Time Value of Money

Refer to Chapter 7 of Textbook Module 1
Time Value of Money
Copyright 2009, FAB Advisors and Mentors Pvt. Ltd. - For educational purpose only
Objectives
After this session you will be able to: Define commonly used terms related to Time Value of Money Calculate value of money at different points of time Prepare amortization schedule for loans
Roadmap
Introduction to Time Value of Money
Future Value
Present Value Annuities Annuity, Growing Annuity, Perpetuity Rate of Return Rate, IRR, XIRR Comparing rate of returns
Loan Amortization Schedule
Time Value of Money

The Time Value of Money is the cornerstone concepts of investment and financial analysis.
The aim of this session is to introduce this concept and at the same time use Microsoft Excel to develop financial plans that utilize these concepts for analyzing investments.
Time Value of Money

If given a choice of Rs. 1000 to be received today or two years later, most people will no doubt choose to receive the money today. The reason is very simple, the Rs. 1000 received today can be put in the banks or in risk free instruments like Treasury Bills to earn interest. In two years time, the Rs. 1000 with interest will be worth more than the Rs. 1000 today. This simple concept forms the basis of the Time Value of Money.
Time Value of Money

Time Value of Money include -
Present Value (PV)

Future Value (FV) Payments (PMT) RATE Number of Compounding Periods (NPER)
Roadmap
Introduction to Time Value of Money
Future Value
Present Value Annuities Annuity, Growing Annuity, Perpetuity Rate of Return Rate, IRR, XIRR Comparing rate of returns
Future Value
What is Future Value (FV)?
FV is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today.
Let us look at an example of FV: Rs.1000 invested for 5 years with simple annual interest of 10% would have a FV of Rs.1500.
Future Value - Formula
Calculation of Future Value

Nitin Kapoors Future Plan: Example of FV
FACTS -> To buy a showroom in a mall after five years -> At present, the showroom cost is estimated to be Rs. 2 crores Assuming prices rise @ 4% p.a., how much will the property cost after five years?
FV = PV (1 + r)n FV = 2 (1 + 4%)5 FV = Rs. 2.43 crores
Ease of Excel
Function PV NPER PMT Description Present Value No. of Compounding Periods Payment made / received each period
RATE
FV
Rate of return / Interest rate per period

Future Value Points to Remember
Denote outflow with a negative sign (-) Rate should be entered either in percentage (%) or in decimals In case of Begin mode: TYPE 1
Calculating FV in Excel
STEP 1
STEP 2
STEP 3
Example
Dravid invests Rs. 2, 00, 000 in a fund. Assuming his investments grow @ 10% p.a., how much money can he expect to have after 10 years?
Roadmap
Introduction to Time Value of Money Future Value Present Value Annuities Annuity, Growing Annuity, Perpetuity Rate of Return Rate, IRR, XIRR Comparing rate of returns
Present Value
What is Present Value (PV)?
PV is the current worth of a future sum of money or stream of cash flows given a specified rate of return.
Let us look at an example of PV: Rs.1500 received after 5 years with simple annual interest of 10% from an investment of Rs. 1, 000. Here Rs. 1, 000 is PV.
Present Value in Excel
Present Value - Example

Mr. Bakshi plans to take his wife on a World Tour, after three years. The cruise is expected to cost Rs. five lacs at that time. Assuming the risk free rate of return to be 5% p.a., how much should he invest today, to realise this dream, without taking any risk?
Present Value of Even Cash Flows

Example
Sneha requires Rs. 10, 000 every year for the next 5 years. Calculate how much she needs to invest today @ 8% p.a. for this need to be met.
Present Value of uneven cash flows

When present value for uneven cash flow needs to be calculated, the function we use is NET PRESENT VALUE (NPV).
Example: Shikha is planning to plan a holiday every year for the next five years. The amount she will need to spend every year is estimated to be:
Year 1 Rs. 10, 000 Year 2 Rs. 15, 000 Year 3 Rs. 13, 000 Year 4 Rs. 17, 000 Year 5 Rs. 12, 000 She wants to invest a lump sum amount today for this purpose. If the cost of capital is 10% p.a., how much should she invest?
Present Value of uneven cash flows
Roadmap
Annuity
An Annuity is a series of equal cash flow over a period of time. The Present Value of an Ordinary Annuity is defined as the total value of the series of equal cash flow discounting compound interests.
Annuity - Types
Ordinary Annuity: Payments or receipts occur at the end of each period. Annuity Due: Payments or receipts occur at the beginning of each period.
Examples of Annuities
Student Loan Payments Car Loan Payments Insurance Premiums Mortgage Payments Retirement Savings
Annuity - Example
A plant expansion (Cost - Rs 20, 00,000) is to be financed as follows; 15% down payment and remainder is borrowed at 9% interest. The loan is to be repaid in 8 equal installments starting 4 years from now. Find the amount of each equal annual installment.
STEP 1
Annuity - Example
A plant expansion (Cost - Rs 20, 00,000) is to be financed as follows; 15% down payment and remainder is borrowed at 9% interest. The loan is to be repaid in 8 equal installments starting 4 years from now. Find the amount of each equal annual installment.
STEP 2
Growing Annuity
Annuity where the amount of savings keeps on increasing periodically, is termed as Growing Annuity. FV = PMT X [(1+R)N (1+G)N] (R G)
PMT R G N
= Amt. Of 1st Input = Rate of Return = Growth Rate = No. of periods
Growing Annuity - Example

