1IntroFinancial-Planning & ManagementCS Compile

The Time Value of Money
Compounding and
Discounting Single Sums
We know that receiving ₹1 today is worth
more than ₹1 in the future. This is due
to opportunity costs.
The opportunity cost of receiving ₹1 in
the future is the interest we could have
earned if we had received the ₹1 sooner.
Today Future
If we can measure this opportunity cost,
we can:
we can:
• Translate ₹1 today into its equivalent in the future
(compounding).
we can:
(compounding).
Today Future
?
we can:
(compounding).
Today Future
?
• Translate ₹1 in the future into its equivalent today
(discounting).
we can:
(compounding).
Today Future
?
• Translate ₹1 in the future into its equivalent today
(discounting).
Today Future
?
Today Future
?
Today Future
?
Future Value
Future Value - single sums
If you deposit ₹100 in an account earning 6%, how
much would you have in the account after 1 year?
Time Value Notations
• t = number of years the deposit is allowed to compound
• m = no. of times compounding occurs during the year
• n = number of periods = mt
• r or inom = per year (annual) interest rate
• i = per period interest rate (periodic rate)
• FVn = Future value at end of period n
• FVt = Future Value at end of tth year.
• PV = Present value (value now t (or n) = 0) = aka PV0
• PVn = Present Value at beginning of nth period n
• PVt = Present Value at beginning of tth year
PV = FV =
0 1
PV = -100 FV =
0 1
Calculator Solution:
m=1 i=r/m = 6/1=6
n=t*m = 1*1=1 PV = -100
FV = ₹106
PV = -100 FV = 106
0 1
m=1 i=r/m = 6/1=6
n=t*m = 1*1=1 PV = -100
FV = ₹106
PV = -100 FV = 106
0 1
Mathematical Solution:
FV = PV (FVIF i, n )
FV = 100 (FVIF .06, 1 ) (use FVIF table, or)
FV = PV (1 + i)n
FV = 100 (1.06)1 = ₹106
much would you have in the account after 5 years?
PV = FV =
0 5
PV = -100 FV =
0 5
m=1 i = r/m = 6/1 = 6
n= t*m = 5*1=5 PV = -100
FV = ₹133.82
PV = -100 FV = 133.82
0 5
m=1 i=r=6
n=t*m = 5*1=5 PV = -100
FV = ₹133.82
PV = -100 FV = 133.82
0 5
FV = 100 (FVIF .06, 5 ) (use FVIF table, or)
FV = PV (1 + i)n
FV = 100 (1.06)5 = ₹133.82
If you deposit ₹100 in an account earning 6% with
quarterly compounding, how much would you have
in the account after 5 years?
PV = FV =
0 ?
PV = -100 FV =
0
20
m=4 i= r/m = 6/1=6%
n = t*m=5*4=20PV = -100
FV = ₹134.68
PV = -100 FV = 134.68
0
20
m=4 i= r/m = 6/1=1.5%
n = t*m=5*4=20 PV = -100
FV = ₹134.68
PV = -100 FV = 134.68
0
20
FV = 100 (FVIF .015, 20 ) (can’t use FVIF table)
FV = PV (1 + i/m) m x N
FV = 100 (1.015)20 = ₹134.68
monthly compounding, how much would you have
PV = FV =
0 ?
PV = -100 FV =
0
60
m = 12 i =r/m = 6 /12 =0.5
n = t*m = 60 PV = -100
FV = ₹134.89
PV = -100 FV = 134.89
0
60
m = 12 i= r/m =6/12 = 0.5%
n = 60 PV = -100
FV = ₹134.89
PV = -100 FV = 134.89
0
60
FV = 100 (FVIF .005, 60 ) (can’t use FVIF table)
FV = PV (1 + i/m) m x n
FV = 100 (1.005)60 = ₹134.89
Future Value - continuous compounding
What is the FV of ₹1,000 earning 8% with
continuous compounding, after 100 years?
PV = FV =
0 ?
PV = -1000 FV =
0 100
FV = PV (e in)
FV = 1000 (e .08x100
) = 1000 (e )
8
FV = ₹2,980,957.99
PV = -1000 FV = ₹2.98m
0 100
FV = PV (e )
in
FV = 1000 (e .08x100
) = 1000 (e )
8
FV = ₹2,980,957.99
Present Value
Present Value - single sums
If you receive ₹100 one year from now, what is the
PV of that ₹100 if your opportunity cost is 6%?
PV = FV =
0 ?
PV = FV = 100
0 1
m=1 i= r /m = 6
n=t*m = 1 FV = 100
PV = -94.34
PV = -94.34 FV = 100
0 1
m=1 i= r /m = 6
n=t*m = 1 FV = 100
PV = -94.34
PV = -94.34 FV = 100
0 1
PV = FV (PVIF i, n )
PV = 100 (PVIF .06, 1 ) (use PVIF table, or)
PV = FV / (1 + i)n
PV = 100 / (1.06)1 = ₹94.34
If you receive ₹100 five years from now, what is the
PV = FV =
0 ?
PV = FV = 100
0 5
m=1 i= r /m = 6
n=t*m = 5 FV = 100
PV = -74.73
PV = -74.73 FV = 100
0 5
m=1 i= r /m = 6
n=t*m = 5 FV = 100
PV = -74.73
PV = -74.73 FV = 100
0 5
PV = FV / (1 + i)n
PV = 100 / (1.06)5 = ₹74.73
What is the PV of ₹1,000 to be received 15 years
from now if your opportunity cost is 7%?
PV = FV =
0
15
PV = FV = 1000
0
15
m=1 i = r/m=7
n=t*m = 15 FV = 1,000
PV = -362.45
PV = -362.45 FV = 1000
0
15
m=1 i = r/m= 7
n=t*m = 15 FV = 1,000
PV = -362.45
PV = -362.45 FV = 1000
0
15
PV = FV / (1 + i)n
PV = 100 / (1.07)15 = ₹362.45
If you sold land for ₹11,933 that you bought 5 years
ago for ₹5,000, what is your annual rate of return?
PV = FV =
0 5
PV = -5000 FV = 11,933
0 5
m= 1 n=t*m = 5
PV = -5,000 FV = 11,933
i = 19% r=i*m= 19%
5,000 = 11,933 (PVIF ?, 5 )
PV = FV / (1 + i)n
5,000 = 11,933 / (1+ i)5
.419 = ((1/ (1+i)5)
2.3866 = (1+i)5
(2.3866)1/5 = (1+i) i = .19
Suppose you placed ₹100 in an account that pays
9.6% interest, compounded monthly. How long will
it take for your account to grow to ₹500?
PV = FV =
0
PV = -100 FV = 500
0 ?
• m = 12 FV = 500
• r = 9.6 PV = -100
• n = 202 months
PV = FV / (1 + i)n
100 = 500 / (1+ .008)n
5 = (1.008)n
ln 5 = ln (1.008)n
ln 5 = n ln (1.008)
1.60944 = .007968 n or n = 202 months
Hint for single sum problems:
• In every single sum future value and
present value problem, there are 4
variables:
• FV, PV, i, and n
• When doing problems, you will be
given 3 of these variables and asked to
solve for the 4th variable.
• Keeping this in mind makes “time
value” problems much easier!
Compounding and Discounting

