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TIMEVALUEOFMONEY
CONTENTS
TimeValueofMoney Anintroduction
Compounding
Discounting
Annuity
FutureValueofAnnuity
PresentValueofAnnuity
ContinuousCompounding&Discounting
p
g
g
EffectiverateofInterest
CHAPTER 4
Valueofmoneyvarieswithtime.
Notonlyistheamountofmoneyimportant,equallyimportantis
Not
only is the amount of money important equally important is
thetimewhenisitreceivedorpaid.
Oneofthemostimportantconceptsusedinfinancialdecision
One of the most important concepts used in financial decision
making.
Applicationsinclude:
o
Personalfinance
Capitalbudgeting
Valuation
Derivativesandriskmanagement.
CHAPTER 4
T IME VALUE
OF
M ONEY
A N I NTRODUCTION
Valueofmoneyvarieswithtimedueto:
Presenceofinflation
Preferenceforcurrentconsumption
Investmentopportunitiesavailable
Presentcashflowsarecompounded tofind
their Future values.
theirFuturevalues.
FutureCashflowsarediscountedtoarriveat
their Present values.
theirPresentvalues.
TIME VALUE OF MONEY
CHAPTER 4
C OMPOUNDING
Applicationofinterestoverinterestis
k
knownascompounding.
di
Presentcashflows,P
Present cash flows P arecompoundedto
are compounded to
theirfuturevalues,F foranestimatedtime
period n atanexpectedrateofinterest,r.
period,n
at an expected rate of interest r
Futurevalueinterestfactor(FVIF
(
r n))
r,n
F P x ( 1 r)n
FVIF ( r , n ) (1 r)n
TIME VALUE OF MONEY
CHAPTER 4
C OMPOUNDING A ND R ATE
Effectofcompoundingincreaseswiththe
increase in interest rates
increaseininterestrates.
10.00
9.00
8.00
Futurre Value
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
1
2
at 5%
4
at 10%
5
at 15%
7
at 20%
8
at 25%
Time (yrs)
CHAPTER 4
C OMPOUNDING A ND T IME
Effectofcompoundingincreasesasthetime
lengthens.
lengthens
(Rs. 1 at 12%)
3.50
3 106
3.106
2.773
3.00
Future Va
alue
2.476
2.50
2.00
1.50
1.120
1.254
1.405
1.574
1 762
1.762
1.974
2.211
1.00
0.50
0.00
Time (yrs)
CHAPTER 4
D ISCOUNTING
Valueofthemoneyreceivedorpaidlateris
lesser than what it is today
lesserthanwhatitistoday.
Theprocessofreductioninvalue
eliminatingtheinterestthatcouldhave
li i ti th i t
t th t
ld h
accruedisknownasdiscounting.
Futurecashflows(F)arediscountedto
theirpresentvalues(P)foranestimated
timeperiod(n)atanexpectedrateof
( )
f
interest(r).
1
P F
( 1 r)
n
CHAPTER 4
D ISCOUNTING
1
( 1 r) n
CHAPTER 4
D ISCOUNTING A ND R ATE
10
Severityofdiscountingincreaseswiththe
increase in the rate of discounting
increaseintherateofdiscounting.
1.00
0.90
0.80
Presen
nt Value
0.70
0.60
0.50
0.40
0.30
0.20
0 10
0.10
0.00
1
2
at 5%
3
at 10%
5
at 15%
7
at 20%
Time (yrs)
at 25%
CHAPTER 4
D ISCOUNTING A ND T IME
11
Effectofdiscountingincreasesasthe
time lengthens
timelengthens.
(Rs. 1 at 12%)
Present Value
1.00
0 893
0.893
0.90
0.80
0.797
0.712
0.70
0.60
0.636
0.567
0.507
0.50
0 452
0.452
0.404
0.40
0.30
0.361
0.322
0.20
0 10
0.10
0.00
Time (yrs)
CHAPTER 4
A NNUITY
12
Equalamountsofcashflowsspaced
uniformly over time normally a year
uniformlyovertime,normallyayear.
