Chapter 3

THE TIME VALUE OF MONEY

 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 problems involve cash flows occurring at
different points of time. For evaluating such cash flows, an
explicit consideration of time value of money is required
 NOTATION
PV : Present value
FVn : Future value n years hence
Ct : Cash flow occurring at the end of year t
A : A stream of constant periodic cash flow over a given
time
r : Interest rate or discount rate
g : Expected growth rate in cash flows
n : Number of periods over which the cash flows
occur.
 DOUBLING PERIOD
Thumb Rule : Rule of 72
72
Doubling period =
Interest rate
Interest rate : 15 percent

Doubling period = 72 / 15 = 4.8 years

A more accurate thumb rule : Rule of 69

69

Interest rate
Doubling period = 0.35 +

Doubling period = 0.35 + 69 /15 = 4.95 years

 FUTURE VALUE OF A SINGLE AMOUNT
Rs
First year: Principal at the beginning 1,000
Interest for the year
(Rs.1,000 x 0.10) 100
Principal at the end 1,100
 

Second year: Principal at the beginning 1,100

Interest for the year
(Rs.1,100 x 0.10) 110
Principal at the end 1,210

Third year: Principal at the beginning 1,210

Interest for the year
(Rs.1,210 x 0.10) 121
Principal at the end 1,331

FORMULA

FUTURE VALUE = PRESENT VALUE (1+r)n

 Future Value of uneven series of Amount
• How much would your investments grow at the end of the fifth year if you
were to make the following investments at the end of the next 5 years in a
FD which fetches an interest rate of 10% :
Year Investment made (Rs)
1 1000
2 2000
3 3000
4 4000
5 5000

1000(1+0.10) 4 +2000(1+0.10) 3 +3000(1+0.10) 2+4000(1+0.10) 1 + 5000(1+0.10) 0

= Rs 17156.1
 FUTURE VALUE OF AN ANNUITY
· An annuity is a series of periodic cash flows (payments and
receipts ) of equal amounts
 

1 2 3 4 5
1,000 1,000 1,000 1,000 1,000
+
1,100

+
1,210
+
1,331
+
1,464
Rs.6,105

Future value of an annuity = A [(1+r)n-1]

r
 Problem
Q.You want to buy a house after 5 years when it is
expected to cost Rs 2 million. How much should you
save annually if your savings earn a compound return
of 12 %.

Annual savings = 20,00,000 / {[ ( 1.12 ) 5 – 1] / 0.12 }

= Rs 3,14,819
 FV of Annuity Due
Future value of an Annuity Due = A (1+r) [(1+r)n-1]
r

How much would your investments grow at the end of the fifth
year if you were to make investments of Rs 2000 at the
beginning of the next 5 years in a FD which fetches an interest
rate of 10% :

FV = 2000 (1+0.1) [(1+0.10)^5-1]/0.1= Rs 13431.22

 PRESENT VALUE OF A SINGLE AMOUNT

PV = FV [1/ (1 + r)n]

What should be the value of your investment today if

you were to receive Rs 1000 three years hence at an
interest rate of 10% ?

1,000 [ 1/ ( 1+ 0.1) 3 ] = 1000*0.7513 = 751

 PRESENT VALUE OF AN UNEVEN SERIES
A project guarantees the following stream of cash flows; Find out the present value of
the future stream of cash flows, assuming opportunity cost of capital to be 12%:
Year Cash Flow (Rs)
1 1,000
2 2,000
3 2,000
4 3,000
5 3,000
6 4,000
7 4,000
8 5,000

Year Cash Flow PVIF12%,n Present Value of

Rs. Individual Cash Flow
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

 PRESENT VALUE OF AN ANNUITY

PVA = A [ ( 1+r )n - 1 ]
r ( 1+r )n

A project guarantees Rs 1000 in each of its 8 year life; Find out the present value of the
future stream of cash flows, assuming opportunity cost of capital to be 12%:

PVA = 1000 [ ( 1+0.12 )8 - 1 ] = Rs 4967.64

0.12 ( 1+0.12 )8
 LOAN AMORTISATION SCHEDULE
Loan : 10,00,000 r = 15% p.a n = 5 years

