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Introduction
For example: (i) When interest on funds raised will have to be paid;
Thus, the fundamental principle behind the concept of time value of money is that
a sum of money received today is worth more than if the same is received after
some time. For example, if an individual is given an alternative either to receive
Rs. 10,000 now or after six months; he will prefer Rs. 10,000 now. This may be
because he may be in a position to purchase more goods with this money than
what he is going to get for the same amount after six months.
Time value of money or time preference for money is one of the central ideas in
finance. It becomes important and some time vital consideration in decision
"Taking”. This will be clear with the following examples.
Example 1: A project needs an initial investment of Rs. 1,00,000. It is expected
to give a return of Rs. 20,000 p.a. for six years at the end of each year. The
project thus involves a cash outflow of Rs. 1,00,000 in the 'zero year' and cash
inflows of Rs. 20,000 per year for six years. In order to decide whether to accept
or reject the project, it is necessary that the present value of cash inflows
received annually for six years is ascertained and compared with the initial
investment of Rs. 1,00,000. The firm will accept the project only when the
present value of the cash inflows at the desired rate of interest is at least equal to
initial investment of Rs. 1,00,000.
Example 2: A firm has to choose between two projects. One involves an outlay
of Rs. 10 crores with a return of 12% from the year one for ten years. The other
requires an investment of Rs. 10 crores with a return of 14% p.a. for 15 years
commencing with the beginning of the sixth year of the project. In order to make
a choice between these two projects, it is necessary to compare the cash
outflows and the cash inflows resulting from the project. In order to make a
meaningful comparison, it is necessary that the two variables are strictly
comparable. This is possible only when the time element is incorporated in the
relevant calculations.
The above examples reflect the need of comparing the cash flows arising at
different points of time in decision - making.
"Illustration 2.1: Rs. 1,000 invested at 10% is compounded annually for three
years. Calculate the Compounded value after three years.
Solutions:
1OOOx 11 = 1,100]
100
Amount at the end of 2nd year will be: 1210
Computation by this formula can also become very time consuming if the number
of years become large, say 10, 20 or more. In such cases to save upon the
computational efforts, Compound Value table* can be used. The table gives the
compound value of Re. 1, after n years for a wide range of combination of ‘I’ and
'n’
For instance, in the above illustration Table gives the compound value of Re. 1 at
10% p.a. at the end of 3 years as 1.331. Hence, the compound value of Rs.
1,000 will amount to:
Formula:
A = (P+ i/m) mx n
Where,
A = Amount after a period.
P = Amount in the beginning of the period.
i = Interest rate
M = Number of times per year compounding is made.
n = Number of years for which compounding is to be done.
Illustration 2.2: Calculate the compounded value when Rs. 1,000 is invested for
3 years and the interest on it is compounded at 10% p.a. semi-annually.
Illustration 2.3: Mrs. Manju invests Rs. 500, Rs. 1,000, Rs. 1,500, Rs. 2,000 and
Rs. 2,500 at the end of each year. Calculate the compound value at the end of 5
years compounded annually when interest is charged at 5% p.a.
Solution:
It may be noted here that we are making use of the Compound interest formula
for each payment separately. For instance, Rs. 500 put in at the end of the first
year compounds for four years, and has a future value of Rs. 608 at 5% interest
[Rs. 500 (1 + 0.05)4]. Similarly, Rs. 1,000 deposited at the end of 2 year
compounds for 3 years and amounts to Rs. 1,158 [Rs. 1000 (1 + 0.05) 3] and so
on.
Rs. 8,020.50
Compound Sum of an Annuity:
An annuity is a stream of equal annual cash flows. Annuities involve
calculations based upon the regular periodic contribution or receipt of a fixed
sum of money.
Illustration 2.4: Mr Ramesh deposits Rs. 2,000 at the end of every year for
5 years in his saving account paying 5% interest compounded annually.
Determine how much sum of money he will have at the end of the 5th year.
Solution:
End of Amount Number of Compounded Future
Year deposited Years Compounded Interest factor Sum
From Table 3
1 2 3 4 5
1 Rs. 2,000 4 1.216 Rs. 2,432
2 Rs. 2,000 3 1.158 2,316
3 2,000 2 1.103 2,206
4 2,000 1 1.050 2,100
5 2,000 0 1.000 2,000
Amount at the end of 5th Year == Rs. 11,054
OR
Taking out the common factor Rs. 2,000
= Rs. 2,000 (1.216 + 1.158 + 1.103 + 1.050 +1.000)
= Rs. 2,000 (5.527)
= Rs. 11,054
From the above, it follows that in order to find the sum of the annuity, the
annual amount must be multiplied by the sum of the appropriate compound
interest factors. Such calculations are available for a wide range of i and n.
