Time Value of Money

Time Value of Money

NAME SURNAME

Finance is all about Risk and Return Models

Individuals value money in hand today rather than in future

There are three reasons that explains time value of money:

1. Inflation: A rupee today has a higher purchasing power than a rupee in the future
due to inflation. As time passes, money looses value and price increase.
2. Preference for present consumption: Money can be productively employed to
enjoy pleasures today. An individual will forgo present consumption for future
consumption when compensated adequately.
3. Uncertainty or Risk: Future is characterized by uncertainty. An individual expects a
risk premium to compensate for the uncertainty associated with the future.
NAME SURNAME

Nominal and Real interest rate

For sacrificing present consumption, money saved commands interest.

Nominal Interest rate = Real interest rate+ Expected rate of inflation +

Risk premium to compensate for uncertainty

Present and Future Value

• PRESENT VALUE: A present value is the discounted value of one or
more future cash flows. Future amount of money is discounted to the
present value.

• FUTURE VALUE: The amount to which a cash flow or series of cash

flows will grow over a given period of time. Present investment will
compound with the expected return rate to a future value.
 Learning Outcomes
Students should learn:

1. The concepts of present and future value of cash flows,

ordinary annuity, annuity due, growing annuity, perpetuity and
growing perpetuity

2. To use the correct time value of money concept in the right

situation

3. To use Excel formulas and Value Tables

 Absolute Returns
Suppose, on an investment of Rs.1000 in Year 0, you are promised cash
flows of Rs.400 in Year 1, Rs.500 in Year 2 and Rs.600 in Year 3. Is the
investment good?

Current
Year 0 Year 1 Year 2 Year 3
-1000 +400 +500 +600 Total: +1500

So, absolute return = -1000+1500 = +500

 Present value
But due to inflation, expected return is 8%. using TVM:

Year 0 Year 1 Year 2 Year 3

-1000 +400 +500 +600
(1+0.08)1 (1+0.08)2 (1+0.08)3

+370
+428
+476
+1275 – 1000 = 275

Note: What is Rs.370?

Rs.370 is today’s value of Rs.400 received after 1 year at an expected returns of 8%
8% is the present value interest factor (PVIF)
 Present Value of Ordinary Annuity and Anuity Due
An annuity is used when cash flows are the same every year.
Year 1 Year 2 Year 3
Present Value (PVIFA)= 400 400 400
(1+ r)1 (1+ r)2 (1+r)3

Present Value (PVIFA) = 400 x [ ++ + ]

Pordinary annuity (PVIFA)= A x −

( )

Pordinary annuity(𝑃𝑉𝐼𝐹𝐴) =Ax [ ]

 Present Value of an Ordinary Annuity
If you are assured to receive $1,000 p.a. over a period of five years, how much should
you invest today if you expect a return (interest rate) of 5% p.a.?
Present value of an ordinary Annuity
(PVIFA):
_𝑛
1− 1+𝑟
=Ax [ 𝑟
]
_
.
=1,000 x [ . ]
=1,000× 4.33
= 4,329.48

You will invest not more than

$4329.48
 Present Value of Annuity Due
But if you are assured to receive $1,000 p.a. over a period of five years at the start of each
year, how much should you invest today if you expect a return (interest rate) of 5% p.a.?

Present value of annuity due:

=Ax − x (1+r)
( )

_𝑛
1− 1+𝑟
=Ax 1+r [ 𝑟
]
_
.
=1,000 x 1.05 x [ . ]

=1,000× 1.05 x 4.33

= 4,545.95

You will invest not more than

$4545.95
 Present Value of Growing Annuity
An annuity has a finite life. In a growing annuity, an annuity grows at a
constant rate.

You get an annual salary of Rs.10 lacs with a promised increment of 5%

annually for the next 5 years. Your required rate of return is 12%. What is
the present value of your earnings?

PV of growing annuity = x 1−

, , .
PV of growing annuity = x 1−
. . .
 Present Value of Perpetuity and Growing Perpetuity
Perpetuity: An annuity has a finite life while a perpetuity has an infinite life

An investor expects a perpetual sum of Rs. 500 annually from his investment. What is the
present value of this perpetuity if the interest rate / expected return on investment is 15%?

PV of perpetuity= =
%
= 3,333.33

Growing Perpetuity:
An investor expects a perpetual sum of Rs. 500 growing annually at 2% on his
investment . What is the present value of this perpetuity if the interest rate / expected
return on investment is 15%?

