CHAPTER 4 TIME VALUE OF MONEY

CONTENTS
Introduction Basis of Time Value

Future Value of Annuity Present Value of Annuity Periodicity of Compounding & discounting Continuous Compounding & Discounting Equated Monthly Instalments
Finding EMIs Segregating EMIs into Interest and Principal
2

Compounding & Discounting Discounting & Present Value

Chapter 4 Time Value of Money

TIME VALUE OF MONEY

Time value of money is probably one of the most important concepts that forms the basis of decision making in almost all areas of finance. The applications range from personal finance areas to corporate finance like capital budgeting and valuation and derivatives and risk management. The time value of money states that not only the amount of money is important but when is it received or paid is equally important.
Chapter 4 Time Value of Money 3

TIME VALUE OF MONEY

The reason for the time value of money is that it has capacity to increase in value even when it is not put to any use. 3 causes creating time value of money.
Presence of inflation, Preference for current consumption, and Investment opportunities available

Time value of money does not account for the risk associated with investment
Chapter 4 Time Value of Money 4

COMPOUNDING
Interest rate prevailing in the market form the basis of finding the time value of money. The value of money increases with time due to application of interest. It grows at a higher rate when interest is applied on the interest. Application of interest over interest is known as compounding.
Future Value F = P x (1+r)n
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COMPOUNDING AND RATE

Effect of compounding/discounting is more pronounced as time extends or the discount rate increases
10.00 9.00 8.00

Future Value

7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 1 2 at 5% 3 at 10% 4 5 at 15% 6 7 at 20% 8 at 25% 9

Time (yrs)

Chapter 4 Time Value of Money

COMPOUNDING AND TIME

Compounding/Discounting effect increases as the time lengthens
(Rs. 1 at 12%) 3.50 3.00 2.773 2.476 1.762 1.974 2.211 3.106

Future Value

2.50 2.00 1.50 1.00 0.50 0.00 1.120 1.254 1.405 1.574

Time (yrs)

Chapter 4 Time Value of Money

DISCOUNTING
Value of the money received or paid later is less than what it is today by the amount of interest for the time. The process of reduction in value eliminating the interest that could have accrued is known as discounting.
P = F (1 + r ) n

Chapter 4 Time Value of Money

DISCOUNTING AND RATE

Effect of discounting is more pronounced as time extends or the discount rate increases
1.00 0.90 0.80

Present Value

0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 1 2 at 5% 3 at 10% 4 5 at 15% 6 at 20% 7 8 at 25% 9

Time (yrs)

Chapter 4 Time Value of Money

DISCOUNTING AND TIME

Compounding/Discounting effect increases as the time lengthens
(Rs. 1 at 12%) 1.00 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 0.893 0.797 0.712 0.636 0.567

Present Value

0.507

0.452

0.404

0.361

0.322

Time (yrs)
Chapter 4 Time Value of Money 10

FUTURE VALUE OF ANNUITY

Future value is simply the amount of principal and the interest for a given time. Annuities refer to the equal amounts of cash flows spaced uniformly over time, normally a year. The value of equal amount of receivable or payable at evenly spaced intervals of time at a given rate of interest is called future value of annuity.
Future Value of Annuity of Rs. 1, FVA (r, n) =
Chapter 4 Time Value of Money

(1 + r)n
1
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FUTURE VALUE OF ANNUITY

Mr. Warren Buffet decided to donate 85% of his $ 44 billion fortune to Bill & Melinda Gatess Foundation in instalments of $ 1.5 billion every year. Mr. Buffet stipulated that the annual payments must be distributed to the beneficiaries within a year before the subsequent payment is made. If Mr. Buffet did not stipulate the condition and instead Gatess Foundation decided to invest annual contribution at 8% and spend the aggregate sum only upon receiving the entire contribution promised, what amount would the foundation have at the end? The donation of Mr. Warren Buffet would last for next 25 years (0.85 x 44/1.5). If Gatess Foundation invested $1.5 billion every year for next 25 years at 8% the value received after 25 years would be = $1.5 billion x FV of Annuity (8%, 25 yrs) = 1.5 x 73.106 = $109.659 billion n
Future Value Annuity Factor at r% for n years, FVA(r, n) =
Chapter 4 Time Value of Money

(1 + r) r

-1

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PRESENT VALUE OF ANNUITY

Similarly for a sum receivable or payable at a future date can be equated with the equal amounts evenly spaced over time at a known rate of interest.
Present Value of Annuity of Rs. 1, PVA (r,n) =

(1+ r)n
1
1

Present Value Annuity Factor at r% for n years, PVA(r, n) = (1 + r)n - 1 r(1 + r)n

Chapter 4 Time Value of Money

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PRESENT VALUE OF ANNUITY

We found that Mr. Warren Buffet, decided to donate 85% of his $ 44 billion fortune to Bill & Melinda Gatess Foundation in instalments of $1.5 billion every year. Do you think that Mr. Warren Buffet has really donated 85% of the wealth? If not what is the % of wealth is being really donated by him assuming that he earns 8% on his wealth? The donation of Mr. Warren Buffet would last for next 25 years (0.85 x 44/1.5). If Gatess Foundation invested $1.5 billion every year for next 25 years at 8% the value received after 25 years would be = $1.5 billion x PV of Annuity (8%, 25 yrs) = 1.5 x 10.6748 = $16.0122 billion The fraction of present wealth being donated = 16.0122/44= 36.39%
Chapter 4 Time Value of Money 14

CONTINUOUS COMPOUNDING
Value of compounding or discounting changes depending upon how often it is done. The value rises/falls exponentially if we assume continuous compounding.

Future Value, F = P x e rt Present Value, P= F x

Chapter 4 Time Value of Money

1 e
rt

=F x e

- rt

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EFFECTIVE RATE OF INTEREST

The effective rate may be found for a given annual rate of r and m number of compounding in a year by
Effective Interest Rate = r m { 1+ } - 1 m

For continuous compounding the effective rate of interest may be found from the expression er 1.
Chapter 4 Time Value of Money 16

EQUATED MONTHLY INSTALMENTS

Loans are repayable normally in Equated Monthly Installments (EMIs), the computation of which uses the concept of time value of money and annuity factors. Each EMI can be bifurcated into interest and principal repayment. The proportion of interest declines and amount towards principal increases with successive EMIs in such a manner that the aggregate of the two remains same.

Chapter 4 Time Value of Money

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FINDING EMI IN ADVANCE

Chapter 4 Time Value of Money

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SEGREGATING EMIs
Principal Amount (Rs.) 20,000 Interest rate (%) 10%

Period (years)

EMI (Rs. Per month)

640.01

Instalment No. Period

Cash Flow for the period

Discount Factor

Present Value

Principal outstanding at the beginning of period

Interest Amount

Principal Repaid

1 2 3 4 5 6

- 19,359.99 640.01 640.01 640.01 640.01 640.01 640.01

1.0000 0.9917 0.9835 0.9754 0.9673 0.9594 0.9514

-19,359.99 634.72 629.48 624.27 619.11 614.00 608.92 19,359.99 18,881.31 18,398.65 17,911.96 17,421.21 16,926.38 161.33 157.34 153.32 149.27 145.18 141.05 478.68 482.67 486.69 490.74 494.83 498.96

Chapter 4 Time Value of Money

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