Time Value of Money

Note 1: Time Value of Money
Ramabhadran S. Thirumalai
Indian School of Business
CFIN1, Term 3, Class of 2017
Introduction
PV and FV
Different Types of Cash Flows
EAR
Loan Amortization
Agenda
1 Introduction
2 PV and FV
Lump-Sum Cash Flow

Stream of Cash Flows
Net Present Value
3 Different Types of Cash Flows
Annuities
Perpetuities
4 EAR
Continuous Compounding
5 Loan Amortization
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Forms of business organizations

Type
Ownership Ability to Liability

raise capital
Taxation
Sole Proprietorship
100% owned by
single individual, who usually also manages the company
Difficult
Unlimited personal liability
Single
Partnership
Two or more individuals
Less difficult
than
sole
proprietorship
Unlimited personal liability
Single
Corporation
Separation of
owners
and
managers
The least difficult of all forms
Limited
to
owners initial
investment
Double
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Role of the financial manager
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Role of the financial manager
Investment decisions
Financing decisions
Working capital management
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Goal of the financial manager

Maximize the wealth of stockholders/owners
or
Maximize price per share
Why? Stockholders invest in the firm because they want to make
money
Note: Maximizing price per share is not necessarily the same as
maximizing earnings per share
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Cash flows and value
The value of an investment is determined by the
future stream of cash flows that the investment generates for the
investor
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Time value of money

You are asked to choose from the following:
1. Receive |100 today
2. Receive |100 one year from now
Would you choose 1 or 2? Choose 1
Basic Principle
A rupee today is worth more than a rupee tomorrow because the
rupee today can be invested to grow to an amount greater than one
rupee tomorrow
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Timelines
To better understand the timing of cash flows, we will make
extensive use of linear representations of the timing of cash

flows called timelines
Drawing a timeline of the cash flows will help you visualize the
financial problem
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Timelines
Here is an example of a timeline with two cash flows, |1,000 at
the end of Year 1 and |1,500 at the end of Year 2:

Cash Flow (CF) 0
Period 0
Today
1,000
1,500
Remember: Today (Time 0) is also the beginning of Year 1, end
of Year 1 is also the beginning of Year 2, etc.

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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Time value of money

Important things to remember:
You may compare, add or subtract values at the same point in
time but not across time
Move values forward in time by compounding cash flows
I
How much is |1,000 worth after two years if interest rate is 10% per
year?
1,000
1,100
1,210
Calculations:
I After Year 1: 1000 (1 + 0.10) = 1,100
I After Year 2: 1100 (1 + 0.10) = 1,210
I Putting the two together, 1000 (1 + 0.10) 2 = 1,210 called the
Future Value (FV)
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Time value of money

Move values backward in time by discounting cash flows
I How much is |2,420 in two years time worth today if interest rate is
10% per year?
2,000
2,200
2,420
Calculations:
I
Ram Thirumalai
2420
= 2,200
After Year 1:
1 + 0.10
2200
Today:
= 2,000
1 + 0.10
2420
Putting the two together,
= 2,000 called the Present
(1 + 0.10) 2
Value (PV)
Time Value of Money
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Introduction
PV and FV
EAR
Loan Amortization
Time value of money

Formulas for lump-sum (single) cash flow:
FVn
(1 + r) n
= PV (1 + r) n
PV =
FVn
where r is the interest rate (also called the discount rate) and n is the
number of periods you are compounding or discounting the cash flow
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Calculating r
We can ask the following question: I have |5,000 today and I
need |6,000 after three years. What must be the minimum rate
of return that will help me achieve this goal?
5,000
6,000
Using FVn = PV (1 + r) n , we can write 6000 = 5000 (1 + r) 3
6000
Solve for r: r =
5000
Ram Thirumalai
! 13
1 = 6.27%
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Calculating n
You had an opened a savings account with Indian Bank many
years ago but do not remember exactly when

It currently has |30,000
You know you had deposited |20,000 when you opened the
account
The savings account interest rate has been a constant 3.5% a
year since you opened the account
How many years ago did you make the initial deposit?
Plugging into FVn = PV (1 + r) n , we get
30000 = 20000 (1 + 0.035) n
log 30000
20000
Solve for n: n =
= 11.79 years
log(1.035)
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Stream of cash flows

What if we have the following stream of annual cash flows? How will
we calculate its PV (today) and FV (after two years) if the discount
rate is 15% per year?
Ram Thirumalai
1,000
1,500
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
PV of stream of cash flows

Calculate the PV of each cash flow separately and add them up
(Value Additivity Principle)
1000
1500
+
(1 + 0.15) 1 (1 + 0.15) 2
= 869.57 + 1134.22
= 2,003.79
PV =
How can we understand this number?

