Time Value of Money

17-03-2010
 Time Value of Money
 Wealth Maximisation objective:
Superior to profit maximisation
 Assets with future benefits
 Funds procured from different
sources
 Cash inflow and outflow comparison
for financial decision making
 Logical and meaningful to compare
at a common point of time
 Rationale
 Time value of money – Time
preference for money
 Reason for time for money:
Opportunity to reinvest
 Time preference for money is
expressed in terms of: Rate of return
or discount rate
 What would you prefer?
 You are chosen for an award for your
merit and you have the option to receive a
sum of Rs. 1,00,000 today or a year later.
Which option would you choose and why?
 Are organisations different?
 An investment of one year life and cash
outlay of Rs. 10,00,000 and generates Rs
10,80,000 in the year. If the funds
borrowed cost 10 per cent would you
invest in the said project? Why?
 What would you need to consider?

 You are raising a loan from a

financial institution for a period of
five years for Rs.10,00,000.
Techniques for evaluating the cash
flows during different time periods
 Compounding: The amount of interest
earned on the initial principal gets added
to the initial principal at the beginning of
every period of interest calculation to form
a new principal. Interest gets
compounded. Present sum is converted
into future sum.
 Discounting: The present value of future
rupees will be lower. The procedure of
finding present values is called
discounting.
 Compounding Technique
 Mr. A invests Rs. 5,00,000 at 6
percent interest compounded
annually. If the amount is invested
for three years how much would he
earn at the end of three years?
 Annual Compounding
Year 1 2 3
Beginning Amount 5,00,000 5,30,000

Interest rate 6% 6%

Amount of Interest 30,000 31,800

Beginning Principal 5,00,000

Ending Principal 5,30,000

 Annual Compounding
 Formula
 A = P(1+i)n
 A- Amount at the end of the period
 P- Principal at the beginning of the
period
 i- Rate of interest
 n- Number of years
 Using of Table
 As interest rate increase for any
given year the compound interest
factor also increases
 For a given interest rate the future
sum of a rupee increase with
passage of time
Semi-Annual Compounding Period
 Two compounding periods within a
year
 Annual rate of interest must be
halved
 Mr. A places his savings of Rs.
3,00,000 in a two year deposit
scheme of a bank which yields 6 per
cent interest compounded semi-
annually.
 Compounding Semi-Annual
Months 6 12 18 24
Beginning Amount 3,00,000 3,09,000

Interest rate 3% 3%

Amount of Interest 9,000 9270

Beginning Principal 3,00,000 3,09,000

Ending Principal 3,09,000 3,18,270

 Quarterly Compounding
 Four compounding periods within a year
 The annual interest rate would be applied
after dividing it by four
 Mr. A places his savings of Rs. 3,00,000 in
a two year deposit scheme of a bank which
yields 6 per cent interest compounded
quarterly.
 Quarterly Compounding
Months 3 6 9 12 15
Beginning Amount 3,00,000 3,04,500

Interest rate 1.5% 1.5% 1.50% 1.50%

Amount of Interest 4,500 4567.5

Beginning Principal 3,00,000 3,04,500

Ending Principal 3,04,500 3,09,067.5

 Future/ Compounded Value of a series of
payments
 Mr. A deposits each year Rs. 50,000; Rs.
1,00,000; Rs. 1,50,000; Rs. 2,00,000;
Rs.2,50,000; and Rs.3,00,000 in his
saving account over a period of five
years. The interest rate is 5 per cent.
What would be the future value of his
deposits at the end of the fifth year.
Assume compounding is annual and the
payment is made at the end of each year.
 Compounded Value
Year end Amount Years of Compounded interest Future
Deposited Compounding factor Value

1 50,000 4 1.216 60800

21,00,000 3 1.158

31,50,000 2 1.103

42,00,000 1 1.050

52,50,000 0 1.000
 Compound Sum of an Annuity
 Annuity: Stream of equal annual cash
flows. Annuities involve calculations
based upon the regular periodic
contribution or receipt of a fixed sum of
money
 Mr. X deposits Rs.2,00,000 at the end of
every year for 5 years in his savings
account paying 5 per cent interest
compounded annually. He wants to
determine how much money he will have
at the end of the 5th year.
 Compound Sum of an Annuity
Year End Amount Compounded Compounded Future value
Deposited Years Factor
12,00,000 4 1.2162,43,200
22,00,000 3 1.158

32,00,000 2 1.103

42,00,000 1 1.050

52,00,000 0 1.000

11,05,400
 Compound Sum of an Annuity
 Formula
 Sn = CVIFA*A
 Sn = Compound Sum of Annuity
 CVIFA = Appropriate factor for the
sum of the annuity for Re.1
 A = The value of annuity
 Present Value or Discounting
Technique
 Money received at some future date
is worth less because the
corresponding interest is lost during
the period
 A rupee received in the future will be
less than the value of rupee in hand
today
 Discounting is the procedure of
finding present values
 Discounting Technique
 Mr. X has been given an opportunity to
receive Rs. 1,060 one year from now. He
knows that he can earn 6 per cent
interest on his investments. What will he
be prepared to invest for this
opportunity?
 The person must be indifferent to receive
Rs.1000 today or Rs.1060. He would be
interested in receiving more than
Rs.1060 or pay less than Rs. 1000 to get
Rs.1060
 Present Value/ Discounting
 Mathematical Formulation
 P = A / (1+i)n or

P=A ( 1/ (1+i)n)
 Present Value Tables
 P = A (PVIF)
 P - Present Value of the future lump
sum
 A – Amount received
 PVIF – Present Value Interest Factor
 Present Value
 Mr. X wants to find the present value
of Rs. 2,00,000 received 5 years
from now, assuming 10 per cent rate
of interest.
 The present value of Rs.2,00,000 will
be 2,00,000*(0.621) = Rs. 1,24,200
 Present Value of a series of cash
flows
 P= ∑ Ct/ (1+i)t
 P is the sum of the individual present
values of separate cash flows
 Ct is the cash flows in different time
periods
 i is the interest rate
 Present Value for Mixed stream of
cash flows
Year Cash flows Present value Present value
factor
1500 .909

21000 .826

31500 .751

42000 .683

52500 .621
 Present Value of an Annuity
 P = PVIFA*A
 PVIFA is also termed as Annuity
Discount Factor
 Present Value - Annuity
Year Cash flows Present value Present value
factor
11000 .909

21000 .826

31000 .751

41000 .683

51000 .621