Chapter - 1

TIME VALUE OF MONEY

- Prof. Geetika Gahlot

 The idea that money available at the present time

is worth more than the same amount in the
future due to its potential earning capacity is
called the time value of money.
This core principle of finance holds that, provided
money can earn interest, any amount of money is
worth more the sooner it is received.
Thus, the time value of money demonstrates
that, all things being equal, it is better to have
money now rather than later.
Geetika Gahlot

1. TIME LINE
Dealing with cash flows that occur at different points in
time is made easier using a time line that shows both
the timing and the amount of each cash flow in a stream.
Thus, a cash flow stream of Rs 1000/- at the end of each
of the next 4 years can be depicted on a time-line as
below:
1000
0

Year 1

1000
Year 2

1000
Year 3

1000
Year 4

In the above figure, 0 refers to present time. A cash flow

that occurs at time 0 is already in present value and
does not require adjustment
for time value of money.
Geetika Gahlot

 A distinction must be made between a period of

time and a point in time.
The portion of the time-line between 0 and 1
refers to period 1.
The cash flow that occurs at the point in time "1"
refers to the cash flow that occurs at the end of
period 1.
Cash flows can be either positive or negative;
positive cash flows are called cash inflows and
negative cash flows are called cash outflows.
Geetika Gahlot

2. COMPOUND INTEREST
The notion of compound interest is central to
the understanding of the mathematics for
finance.
The term implies that interest on the principal
for a period is added to the principal for the
next period, and so on.
As a result, interest is also earned on interest.

Geetika Gahlot

(a) Compound interest in case of simple cash flow:

Suppose a person has taken a loan of P @ r% p.a. for
two years with interest compounded annually. The
Future Value (FV) or Terminal Value (TV) at the end of
year 1 would be:
FV1 = Principal (P) + Interest on P
= P + Pr = P (1+r)
Similarly, the Future Value at the end of year 2 would be
Principal amount at the beginning of year 2 plus interest
thereon:
FV2 = FV1 + FV1r = FV1 (1+r)
= P (1+r)(1+r) = P (1+r)2
Geetika Gahlot

 Thus, Future Value at the end of year n would be:

FVn = P (1+r)n
or
FVn = P FVIF(n,r)
where FVIF(n,r) = Future Value Interest Factor for n
years @ r%.
Q: Mr. X deposited Rs.75,000/- in a company fixed deposit for a
period of 10 years that pays interest @ 12% p.a., compounded
annually. What amount would he receive at the end of year 10?
Ans: Given: P = Rs 75,000; r = 12% p.a.; n = 10 years. Required: A10
An = P (1+r)n
A10 = 75,000 (1+0.12)10
or A10 = 75,000 FVIF (10,12%)
= 75,000 3.106 = Rs 2,32,950
Geetika Gahlot

(b) Compound Value of an Annuity:

Annuity is a fixed amount of payment (or receipt) paid
(or received) in each year (period) over a specified
period of time.
Mathematically, Compound value (Future Value) of an
annuity is given as follows:
FV of an Annuity = P (1+r)n 1
r
or
FV of an Annuity = P FVIFA (n,r)
E.g.: Recurring deposit with a Bank. Suppose, Rs
10,000/- is being deposited for a period of 3 years (at the
end of each year) with the deposit earning interest @ 6%
p.a.
Geetika Gahlot

(c) Compounding more than once a year (Multiperiod compounding):

Future Value at the end of n years where interest is paid
m times a year is:
FVn = P (1+r/m)nm

(d)
Continuous
Compounding):

Compounding

(Daily

As m approaches infinity (), the term (1+r/m)

approaches ern (where e =2.71828 and is defined as
e = limit (1+1/m)m. Thus future value, in case of Daily
Compound is:
A = P ern
Geetika Gahlot

(e) Sinking fund:

How much amount should be kept aside each year,
which together with the interest thereon, is equal to a
target amount.
Q: Suppose the target amount required to be saved by the
end of 6 years is Rs.55,800/- and the rate of interest is
6% p.a., what amount should be invested every year,
which together with the interest thereon is equal to the
target amount?
Ans: Given: FV6 = 55,800/-; n = 6 years; r = 6% p.a.
FV6 = P FVIFA (6,6%)
55,800 = P 6.975
Geetika=
Gahlot
P= 55,800/6.975
Rs. 8,000/-

(f) Doubling period:

Investors commonly ask: How long would it take to
double the amount at a given interest rate? The
following thumb rules gives us the approximate doubling
period:
Rule of 72: Divide 72 by the interest rate
o If r = 8%; then the doubling period = 72/8 = 9 years
o If r = 4%; then the doubling period = 72/4 = 18 years
Rule of 69 (more accurate): 0.35+ 69/Interest Rate
o If r = 8%; then the doubling period = 0.35 + 69/8 = 8.975
years
o If r = 10%; then the doubling period = 0.35 + 69/10 = 7
years
Geetika Gahlot

(g) Finding the Compounded Average

Growth Rate (CAGR):
Suppose the CAGR of the following sales figures have to
be calculated.
Years

Sales (Rs.
Lacs)

2001

2002

2003

2004

2005

2006

50

57

68

79

86

99

1. Find ratio of Sales of last year (2006) to first year (2001)

= 99/50 = 1.98
2. Use FVIF table and look at row for year 5 (6-1) till you
find the value nearest to 1.98, and then read the interest
rate corresponding to that value. That would be the
CAGR.
Geetika Gahlot

(h) Effective Vs. Nominal Rate:

When interest is compounded more than once in a given
period of time, it is called Multi-period Compounding.
If r is the nominal interest rate for a period, the effective
interest rate (r*) will be more than the nominal interest
rate, since interest on interest within a year will also be
earned.
EIR = (1+r/m) m 1
Q: A bank offers interest @8% p.a. which is compounded
quarterly compounding. What is the effective rate of interest?
Ans: EIR = (1+r/m)m 1
= (1+0.08/4)4 1
Geetika Gahlot
= 1.0824 1 = 0.824
= 8.24%

3. PRESENT VALUE
Cash Flows may occur at different time periods
in the future.
Cash flow occurring at the end of 2nd year is not
equal to the cash flow occurring at the end of 1st
year because of Time Value of Money (TVM).

Geetika Gahlot

Why a cash flow in the future is

worth less than a similar cash flow
today?

Geetika Gahlot

 Preference for present consumption over future

consumption: People would have to be offered more in
the future to give up present consumption.
Inflation: The value of currency decreases over time. The
greater the inflation, the greater the difference in value
between a cash flow today and the same cash flow in the
future.
Uncertainty: A promised cash flow might not be
delivered for a number of reasons: the promisor might
default on the payment, the promisee might not be
around to receive payment; or some other contingency
might intervene to prevent the promised payment or to
reduce it. Any uncertainty (risk) associated with the cash
flow in the future reduces the value of the cash flow.
Geetika Gahlot

 The process by which future cash flows are

adjusted to reflect these factors is called
discounting, and the magnitude of these factors is
reflected in the discount rate.
Thus, the cash flows in different time periods have
to be made comparable by converting them into
present values.
The process of calculating the present value of the
future cash flows is called discounting and the
interest rate used for discounting is called the
discount rate.
Geetika Gahlot

(a) Present Value of a simple cash flow:

Discounting a cash flow converts it into present
value rupees and enables the user to do several
things.
First, once cash flows are converted into present
value rupees, they can be aggregated and
compared.
Second, if present values are estimated correctly,
the user should be indifferent between the future
cash flow and the present value of that cash flow.
Geetika Gahlot

 From our understanding of compound value, we know

that FVn = P (1+r)n , hence
P = FVn/(1+r)n
or
P = FV PVIF(n,r)
where PVIF(n,r) = Present Value Interest Factor for n
years @ r%.
Q: Find the present value of Rs.50,000/- to be received at
the end of 10 years, discounting rate being 12% p.a.
Ans: FV = 50,000; n = 10 years; r = 12% Required = P
P = FV PVIF (10, 12%)
P = 50,000 0.322 = Rs.16,100/Geetika Gahlot

(b) Present Value of an Annuity:

The present value of an annuity may be estimated by
discounting each of the cash flows back to the present
and aggregating the present values.
Mathematically, present value of an annuity is given as
follows
PV of an Annuity = A (1+r)n 1
r(1+r)n
or
PV of an Annuity = A PVIFA (n,r)

Geetika Gahlot

(c) Capital Recovery Factor:

It is the inverse of the Present Value Interest Factor
Annuity and is useful in determining the income to be
earned to recover an investment at a given interest rate.
Q: Mr. X plans to invest Rs.10,000/- @ 10% pa. for a period of 4
years. What income should he earn from the investment so
as to recover his investment over the next 4 years?
Ans: P = 10,000; n = 4 years; r = 10%. Required = A
P = A PVIFA (n, r)
10,000 = A PVIFA (4,10%)
A = 10,000/PVIFA (4,10%)
Geetika=Gahlot
A = 10,000/3.170
Rs.3,154.57

4. ANNUITY DUE
The concepts of compound value and present
value of an annuity discussed so far are based on
the assumption that the series of payments
(receipts) are made at the end of each period.
Such payments can however, be made at the
beginning of the period as well.
Such series of fixed payments starting at the
beginning of each period for a specified number
of periods is called an Annuity Due.
Geetika Gahlot

(a) Present Value of Annuity Due:

In general, the present value of a beginning ofthe-period annuity over n years can be written as
follows:
PV of Annuity Due = A + A (1+r)n 1
r(1+r)n

This present value will be higher than the present

value of an equivalent annuity at the end of each
period.
Geetika Gahlot

(b) Compound Value of Annuity Due:

The future value of a beginning-of-the period
annuity typically can be estimated by allowing for
one additional period of compounding for each
cash flow:
FV of Annuity Due = A(1+r) (1+r)n 1
r
This future value will be higher than the future
value of an equivalent annuity at the end of each
period.
Geetika Gahlot

5. GROWING ANNUITY
A growing annuity is a cash flow that grows at a constant
rate for a specified period of time.
If A is the current cash flow, and g is the expected
growth rate, the time-line for a growing annuity appears
as follows:

A(1+g)

A(1+g)2

A(1+g)3 .. A(1+g)n

Note that, to qualify as a growing annuity, the growth

rate in each period has to be the same as the growth
rate in the prior period.
Geetika Gahlot

Present Value of a Growing Annuity:

In most cases, the present value of a growing annuity
can be estimated by using the following formula:
PV of Growing Annuity = A(1+g) [{1-(1+g)n/(1+r)n} / (r-g)]

The present value of a growing annuity can be estimated

in all cases, except when the growth rate is equal to the
discount rate. In such a case, the present value is equal
to the nominal sums of the annuities over the period,
without the growth effect.
PV of Growing Annuity for n years (when r=g) = n A
Geetika Gahlot

6. PERPETUITY
Perpetuity is a constant cash flow at regular intervals
forever.
The present value of perpetuity can be written as:
PV of Perpetuity = A / r
where A is the perpetuity.
The future value of perpetuity is infinite.
Q: Assume that you have a 6% irredeemable preference share
of face value Rs 1000/-. What is the value of this preference
share if the discount rate is 9%?
Ans: Value of Irredeemable Preference Share = Rs 60/9% = Rs
Geetika Gahlot
667/-

7. GROWING PERPETUITY
A growing perpetuity is a cash flow that is expected to
grow at a constant rate forever.
The present value of a growing perpetuity can be written
as:
PV of a Growing Perpetuity = CF1 / (r-g)
where CF1 is the expected cash flow next year, g is the
constant growth rate and r is the discount rate.
While a growing perpetuity and a growing annuity share
several features, the fact that a growing perpetuity lasts
forever puts constraints on the growth rate. It has to be
less than the discount rate for this formula to work
Geetika Gahlot

1. If you invest Rs 5,000 today at a compound interest of

9%, what will be its future value after 75 years?
2. If the interest rate is 12%, what are the doubling periods
as per the rule of 72 and the rule of 69 respectively?
3. A borrower offers 16% nominal rate of interest with
quarterly compounding. What is the effective rate of
interest?
4. Fifteen annual payments of Rs 5,000 are made into a
deposit account that pays 14% interest per year. What is
the future value of this annuity at the end of 15 years?
5. A finance company advertises that it will pay a lump
sum of Rs 44,650 at the end of five years to investors
who deposit annually Rs 6,000 for 5 years. What is the
interest rate implicit in this
offer?
Geetika Gahlot

6. What is the present value of Rs 10,00,000 receivable 60

years from now, if the discount rate is 10%?
7. What is the present value of the following cash stream
if the discount rate is 14%?
Year

Cash Flow

5,000

6,000

8,000 9,000 8,000

8. Mahesh deposits Rs 2,00,000 in a bank account which

pays 10% interest. How much can he withdraw annually
for a period of 15 years?

Geetika Gahlot