HEMA KRISHNAMURTHY, FCA HK/1098

BUSINESS SYSTEMS,
BANGALORE

TIME VALUE OF MONEY

Money has time value. A rupee today is more valuable than a rupee a year hence. This is because
of the following:
* People prefer current consumption to future consumption.
* Capital can be employed to generate returns. An investment of Re. 1 today will
grow to 1+ r a year hence (r. is the rate of return earned on the investment).
* In an inflationary period a rupee today represents a greater real purchasing power
than a rupee a year hence.

Formulae for determining the time value of some of the cash flows are given below:

1. FUTURE VALUE OF SINGLE AMOUNT

FVn = PV (1 + k)n
Where FVn = Future value n years hence.
PV = Cash today (present value)
k = Interest rate per year
n = Number of years for which compounding is done.

The factor (1+ k)n is referred to as the future value interest factor (FV1F k n ). To reduce the
tedium of calculation, published tables are available showing the value of (1+ k)n for
various combinations of k and n.

1.1 DOUBLING PERIOD

Often investors would be interested in knowing when their investments would double given
a certain rate of return. There is a rule of thumb called rule of 72, which gives an
approximate time period in which the investment would double.

72
Rule of 72 - = No of years in which an investment will double.
Rate of int erest

 72 
Eg. If when the interest rate is 12%, investment will double in 6 years  
12 
If one requires a greater degree of accuracy, rule of 69 can be applied which is -

69
Rule of 69 = 0.35 +
Interest R ate
 69 
Eg. If interest rate = 10% then investment will double in 7.25 years  0.35 + 
10 
 -2-

1.2 FINDING GROWTH RATE

To calculate the compound interest growth rate of some series, say sales over the last 6
years, we can employ the future value interest factor table. Eg:
1991 1992 1993 1994 1995 1996
Sales (Rs.Mill) 50 57 68 79 86 99
To determine the growth rate -
99
a) Find the ratio of sales of 1996 to 1991 = = 1.98
50

b) Consult the FVIFk n table and look at the row for 6 years till you find a value which is
closest to 1.98. Read the interest rate corresponding to that value. In this case the
closest value 1.974 corresponds to 12%.

1.3 SHORTER COMPOUNDING PERIOD:

When the interest rates are given per annum but compounding at shorter periods, then
mx n
 k
FVn = PV 1 + 
 m
Where FVn = Future value after n years
PV = Cash today (present value)
k = Nominal annual rate of interest
m = Number of times compounding is done during a year
n = Number of years for which compounding is done.

1.4 EFFECTIVE Vs. NORMAL RATE

When interest rate is given as say 12% p.a. compounding half yearly, we would be
interested in knowing how this compares with another investment which gives 12% p.a.
compounding quarterly. Hence we would like to know the effective rate of interest as
against the nominal rate.

The general relationship between the effective rate of interest and the nominal rate of
interest is as follows:
m
 k
r = 1 +  – 1 where r = effective rate of interest
 m
k = nominal rate of interest
m = frequency of compounding per year
Eg: If a bank offers 8% nominal rate compounding quarterly, the effective rate =
4
 0.08 
1 +  – 1 = 8.24 %
 4 
 -3-

2. FUTURE VALUE OF AN ANNUITY

An annuity is a series of periodic cash flows (payments or receipts) of equal amounts. Eg.
insurance premium paid on life policy. When the cash flows occur at the end of each
period the annuity is called a regular annuity or a deferred annuity. When the cash flows
occur at the beginning of each period the annuity is called annuity due.
In general terms the future value of an annuity is given as
FVAn = A (1 + K)n - 1 + A (1 + K)n - 2 + .......+ A
(1 + K) n − 1
= A  
 k 

Where FVAn = Future value of an annuity which has a duration of n periods

A = Constant periodic flow
k = interest rates per period
n = duration of the annuity
Eg: If Rs.1000 is deposited annually in a bank for 5 years, and the deposit earns a
compound interest rate of 10%, the value of this series at the end of 5 years =
 (1 + 01
. )5 −1 
1000   = Rs.6105
 01. 

(1 + k ) n − 1
The term is referred to as the future value interest factor for an annuity
k
(FVIFAk , n). Tables are available for different values of k & n.
2.1 SINKING FUND
We want to know how much we should save annually to accumulate Rs.200,000 at the end
of 10 years, if the savings earn an interest of 12%. Following from 2.0 above we know
(1 + K) n − 1  k 
FVAn = A   ∴ A = FVAn  
 (1 + k ) − 1
n
 k 

In the given problem - FVAn = Rs.2,00,000

k = 12%
n = 10 years
 012
. 
∴ the amount to be deposited annually = 2,00,000  = Rs.11,400
. )10 − 1
(1 + 012 

 k 
 (1 + k ) n − 1 is referred to as the sinking fund factor.
 