One simple way is as follows: How much should you invest
today in an account that pays an interest of 15% per year if you

want to withdraw |1,000 after one year and |1,500 after two
years? The answer is |2,003.79
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
PV of stream of cash flows

After one year, you will have 2003.79 (1 + 0.15) = 2, 304.36
Withdraw |1,000
You are left with 2304.36 1000 = 1, 304.36, which will
continue to earn interest at 15% in the second year

After two years, you will have 1304.36 (1 + 0.15) = 1, 500
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
FV of stream of cash flows

Calculate the FV of each cash flow separately and add them up (value
additivity principle works for FV calculations also)
FV = 1000 (1 + 0.15) 1 + 1500 (1 + 0.15) 0
= 1, 150 + 1, 500
= 2, 650
Is there an easier way to calculate FV?
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
FV of stream of cash flows
Yes
We already know the PV of the stream of cash flows
Treat this as a lump-sum and calculate its FV
We can verify that we will arrive at the same FV of |2,650
2003.79 (1 + 0.15) 2 = 2,650
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Calculating the NPV
Calculating the net present value (NPV) of future cash flows
allows us to evaluate an investment decision

It compares the PV of cash inflows (benefits) to the PV of cash
outflows (costs)
NPV = Benefit Cost
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
NPV of an investment opportunity

Suppose you invest in a project that requires an initial
investment of |100,000
This project will generate |50,000 at the end of each of the next
three years
The discount rate for project is 10%
Should you accept the project?
Benefit of the project
50000
50000
50000
=
+
+
= 124,342.60
(1 + 0.10) 1 (1 + 0.10) 2 (1 + 0.10) 3
Cost of the project = 100,000
NPV = 124,342.60 100,000 = 24,342.60 > 0 ACCEPT
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
What is an annuity?
An annuity is a stream of N equal cash flows paid at regular
intervals
An example of an annuity:
500
500
500
500
500
500
500
0
Not an annuity:
500
0
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Types of annuities
Ordinary annuity: Each cash flow occurs at the end of the period
500
500
500
500
500
Annuity due: Each cash flow occurs at the beginning of the
period
Ram Thirumalai
500
500
500
500
500
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
PV and FV of an ordinary annuity

PV(Ordinary Annuity) =
=
FV(Ordinary Annuity) =
=
=
Ram Thirumalai
C
C
C
+
+
+
2
(1 + r) N
(1 "+ r) 1 (1 + r)
#
C
1
1
r
(1 + r) N
PV(Ordinary Annuity) (1 + r) N
"
#
C
1
1
(1 + r) N
N
r
(1 + r)
f
g
C
N
(1 + r) 1
r
Time Value of Money
25 / 56
Introduction
PV and FV
EAR
Loan Amortization
PV of an annuity due
For an annuity due, each cash flow is one period earlier
So what can we say about the PV and FV of an annuity due
relative to those of an ordinary annuity?

PV(Annuity Due) = PV(Ordinary Annuity) (1 + r)
"
#
C
1
=
1
(1 + r)
r
(1 + r) N
"
#
C
1
=
1+r
r
(1 + r) N1
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
FV of an annuity due
FV(Annuity Due) = PV(Annuity Due) (1 + r) N

"
#
1
C
1+r
=
(1 + r) N
N1
r
(1 + r)
g
Cf
=
(1 + r) N+1 (1 + r)
r
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Growing annuity
Growing annuity is a series of N cash flows that grow at a constant rate every
period
An example of a growing annuity with a constant growth of 5% per year:
500
525
551.25
578.8125 607.753125
3
4
5
!N
C
1 + g
PV(Growing Annuity) =
1
, where g is the annual growth
rg
1 + r
rate and C is the first cash flow of the growing annuity

You can verify that the PV of the above growing annuity, with a discount rate
of 10%, is |2,075.30
Ram Thirumalai
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Growing annuity
FV(Growing Annuity) = PV(Growing Annuity) (1 + r)

!N
1 + g
C
1
=
(1 + r)
r g
1 + r
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Constant perpetuity
A constant perpetuity is a stream of equal cash flows paid at
regular intervals and goes on forever

An example of a constant perpetuity:
0
500
500
500
...
PV(C in perpetuity) =
Ram Thirumalai
C
r
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Growing perpetuity
A growing perpetuity is a series of cash flows that grows at a
constant rate every period and goes on forever

An example of a growing perpetuity with a constant growth rate
of 8%:
...
10
10.8
11.664
2
3
C
PV(Growing Perpetuity) =
called the Gordon Growth
rg
Model, which is used to value stocks
0
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Wealthy alumnus example