Cash Flow Streams
0 1 2 3 4
Annuities
• Annuity: a sequence of equal cash flows,
occurring at the end of each period.
Annuities
• Annuity: a sequence of equal cash flows,
occurring at the end of each period.
0 1 2 3 4
Examples of Annuities:
• If you buy a bond, you will
receive equal semi-annual coupon
interest payments over the life of
the bond.
• If you borrow money to buy a
house or a car, you will pay a
stream of equal payments.
Examples of Annuities:
• If you buy a bond, you will
receive equal semi-annual coupon
interest payments over the life of
the bond.
• If you borrow money to buy a
house or a car, you will pay a
stream of equal payments.
Future Value - annuity
If you invest ₹1,000 each year at 8%, how much
would you have after 3 years?
0 1 2 3
1000 1000 1000
0 1 2 3
m=1 r=8 t=3
PMT = -1,000
FV = ₹3,246.40
1000 1000 1000
0 1 2 3
m=1 r=8 t=3
PMT = -1,000
FV = ₹3,246.40
FV = PMT (FVIFA i, n )
FV = 1,000 (FVIFA .08, 3 ) (use FVIFA table, or)
FV = PMT (1 + i)n - 1
i
FV = PMT (1 + i)n - 1
i
FV = 1,000 (1.08)3 - 1 = ₹3246.40
.08
Present Value - annuity
What is the PV of ₹1,000 at the end of each of the
next 3 years, if the opportunity cost is 8%?
0 1 2 3
1000 1000 1000
0 1 2 3
m=1 r=8 t= 3
PMT = -1,000
PV = ₹2,577.10
1000 1000 1000
0 1 2 3
m=1 i=8 n=t*m = 3
PMT = -1,000
PV = ₹2,577.10
PV = PMT (PVIFA i, n )
PV = 1,000 (PVIFA .08, 3 ) (use PVIFA table, or)
1
PV = PMT 1 - (1 + i)n
i
1
PV = PMT 1 - (1 + i)n
i
1
PV = 1000 1 - (1.08 )3 = ₹2,577.10
.08
0 1 2 3
Other Cash Flow Patterns

Perpetuities
• Suppose you will receive a fixed

payment every period (month, year,
etc.) forever. This is an example of
a perpetuity.
• You can think of a perpetuity as an
annuity that goes on forever.
Present Value of a
Perpetuity
• When we find the PV of an annuity,
we think of the following
relationship:
Present Value of a
Perpetuity
• When we find the PV of an annuity,
we think of the following
relationship:
Mathematically,
Mathematically,
(PVIFA i, n ) =
Mathematically,
1
n
(PVIFA i, n ) = 1- (1 + i)
i
Mathematically,
1
n
(PVIFA i, n ) = 1- (1 + i)
i
We said that a perpetuity is an
annuity where n = infinity. What
happens to this formula when n
gets very, very large?
When n gets very large,
1
n
1- (1 + i)
i
1
this becomes zero.
n
1- (1 + i)
i
1
this becomes zero.
n
1- (1 + i)
1
So we’re left with PVIFA =
i
Present Value of a Perpetuity
• So, the PV of a perpetuity is very

simple to find:
Present Value of a Perpetuity
• So, the PV of a perpetuity is very

simple to find:
PMT
PV =
i
What should you be willing to pay in
order to receive ₹10,000 annually
forever, if you require 8% per year
on the investment?
on the investment?
PV = PMT = ₹10,000
i .08
on the investment?
PV = PMT = ₹10,000
i .08
= ₹125,000
Ordinary Annuity
vs.
Annuity Due
₹1000 ₹1000 ₹1000
4 5 6 7 8
Begin Mode vs. End Mode
1000 1000 1000
4 5 6 7 8
1000 1000 1000

year year year
4 5 6 7 8
5 6 7
1000 1000 1000

year year year
4 5 6 7 8
5 6 7
PV
in
END
Mode
1000 1000 1000

year year year
4 5 6 7 8
5 6 7
PV FV
in in
END END
Mode Mode
1000 1000 1000
4 5
year
6
year
7 8
year
6 7 8
1000 1000 1000
4 5
year
6
year
7 8
year
6 7 8
PV
in
BEGIN
Mode
1000 1000 1000
4 5
year 6
year 7
year 8
6 7 8
PV FV
in in
BEGIN BEGIN
Mode Mode
Earlier, we examined this
“ordinary” annuity:
1000 1000 1000
0 1 2 3
1000 1000 1000
0 1 2 3
Using an interest rate of 8%, we
find that:
1000 1000 1000
0 1 2 3
find that:
• The Future Value (at 3) is
₹3,246.40.
1000 1000 1000
0 1 2 3
find that:
• The Future Value (at 3) is
₹3,246.40.
• The Present Value (at 0) is
₹2,577.10.
What about this annuity?
1000 1000 1000
0 1 2 3
• Same 3-year time line,
• Same 3 ₹1000 cash flows, but
• The cash flows occur at the
beginning of each year, rather
than at the end of each year.
• This is an “annuity due.”
Future Value - annuity due
If you invest ₹1,000 at the beginning of each of the
next 3 years at 8%, how much would you have at the
end of year 3?
0 1 2 3
end of year 3?
-1000 -1000 -1000
0 1 2 3
Mode = BEGIN P/Y = 1 I=8
N=3 PMT = -1,000

end of year 3?
-1000 -1000 -1000
0 1 2 3
Mode = BEGIN m = 1 i=r/m = 8
n=t*m = 3*1=3 PMT = -1,000

end of year 3?
Mathematical Solution: Simply compound the FV of the
ordinary annuity one more period:
end of year 3?
FV = PMT (FVIFA i, n ) (1 + i)
end of year 3?
FV = 1,000 (FVIFA .08, 3 ) (1.08) (use FVIFA table, or)
end of year 3?
FV = PMT (1 + i)n - 1 (1 + i)
i
end of year 3?
FV = PMT (1 + i)n - 1 (1 + i)
i
FV = 1,000 (1.08)3 - 1 (1.08) = ₹3,506.11
.08
Present Value - annuity due
What is the PV of ₹1,000 at the beginning of each of
the next 3 years, if your opportunity cost is 8%?
0 1 2 3
1000 1000 1000
0 1 2 3
Mode = BEGIN m = 1 i=r/m= 8
n = t *m = 3 PMT = 1,000
1000 1000 1000
0 1 2 3
Mode = BEGIN m = 1 i=r/m= 8
n = t *m = 3 PMT = 1,000
PV = ₹2,783.26
PV = PMT (PVIFA i, n ) (1 + i)
PV = 1,000 (PVIFA .08, 3 ) (1.08) (use PVIFA table, or)
1
PV = PMT 1 - (1 + i)n (1 + i)
i
1
PV = PMT 1 - (1 + i)n (1 + i)
i
1
(1.08)
PV = 1000 1 - (1.08 )3 = ₹2,783.26
.08
Uneven Cash Flows
-10,000 2,000 4,000 6,000 7,000
0 1 2 3 4
• Is this an annuity?
• How do we find the PV of a cash flow
stream when all of the cash flows are
different? (Use a 10% discount rate).
Uneven Cash Flows
-10,000 2,000 4,000 6,000 7,000
0 1 2 3 4
• Sorry! There’s no quickie for this one.