 -4-

2.2 FINDING THE INTEREST RATE

Given the relationship between FVAn, k & n, k can be found out if the other three values
are given.

Eg: A finance company advertises that it will pay Rs.8000 at the end of 6 years if Rs.1000 is
deposited annually. The interest rate would be as follows:

a) Find the FVIFAk , n for this contract as follows:

8000 = 1000 X FVIFAk ,n

8
∴ FVIFAk ,n = = 8
1

b) Look at the FVIFAk ,n table and read the row corresponding to 6 years for the value
closest to 8. In this case FVIFA12 % , 6 is 8.115.

Hence the effective interest is slightly below 12%.

3. PRESENT VALUE OF A SINGLE CASH FLOW

This is the converse of future value and indicates the discounted today’s value of a future
cash flow.

Present value is given as follows:

 1 
PV = FV  n Where PV = Present value
 (1 + k ) 
FV = Future value
k = discount rate
n = number of years.

Eg: If Rs.1000 is promised at the end of 3 years, the present value given a discount rate of
10% would be
1
1000 X = Rs. 751.
(1 + 01
. )3

1
The term is referred to as the discount factor or present value interest factor.
(1 + k ) n
Tables are available for different combinations of k and n.

3.1 PRESENT VALUE OF AN UNEVEN SERIES

In financial analysis we come across uneven cash flow streams. For eg. the dividend stream
associated with an equity is usually uneven.
-5-
The Present value of such a stream is given as follows:

A1 A2 An n
At
PVn =
1+ k
+
(1 + k ) 2
+.........+
(1 + k ) n
= ∑
t =1 (1 + k ) t
 Where PVn = Present value of a cash flow stream
At = cash flow occuring at the end of year t
k = discount rate
n = duration of the cash flow stream
The tedium can be easily resolved by referring the Present value interest factor table.
Eg: The Present value of the following cash flow stream of a project at a discount rate of
15% would be -
Year Cash flow PVIF15 , n Present value of cash flow
0 5,000 1 5,000
1 8,000 0.870 6,960
2 10,000 0.756 7,560
3 25,000 0.658 16,450
48,000 35,970
3.2 PRESENT VALUE OF AN ANNUITY

 (1 + k ) n − 1
This is given as - PVAn = A  n 
 k (1 + k ) 

Where PVAn = Present value of an Annuity which has a duration of n periods

A = Constant periodic flow
k = discount factor
Eg: If we expect to receive Rs.1000 annually for 3 years, each receipt occurring at the end
of the year, the present value of this stream at a discount factor of 10% would be

(1 + 01. ) 3 −1

1000   = 2478.8
. (1 + 01
 01 . )3 

 (1 + k ) n − 1
The term  n  is referred to as the present value interest factor for an annuity.
 k (1 + k ) 
3.3 CAPITAL RECOVERY FACTOR
If a person deposits Rs.1,00,000 in a bank which pays 10% annual interest, How much can
he withdraw annually for a period of 10 years ? We can find this by manipulating the
formula for Present value of annuity as given below:

 k (1 + k ) n 
A = PVAn   Where A = constant periodic flow
 (1 + k ) − 1
n

PVAn = Present value of Annuity which has a duration of n years k = discount rate
 -6-

 k (1 + k ) n 
The term   is called the capital recovery factor.
 (1 + k ) − 1
n

Thus the amount he can withdraw annually would be

1 1
A= 1,00,000 X PVIF = 1,00,000 X = 16,273.
10%, 10 61
. 45

3.4 FINDING THE DISCOUNT RATE

If we deposit Rs.10,000 with a financier, he promises to pay Rs.2500 annually for 6 years.
What is the rate of interest earned on this deposit.
a) Find the PVIFAk , 6 by the following:
10,000 = 2500 X PVIFAk , 6

10 ,000
∴ PVIFAk , 6 = = 4
2500

b) From the PVIFA table read off the interest which corresponds to the value closest to 4
in the 6 year row. In this case 12% corresponds to 4.111 and 14% corresponds to
3.889. Since 4 lies in the middle of these values, the interest rate lies approximately in
the middle. So the interest rate is 13%

3.5 PRESENT VALUE OF A PERPETUITY

A perpetuity is an annuity of infinite duration. Present value is given as follows:

P∝ = A X PVIFAk , ∝

Where P∝ = Present value of perpetuity

A = Constant annual payment
PVIFAk , ∝ = Present value interest factor for a perpetuity

1
PVIFAk , ∝ =
k

Eg. The present value of a perpetuity of Rs.10,000 if the interest rate is 10% would be
Rs.1,00,000 (10,000/0.1). Intuitively this is quite convincing because an initial sum of
Rs.1,00,000 invested at 10% would provide a constant annual income of Rs.10,000 for
ever without any impairment of the capital value.

Enclosures: Tables
1) FVIF(k, n) 3) PVIF(k, n)
2) FVIFA(k, n) 4) PVIFA(k, n)