772 = Rs.1772

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Present value of a Single Cash Flow

PV = A × 1/(1+K)n

PVIF(k,n) = 1/(1+K)n

PV = A × PVIF(k,n)

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Present Value of a Single Amount

n/r 6% 8% 10% 12% 14%

2 0.890 0.857 0.826 0.797 0.770
4 0.792 0.735 0.683 0.636 0.592
6 0.705 0.630 0.565 0.507 0.456
8 0.626 0.540 0.467 0.404 0.351
10 0.558 0.463 0.386 0.322 0.270
12 0.497 0.397 0.319 0.257 0.208

Time Value of Money_09 10

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 Present Value of an Uneven Series
CF1 CF2 CFn
PVn = + + …… +
(1 + r)1 (1 + r)2 (1 + r)n
n CFt
= 
t =1 (1 + r)t

Year Cash Flow(Rs.) PVIF12%,n Present Value of Cash Flow(Rs.)

1 1,000 0.893 893
2 2,000 0.797 1,594
3 2,000 0.712 1,424
4 3,000 0.636 1,908
5 3,000 0.567 1,701
6 4,000 0.507 2,028
7 4,000 0.452 1,808
8 5,000 0.404 2,020

Present Value of the Cash Flow Stream 13,376

Time Value of Money_09 11

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Doubling Period

* Rule of 72

* Rule of 69
0.35+ 69/ Interest rate(in %)

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Thumb Rule : Rule of 72
72
Doubling period =
Interest rate
Interest rate : 15 percent
Doubling period =
72 = 4.8 years
15
A more accurate thumb rule : Rule of 69

Doubling period = 0.35 +

69
Interest rate

Interest rate : 15 percent

69
Doubling period = 0.35 + = 4.95 years
15
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e.g.:
How long would it take to double the amount Rs.
5000 ? Assume the rate of interest @ 12% p.a.?

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e.g.:
How long would it take to double the amount Rs.
5000 ? Assume the rate of interest @ 12% p.a.?
Solution:
Given,
k = rate of interest = 12%
n = no. of years = ??
Using rule of 72, we have
 n = 72/12 = 6 years
Hence Rs. 5000 will be doubled in 6 years.

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Shorter Compounding Period

FVn = A × (1+K/m)mn

Where,

FVn = Future value at the end of n years

A = Amount
k = Rate of interest per annum
m = Frequency of compounding done in a year
n = No. of years

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Effective rate of interest Vs. Nominal rate
of interest

r = (1+k/m)m – 1
Where,
r = Effective rate of interest
k = Nominal rate of interest
m = Frequency of compounding done in a year

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e.g.
A bank offers 8% nominal rate of interest and the
amount is compounded quarterly.
Compute the effective rate of interest.

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Effective Vs. Nominal Rate

r = (1+k/m)m –1
r = effective rate of interest
k = nominal rate of interest
m = frequency of compounding per year
e.g.: k = 8 percent, m=4
r = (1+.08/4)4 – 1 = 0.0824
= 8.24 percent
Nominal and Effective Rates of Interest
Effective Rate %
  Nominal Annual Semi-annual Quarterly Monthly
Rate % Compounding Compounding Compounding Compounding
8 8.00 8.16 8.24 8.30
12 12.00 12.36 12.55 12.68
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Annuity
It is a series of equal cash flows made at the
equal intervals of time. It will have the following
characteristics:
* Fixed/Constant Amount
* Regular intervals
e.g.: Monthly, Quarterly, yearly etc.
Types of Annuity
* Annuity Due
* Regular Annuity
* Deferred Annuity

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Future value of Annuity

FVAn = A × [(1+k)n- 1]/k

Where, FVIFA(k,n) = [(1+k)n- 1]/k

 FVAn = A × FVIFA(k,n)
where,
FVAn = Future value of annuity
A = Amount
k = Interest rate per annum
n = No. of years

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e.g.:
Mr. Y deposits Rs. 2000 at the end of every year
Annually for 4 years .
Compute the value of the accumulated deposit at the
end of 4 years. Assume the rate of interest@ 10%
p.a.

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e.g.: Mr. Y deposits Rs. 2000 at the end of every year annually
for 4 years . Compute the value of the accumulated deposit
at the end of 4 years. Assume the rate of interest@ 10% p.a.
Solution
Given,
k = rate of interest = 10%
n = no. of years = 4
A = Rs. 2000
Now, we have
Value of the accumulated deposit
= Rs. 2000 × FVIFA (10%,4)
= Rs. 2000 × 4.641 = Rs. 9282

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Sinking Fund Factor

Sinking fund factor

= k/[(1+k)n- 1]
where,
k = Interest rate per annum
n = No. of years
It is reciprocal of FVIFA(k,n).

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e.g.:

Mr. Y wants to save Rs. z annually at the end of

every year for 10 years to have an accumulated
deposit of Rs. 20,000.
Compute the value of Z assuming a rate of interest
@ 12% p.a.

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e.g.
Mr. Y wants to save Rs. z annually at the end of every year for
10 years to have an accumulated deposit of Rs. 20,000.
Compute the value of Z assuming a rate of interest @ 12%
p.a.
Solution

Given,
k = 12% p.a. , n = 10 years
FVA10 = Rs. 20,000 , A = Rs. Z
Now, we have
20,000 = Z × FVIFA (12%,10)
= Z × 17.549
 Z = 20,000/ 17.549 = Rs. 1139.67

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Present Value of Annuity

PVA = A × [(1+k)n- 1]/ [k (1+k)n]

Where, PVIFA(k,n) = [(1+k)n- 1]/ [k (1+k)n]

 PVA = A × PVIFA(k,n)
where,
PVA = Present value of annuity
A = Amount
k = Interest rate per annum
n = No. of years
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Present Value of an Annuity
(Value of PVIFA (k,n) for Various Combinations of k and n)

n/k 6 % 8% 10 % 12 % 14 %
2 1.833 1.783 1.737 1.690 1.647
4 3.465 3.312 3.170 3.037 2.914
6 4.917 4.623 4.355 4.111 3.889
8 6.210 5.747 5.335 4.968 4.639
10 7.360 6.710 6.145 5.650 5.216
12 8.384 7.536 6.814 6.194 5.660

Time Value of Money_09 28

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Capital Recovery Factor

Capital recovery factor

= [k (1+k)n]/ [(1+k)n- 1]
where,
k = Interest rate per annum
n = No. of years
It is reciprocal of PVIFA(k,n).

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Present Value of a Growing Annuity

A cash flow that grows at a constant rate for a specified period of time is
a growing annuity. The time line of a growing annuity is shown below:

A A(1 + g) ------------ A(1 + g)n

1–
0 1 2 3 n

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e.g.
Suppose you have the right to harvest a teak
plantation for the next 20 years over which you expect
to get 100,000 cubic feet of teak per year. The current
price per cubic foot of teak is Rs 500, but it is
expected to increase at a rate of 8 percent per year.
The discount rate is 15 percent.
Compute the present value of the teak that you can
harvest from the teak forest.

Time Value of Money_09 31

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Perpetuity
Present value of Perpetuity = A/k
where,
A = Amount
k = Interest rate per annum

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