Examplesinclude:
Premiumofinsurancepolicy
EMIofaloan
f l
Depositstoarecurringdepositaccount.
CHAPTER 4
13
Futurevalueofannuity(FVAr,n)depends
upon:
Amountofcashflow(i.e.annuity)
Rateofinterestperperiod
Numberofperiods.
( 1 r)n 1
FVAr,n Annuity
r
Futurevalueinterestfactorforannuity
FVIFA r,n
TIME VALUE OF MONEY
( 1 r) n 1
CHAPTER 4
14
Presentvalueofannuity(PVAr,n)likeits
future value depends upon:
futurevaluedependsupon:
Amountofcashflow(i.e.annuity)
Rateofinterestperperiod
Numberofperiods.
PVA r , n
(1 r ) n 1
Annuity
r (1 r ) n
Presentvalueinterestfactorforannuity
PVIFA
TIME VALUE OF MONEY
r ,n
(1 r ) n 1
r (1 r ) n
CHAPTER 4
C ONTINUOUS C OMPOUNDING
15
Valueofcompoundingordiscounting
p
g
g
dependsuponitsfrequency.
Thevaluerises/fallsexponentiallyincase
The al e rises/falls e ponentiall in case
ofcontinuouscompounding.
Future Value, F = P x e rt
1
Present Value, P = F x rt = F x e - rt
e
CHAPTER 4
E FFECTIVE R ATE O F
I NTEREST
16
Theeffectiveratemaybefoundfora
The
effective rate may be found for a
givenannualrate(r)andfrequencyof
compounding(m)
compounding (m) inayear.
in a year
m
r
Effective
Eff
ti
I t
Interest
t R ate
t = 1 1
m
CHAPTER 4
E QUATED M ONTHLY
I NSTALMENTS
17
LoansarerepayablenormallyinEquated
Loans
are repayable normally in Equated
MonthlyInstallments(EMIs).
EMIsareaformofannuity.
EMIs are a form of annuity
EachEMIcanbebifurcatedintointerest
andprincipalrepaymentcomponents.
d i i l
TheinterestcomponentofEMIsdeclines
whiletheprincipalcomponentincreases
withsuccessiveEMIs.
CHAPTER 4
18
CHAPTER 4
S EGREGATING EMI S
19
CHAPTER 4
E QUATED M ONTHLY
I NSTALMENTS
20
Acarloanfor3yearsforRs10,00,000
A
car loan for 3 years for Rs 10 00 000
at12%.
FindEMIinadvanceandinarrears
CHAPTER 4
21
CHAPTER 4
S EGREGATING EMI S
22
Period Outstanding
0
10 00 000 00
10,00,000.00
1
9,67,114.54
2
9,43,900.23
3
9,20,453.78
9 20 453 78
4
8,96,772.86
5
8,72,855.14
6
8,48,698.23
7
8,24,299.76
8
7,99,657.30
9
7,74,768.42
10
7,49,630.65
11
7,24,241.50
TOTALIst Year
TIME VALUE OF MONEY
EMI
32 885 46
32,885.46
32,885.46
32,885.46
32,885.46
32 885 46
32,885.46
32,885.46
32,885.46
32,885.46
32,885.46
32,885.46
32,885.46
32,885.46
3,94,625.46
Interest
000 00
000.00
9,671.15
9,439.00
9,204.54
9 204 54
8,967.73
8,728.55
8,486.98
8,243.00
7,996.57
7,747.68
7,496.31
7,242.42
93,223.92
PrincipalRepaid
32 885 46
32,885.46
23,214.31
23,446.45
23,680.92
23 680 92
23,917.73
24,156.90
24,398.47
24,642.46
24,888.88
25,137.77
25,389.15
25,643.04
3,01,401.54
CHAPTER 4