We have to discount each cash flow
back separately.
Uneven Cash Flows
-10,000 2,000 4,000 6,000 7,000
0 1 2 3 4

back separately.
Uneven Cash Flows
-10,000 2,000 4,000 6,000 7,000
0 1 2 3 4

back separately.
Uneven Cash Flows
-10,000 2,000 4,000 6,000 7,000
0 1 2 3 4

back separately.
Uneven Cash Flows
-10,000 2,000 4,000 6,000 7,000
0 1 2 3 4

back separately.
-10,000 2,000 4,000 6,000 7,000
0 1 2 3 4
period CF PV (CF)
0 -10,000 -10,000.00
1 2,000 1,818.18
2 4,000 3,305.79
3 6,000 4,507.89
4 7,000 4,781.09
PV of Cash Flow Stream: ₹ 4,412.95
Annual Percentage Yield (APY)
Which is the better loan:

• 8% compounded annually, or
• 7.85% compounded quarterly?
• We can’t compare these nominal (quoted) interest rates,
because they don’t include the same number of
compounding periods per year!
We need to calculate the APY.
m
APY = ( 1+
m
)
quoted rate
- 1
m
APY = ( 1+
m
)
quoted rate
- 1
• Find the APY for the quarterly loan:

m
APY = ( 1+
quoted rate
m
) - 1
4
APY = ( 1+
.0785
4
) - 1
m
APY = ( 1+
quoted rate
m
) - 1
4
APY = ( 1+
.0785
4
) - 1
APY = .0808, or 8.08%

m
APY = ( 1+
quoted rate
m
) - 1
4
APY = ( 1+
.0785
4
) - 1
APY = .0808, or 8.08%
• The quarterly loan is more expensive than

the 8% loan with annual compounding!
Practice Problems
CHAPTER 3
HOW TO CALCULATE PRESENT VALUES
TERMINOLOGIES
• Rates of return/IR (Simple & Compound)
• Future value
• Present value
• Annuity
• Amortization
How do we identify good investments?
• Operational Management - Short-term
– Working Capital Management
• Capital Budgeting Decision - Long-term
• What things should the firm own?
• Develop Algorithms and their use?
• Consider benefits and limitations?
• How do we measure performance?
Environment of Firm
• Laws
• Constraints
• Opportunities
Laws
• Legislated Laws
• Natural Laws
Legislated Laws
• Speed limits
• Restrictions on ownership
• Restrictions on activities
– Interest rate limits - paid or charged
– Operating as monopoly - restraint of trade
– Combining certain activities
• Tax structure
Natural Laws
Control Physical World
• Law of gravity
• Laws of thermodynamics
• How do people respond to opportunities?
• How do people respond to money?
Three key investor preferences

Investor Preferences
More money preferred over less money
Money now preferred over later money
Prefer a greater chance of having money over a smaller chance to
have money
Opportunities
Ideas of founders
Ideas of managers
Investment ideas
Financing ideas
Available resources
Time Value of Money Symbols used
P = Principal & Pt = Principal at time t

t = no. of years
m = no. of compounding per year
n = no of periods (= t*m)
r or inom = Annual IR
i = per period IR [(r or inom / m )]
PVt (FVt) = PV (FV) at end of year t
PVn = Present Value at (end of) period n
FVn = FV at (end of) period n
Measuring Return
How do we determine that the benefit realized on an investment

makes it worthwhile?
For example - Gain of Rs.1,000,000
Should we consider the cost of capital/Hurdle Rate?
If we invested Rs.5,000,000 vs. Rs.100,000,000
Measuring Return
Calculations
• Finding interest rate earned
• Begin with some amount of money P0
• After a period (one year) it grows to P1
• What has been earned?
• P1 - P0 = Earnings
Earnings Relative to Investment
P1  P0
P0
Earnings Relative to Investment
Specified as an Interest Rate
P1  P0
r
P0
r = (RoI) interest rate earned
Separate Fraction
P1 P0
 r
P0 P0
Substitute 1 for P0/P0
P1 P0 P1
  1  r
P0 P0 P0
Rewrite Equation
By adding 1 to both sides
P1
 (1  r )
P0
Future Value
Solve for P1
P1
 (1  r )
P0
P1  P0 (1  r )
Present Value
Solve for P0
P1
 (1  r )
P0
P1  P0 (1  r )
P1
P0 
(1  r )
Extend Time Frame
P1  P0  P0 r
P2  P1  P1r
Extend Time Frame
P2  P1  P1r
P2  P1 (1  r )
Extend Time Frame
Substitute for P1
P2  P1  P1r
P2  P1 (1  r )
P2  P0 (1  r )(1  r )
Extend Time Frame
Combine Terms
P2  P1  P1r
P2  P1 (1  r )
P2  P0 (1  r )(1  r )
P2  P0 (1  r ) 2
Extend for Third Year
P3  P2  P2 r
P3  P2 (1  r )
P3  P0 (1  r ) (1  r )
2
P3  P0 (1  r ) 3
Generalize for t years
Pt  P0 (1  r ) t
Generalize for n Periods
Pn  P0 (1  i ) n
Table Factor
Rearrange terms for present value

Pn 1
P0   Pn
(1  i ) n
(1  i ) n
Table Factor
Repetitive Cash Flows
+…………+
P P P
P0 = 1
1 + 2
2 + + n
n
(1 + i ) (1 + i ) (1 + i )
More Compact Summation Notation
n
Pt
P0 = å t
t =1 (1 + i )
P P P
P0 = 1
1 + 2
2 + + n
n
(1 + i ) (1 + i ) (1 + i )
n n
Pt = 1
P0 = å På
t =1 (1 + i )
t t
t =1 (1 + i )
Table Factor
Future Value of a Single Payment
An Example
New York City's five boroughs overview
Jurisdiction Population Land area
1 July 2013 square
Borough County
Estimates km
Manhattan New York 1,626,159 59
The Bronx Bronx 1,418,733 109
Brooklyn Kings 2,592,149 183
Queens Queens 2,296,175 283
Staten Island Richmond 472,621 151
City of New York 8,405,837 786
State of New York 19,651,127 122,284
IN 1626,
PETER MINUIT BOUGHT MANHATTAN ISLAND
FOR $ 24 FROM THE INDIANS
• WE GENERALLY BELIEVE THE INDIANS GOT A BAD DEAL

• IF THE INDIANS HAD INVESTED THE MONEYAT 10% PER
YEAR, VALUE TODAY OF THE $ 24 IN 1626 =24
(1.1)393
=$4.44x1017
=$444,000 TRILLION
ENOUGH MONEY TO BUY THE WORLD!
INVESTING FOR MORE THAN ONE PERIOD
• I INVEST P=Rs.100 FOR 2 YEARS AT i =0.1 PER YEAR.
• AT END OF YEAR 1,
• I HAVE FV1 = 100X1.1=110 IN MY ACCOUNT,
WHICH IS MY BEGINNING PRINCIPAL FOR YEAR 2.
• AT THE END OF YEAR 2, I WILL HAVE FV2

=FV1(1+i)
=P(1+i)(1+i)
=P(1+i)2
=121
• I WILL EARN Rs.10 INTEREST IN YEAR 1,
Rs.11 INTEREST IN YEAR 2,
– ALTHOUGH i =0.1 IN BOTH YEARS.
• WHY?
FV OF PRINCIPAL, P,
AT END OF t YEARS IS
FVt=P(1+i) t
FUTURE VALUE OF Rs.121 HAS FOUR PARTS
FV2=P(1+i)2=P+2iP+Pi2
• P=100
RETURN OF PRINCIPAL
• 2iP=20
SIMPLE INTEREST ON PRINCIPAL FOR 2 YEARS AT 10% PER YEAR
• Pi 2=1
INTEREST EARNED IN YEAR 2 ON Rs.10,
INTEREST PAID IN YEAR 1
 AMOUNT OF SIMPLE INTEREST CONSTANT EACH YEAR