PV of growing perpetuity= = = 3,846.15

. .
The formula fails when r < g. But in real life the chances of r < g is negligible
Most of the value in perpetuity comes from the near future as the value in 100th year nearly becomes zero
 Present Value Case-lets
• Suppose a particular investment opportunity provides us with Rs. 1000, Rs.
1500, Rs. 800, Rs 1100, and Rs. 400 at the end of year 1 through 5 years. Find
the present value of these uneven cash flows with 8% interest rate.
Sol: PV = 1000 ÷ (1.08)1 + 1500 ÷ (1.08)2 + 800 ÷ (1.08)3 + 1100 ÷ (1.08)4 + 400 ÷ (1.08)5 = Rs. 3,927.76

• Compute the present value for a bond that promises to pay interest of Rs. 150
per year for thirty years & Rs. 1,000 at maturity. Interest rate @ 7% p.a.
Sol: PV = 150 x [(1- (1.07^-30)/0.07] + 1000/(1.07)^30 = 150 x PV of annuity (7%,30 years) + 1000/(1.07)^30 =
(150 x 12.4090)+ 131.36 = 1861.32+131.36 = 1992.68

• Assume that you are given a choice between incurring an immediate outlay of
Rs. 10,000 or having to pay Rs. 2,310 a year for 5 years, the discount rate is
12%. What would be our choice?
Sol: PV = 2310 x [(1- (1.12^-5)/0.12] x 1.12= 2310 x PV of annuity (12%,5 years) x 1.12
= 2310 x 3.6048 x 1.12 = 9,326.34
Present Value Practice Problems

1. A bank promises to give you Rs.10,000 after 2.5 years at the rate of 10 % interest.
How much should you deposit today?
2. Ratan wants to find the present value of Rs 2,000 to be received 5 years from now
assuming an interest rate of 10%.
3. Determine the present value of the cash inflows of Rs. 3000 at the end of each year
for the next 4 years & Rs. 7,000 & Rs. 1,000 respectively at the end of year 5 & 6.
The appropriate discount rate is 14%.
4. A finance company has introduced a scheme of investment of Rs. 40,000. The
returns would be Rs. 8,000, 9,000, 10,000, 11,000, and 12,000 in the next five
years. The indicated rate of interest is 10%. Compute the present value of the
investment and advise regarding the investment.
NAME SURNAME

Present Value of Ordinary Annuity Practice Problems

1. What is the present value of an ordinary annuity of Rs. 5,000 p.a. when the interest
rate is 7% for 8 years?
2. Calculate the present value of an ordinary annuity of Rs 6,000 received annually for 4
years when the discounting factor is 12%.
3. Find out the present value of an ordinary annuity of Rs. 30,000 annually over 3 years
@9% p.a.
4. Raman plans to lend Rs.1,00,000 for a period of 5 years at an interest rate of 12%.
How much money should he receive at the end of each year to recover the
investment back.
5. Rahul has borrowed 30,00,000 from Akruti Bank Ltd to finance the purchase of his
house for a period of 15 years. The rate of interest on such a loan is 24% p.a.
Compute the annual payment or installment.
NAME SURNAME

Present Value of Annuity Due Practice Problems

1. Mr. Sundaram is planning to retire this year. His company can pay him a lump sum
retirement payment of Rs. 2,00,000 or Rs. 25,000 life time annuity. Whichever he
chooses Mr. Sundaram is in good health & estimate to live for at least 20 more years.
If his expected return on investment is 12%, which alternative should he choose?
 Future Value of Money

The formula :

FV = PV (1+ )n x m

where,

FV is the future value

PV is the present value
m is the number of times per year compounding is made
n is the number of years
r is the future value interest factor (FVIF) rate of interest
 Future Value

1. If Mr. Desai invests in a savings bank account of Rs.1,000 at 5% interest

compounded annually, what amount will he get at the end of the year?
Sol: FV = 1000 x (1+0.05)1 = 1,050.00

2. If Mr. Desai invests the same with interest compounded semi-annually,

what amount will he get at the end of the year?
Sol: FV = 1000 x (1+0.05/2)1x2 = 1,050.625

3. If Mr. Desai invests the same with interest compounded quarterly for 2
years, what amount will he get at the of the year?
Sol: FV = 1000 x (1+0.05/4)2x4 = 1,050.945
 Future Value of Multiple Flows

Ram invests Rs. 1,500 at the beginning of the first year, Rs. 2,000 at the
beginning of the second year, and Rs. 5,000 at the beginning of the third year
at a rate of interest of 5% per annum. What will the accumulated value of all
these cash outflows be at the fifth year’s end?