A wealthy alumnus wants to set up an endowment fund to
finance a Chair position in the name of her favourite finance

professor
The endowment can earn 10% per year
How much does she have to set aside today if
1. she wants to finance a salary supplement of |1,500,000 each year for
20 years?
I
PV(Ordinary Annuity) =
12,770,345.58
"
#
"
#
C
1500000
1
1
=
1
1
=
r
0.10
(1 + r) N
(1 + 0.10) 20
2. she wants to finance a salary supplement of |1,500,000 each year for

forever?
I
Ram Thirumalai
PV(C in perpetuity) =
C 1500000
=
= 15,000,000
r
0.10
Time Value of Money
32 / 56
Introduction
PV and FV
EAR
Loan Amortization

3. she wants to finance a salary supplement for 20 years starting at
|1,500,000 at the end of the first year but wants to build in a growth
rate of 5% each year?
I
!N
C
1 + g
1
=
r g
1 + r
! 20
1 + 0.05
1500000
1
= 18,168,126.09
0.10 0.05
1 + 0.10
PV(Growing Annuity) =
4. she wants to finance a salary supplement forever starting at |1,500,000

at the end of first year and growing at 5% each year?
I
Ram Thirumalai
PV(Growing Perpetuity) =
C
1500000
=
= 30,000,000
r g 0.10 0.05
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
For each of the four cases in the wealth alumnus example, what
is the ending balance in the endowment account each year for

the next 20 years after making the payment for the year?
Answers will be posted on LMS
Ram Thirumalai
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Ordinary annuity: Find PV

You are thinking of buying a rental property
The yearly rent from this property will be |300,000
You expect that the property will generate this rent for the next
twenty five years, after which you will be able to sell it for
|10,000,000
Your required rate of return is 15% per year
What is the maximum amount that you would pay for this
property today?
PV = |2,243,021.10
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Ordinary annuity: Find FV
You open an account today with |200,000

At the end of each of the next 15 years, you deposit |25,000 in it
The interest rate is 7% per year
What will be the balance in the account after 15 years?
FV = |1,180,031.86
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Ordinary annuity: Find r

You lend your friend |100,000
He will pay you |12,000 per year for ten years
He will also make a balloon payment of |50,000 at the end of
ten years
What interest rate are you charging your friend?
r = 8.6543%
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Ordinary annuity: Find PMT

Next year, you will start to make annual deposits of |200,000 in
a retirement plan
You expect to do this for 35 years (contributions from t = 1 to t =
35)
After your last contribution, you will buy a retirement annuity
for 20 years with equal annual payments (from t = 36 to t = 55)
from a life insurance company
The annual rate of return is expected to be a constant 12% per
year over this entire period
What is the annual payment of the annuity?
PMT = |11,558,116.46
Ram Thirumalai
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Ordinary annuity vs annuity due: Example

You have a rental property that you want to rent out for ten years
Prospective tenant A promises to pay a rent of |240,000 per year
with payments made at the end of each year

Prospective tenant B promises to pay a rent of |240,000 per year
with payments made at the beginning of each year
The appropriate discount rate is 10% per year
Which is the better deal for you?
PV (Tenant A) = |1,474,696.11
PV (Tenant B) = |1,622,165.72
Ram Thirumalai
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Ordinary annuity vs annuity due: Example

An asset promises the following series of cash flows:
I At the end of each of the first three years, |5,000
I At the end of each of the following four years, |7,000
I And, |9,000 each year subsequently forever
Your required rate of return is 10 percent
How much is this asset worth to you?
PV = |75,289.46
Ram Thirumalai
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Compounding period less than 1 year

Saying that compounding period is less than 1 year is equivalent to
saying that frequency of compounding is more than once per year
Ram Thirumalai
Compounding period
Compounding frequency
Six-months/semiannual
Quarter
Month
Week
Day
2
4
12
52
365
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Example
Suppose that your bank states that the interest on your account
is 8% per annum (p.a.)