COMPOUND INTEREST
INTEREST EARNED ON PRINCIPAL AND

REINVESTED INTEREST OF PRIOR PERIODS
SIMPLE INTEREST
INTEREST EARNED ON THE ORIGINAL

PRINCIPAL ONLY
PRESENT VALUE
PRESENT VALUE OF Rs.1 PRESENT VALUE
1.2
Year 5% 10% 15%
1 1 .952 .909 .870
2 .907 .826 .756
5 .784 .621 .497
0.8
10 .614 .386 .247
20 .377 .149 .061
0.6
i = 15%
i = 5%
0.4
i = 10%
0.2
0
0 2 4 6 8 10 12 14 16 18 20
YEARS
USING DIFFERENT SCALES
• WITH THE LINEAR SCALE OF THESE GRAPHS, IT APPEARS
THAT RATE OF GROWTH IS CONSTANT UNDER SIMPLE
INTEREST AND INCREASING UNDER COMPOUND INTEREST
• IN FACT, WITH COMPOUND INTEREST, WEALTH GROWS AT
CONSTANT 10% RATE
• WITH SIMPLE INTEREST, WEALTH GROWS AT A DECLINING
RATE
• IF WE HAD USED A SEMILOGARITHMIC SCALE, FUTURE
VALUE WOULD PRESENT AS A STRAIGHT LINE WITH
COMPOUND INTEREST, AND AS A LINE WITH DECREASING
SLOPE WITH SIMPLE INTEREST
FUTURE VALUE PRESENT VALUE
• COMPOUND • DISCOUNT A
PRINCIPAL AMOUNT FUTURE VALUE
FORWARD BACK TO THE
INTO THE FUTURE PRESENT
Three Ways to Find PVs & FVs
Solve the equation with a

• REGULAR / FINANCIAL CALCULATOR
• FUTURE VALUE TABLES
• SPREADSHEET PROGRAM
Table Values
• To Simplify Calculations
• Present Value of a Single Future Payment
• Present Value of a Series of Future Payments (i.e.
an annuity)
Present Value of a Single Future Payment
Present Value of a Single Future Amount
Realized in n Periods
FutureAmount
PV0 
(1  i ) n
Generalize for t years
FVt  PV0 (1  r ) t
Table Factor
FVt 1
PV0   FVt
(1  i ) t
(1  r ) t
Table Factor
Generalize for n Periods
FVn  PV0 (1  i ) n
Table Factor
FVn 1
PV0   FVn
(1  i ) n
(1  i ) n
Table Factor
SOLVE PRESENT VALUE PROBLEMS:
• FINANCIAL/REGULAR CALCULATOR
• SPREADSHEET PROGRAM
• PRESENT VALUE TABLES
Sample Calculations
for Single Payment
• Payment of Rs.1,000
• Received at the end of 3 years
• Discount rate of 10%
• What is the Present Value?
Rs.1000 Rs.1000
PV0  3
  Rs. 751 . 31
(1.1) 1.331
Calculation
Using Calculator
Rs.1000 Rs.1000
PV0  3
  Rs. 751 . 31
(1.1) 1.331
Using Present Value Table
PV0  Rs.1000  0.751  Rs.751

Table Factor
Factor Calculation
• Values beyond table values
• 10 years at 50%
1 1
PVIF    0 .01734
(1  .50)10
57.6650
Why are Time Value Adjustments Important?
• Cannot easily compare two things measured in different units
• Need to convert items to the same measuring units
• For example
–Compare 15 centimeters with 6 inches
• Which is longer?
Convert Measures to Same Units
Know 1 inch equals 2.54 centimeters
6 in. X 2.54 cm./in. = 15.24 cm
Demonstrates that 15cm. < 6in. = 15.24 cm.

To Add Cash Flows Realized in Different
Periods
Must adjust the cash flows to a common period.

Could use any common period
By using Present Value - The worth at the present
-- the values are consistent with something we can
appreciate.
Time lines show timing of cash flows.
0 1 2 3
i%
CF0 CF1 CF2 CF3
Tick marks at ends of periods, so Time 0 is

today; Time 1 is the end of Period 1; or the
beginning of Period 2.
Time line for a Rs.100 lump sum due at the end of
Year 2.
0 1 2 Year
i%
100
Time line for an ordinary annuity of Rs.100 for 3
years.
0 1 2 3
i%
100 100 100

Time line for uneven CFs -Rs.50 at t = 0 and Rs.100,
Rs.75, and Rs.50 at the end of Years 1 through 3.
0 1 2 3
i%
-50 100 75 50
What’s the FV of an initial Rs.100 after 3 years if i =
10%?
0 1 2 3
10%
100 FV = ?
Finding FVs is compounding.

After 1 year:
FV1 = PV + INT1 = PV + PV (i)

= PV(1 + i)
= Rs.100(1.10)
= Rs.110.00.
After 2 years:
FV2 = PV(1 + i)2
= Rs.100(1.10) 2
= Rs.121.00.
After 3 years:
FV3 = PV(1 + i)3
= 100(1.10)3
= Rs.133.10.
In general,
FVn = PV(1 + i) n
What’s the PV of Rs.100 due in 3 years if i =
10%?
Finding PVs is discounting, and it’s the
reverse of compounding.
0 1 2 3
10%
PV = ? 100
Solve FVn = PV(1 + i ) for PV:
n
n
FVn  1 
PV = = FVn  
1 + in
 1+ i 
( )
3
1
PV = Rs.100
1.10
= Rs.100 (PVIF i,n )
= Rs.100 ( 0.7513) = Rs.75.13
If sales grow at 19% per year, how long before sales
double?
Solve for n:
n
FVn = 1(1 + i) ;
n
2 = 1(1.19)
Assuming PV = 1
FINDING n, THE NUMBER OF PERIODS
FVn
PV0  n
(1  i )
Q. I HAVE Rs.20,000 AND I WANT TO BUY A LAPTOP
FOR Rs.50,000. I CAN EARN 12% PER YEAR.
HOW LONG WILL IT TAKE ME TO BUY MY LAPTOP,
(IF THE PRICE DOESN’T GO UP)?
A. WE KNOW FVn/PV0 = 2.5 AND i = .12

(1.12)n = 2.5
TAKE LOGS.
LOG(1.12)n = LOG(2.5) = n LOG(1.12)
n =8.085
VALUING LONG - LIVED ASSETS
C1
PV  DF1 x C 1 
(1  i1 )
 C1 YEAR-1 CASH FLOW (AT TIME 1)
DF1 DISCOUNT FACTOR FOR YEAR-1 CASH FLOW
i1 ANNUAL RATE OF INTEREST ON MONEY
INVESTED FOR 1 YEAR
EXAMPLE:
GUARANTEED CASH FLOW OF Rs.100 AT TIME 1 (C1=100)
RATE OF INTEREST ON 1-YEAR T-BILLS IS 7.0% (r1=i1=.07)
100
PV   93.46
1.07
PRESENT VALUE OF YEAR-2 CASH FLOW
C2
PV  DF2 x C 2 
(1  i2 ) 2
C2 YEAR-2 CASH FLOW (AT TIME 2)

DF2 DISCOUNT FACTOR FOR YEAR-2 CASH FLOW
 i2 ANNUAL RATE OF INTEREST ON MONEY
INVESTED FOR 2 YEARS
EXAMPLE:
GUARANTEED CASH FLOW OF Rs.100 AT TIME 2 (C2=100)
RATE OF INTEREST ON 2-YEAR T-NOTES IS 7.7% PER YEAR
(r2=i2=.077) 100
PV   86.21
1.077 2
PRESENT VALUE
OF MULTIPLE CASH FLOWS
• ADDITIVITY RULE
– CASH FLOWS OCCURRING AT DIFFERENT TIMES EXPRESSED
IN CURRENT RUPEES
– CALCULATE PV OF EACH CASH FLOW AND ADD THEM UP
• WHY IS THIS REASONABLE?
– WHEN WE CALCULATE PV, WE’RE ASKING HOW MUCH I HAVE
TO INVEST TODAY TO GIVE ME THE FUTURE CASH FLOW
– WE CAN OBVIOUSLY MAKE THE CALCULATION SEPARATELY
FOR EACH FUTURE CASH FLOW AND ADD UP THE PRESENT
VALUES
– THINK OF INVESTING EACH OF THE PRESENT VALUES IN
SEPARATE BANK ACCOUNTS
C2 Cn
C0  1
  ....... 
PV0 = (1  r1 ) (1  r2 ) 2
(1  rn ) n
DISCOUNTED CASH FLOW (DCF) EQUATION

