Copyright © 2015 by McGraw Hill Education (India) Private Limited

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
 TIME LINE
Part A

0 1 2 3 4 5
12% 12% 12% 12% 12%

10,000 10,000 10,000 10,000 10,000

Part B

0 1 2 3 4 5
12% 12% 12% 12% 12%

10,000 10,000 10,000 10,000 10,000

FUTURE VALUE OF A SINGLE AMOUNT

FORMULA
FUTURE VALUE = PRESENT VALUE (1+r)n
VALUE OF FVIFr,n FOR VARIOUS
COMBINATIONS OF r AND n

n/r 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
 DOUBLING PERIOD
Thumb Rule : Rule of 72
Doubling period = 72
Interest rate
Interest rate : 15 percent
Doubling period = 72 = 4.8 years
15
A more accurate thumb rule : Rule of 69
69
Doubling period = 0.35 +
Interest rate
Interest rate : 15 percent
69
Doubling period = 0.35 + = 4.95 years
15
 PRESENT VALUE OF A SINGLE AMOUNT

PV = FVn [1/ (1 + r)n] PVIF, r, n

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
 PRESENT VALUE OF AN UNEVEN SERIES
A1 A2 An
PVn = + + …… +
(1 + r) (1 + r)2 (1 + r)n
n At
= 
t =1 (1 + r)t

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

 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
 WHAT LIES IN STORE FOR YOU
Suppose you have decided to deposit Rs.30,000 per year in
your Public Provident Fund Account for 30 years. What
will be the accumulated amount in your Public Provident
Fund Account at the end of 30 years if the interest rate is
11 percent ?
 WHAT LIES IN STORE FOR YOU
Suppose you have decided to deposit Rs.30,000 per year in your Public
Provident Fund Account for 30 years. What will be the accumulated
amount in your Public Provident Fund Account at the end of 30 years if
the interest rate is 11 percent ?
The accumulated sum will be :
Rs.30,000 (FVIFA11%,30yrs)
= Rs.30,000 (1.11)30 - 1
.11
= Rs.30,000 [ 199.02]
= Rs.5,970,600
 HOW MUCH SHOULD YOU SAVE
ANNUALLY
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 percent ?
 HOW MUCH SHOULD YOU SAVE ANNUALLY
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 percent ?

The future value interest factor for a 5 year annuity, given an interest
rate of 12 percent, is :
(1+0.12)5 - 1
FVIFA n=5, r =12% = = 6.353
0.12
The annual savings should be :
Rs.2000,000 = Rs.314,812
6.353
 ANNUAL DEPOSIT IN A SINKING
FUND
Futura Limited has an obligation to redeem Rs.500
million bonds 6 years hence. How much should the
company deposit annually in a sinking fund account
wherein it earns 14 percent interest to cumulate
Rs.500 million in 6 years time ?
 ANNUAL DEPOSIT IN A SINKING FUND
Futura Limited has an obligation to redeem Rs.500 million bonds 6
years hence. How much should the company deposit annually in a
sinking fund account wherein it earns 14 percent interest to
cumulate Rs.500 million in 6 years time ?
The future value interest factor for a 5 year annuity, given an
interest rate of 14 percent is :
FVIFAn=6, r=14% = (1+0.14)6 – 1 = 8.536
0.14
The annual sinking fund deposit should be :
Rs.500 million = Rs.58.575 million
8.536
 PRESENT VALUE OF AN ANNUITY
1- 1
Present value of an annuity = A (1+r)n
r
Value of PVIFAr,n for Various Combinations of r and n
n/r 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
 LOAN AMORTISATION SCHEDULE
Loan : 1,000,000 r = 15%, n = 5 years
1,000,000 = A x PVIFAn =5, r =15%
= A x 3.3522
 A = 298,312
Amortization schedule
 EQUATED MONTHLY INSTALMENT

Loan = 1,000,000, Interest = 1% p.m, Repayment period = 180

months

A x [1-1/(1.01)180]
1,000,000 =
0.01
A = Rs.12,002
 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–
(1 + r)n
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. The present value of the teak that you can
harvest from the teak forest can be determined as follows:
 PRESENT VALUE OF A GROWING ANNUITY
For example, 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. The present value of the teak that you can harvest from the
teak forest can be determined as follows:

1.0820
1–
1.1520
PV of teak = Rs 500 x 100,000 (1.08)
0.15 – 0.08

= Rs.551,736,683
PRESENT VALUE OF PERPETUITY

A
Present value of perpetuity =
r
 Present value of growing perpetuity
• PV=C/r-g;
• Where,
• C=Cash flow in future
• r= capitalization factor
• g=growth rate
 PV of growing perpetuity
• Imagine an apartment building where cash
flows to the landlord after expenses will be
₹100,000 next year. These cash flows are
expected to rise at 5 % per year. The rise will
continue indefinitely. Discount rate is 11%
 PV of growing perpetuity
• Imagine an apartment building where cash
flows to the landlord after expenses will be
₹100,000 next year. These cash flows are
expected to rise at 5 % per year. The rise will
continue indefinitely. Discount rate is 11%

• PV=C/r-g
• =100,000/(.11-.05)=₹ 1,666,667
 SHORTER COMPOUNDING PERIOD

Future value = Present value 1+ r mxn

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 : Rs.5000, 12 percent, 4 times a year, 6 years
5000(1+ 0.12/4)4x6 = 5000 (1.03)24
= Rs.10,164
 SUMMING UP
 Money has time value. A rupee today is more valuable than a
rupee a year hence.
 The general formula for the future value of a single amount is :
 Future value = Present value (1+r)n

 According to the rule of 72,

 the doubling period = 72/ interest rate.
Rule 69= 0.35+69/i
 The general formula for the future value of a single cash amount
when compounding is done more frequently than annually is:
 Future value = Present value [1+r/m]m*n
 An annuity is a series of periodic cash flows (payments and receipts)
of equal amounts.
 Future value of an annuity
 = [(1+r)n – 1)/r]

 Present value = Future value x 1/(1+r)n

The present value of an annuity is:
= Constant periodic flow [1 – 1/ (1+r)n] /r

 A perpetuity is an annuity of infinite duration. In general

terms:
 Present value of a perpetuity = Constant periodic flow [1/r]