Sol: FV = [1500 X (1.05)5 ]+ [2000 X (1.05)4 ]+ [5000 X (1.05)3 ]

 Future Value of Multiple Flows
The formula when investment is made at the end of the year :

𝐹𝑉𝑛 = 𝐶𝐹𝑡 (1 + 𝑟)

CF is the cash flow occurring at time t, r is the interest rate per period, n is
the number of periods

e.g. Ram invests Rs 500 at the end of the 1st year, Rs. 1,000 at the end
of the 2nd year, Rs. 1,500 at the end of the 3rd year, Rs. 2,000 at the end
of the 4th year and Rs. 2,500 at the end of the 5th year at a rate of
interest 5% per annum. What will be the accumulated value of all these
cash outflows be at the fifth year’s end?

Sol: FV = [500 x (1.05)4 ] + [1000 x (1.05)3 ] + [1500 x (1.05)2 ] + [2000 x (1.05)1 ] + [2500 x
(1.05)0 ] = Rs. 8019.13
 Future Value of Ordinary Annuity and Anuity Due
An annuity is used when cash flows are the same every year.
Year 1 Year 2 Year 3

Future Value (FVIFA) = 400 x (1+ r)1 + 400 (1+ r)2 + 400 x (1+r)3

Future Value (FVIFA) = 400 x {(1+ r)1 + (1+ r)2 + (1+r)3 }

FV Ordinary Annuity= A x [ ]

FV Annuity Due = A x x (1 + 𝑟)
 Future Value of an Ordinary Annuity
What amount will get accumulated on investing $1,000 at the end of each year for next 5
years at 5% p.a. interest rate?
Future value of an ordinary
Annuity (FVIFA)
1+𝑟 𝑛 −1
= Ax [ ]
𝑟

=1,000× (1+0.05)5−1
0.05
=1,000×5.53= 5,525.63
 Future Value of Annuity Due
What amount will get accumulated on investing $1,000 at the beginning of each year for
next 5 years at 5% p.a. interest rate?

Future value of annuity due

=Ax x (1 + 𝑟)

=1,000× (1+0.05)5−1 x 1.05

0.05
=1,000×5.53 x 1.05

= 5,801.91
 Future Value of Growing Annuity
You get an annual salary of Rs.10 lacs with a promised increment of 5%
annually for the next 5 years. Your required rate of return is 12%. What is
the future value of your earnings?

FV of growing annuity = 𝑃𝑉𝐺𝐴 x 1 + 𝑟 𝑛 = x 1− x 1+𝑟 𝑛

, , .
FV of growing annuity =
. .
x 1−
.
x (1+0.12)5
 Future Value Case-lets
• A bank offers to lend you Rs. 1,00,000 if you sign a note to repay Rs. 1,61,050 at
the end of five years. What rate of interest are you paying ?
Sol: 161050 = 100000 x (1+r)^5 , 161050/100000 = (1+r)^5 Therefore r = 10% (from Future Value table, 5 years)

• Jaichand is planning for his retirement. He is 45 years old today, & would like to
have Rs. 3,00,000 when he attains the age of 60. He intends to deposit a constant
amount of money at 12% each year in the public provident fund with SBI to
achieve his objective. How much money should Jaichand invest at the end of each
year for the next 15 years to obtain Rs. 3,00,000 at the end of that period?
Sol: 300000 = A x [(1.12^15 - 1)/0.12] = 300000/ FV of annuity (12%,15 years) = 300000 /37.279 = 8047.43

• A company has issued a debenture of Rs. 50 lakh to be repaid after 7 years. How
much should the company invest in a sinking fund earning 12% to repay
debenture?
Sol: 5000000 = A x [(1.12^7 - 1)/0.12] x 1.12= 5000000/ (10.089 x 1.12) = 4,42,490.41
Future Value Practice Problems

1. Rs. 2,000 is invested at an annual rate of interest of 10% per annum. What
is the amount after two years if compounding is done (a) annually (b) semi-
annually (c) quarterly (d) monthly?

2. Mr. Mukesh has invested Rs. 10,000 in a bank deposit for 2 years at 8%
interest p.a. How much will he receive at maturity?