NOTE: USE TODAY’s COST OF CAPITAL,
NOT HISTORICAL COST OF CAPITAL
PV =
Cn
(1  in ) n
PRESENT VALUE OF A SERIES OF CASH FLOWS,

WHERE THE SUMMATION IS
OVER ALL THE CASH FLOWS OF INTEREST
Cn
NPV = (1  in ) n
NET PRESENT VALUE OF A PROJECT

WHERE THE SUMMATION IS OVER ALL THE CASH
FLOWS
GENERATED BY THE PROJECT,
INCLUDING INITIAL NEGATIVE CASH FLOWS
AT THE START OF THE PROJECT, C0 ETC.
EXAMPLE
 C0 = -500, C1 = +400, C2 = +400
 i1 = i2 = .12
NPV = -500 + 400 + 400

1.12 (1.12)2
= -500 + 400 (.893) + 400 (.794)

= -500 + 357.20 + 318.80 = +176
CAN DISCOUNT FACTORS DECLINE OVER TIME?
DFt+1 < DFt ?
• IS THIS POSSIBLE?
DF1 =1/(1.2) =.83
DF2 =1/(1.07)2 =.87
• NO!
• IMPLIES POSSIBILITY OF RISKLESS ARBITRAGE
– BORROW PV OF Rs.1,200 FOR 2 YEAR S=Rs.1,200/(1.07)2=Rs.1,048
– INVEST Rs.1,000 OF THIS AMOUNT
– HAVE Rs.1,200 AT END OF YEAR 1 AND AT LEAST Rs.1,200 AT END OF YEAR 2, WHICH WE USE TO PAY OFF
OUR LOAN
– MAKE RISKLESS Rs.48 PROFIT
• BUT THERE IS NO MONEY MACHINE!

TERM STRUCTURE OF INTEREST RATES
• RELATIONSHIP BETWEEN INTEREST RATE AND
MATURITY
• FOR NOW, ASSUME FLAT TERM STRUCTURE
– INTEREST RATES ARE SAME i1 = i2 = i3 =.....= i
C1 C2 Cn
NPV0 = C0    ....... 
(1  i ) (1  i ) 2
(1  i ) n
SHORTCUTS FOR VALUING
LEVEL CASH FLOWS:
ANNUITIES
ORDINARY ANNUITY:
SERIES OF EQUAL CASH FLOWS
AT END OF SUCCESSIVE PERIODS
-MORTGAGES
-CONSUMER LOANS
SHORTCUTS FOR VALUING
LEVEL CASH FLOWS:
PERPETUITIES
• SERIES OF EQUAL CASH FLOWS
AT END OF SUCCESSIVE
PERIODS CONTINUING
FOREVER
How to represent an ordinary annuity?
Ordinary Annuity
0 1 2 3
i%
PMT PMT PMT
A A A
PV0    ....... 
(1  i ) (1  i ) 2
(1  i ) n
• WHAT KIND OF A SERIES IS THIS?

• GEOMETRIC SERIES
• FIRST TERM ?
• COMMON FACTOR ?
SUM OF A GEOMETRIC SERIES
S= a + ax + ax2 + ..... +ax(n-1)

S= a + ax + ax2 + ..... +ax(n-1)
xS=ax + ax2+..... +ax(n-1) + axn

S= a + ax + ax2 + ..... +ax(n-1) ………(1)
xS=ax + ax2+ +ax(n-1) + axn ………(2)
Subtracting (2) from (1) we get:
S(1-x)=a - axn
S= a + ax + ax2 + ..... +ax(n-1) ------(1)
xS= ax + ax2+ +ax(n-1) + axn ------ (2)

S(1-x)=a - axn
n
(1  x )
S = a
(1  x)
A A A
  ....... 
PV = (1  i ) (1  i ) 2
(1  i ) n
 1 
 1 
A  (1  i ) n


(1  i )  1  1 
 (1  i ) 
 
 1 
1 
 (1  i ) n

 A
 i 
 
 
Annuity Formula Derivation
Constant repetitive payment
Assume A (PMT) Rupees per period

Annuity of A Rupees Per Year
A A A A
PV0      
(1  i )1
(1  i ) 2
(1  i ) 3
(1  i ) n
Multiply both sides by (1+i)
A A A A
PV0    
(1  i )1
(1  i ) 2
(1  i ) 3
(1  i ) n
A A A
PV0 (1  i )  A    n 1
(1  i )1
(1  i ) 2
(1  i )
A A A A
PV0    
(1  i )1
(1  i ) 2
(1  i ) 3
(1  i ) n
A A A
PV0 (1  i )  A      n 1
(1  i )1
(1  i ) 2
(1  i )
Subtract original equation from the new one
A
PV0 (1  i )  PV0  A 
(1  i ) n
A
PV0 (1  i )  PV0  A 
(1  i ) n
A
PV0  PV0i  PV0  A 
(1  i ) n
A
PV0i  A 
(1  i ) n
A
A
(1  i ) n
PV0 
i
PV Factor of Annuity of A Rupees Per
Period
 1 
 1  
(1  i ) n
PV0  A 
 i 
 
Table Factor
A A A
  ....... 
PV = (1  i ) (1  i ) 2
(1  i ) n
 1 
1 n 
 (1  i ) 
 A
 i 
 
 
FOUR VARIABLES, PV, i, n, A
IF WE KNOW ANY THREE, SOLVE FOR THE FOURTH
Perpetuity
1
1
(1  i ) n
Annuity _ Factor 
i
As N approaches infinity, the term 1/(1+i)n in

the box approaches 0 and the factor
approaches 1/i
Perpetuity
1
Perpetuity _ Factor 
i
ALTERNATIVE WAY
TO VALUE A PERPETUITY
IF I LEAVE AN AMOUNT OF MONEY, P, IN THE BANK,

I CAN EARN ANNUAL INTEREST OF A = iP FOREVER
A
P
i
(earn iP in 1st year, which we withdraw. So we are left again with P which
earns iP again at the end of 2nd year, . And so on for end of every year…..
VALUING PERPETUITIES
C
PV = i
EXAMPLE:
 SUPPOSE YOU WANT TO ENDOW A CHAIR AT YOUR OLD

UNIVERSITY, WHICH WILL PROVIDE Rs.100,000
EACH YEAR FOREVER. THE INTEREST RATE IS 10%
Rs.100,000
PV = = Rs.1,000,000
0.10
A DONATION OF Rs.1,000,000 WILL PROVIDE AN ANNUAL
INCOME OF 0.10 X Rs.1,000,000 = Rs.100,000 FOREVER.
GROWING PERPETUITIES
A1 A2 A3 A4
PV   2
 3
 4
 .........
(1  i) (1  i ) (1  i ) (1  i )
A1 A2 A3 A4
PV   2
 3
 4
 .........
(1  i) (1  i ) (1  i ) (1  i )
2
A1 A1 (1  g) A1 (1  g)
  2
 3
 ....
(1  i ) (1  i ) (1  i )
A1 A2 A3 A4
PV   2
 3
 4
 .........
(1  i) (1  i ) (1  i ) (1  i )
2
A1 A1 (1  g) A1 (1  g)
  2
 3
 ....
(1  i ) (1  i ) (1  i )
A1 1 A1
 
