TIME VALUE OF MONEY

Time Value of Money

• Recognition of time value of money in

financial decision making is extremely
important.
• The objective of wealth maximization is
considered superior to the profit
maximization objective because the former
incorporates the timing of benefits received
while the latter ignores it.
 Why Consider Time Value of
Money
• A financial decision taken today has implications for a
number of years in future.
• For example, firms have to acquire fixed assets for which
they have to pay a certain sum of money to the vendors.
• The benefits arising out of acquisition of such assets will
be spread over a number of years in the future till the
working life of the assets.
• On the other hand, funds have to be procured from
different sources involving cash inflow at the time of
raising funds as well as an obligation to pay
dividend/interest and repayment of principal in future.
 Why Consider Time Value of
Money
• Financial decisions are made on the basis of comparison
of cash outflows and cash inflows.

• For a meaningful comparison, the two variables must be

strictly comparable.

• For this purpose, it is necessary to convert the cash flows

to a common point of time.

• This is done by incorporating the time element in the

calculation.
 Why Consider Time Value of
Money
• Time value of money is also important due to the following
reasons
• Preference for current consumption over future consumption
• Productivity of capital due to reinvestment income
• Inflation
 Time Lines
• Time lines are an important tool in visualizing a problem
in time value analysis.
• The intervals from 0 to 1, 1 to 2, and 2 to 3 are time
periods such as years or months or some other time period.
• Time 0 is today and it is the beginning of period 1.
• Time 1 is one period from today. It is both the end of
period 1and the beginning of the period 2; and so forth.
• Each tick mark corresponds to both the end of one period
and the beginning of the next.
• Cash flows are shown directly below the tick marks.
• Each problem starts with setting up a time line to illustrate
the situation.
• Thereafter, an equation is solved using a regular calculator,
or a financial calculator or a spreadsheet to find the answer
 TIME LINE
Part A

0 1 2 3 4 5

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

Part B

0 1 2 3 4 5

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

 Future Value of a Single Amount
• The techniques that are used to convert cash flows to a
common point of time are compounding and discounting.
• Compounding Technique can be used to compute the future
value of an investment
• The future value of an investment can be calculated by the
following equation:
FVn = PV(1+r)n
Where FVn = Future value n periods hence
P V = Present value
r = rate of interest per period
n = number of periods over which cash flows
occur
 Future Value Interest Factor
• The factor (1+r)n is called the Future Value Interest Factor
(FVIF) and can be referred to from standard tables.

• 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

 More Frequent Compounding
• If interest is compounded more than once a year, the future
value can be calculated by the following formula:
mn
 r
FVn = PV 1 + m 
 

• where m is the number of times per year compounding is

made.
• For semi-annual compounding m is 2, for quarterly
compounding it is 4, for monthly, weekly and daily
compounding it is 12, 52 and 365 respectively.
 Example
Mr. X invests Rs. 1,000 in a two year time deposit which
yields 12% interest. Calculate the amount that he will get
after two years assuming that interest is compounded (i)
annually (ii) semi-annually (iii) quarterly (iv) monthly

(i) Rs.1000*1.2544=Rs.1,254.40 (1.12)^2=1.2544

(ii) Rs.1,000*1.2625 = Rs.1262.50 (1.06)^4=1.2625
(iii) Rs.1,000*1.2668 =Rs.1266.80 (1.03)^8=1.2668
(iv) Rs. 1,000*1.2697 = Rs.1269.70 (1.01)^24=1.2697
 Continuous Compounding
• When the compounding frequency m approaches infinity, the
term (1+r/m)mn approaches e rn where e is approximately
2.71828.
• The terminal value at the end of n years of an initial deposit of
X0 when the rate of interest is compounded continuously at a
rate of r is :
TVn=X0ern
• For example, the terminal value of a Rs.100 initial investment
after 3 years at a continuously compounded interest rate of 8%
is 100*(2.71828)(0.08*3)=Rs.127.12.
• The terminal value with annual, semiannual, quarterly, and
monthly compounding is Rs.125.97, Rs.126.53, Rs.126.82, and
Rs.127.02, respectively. Continuous compounding results in the
maximum terminal value.
Future/Compounded Value of a Series of Payments
• In the case of a series of payments, compounding is done for
each payment separately and their sum represents the
compounded value of the series.