However, interest is paid semi-annually, that is, every six
months or twice a year
The 8% is called the stated interest rate (also called the
nominal interest rate or the annual percentage rate APR)
But the bank will pay 4% interest every six months
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Example
You would like to deposit |100 in a bank
The bank offers you two choices
1. 8% p.a. with annual compounding
2. 8% p.a. with semi-annual compounding
Which would you prefer?
Under the first choice, your |100 will become
100 (1 + 0.08) = 108

Under the second choice:
I
I
I
Ram Thirumalai
After six months, you will have 100 (1 + 0.04) = 104

After one year, you will have 104 (1 + 0.04) = 108.16
You have effectively earned (108.16 100)/100 = 8.16%
Time Value of Money
43 / 56
Introduction
PV and FV
EAR
Loan Amortization
EAR
The effective annual rate (EAR) is the rate if compounded
annually will produce the same future value as a stated or

nominal rate of APR% compounded k times each year
The following formula calculates EAR
APR k
EAR = 1 +
1,
k

where k is the compounding periods per year
Ram Thirumalai
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Modified PV and FV formulas

Lump-sum
FV
r kn
1+
k

r kn
FV = PV 1 +
k
PV =
Ram Thirumalai
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Annuity with semi-annual compounding

You would like to accumulate |1,000,000 over the next 8 years
How much must you deposit every six months, starting six
months from now?

Interest rate is 4 percent per annum with semiannual
compounding
Payment every six months = |53,650.13
Ram Thirumalai
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Example: Stated and effective rates

You have decided to buy a car whose price is |1,200,000
The dealer offers to finance the entire amount and requires 60
monthly payments of |30,000 per month

What are the yearly stated and effective interest rates for this
financing?
Stated rate = 17.27%
EAR = 18.71%
Ram Thirumalai
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Doubling your money

The stated interest rate for a bank account is 7 percent and
interest is paid semi-annually

How many years will it take you to double your money in this
account?
Number of periods = 20.1488 semi-annual periods
Number of year = 20.148/2 = 10.0744 years
Ram Thirumalai
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Continuous compounding
Continuous compounding is a special case of compounding
more often than once a year

In this case, the compounding frequency is infinity
FV = PV erN
PV = FV erN
where e is the exponential function (that appears on your
financial calculator as [ex ]), r is the stated interest rate (or APR),
and N is the number of years
Ram Thirumalai
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
If the stated interest rate is r p.a., the effective interest rate with
continuous compounding is given by

Effective interest rate = er 1
Example: Suppose the stated interest rate is 9 percent p.a., then,
with continuous compounding, the effective interest rate is

Effective interest rate = e0.09 1 = 1.094171 = 0.09417 or 9.417%
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Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Problem: BNM Bank pays a stated interest of 4% per year and
utilizes continuous compounding. You deposit |1,800 into this

account. What will be your account balance in 11 years?
I
Verify that answer is |2,794.87
Problem: ZXC bank pays a stated interest of 5% p.a. and
utilizes continuous compounding. How long will it take you to

double your money in this account? (Your answer can contain
fractional years.)
I
Ram Thirumalai
Verify that answer is 13.863 years
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Loan amortization
Amortization is the process of separating a payment into two
parts:
1. The interest payment
2. The repayment of principal
Note:
I Interest payment decreases over time
I Principal repayment increases over times
Essentially, the equated monthly installment (EMI) on any loan
consists of interest payment and principal repayment
Ram Thirumalai
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Example
You have borrowed |100,000 from a bank
You have promised to repay the loan in five equal yearly
payments
The first payment is at the end of the first year
The interest rate on this loan is 10% p.a.
Draw up the amortization schedule for this loan
Amortization schedule is a table that shows how each payment
is split into principal repayment and interest payment
Ram Thirumalai
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
Example
The periodic payment is |26,379.75
Amortization for first year
Interest payment = 100000 0.10 = 10,000

Principal repayment = 26379.75 10000 = 16,379.75
Immediately after first payment, the principal balance is
= 100000 16379.75 = 83,620.25
Ram Thirumalai
Time Value of Money

54 / 56
Introduction
PV and FV
EAR
Loan Amortization
Example
Amortization for second year
Interest payment = 83620.25 0.10 = 8,362.025

Principal repayment = 26379.75 8362.025 = 18,017.725
Immediately after second payment, the principal balance is
= 83620.25 18017.725 = 65,602.525
Verify the entire schedule (on the next slide) and that the ending
balance each year is the PV of remaining payments
Ram Thirumalai
Time Value of Money

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Introduction
PV and FV
EAR
Loan Amortization
The amortization schedule

Year Beginning
Balance
1
2
3
4
5
100,000.00
83,620.25
65,602.53
45,783.03
23,981.59
Ram Thirumalai
Payment
Interest
Principal
Ending
Balance
26,379.75 10,000.00 16,379.75 83,620.25

26,379.75 8,362.03 18,017.72 65,602.53
26,379.75 6,560.25 19,819.50 45,783.03
26,379.75 4,578.30 21,801.44 23,981.59
26,379.75 2,398.16 23,981.59
0.00
Time Value of Money

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Note 1: Time Value of Money

Different Types of Cash Flows

Lump-Sum Cash Flow