(1  i ) 1  (1  g) (1  i )  (1  g)
(1  i )
A1 A2 A3 A4
     .........
PV 1  i (1  i ) 2
(1  i ) 3
(1  i ) 4
2
A1 A1 (1  g) A1 (1  g)
  2
 3
 ....
(1  i ) (1  i ) (1  i )
A1 1 A1
 
(1  i ) (1  g) (1  i )  (1  g)
1
(1  i )
A1

i g
Growing Perpetuity Factor
1
Growing _ Perpetuity _ Factor 
ig
• SUPPOSE YOU WISH TO ENDOW A CHAIR AT

YOUR OLD UNIVERSITY WHICH WILL
PROVIDE Rs.100,000 PER YEAR GROWING AT
4% PER YEAR TO TAKE INTO ACCOUNT
INFLATION. THE INTEREST RATE IS 10% PER
YEAR.
PRICE AN ANNUITY AS EQUAL TO THE DIFFERENCE BETWEEN TWO
PERPETUITIES
Asset Year of payment Present Value
1 2.. t+1 . .
Perpetuity A
(first payment year 1) i
Perpetuity A 1
(first payment year t + 1) ( ) i (1+i) t
Annuity from year 1 A A 1

to year t i
-
( ) i (1+i) t
CALCULATING PV WHEN I KNOW A, i, n
OR HOW MUCH AM I PAYING FOR MY CAR?
ANNUITY TABLE
No. of Interest Rate
Years 5% 8% 10%
1 0.952 0.926 0.909
2 1.589 1.783 1.736
3 2.723 2.577 2.487
5 4.329 3.993 3.791
10 7.722 6.710 6.145
What’s the difference between an ordinary
annuity and an annuity due?
Ordinary Annuity
0 1 2 3
i%
PMT PMT PMT
Annuity Due
0 1 2 3
i%
PMT PMT PMT

CALCULATION HINTS
• WE CAN CALCULATE PVs AND FVs
IN ANY ORDER AS CONVENIENT.
• THE ANSWERS WILL ALWAYS BE THE SAME
BECAUSE, AT EACH STEP,
WE’RE CALCULATING CASH FLOWS
WHICH HAVE THE SAME VALUE.
• For converting PV to FV use,
FVn  PV0 (1  i ) n
Calculation of FV Factor of Annuity of A Rupees Per
Period
 1 
 1  
(1  i ) n
PV0  A 
 i 
 
FVn  PV0 (1  i ) n
FV Factor of Annuity of A Rupees Per Period
 1 
 1  n 
(1  i )
FVn  PV0 (1  i )  A
n
 (1  i ) n
 i 
 
FV Factor of Annuity of A Rupees Per Period
 (1  i )  1 n
FVn  A 
 i 
Table Factor
EXAMPLE
• TO CALCULATE FV OF AN ANNUITY, FIRST

CALCULATE PV OF THE ANNUITY, AND THEN
CALCULATE FV.
• EXAMPLE: CALCULATE FV OF A 20-YEAR Rs.100,000
ANNUITY AT 10% PER YEAR
Method1: Calculate first PV and then FV of the PV
PV = Rs.851,400 using or
A - A 1 t
& then FV = PV x 1.10 20
i ( i ) (1+i)
= Rs.5.73 MILLION
Method2: Calculate the FV directly
FV = Rs. 100,000 * {(1+i)n-1}/i =Rs.5.73 MILLION
What’s the FV of a 3-year ordinary annuity of Rs.100
at 10%?
0 1 2 3
10%
100 100 100

What’s the PV of this ordinary annuity?
0 1 2 3
10%
100 100 100
= PV
Find the FV and PV if the
annuity were an annuity due.
0 1 2 3
10%
100 100 100

What is the PV of this uneven cash
flow stream?
0 10%
1 2 3 4
100 300 300 -50
= PV
HOW DO WE COMPARE INTEREST RATES ON DIFFERENT
SECURITIES, WHEN COMPOUNDING PERIODS ARE
DIFFERENT?
• DIFFERENT SECURITIES HAVE DIFFERENT
COMPOUNDING PERIODS
– IN U.S. AND BRITAIN, COUPON BONDS PAY SEMIANNUAL
INTEREST
– IN INDIA, FRANCE AND GERMANY, COUPON BONDS PAY
ANNUAL INTEREST
• TO COMPARE SECURITIES, WE NEED TO COMPARE RATES
COMPOUNDED OVER THE SAME LENGTH OF TIME,
USUALLY ONE YEAR
HOW DO WE COMPARE INTEREST RATES ON
DIFFERENT SECURITIES?
• DIFFERENT SECURITIES HAVE DIFFERENT

COMPOUNDING PERIODS
– IN U.S. AND BRITAIN, COUPON BONDS PAY SEMIANNUAL
INTEREST
– IN FRANCE AND GERMANY, COUPON BONDS PAY ANNUAL
INTEREST
• TO COMPARE COMPOUNDED SECURITIES, WE NEED TO
COMPARE RATES OVER
COMPARE THE SAME
SECURITIES LENGTH
IN TERMS OF TIME,
OF EAR,
USUALLY ONE YEAR
EQUIVALENT ANNUALLY COMPOUNDED RATE
How to compare interest rates investments when
compounding period do not match the stated interest
rate period
• Two situations can occur when stated interest rate period &
the compounding period are different
• Compounding is done more frequently (than the stated interest rate

period)
• Compounding is done less frequently (than the stated interest rate period)
Will the FV of a lump sum be larger or smaller if we
compound more often, holding the stated i% constant?
Why?
LARGER! If compounding is more

frequent than once a year--for example,
semiannually, quarterly,
or daily--interest is earned on interest
more often.
0 1 2 3
10%
100 133.10
Annually: FV3 = 100(1.10) = 133.10.
3
0 1 2 3
0 1 2 3 4 5 6
5%
100 134.01
Semiannually: FV6 = 100(1.05) = 134.01.
6
What’s the value at the end of Year 3
of the following CF stream if the quoted interest rate is
10%, compounded semiannually?
0 1 2 3 4 5 6 6-mos.
5% periods
100 100 100

• Payments occur annually, but compounding occurs
each 6 months.
• So we can’t use normal annuity valuation techniques.
Compound Each CF
0 1 2 3 4 5 6
5%
100 100 100.00
FV3 = 100(1.05)4 + 100(1.05)2 + 100

=
What’s the PV of this stream?
0 1 2 3
5%
100 100 100

ANNUAL PERCENTAGE RATE (APR)
• use APR when compounding is done once a year but the stated interest rate period is less than
a year
• DISCLOSURE REQUIRED BY TRUTH IN LENDING LAWS
APR = INTEREST RATE PER PERIOD X
NUMBER OF PERIODS IN A YEAR
• EXAMPLE: CAR LOAN CHARGES INTEREST AT 1% PER
MONTH
• APR OF 12% PER YEAR
BUT EAR=(1+.01)12-1=12.6825% PER YEAR
• THIS IS THE RATE YOU ACTUALLY PAY
• IMAGINE THE LOBBYING IN DEFINING APR!
YEAR(6.0%/Year) 1 6.000% 6.000%
QUARTER(1.5%/Qtr) 4 6.136% 6.000%
MONTH(0.5%/Month)12 6.168% 6.000%
DAY(6/365%/Day) 365 6.183% 6.000%
MINUTE 525,600 6.184% 6.000%
CONTINUOUSLY  6.184% 6.000%