They are given in Table. To find the answer to the annuity question of
illustration 2.4 we are required to look for the 5% column and the row for the
fifth year and multiply the factor by annuity amount of Rs. 2000. From the
table we find that the sum of annuity of Re. 1 deposited at the end of each
year for 5 years is 5.526 (IF). Thus, when multiplied by Rs. 2,000 annuity (A)
we find the total sum as Rs. 11,052.
Symbolically, Sn = IFxA
Where,
A - is the value of annuity
IF - represents the appropriate factor for the sum of the annuity of Re. 1
Sn - represents the compound sum of an annuity.
Annuity tables are great innovations in the field of investment banking as they
guide the depositors and investors as to what sum an amount (X) paid for
number of years, n, will accumulate to at a stated rate of compound interest.
Illustration 2.5: Find the compound value of annuity, when three equal yearly
payments of Rs. 2,000 are deposited into an account that yields 7% compound
interest.
Solution: The Annuity Table gives the compound value as 3.215 when Re. 1 is
paid every year for 3 years at 7%. Thus, the compounded value of annuity of Rs.
2,000 is:
Sn = IFxA
Sn = 3.215x2000
Sn = 6,430
The concept of present value is the exact opposite of that of compound value.
In case of compounding we calculate the future value of a sum of money or
series of payments, while in case of present value concept, we estimate the
present worth of a future payment/installment or series of payments adjusted for
the time value of money. The basis of present value approach is that opportunity
cost exists for money lying idle. That is to say, that interest can be earned on the
money. This return is termed as 'discounting rate'.
Given a rate of interest, the present value of future rupee will always be
lower. The technique for finding the present value is termed as
'discounting'.
Formula:
PV = ----------
(1 + I )n
Where:
i = Interest rate.
n = Number of years.
With this formula, we can directly calculate the amount, any depositor
would be willing to sacrifice at present, with a time preference rate or
discount rate of x %.
Example: If Mr X, depositor, expects to get Rs. 100 after one year at the
rate of rate of 10 % the amount he will have to forego at present can be
calculated as follows:
PV = A_
(1 + i)n
C1 C2 G3 Cn
PV = —— + —— + --------- + -------
(1 + i)1 (1 + i)2 (1 + i)3 (1+i)n
Where,
PV = sum of individual present values of each cash flow; C1, C2, C3.........
Cn = Cash flows after period 1, 2, 3...........n
i = Discounting rate.
However, a project may involve a series of cash inflows and outflows. The
computation of the present value of inflows by the above equation is a tedious
problem. Hence, present value Table is used (i.e. Table 1)
Illustration 2.6: Given the time value of money as 10% (i.e. the discounting
factor), You are required to find out the present value of future cash inflows that
will be received over next four years.
Solution:
1 2 3 4(2x3)
Year Cashflows Present Value Present
Factor at 10% value
1 1,000 0.909 909
2 2,000 0.826 1,652
3 3,000 0.751 2,253
4 4,000 0.683 2,732
Present value of series of Cash flows 7,546
Present value of an Annuity: In the above case there was a mixed stream of
cash inflows. An individual or depositor may receive only constant returns over a
number of years. This implies that the cash flows are equal in amount. To find
out the present value of annuity either we can find the present value of each
cash flow or use the annuity table. The annuity table gives the present value of
an annuity Re. 1 for interest rate over number of years 'n'.
Illustration: Calculate the present value of annuity of Rs. 500 received annually
for four years, when discounting factor is 10%.
Solution:
Present Value of Annuity of Rs. 500
1 2 3 4
Year Cash Inflows Present Present
Value factor value
@ 10% (2 x3 )
1 500 0.909 454.50
2 500 0.827 413.50
3 500 0.751 375.50
4 500 0.683 341.50
3.170 -----------
Present value of annuity of Rs. 500 1,585.00
This basically means add up the Present Value Factors and multiply with Rs. 500
i.e., 3.170 x 500 = Rs. 1,585
The figure of 3.170 has been picked up directly from the Annuity Table for
present value (Table 2).
Illustration 2.8: Find out the present value of an annuity of Rs. 5,000 over 3
years when discounted at 5%
Solution:
PVAn = A x ADF
5000 x 2.773 =
13,865
Where PVAn = Present value of an annuity having a duration of ‘n’ periods
A = Value of single installment
ADF = Annuity Discount Factor
P = A = 5000 = 50,000
I .10
Illustration 2.10
Mr. Nandan intends to have a return of Rs. 10,000 p.a. for perpetuity. Incase the
discount rate is 20%, calculate the present value of this
perpetuity.
Solution:
P= A = 10000 =50,000
i .20
This means that Mr. Nandan should invest Rs. 50,000 at 20% to get an
annual return of Rs. 10,000 for perpetuity.