10,00,000 = A [ ( 1+0.15 )5 - 1 ] = 298 315

0.15 ( 1+0.15 )5

Year Beginning Annual Interest Principal Remaining

Amount Installment Repayment Balance
(1) (2) (3) (2)-(3) = (4) (1)-(4) = (5)
1 10,00,000 298,315 150,000 148,315 851,685
2 851,685 298,315 127,753 170,562 681123
3 681,123 298,315 102,168 196,147 484,976
4 484,976 298,315 727,46 225,569 259,407
5 259,407 298,315 38,908 259,407 0

  a     Interest is calculated by multiplying the beginning loan balance by the interest rate.
b.   Principal repayment is equal to annual installment minus interest.
* Due to rounding off error a small balance is shown
 PV of annuity due
• PV of annuity due =
PVA = A [ ( 1+r ) (n - 1) - 1 ] + A
r ( 1+r ) (n- 1)

Calculate the present value of an annuity of Rs 1,000

received at the beginning of each year for 3 years at a
discount factor of 5%.

PVA = 1000 [ ( 1+0.05 ) (3 - 1) - 1 ] + 1000 = Rs 2859

0.05 ( 1+0.05) (3- 1)
 PRESENT VALUE OF PERPETUITY
A
Present value of perpetuity = r

Find the present value of a Annuity of Rs 10000 if interest rate is

10 % :

PV = 10000/ 0.10 = Rs 100000

 PV of growing perpetuity
• Pv of growing perpetuity = A / ( r – g )

• RPG Ltd is expected to pay Rs 2 as dividend in the next financial year. It is

expected that the dividend would grow annually by 2%. How much

would investors be willing to pay for the stock with a required rate of

return of 5%?

• PV = Rs 2 / (0.05 – 0.02) = Rs 66.6

 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(1 + g) A(1 + g)2 A(1 + g)n
0 1 2 3 n
The present value of a growing annuity can be determined using the following
formula :
(1 + g)n
(1 + r)n 1–

PV of a Growing Annuity = A (1 + g)
r–g

The above formula can be used when the growth rate is less than the discount rate
(g < r) as well as when the growth rate is more than the discount rate (g > r).
However, it does not work when the growth rate is equal to the discount rate
(g = r) – in this case, the present value is simply equal to n A.
 PRESENT VALUE OF A GROWING ANNUITY
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.
Find out present value of the teak that you can harvest from the teak
forest

PV of teak =
500 * 1,00,000 ( 1 + 0.08 ) [ 1- ( 1 + 0.08 ) 20 ]
( 1 + 0.15 ) 20
0.15 – 0.08
= Rs 55,17,36,683
 SHORTER COMPOUNDING PERIOD

Future value = Present value 1 + r m*n

m
Where r = nominal annual interest rate
m = number of times compounding is done in a year
n = number of years over which compounding is done
Example : you deposit Rs.5000, @12 percent, quarterly
compounding , maturity of 6 years
FV = 5000(1+ 0.12/4)4x6 = 5000 (1.03)24
= Rs.10,164
 EFFECTIVE VERSUS NOMINAL RATE
ERI = (1+ r/m)m –1
E = effective rate of interest
r = nominal rate of interest
m = frequency of compounding per year
Example : r = 8 percent, m=4
k = (1+0.08/4)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
 Continuous Compounding
• Value of compounding or discounting depends upon its
frequency.
• The value rises/falls exponentially in case of continuous
compounding.
• In practice, no one compounds interest continuously
but it is used extensively for pricing options, forwards
and other derivatives.
e = 2.7183.

• Fv = Pv * e (r*n)
21
 Problem
• What will be the maturity value of a two year
deposit of Rs 1000 which is compounded
continuously at 10 % .

• FV = 1000*[2.7183](0.10*2)
= Rs 1221.4
 Use of excel Spreadsheet
Parameter Symbol Built in formula in excel

Present value PV =PV(rate, nper, pmt, [fv], [type])

 FV (if omitted—it’s assumed to be 0 and PMT must be
included)
Type : When payments are made (0, or if omitted—
assumed to be at the end of the period, or 1—assumed
to be at the beginning of the period) 
Future Value FV =FV(rate,nper,pmt,pv,type)
No of continuous successive Periods NPER =NPer(rate, pmt, pv, fv, type)
Payment per period PMT =PMT(rate,nper,pv,[fv],[type])
Interest rate RATE =Rate(nper,pmt,pv,fv,type,guess)

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