Mr. X deposits each year Rs. 500, Rs. 1000, Rs. 1,500, Rs
2,000 and Rs. 2,500 in his saving bank account for 5
years. The interest rate is 5%. Find out the value of his
deposits at the end of the 5th year. (deposits are made at year-end)
Deposit FVIF Compound Deposit FVIF Compound
Value Value
Rs. 500 1.216 Rs. 608 Rs. 2,000 1.050 Rs.2,100
Rs. 1,000 1.158 Rs.1,158 Rs.2,500 1.000 Rs.2,500
Rs. 1,500 1.102 Rs. 1,653 Total Rs.8,019
 Future Value of an Annuity
• An annuity is a stream of equal annual or periodic cash
flows. In the case of an ordinary(deferred) annuity, the
cash flows occur at the end of each period. In the case of
an annuity due, the cash flows occur at the beginning of
each period.
• The future value of an annuity can be calculated either as a
sum of compound value of a series of payments or simply
by multiplying the periodic cash flow by the appropriate
future value interest factor annuity (FVIFA) which are
available for a wide range of r and n.
• The following formula may be used to calculate the future
value of an ordinary annuity
• Future value of an annuity = A [(1+r)n-1]
----------------
r
 FUTURE VALUE OF AN ANNUITY
• An annuity is a series of periodic cash flows (payments and
receipts ) of equal amounts (r=10%p.a., n=5)
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 =1000[(1.1)5 -1)]/0.1
=6,105
 Example
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
 Example 2
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.2,000,000 = Rs.314,812
6.353
 Example3
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 6 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
 FINDING THE INTEREST RATE
A finance company advertises that it will pay a lump sum of Rs.8,000 at the end of 6
years to investors who deposit annually Rs.1,000 for 6 years. What interest rate is
implicit in this offer?
The interest rate may be calculated in two steps :
1. Find the FVIFAr,6 for this contract as follows :
Rs.8,000 = Rs.1,000 x FVIFAr,6
FVIFAr,6 = Rs.8,000 = 8.000
Rs.1,000
2. Look at the FVIFAr,n table and read the row corresponding to 6 years
until you find a value close to 8.000. Doing so, we find that FVIFA12%,6 is 8.115 and
FVIFA11%,6 is 7.9129. So, we conclude that the interest rate is slightly below 12
percent. The exact rate can be found using interpolation as follows:
=11%+(8.0-7.913)/(8.115-7.913)=11.43%
 HOW LONG SHOULD YOU WAIT
You want to take up a trip around the world which costs Rs.1,000,000. The cost is
expected to remain unchanged in nominal terms. You can save annually Rs.50,000 to
fulfill your desire. How long will you have to wait if your savings earn an interest of
12 percent ? The future value of an annuity of Rs.50,000 that earns 12 percent is
equated to Rs.1,000,000.
50,000 x FVIFAn=?,12% = 1,000,000
50,000 x 1.12n – 1 = 1,000,000
0.12
1.12n - 1 = 1,000,000 x 0.12 = 2.4
50,000
1.12n = 2.4 + 1 = 3.4
n log 1.12 = log 3.4
n x 0.0492 = 0.5315
n = 0.5315 = 10.8 years
0.0492
You will have to wait for about 11 years.
 Present Value of a Single Amount
• Present values are calculated using the discounting technique.
• The following equation is used to find the present value of an
amount to be received or spent in future:

PV = FVn 1/ (1 + r ) n 
• The factor 1/(1+r)n is called the discounting factor or present
value interest factor (PVIFr,n) .

• The values of PVIFr,n for various combinations of r and n are

available from standard tables.
 PRESENT VALUE OF A SINGLE AMOUNT

PV = FVn [1/ (1 + 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

 Present Value of an Annuity

• The present value of an annuity can be calculated :

• Either as a sum of present value of a series of payments, or
• Simply by multiplying the periodic cash flow by the appropriate
present value interest factor annuity (PVIFAr,n) which are
available for a wide range of r and n.
• The following formula may be used to calculate the present
value of an immediate (ordinary) annuity ( A is the periodic
constant cash flow)  1 
1 − (1 + r ) n 
PV of an annuity = A  
 r 
 
 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

Year Beginning Annual Interest Principal Remaining

Amount Instalment Repayment Balance
(1) (2) (3) (2)-(3) = (4) (1)-(4) = (5)
1 1,000,000 298,312 150,000 148,312 851,688
2 851,688 298,312 127,753 170,559 681,129
3 681,129 298,312 102,169 196,143 484,986
4 484,986 298,312 727,482 225,564 259,422
5 259,422 298,312 38,913 259,399 23*

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
 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 an Infinite Life
Annuity (Perpetuity)
• An annuity that goes on for ever is called a perpetuity.
• The present value of a perpetuity of an amount A can be
calculated as A/r

Example: Find the present value of a perpetual annuity of

Rs. 500 assuming an interest rate of 5 percent.