3. Shashikant deposits Rs. 1,00,000 with a bank that pays 10% p.a. interest for
a period of 3 years. How much amount he would get at maturity?
NAME SURNAME

Future Value of Ordinary Annuity Practice Problems

1. If one invests Rs.25,000 at the end of each year at the rate of 8% p.a., to what
amount would this investment grow after 5 years?
2. Raju deposits Rs 2,000 at end of every year for a period of 5 years in his savings
account paying 5 % interest compounded annually. He wants to determine how much
money he will have at the end of the 5th year.
NAME SURNAME

Future Value of Annuity Due Practice Problems

1. Four equal payments of Rs. 5,000 are made into a deposit account that
pays 7.5% p.a. What is the future value of this annuity at the end of 4
years?
2. How much is required to be invested at the start of every year to
accumulate Rs. 3,00,000 at the end of 10 years if interest is compounded
annually at 10%?
NAME SURNAME

Excel formulas
1. Future Value =FV(rate,nper,pmt,[pv],[type])
2. Present Value =PV(rate,nper,pmt,[fv],[type])
3. Annuity = PMT(rate,nper,pv,[fv],[type])

where rate = measure of risk / expected return from the investment

nper = period of investment
pmt = equal instalment amount
type = timing of cash flows either beginning (1) or end of the period (0)
Loan Amortization Schedule

You have recently secured a job at Bajaj Finance. Mrs. Peswani intends to
purchase a property of 700 sq feet with one car parking space in Mira
Road for Rs. 1,30,00,000. She is capable of paying Rs. 60,00,000 as
down-payment. She intends to finance the balance amount through a
home loan against the property. She approaches you. Considering her
age, salary, and number of years to retirement, Bajaj Finance sanctions a
loan amount of Rs. 70,00,000 for a tenure of 10 years. As Mrs. Peswani’s
Cibil score is above 800 with no current loan in progress or EMIs, you
agree to give her the amount at 8.75% p.a. interest rate. Prepare a loan
amortization table to help her plan the monthly instalments for next 10
years.
Case-let
As in year 2020, Mr. Rastogi owns 2 flats in Borivali. He lives in one of the flats with his family. He
plans to sell the second flat for 20 lacs which he had purchased in 2001 for Rs. 5 lacs. He will have
to pay long-term capital gain tax (as he held the property for more than 24 months). He can save the
capital gain tax if he invests the money in NHAI and REC bonds for 5 years at a 5.75% interest rate.
Capital gain is computed as the difference between the indexed cost of the flat and the sale
proceeds. For the purpose of property valuation, in 2001 index was 100 and it is 280 in 2020. Mr.
Rastogi is planning to invest capital gain and sale proceeds from the property as follows:

1. Invest capital gain from the sale of the flat in NHAI bonds for 5 years at a 5.75% annual rate of
interest.
2. Invest Rs.5 lacs in a 5-year fixed deposit account of SBI at 8% interest rate payable quarterly.
3. Invest Rs.5 lacs in a zero coupon bond of a large public sector company that will repay
Rs.950000 after 5 years.
4. Invest the remaining amount in 13% 5-year bonds of private sector companies. The company
will repay bonds after 5 years at a premium of 10%.
Mr. Rastogi’s expected rate of return is 10%. Calculate the amount of capital gain, Future and
present values of all 4 investments, the effective rate on zero-interest bonds and 13% bonds.
Assignment

Case 1: You have an opportunity to purchase a property in Mira Road at Rs.50 lacs
which will give a rent of Rs. 2 lacs p.a. receivable at the end of the year. You expect the
property price to increase to Rs.60 lacs in next 2 years.
You can earn 12% p.a. return on investing the same money in a small case. Should you
purchase the property?

Case 2: Now assume that a banker approaches you and offers you to fund the
purchase at an interest rate of 8% p.a. Does your opportunity cost of capital or discount
rate now change to 8% instead of 12%?

Case 3: If you have an opportunity to invest in a similar project that guarantees you a
return on investment of 14%, does your opportunity cost of capital increase to 14% from
12%?
Single Cash Flow

𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝐹𝑎𝑐𝑡𝑜𝑟 = 1/ (1 + 𝑟)𝑛

𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝐹𝑎𝑐𝑡𝑜𝑟 = (1 + 𝑟)𝑛

𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 (𝐹𝑉𝑛) = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 (𝑃𝑉) 𝑋 (1 + 𝑟)𝑛 = (𝑃𝑉) × 𝐹𝑉𝐼𝐹(𝑛 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 ,𝑟%)

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 (𝑃𝑉) = Future V𝑎𝑙𝑢𝑒 (F𝑉) 𝑋 1/(1 + 𝑟)𝑛 = (F𝑉) × P𝑉𝐼𝐹(𝑛 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 ,𝑟%)