A 30 year old employee is currently earning annual salary of Rs. 3 lacs. He has started saving 10 % of his salary at the end of each year in a savings plan yielding 6 % interest per annum. His salary will increase by 5 % per annum. What accumulated amount would he be having on his retirement at age 60?
Solution : FV = PMT X = = FV = [(1+R)N (1+G)N] (R G) 30,000 [(1.06)30- (1.05)30] (0.01) 30,000 [ 5.74349 4.32194] 0.01 42,64,650/-
Perpetuity
A Perpetuity is a series of indefinite cash flows. It can thus be considered as a special case of an Annuity where the annuity extends indefinitely. Formula of Present Value of a Perpetuity
PV = A / r
PV is Present Value r is the interest rate A is the Annuity amount
Roadmap
Rate of Return
Rate of return is the interest rate per period of a loan or an investment.
Rate of Return
Example
Internal Rate of Return (IRR)

Example
Calculate the IRR of a project that has an initial outflow of 5,000 and will generate the following cash flows: Year 1 - 3,000 Year 2 500 Year 3 - 2,500 Year 4 - 500 Year 5 - 1,500
Internal Rate of Return (IRR)

Example
Internal Rate of Return (XIRR)

FACTS
Mr. Sehwag invested rupees ten thousand in the IPO of an equity fund on 24 Sep 1994 (NAV 10.00) He again invested rupees ten thousand on 24 Oct 2000 in the same fund and plan at an NAV of Rs. 19.66
He withdrew rupees six thousand from the fund on 08 May 2001 at an NAV of 20.64
What should be the annualized return of Mr. Sehwags investment from the scheme as on 31 March 2003. The NAV on the date was 22.50. Ignore loads in your calculations.
Internal Rate of Return (XIRR)
Roadmap
Nominal Rate of Return vs. Effective Rate of Return

Nominal Rate of Return Nominal rate of return is the stated rate of interest, exclusive of any compounding, that is paid on an investment.
Effective Rate of Return Effective rate of return is an investment's annual return when compounding occurs more often than once a year. Example: Consider a stated annual rate of 10%. Compounded yearly, this rate will turn Rs. 1000 into Rs. 1100. However, if compounding occurs monthly, Rs. 1000 would grow to Rs. 1104.70 by the end of the year, rendering an effective annual interest rate of 10.47%.
Basically the effective annual rate is the annual rate of interest that accounts for the effect of compounding.
Comparing Rate of Returns - Example

Mr. Rao has the choice of investing in: A one year bond with the coupon rate of 7% p.a., where interest is paid monthly
OR
A one year bond with the coupon rate of 7.25 % p.a., where interest is paid half yearly Which one of the two would you recommend?
Real Rate of Return

The Real Rate of Return on an investment factors in inflation to give you a clearer picture of how much your purchasing power has increased.
Formula for Real Rate of Return
Roadmap

When a lender like a bank extends a loan to a borrower, provisions will be made for the borrower to repay the loan amount some time in the future or in parts periodically. At the same time, the lender will expect to receive interests from the borrower as a reward of undertaking the risk to lend out the money.
When the loan amount is repaid by parts over a certain amount of time, the loan is called an amortized loan.

A borrower will typically be interested in knowing how much he will have to pay periodically if he takes up a loan of a certain amount over a certain period of time. Other information like how much total interest he will have to incur, the total principal loan amount outstanding at a specific point in time and whether he will be able to afford the loan if he shorten the total loan period will also be of interest to the borrower. All these information can be easily illustrated using a Loan Amortization Schedule.

A loan amortization schedule usually takes the following inputs.
Beginning Date The date where the loan is taken. Loan Amount The amount that the lender will loan to the borrower.
Annual Interest rate The interest rate per year. Payment Period The total number of payment periods. If Payment Frequency selected is Annually and Payment period is 10, it means 10 years. If Payment Frequency is Monthly and Payment Period is 12, it means 12 months.
Loan Amortization Schedule - Example

Sonia has taken a housing loan for: Rs. 20 Lacs To be repaid in 20 Yrs. at the rate of 10% p.a.
EMI would be:

For the Principal component of EMI column, use the financial function PPMT:

For the Interest component of EMI column, use the financial function IPMT:

Amortisation Schedule
Loan Amount Tenure Rate Rs. 20,00,000 20 Years 10% EMI No.
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
O/S Loan Amt

2000000 Rs. 19,97,366.23 Rs. 19,94,710.52 Rs. 19,92,032.67 Rs. 19,89,332.51 Rs. 19,86,609.85 Rs. 19,83,864.50 Rs. 19,81,096.27 Rs. 19,78,304.97 Rs. 19,75,490.42 Rs. 19,72,652.40 Rs. 19,69,790.74 Rs. 19,66,905.23 Rs. 19,63,995.68 Rs. 19,61,061.87 Rs. 19,58,103.62 Rs. 19,55,120.72
EMI
Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43 Rs. 19,300.43
PPMT
IPMT

Important Points to Remember:
That the principal component is rising with each installment.
That the interest component is falling with each installment.

That for each row the total of interest and principal component is same and equal to the total EMI. That the total of the principal component column adds up to the total loan amount which is Rs. 20 lacs.
That the total of the interest component column gives the total
interest outgo during the entire tenure of the loan.
Summary
Future Value Value of money after a specified time in future
Present Value Value of money today Annuity Series of cash flows
Perpetuity Series of cash flows when time period is indefinite

Rate of Return - Rate of return is the interest rate per period of a loan or an investment. Effective rate of Return Return earned by investment when compounding is done more than once in an year. Real rate of return Inflation adjusted rate of return Loan Amortization Schedule A schedule prepared to show the EMI, principal component, interest component and outstanding loan amount for a loan

Time Value of Money

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Refer to Chapter 7 of Textbook Module 1