PV of Perpetuity = Rs.500/0.05 = Rs. 10,000

 ANNUITY DUE

A A … A A
Ordinary
annuity
0 1 2 n–1 n

A A A … A
Annuity
due
0 1 2 n–1 n

Thus,
Annuity due value = Ordinary annuity value (1 + r)
This applies to both present and future values
 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
 EFFECTIVE VERSUS NOMINAL RATE

r = (1+k/m)m –1
r = effective rate of interest
k = nominal rate of interest
m = frequency of compounding per year
Example : 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
 Finding the Growth Rate
• If the revenue of a company grows from Rs.100 million to
Rs.1000 million in 10 years, the growth rate g is:

• 100(1+g)10 =1000
• (1+g)10 = 10
• 1+g = 101/10
• = 1.26
• g = 0.26 or 26%
 Valuing an Infrequent Annuity
• A person receives an annuity of Rs.50,000, payable once
every two years. The payments will be received over a
period of 30 years. The first payment will be received at
the end of two years. The interest rate is 8% p.a. The PV of
the annuity will be calculated as follows:

• Interest rate for 2 years = (1+0.08)2 -1= 16.64%

• There will be 15 payments.
• PV = Rs.50,000[{1-(1/(1.1664)15 }]/0.1664 = Rs.270,620
 Excel Function FV
• The FV function can be used to find the future value of a single
cash flow, ordinary annuity or an annuity due.
• The syntax of the function is:
• FV(rate, nper, pmt, pv, type)
• Rate is the interest rate per period.
• Nper is the total number of payment periods in an annuity.
• Pmt is the payment made over the period. It does not change
over the life of the annuity.
• Pv is the present value or the lump sum amount that a series of
future payments is worth right now. It is ignored when
calculating the FV of an annuity
• Type is denoted by number 0 or 1. It indicates when payments
are due. The number is 0 for an ordinary annuity and 1 for an
annuity due. The default value is 0.
 Excel Function PV
• The PV function can be used to find the present value of a single
cash flow, ordinary annuity or an annuity due.
• The syntax of the function is:
• PV(rate, nper, pmt, fv, type)
• Rate is the interest rate per period.
• Nper is the total number of payment periods in an annuity.
• Pmt is the payment made over the period. It does not change
over the life of the annuity.
• Fv is the future value or a cash balance you want to attain after
the last payment is made. It is ignored when calculating the PV
of an annuity.
• Type is denoted by number 0 or 1. It indicates when payments
are due. The number is 0 for a regular annuity and 1 for an
annuity due. The default value is 0.
 Excel Function PMT
• The function can be used to calculate the periodic
contribution required to attain a target sum (sinking fund) or
to calculate equated installments to pay off a given loan
(capital recovery).
• The syntax of the function is:
• PMT(rate, nper, pv, fv, type)
• Rate is the interest rate per period.
• Nper is the total number of payments.
• Fv is the future value or a cash balance you want to attain
after the last payment is made.
• Type is denoted by number 0 or 1. It indicates when payments
are due. The number is 0 for a regular annuity and 1 for an
annuity due. The default value is 0.
 Excel Function IRR
• The function calculates the internal rate of return for a series of
cash flows represented by numbers in values. The IRR is the
discount rate that equates the PV of expected cash outflows
with the PV of expected cash inflows.
• These cash flows do not have to be even, as they are for an
annuity.
• However, the cash flows must occur at regular intervals, such
as monthly or annually.
• The syntax of the function is IRR(values, guess).
• Values are an array or a reference to cells that contain numbers
for which IRR is to be calculated. Values must contain at least
one positive value and one negative value.
• Guess is a number that you guess is close to the result of IRR.
If it is omitted, it is assumed to be 0.1(10 percent).
 Excel Function IPMT
• The function can be used to calculate the interest component
of an equated installment.
• The syntax of the function is:
• IPMT(rate, per, nper, pv, fv, type)
• Rate is the interest rate per period.
• Per is the period for which you want to find the interest
• Nper is the total number of payment periods.
• Pv is the present value or the lump sum amount that a series
of future payments is worth right now
• Fv is the future value or a cash balance you want to attain
after the last payment is made.
• Type is denoted by number 0 or 1. It indicates when payments
are due.
 Excel Function PPMT
• The function can be used to calculate the principal
component of an equated installment.
• The syntax of the function is:
• PPMT(rate, per, nper, pv, fv, type)
• Rate is the interest rate per period.
• Per is the period for which you want to find the interest
• Nper is the total number of payment periods.
• Pv is the present value or the lump sum amount that a
series of future payments is worth right now
• Fv is the future value or a cash balance you want to attain
after the last payment is made.
• Type is denoted by number 0 or 1. It indicates when
payments are due.