Prasanna Chandra

6e

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FUNDAMENTALS OF
FINANCIAL MANAGEMENT
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THE TIME VALUE OF
MONEY
Chapter 8
 OUTLINE

▪ Why Time Value

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▪ Future Value of a Single Amount
▪ Future Value of an Annuity
▪ Present Value of a Single Amount
▪ Present Value of an Annuity
 WHY TIME VALUE
A rupee today is more valuable than a rupee a year

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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.
 FUTURE VALUE OF A
SINGLE AMOUNT
Rs

First year: Principal at the beginning 1,000

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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
 VALUE OF FVr,n FOR VARIOUS
COMBINATIONS OF r AND n

n/r 6 % 8 % 10 % 12 % 14 %

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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
72

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Doubling periodInterest
= rate
Interest rate : 15 percent
72
Doubling period15 = = 4.8 years

A more accurate thumb rule : Rule of 69

69
Doubling period = 0.35 + Interest rate
Interest rate : 15 percent
69
Doubling period =150.35 + = 4.95 years
 SHORTER
COMPOUNDING PERIOD
Future value = Present value 1+ r mxn
m

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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
 EFFECTIVE VERSUS
NOMINAL RATE
r = (1+k/m)m –1
r = effective rate of interest

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

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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

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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 (FVA11%,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

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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
FVA 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

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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 :
FVAn=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

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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 FVAr,6 for this contract as follows :
Rs.8,000 = Rs.1,000 x FVAr,6
FVAr,6 = Rs.8,000 = 8.000
Rs.1,000
2. Look at the FVAr,n table and read the row corresponding to 6 years
until you find a value close to 8.000. Doing so, we find that
FVA12%,6 is 8.115So, we conclude that the interest rate is slightly below 12
percent.
 HOW LONG SHOULD YOU WAIT
You want to take up a trip to the moon 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

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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 FVAn=?,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
AN ANNUITY
1 1- (1+r)n
Present value of an annuity = A r

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Value of PVAr,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 2.312 3.170 3.037 2.914
64.917 4.623 4.355 4.111 3.889
86.210 5.747 5.335 4.968 4.639
107.360 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 PVAn =5, r =15%

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= 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 instalment minus interest.
*Due to rounding off error a small balance is shown
 EQUATED MONTHLY
INSTALMENT

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

1,000,000 = A x 1-1/(0.01)180
0.01
A = Rs.12,002
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PERPETUITY
PRESENT VALUE OF