GENERAL RESULT
i nom m
(1  ) 1
EAR = m
inom IS THE QUOTED ANNUAL RATE,
COMPOUNDED m TIMES PER YEAR
=e i
AS m INCREASES WITHOUT LIMIT
Rs.1 INVESTED CONTINUOUSLY
AT AN INTEREST RATE i FOR t YEARS BECOMES e it

10% PER YEAR CONTINUOUSLY COMPOUNDED
EAR = e - 1
.1
= 10.51709%
CONTINUOUS CASH FLOWS
• IN CAPITAL BUDGETING,
IT MAY BE REASONABLE TO ASSUME
THAT CASH FLOWS OCCUR UNIFORMLY
THROUGHOUT THE YEAR
• ERRORS INTRODUCED BY TREATING CASH FLOWS
AS OCCURRING AT END OF YEAR OFTEN WITHIN
ACCURACY OF THE ANALYSIS
LOANS
• IN SOME LOANS, PRINCIPAL IS REPAID OR AMORTIZED

OVER LIFE OF LOAN
• BORROWER MAKES FIXED PAYMENT EACH PERIOD
– EXAMPLES: MORTGAGES, CONSUMER LOANS.
LOANS
• EXAMPLE: AMORTIZATION SCHEDULE FOR 5-YEAR , Rs.5,000 LOAN, 9%
INTEREST RATE, ANNUAL PAYMENTS IN ARREARS. WHAT IS THE
AMORTIZATION AMOUNT?
Step I: SOLVE FOR PMT AS ORDINARY ANNUITY PMT=Rs.1,285.46

Step II: WE KNOW THE TOTAL PAYMENT,
WE CALCULATE THE INTEREST DUE IN EACH PERIOD AND
BACK CALCULATE THE AMORTIZATION OF PRINCIPAL FOR EACH OF
THE PERIODS.
AMORTIZATION SCHEDULE
YEAR BEGINNING TOTAL INTEREST PRINCIPAL ENDING
...............BALANCE PAYMENT PAID PAID BALANCE
1 5,000 1,285.46 450.00 835.46 4,164.54

2 4,165 1,285.46 374.81 910.65 3,253.88
3 3,254 1,285.46 292.85 992.61 2,261.27
4 2,261 1,285.46 203.51 1,081.95 1,179.32
5 1,179 1,285.46 106.14 1,179.32 0
INTEREST DECLINES EACH PERIOD

AMORTIZATION OF PRINCIPAL INCREASES OVER TIME
14000
Rs.
12000
10000
AMORTIZATION
8000
$
6000
4000
2000
INTEREST
0
1 6 11 16 21 26
30 Year
Year
AMORTIZING LOAN
NOMINAL AND REAL RATES OF INTEREST
• A BANK OFFERING AN INTEREST RATE OF 10%

PER YEAR ON A Rs.1,000 CD WILL PAY Rs.1,100
AT THE END OF THE YEAR
• BANK MAKES NO PROMISE ABOUT WHAT THE
Rs.1,100 WILL BUY AT THE END OF THE YEAR
– DEPENDS ON RATE OF INFLATION OVER THE
YEAR
• CPI MEASURES INFLATION IN PURCHASES OF
A TYPICAL FAMILY
• NOMINAL CASH FLOW FROM BANK CD IS Rs.1,100
• IF INFLATION IS 6% OVER THE YEAR, REAL CASH FLOW
IS
Rs.1,100
 Rs.1,037.74
1.06
NOMINAL CASH FLOW
• REAL CASH FLOW = (1  AVERAGE INFLATION RATE )t
MEASURED IN CONSTANT RUPEES

(RUPEES OF CONSTANT PURCHASING POWER)
NOMINAL RETURNS
NOT ADJUSTED FOR INFLATION
• REAL RETURNS
– RETURNS ADJUSTED FOR INFLATION
– PERCENTAGE CHANGE IN HOW MUCH I CAN BUY
AS A RESULT OF THE CHANGE IN VALUE OF MY
INVESTMENT
– PERCENTAGE CHANGE IN THE VALUE OF MY
INVESTMENT MEASURED IN UNITS OF CONSTANT
PURCHASING POWER
• 20-YEAR CD
– Rs.1,000 INVESTMENT
– 10% PER YEAR INTEREST RATE
– EXPECTED AVERAGE FUTURE INFLATION 6% PER YEAR
• FUTURE NOMINAL CASH FLOW
• = Rs.1,000x1.120
• = Rs.6,727.50
• FUTURE REAL CASH FLOW
NOMINAL RATE OF RETURN 10%
• REAL RATE OF RETURN
1.1
 1  3.774%
1.06
FISHER EQUATION
(1+ rnominal) = (1+ rreal)(1+EXPECTED INFLATION RATE)
= 1 + rreal + EXPECTED INFLATION RATE
+ rreal (EXPECTED INFLATION RATE)
APPROXIMATELY,
rnominal = rreal +EXPECTED INFLATION RATE
When I earn a real return, rreal,
my nominal return has to be increased by

the expected inflation rate, to compensate me
for the effect of inflation on my original principal,
and an additional rreal times the expected inflation rate,
to compensate me for the effect of inflation on the
interest.
BONDS
• INTEREST ONLY LOANS, PRINCIPAL OR FACE VALUE OR
PAR VALUE REPAID AT END OF LOAN
• STATED INTEREST RATE CALLED COUPON
• DENOMINATIONS (OR PAR VALUES) OF CORPORATE
BONDS TYPICALLY Rs.1,000. GOVERNMENT BONDS
USUALLY HAVE GREATER PAR VALUES. BOND SELLING
AT PAR IS SELLING “FLAT.”
• MATURITY SOMETIMES CASUALLY USED FOR
REMAINING LIFE OF BOND OR CURRENT MATURITY
• MOST BONDS PAY INTEREST SEMIANNUALLY/ANNUALLY
• PRICE OFTEN STATED AS PERCENTAGE OF PAR VALUE
6%, 5 year bonds
• CASH FLOWS AT END OF EACH YEAR
• (IGNORING SEMIANNUAL PAY)
• 1995 1996 1997 1998 1999

• 60 60 60 60 1,060
• SIMILAR BONDS RETURN 6.9%
60 60 60 60 1,060
PV       963
(1.069) (1.069)2 (1.069)3
(1.069)4
(1.069)5
BOND IS SELLING AT 96.3 (PERCENT OF PAR VALUE)

AFTER BOND IS ISSUED,
INTEREST RATES ON SIMILAR BONDS CHANGE
BUT CASH FLOWS FROM BOND STAY SAME
• PRICE OF BOND WILL VARY BECAUSE THE PRICE IS THE

PV OF THE REMAINING CASH FLOWS
• DISCOUNT RATES CHANGE WITH CHANGES IN YIELD
TO MATURITY (YTM) OR YIELD ON SIMILAR BONDS!
PV(BOND) = PV (COUPON PAYMENTS)
+ PV (FINAL PAYMENT)
• PV(COUPON PAYMENTS) IS THE PV OF AN ANNUITY
PV(BOND)  60( 1

1
.069 .069(1.069)5
) 
1,000
(1.069)5
= 246.67 + 716.33
= Rs.963
YTM
• TURN THE QUESTION AROUND

• ASK WHAT RETURN, r, DO INVESTORS EXPECT WHEN A 5-YEAR, 6%
COUPON BOND IS PRICED AT 96.3?
• WE NEED TO FIND THE VALUE OF r THAT SATISFIES THE EQUATION
60 60 60 60 1,060
963     
(1 + R) (1 + R)2 (1 + R)3
(1 + R)4
(1 + R)5
r IS THE YIELD TO MATURITY (YTM) OR YIELD

WE ASSUME A FLAT TERM STRUCTURE
OF INTEREST RATES
INTEREST RATE RISK
WHEN MARKET INTEREST RATES RISE, BOND PRICES FALL.
WHEN MARKET INTEREST RATES FALL, BOND PRICES RISE.
BOND PRICE SENSITIVITY TO CHANGES IN INTEREST RATES

GREATER
1. LONGER CURRENT MATURITY
2. LOWER THE COUPON RATE.

WHY ARE LONGER MATURITY BONDS MORE
SENSITIVE TO CHANGES
IN MARKET INTEREST RATES?
• MORE OF THE PRICE OF THE BOND IS DERIVED
FROM CASH FLOWS (INTEREST AND PRINCIPAL)

THAT OCCUR LATER IN TIME
• AND THEREFORE HAVE TO BE DISCOUNTED
MORE
• MORE SENSITIVE TO CHANGES IN INTEREST
RATES
EXAMPLE:
1 IS MORE SENSITIVE
r 60 TO CHANGES IN r THAN
(1  )
2
1
r 2
(1  )
2
BONDS MAKE SEMI-ANNUAL COUPON PAYMENTS
• ANNUAL COUPON RATE IS QUOTED AS TWICE THE
SEMIANNUAL COUPON RATE
– 6% COUPON BOND PAYS Rs.30 TWICE A YEAR
• BOND YIELD IS QUOTED AS TWICE THE
SEMIANNUAL BOND YIELD
30 30 1,030
PV    . . . . . . . . . . . . . . . . . . . . . . . . . .
(1.0345) (1.0345)2 (1.0345) 10
VALUE OF A BOND
ANNUAL COUPON C, ANNUAL YIELD TO MATURITY r

C C C
PV  2
 2  . . . . . . . . . . . . 2
r r 2 r 2n
(1  ) (1  ) (1  )
2 2 2
PV & FV Formulas and Notations
t = number of years the deposit is allowed to compound

m = no. of times compounding occurs during the year
n = number of periods = mt
r or inom = per year (annual) interest rate
i = per period interest rate (periodic rate)
FVn = Future value at end of period n
FVt = Future Value at end of tth year.
PV = Present value (value now t =0 or PV0)
PVn = Present Value at beginning of nth period n
PVt = Present Value at beginning of tth year
A or PMT = per period annuity amount
Convert IR to APR for comparison
APR  INTEREST RATE PER PERIOD X
NUMBER OF PERIODS IN A YEAR
APR  i * m
Use EAR for Calculation
m
 i nom 
Effective (Annual) Interest Rate, EAR  1   1. 0
 m 
Future Value
Future Value of a Single Amount
Future Value: FVn = PVo * (1+inom)t
If compounding is done more than once in a year, then

FVn =PV0 *[1 + (inom/m)]mt = PV0 * (1+i)mt = PV0 * (1+i)n
and the Effective Interest Rate = [1 + (i nom/m)]m –1
OR
FVn = PVo*(1+EAR)t
=PVo*(1+inom/m)mt
=PV0 * (1+i)mt
= PV0 * (1+i)n
Future Value of a Single Amount
FV =PV * (FVIF i,n)
FVIF i,n= (1+i)n
Where: FV = Future Value, the ending amount
PV = Present Value, the starting amount
FVIF i,n = Future Value Interest Factor
given interest rate, i,
and number of periods, n.
FV of Annuity
 (1  i )  1  n
FVn  A 
 i 
 (1  i )  1
n
FVannuity = PMT (A) *FVIFAi,n FVIFA i,n  

 i 
FVannuity due = FVordinary annuity * (1+i)

[As perpetuities ends at , it is difficult to calculate their
future value – we need to a time point to calculate its value]
Present Value
Present Value of a Single Amount
PVo = FVn/ (1+i)n
PV =FV * (PVIF i,n)
Where: FV = Future Value, the ending amount

PV = Present Value, the starting amount
PVIF i,n = Present Value Interest Factor
given interest rate, i, and
number of periods, n.
Present Value of a Series of Future Payments
(i.e. an annuity)
1
1
(1  i ) n
PV0  PMT ( A) 
i
PV0  PMT ( A)  Factor
1
1
(1  i ) n
PVIFAi , n 
i
Present Value of Annuity
PVannuity = PMT * PVIFAi,n

[PVIFAi,n =[(1+i)n-1]/[i(1+i)n] or = {1-[1/(1+i)n]}/i ]
PVannuity due = PVordinary annuity * (1+i)
PVperpetuity = PMT / i
Pbond = Coup (PVIFAkd,n) + Mat (PVIFkd,n )
All Present Value Formulas
PVo = FVn/ (1+i)n
PVannuity = PMT * PVIFAi,n

[PVIFAi,n =[(1+i)n-1]/[i(1+i)n] or = {1-[1/(1+i)n]}/i ]
PVannuity due = PVordinary annuity * (1+i)
PVperpetuity = PMT / i
Pbond = Coup (PVIFAkd,n) + Mat (PVIFkd,n )
THANK YOU

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The Time Value of Money

The Time Value of Money

Compounding and Discounting

1000 1000 1000

1000 1000 1000

1000 1000 1000

1000 1000 1000

Other Cash Flow Patterns

• Suppose you will receive a fixed

• So, the PV of a perpetuity is very

• So, the PV of a perpetuity is very

₹1000 ₹1000 ₹1000

1000 1000 1000

1000 1000 1000

1000 1000 1000

1000 1000 1000

1000 1000 1000

1000 1000 1000

1000 1000 1000

1000 1000 1000

N=3 PMT = -1,000

n=t*m = 3*1=3 PMT = -1,000

1000 1000 1000

1000 1000 1000

• Sorry! There’s no quickie for this one.

• Sorry! There’s no quickie for this one.

• Sorry! There’s no quickie for this one.

• Sorry! There’s no quickie for this one.

• Sorry! There’s no quickie for this one.

Which is the better loan:

• Find the APY for the quarterly loan:

• Find the APY for the quarterly loan:

• Find the APY for the quarterly loan:

APY = .0808, or 8.08%

• Find the APY for the quarterly loan:

APY = .0808, or 8.08%

• The quarterly loan is more expensive than

Three key investor preferences

More money preferred over less money

Money now preferred over later money

Prefer a greater chance of having money over a smaller chance to

P = Principal & Pt = Principal at time t

How do we determine that the benefit realized on an investment

• Finding interest rate earned

• Begin with some amount of money P0

• After a period (one year) it grows to P1

• What has been earned?

Rearrange terms for present value

• WE GENERALLY BELIEVE THE INDIANS GOT A BAD DEAL

• AT THE END OF YEAR 2, I WILL HAVE FV2

 AMOUNT OF SIMPLE INTEREST CONSTANT EACH YEAR

INTEREST EARNED ON PRINCIPAL AND

INTEREST EARNED ON THE ORIGINAL

Solve the equation with a

PV0  Rs.1000  0.751  Rs.751

Know 1 inch equals 2.54 centimeters

6 in. X 2.54 cm./in. = 15.24 cm

Demonstrates that 15cm. < 6in. = 15.24 cm.

Must adjust the cash flows to a common period.

CF0 CF1 CF2 CF3

Tick marks at ends of periods, so Time 0 is

100 100 100

Finding FVs is compounding.

FV1 = PV + INT1 = PV + PV (i)

1IntroFinancial-Planning & ManagementCS Compile

1IntroFinancial-Planning & ManagementCS Compile

n=tm = 31=3 PMT = -1,000