Time Value of Money, Part-9

Posted by Prashant Shah on September 6, 2010 If Mr. A is earning 12% rate of return and inflation for the same period happened to be 8%. The real rate of return earned by him is.. Lets first of all understand the concept of real rate. Real rate is the adjusted rate. This adjustment can done with any rate say for example an automobile companys sales has grown by 10% and the price rise during the year is 5%. The real growth in the sales of the company is Real growth is [(1+0.10)/(1+0.05)]-1 = 4.76% The equation above which we have used is Fishers equation. In the case of Mr. A the answer is [(1.12)/(1.08)] 1 = 3.70%. Hence we can say that Mr. A has earned 3.70% in terms of purchasing power even though the total rate of 12%. The concept of real rate is useful for financial planning while doing the retirement planning especially at the withdrawal stage. Now lets take up some of the miscellaneous approaches for time value First is rule of 72 If Mr. earns 12% rate of return, within how many years his money will get doubles Equation: 72/r Where r= rate of interest Answer: 72/0.12 = 6 years Second is rule of 69 Equation: 0.35 + (69/r) If we find the doubling period using previous question, the same will be Answer: 0.35 + (69/.12) = 6.1 years. Rule of 72 and 69 both are the approximation methods however rule of 69 gives better approximation.
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Important: Both the methods assume compound interest. Posted in TVM | 2 Comments

Time Value of Money, Part-8

Posted by Prashant Shah on September 4, 2010 Let say Mr. A wants to arrange money for his children forever. Will time value of money be useful to understand such arrangement? Yes definitely. The concept which we are talking about is Perpetuity. Lets understand with an example. Mr. A has Rs.10 lakh with him and wants to give some money to his children every year at the end of year. If rate of return which he can earn is 10%, what amount of money he can give to his children? 1000000 0.10 = Rs.1,00,000 forever, if rate of return is constant at 10%. Mr. A wants Rs.1 lakh forever. Rate of return is 12%, what amount of money he is required to invest now? This is the question of present value of perpetuity. PV = 100000/0.12 Answer: Rs.8,33,333 Mr. A wants Rs.1 lakh forever from today. Rate of return is 12%, what amount of money he is required to invest now? This is the question of present value of perpetuity due. PV = (100000/0.12) 1.12 Answer: Rs.9,33,333 Alternatively you can find the PV of perpetuity in normal way and can add up the required money today. Say 8,33,333+1,00,000 = Rs.9,33,333. Mr. A wants Rs.1 lakh forever at an interval of every two years. Rate of return is 12%, what amount of money he is required to invest now? We require the compound rate for two years. i.e. (1.12)2 1 = 25.44% PV = 100000/0.2544 Answer: Rs.3,93,082
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Now lets take up a challenge question Mr. A requires Rs.2 lakh forever at an interval of every three years. First withdrawal is after 1 year from today. Rate of return is 9% per annum. The amount of money to be invested today for the same is.. Answer: Keep trying All the best! Note: Answer will be published in the coming posts. Posted in TVM | Leave a Comment

Time Value of Money, Part-7

Posted by Prashant Shah on September 1, 2010 If Mr. A has been approached by Mr. B for a loan. Mr. B agrees to pay Rs. 20,000 every year increasing at the rate of 5% per annum for 10 years. Rate of interest on loan is 12%. What amount of money should Mr. A finance to Mr. B? This is the question of present value of growing annuity, where subsequent payments are increasing at a constant rate. The formula which we are going to use is as below: PV = {A [(1+r)n (1+g)n]/ (r-g)}/(1+r)n PV = {20000 [(1+0.12)10 (1+0.05)10]/(0.12-0.05)}/(1.12)10 Hence, the answer is Rs.1,35,868 Alternatively, First find the FV of growing annuity FV = 20000 [(1+0.12)10 (1+0.05)10]/(0.12-0.05) FV = 421986 Now, FV = 421986 N = 10 i/y = 12 PV = ? Answer: 1,35,868

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Mr. A wants Rs.1,00,000 per year for next 10 years from today. Every year his withdrawal will grow by 5%. He is quite sure to earn 12% return per annum. What amount of money he should deposit today so that is requirement is fulfilled. This is the question of present value of growing annuity in due mode. This question may be the most complicated in the set of growing annuity concept. It can be solved using following equation: PV = {A(1+r) [(1+r)n (1+g)n]/ (r-g)}/(1+r)n PV = {20000(1.12) [(1+0.12)10 (1+0.05)10]/(0.12-0.05)}/(1.12)10 Answer: Rs.1,52,172. As the questions of growing annuity cannot be solved using the preset equation of financial calculator, remembering all the formula is quite important because you can expect at least one question on this concept in the exam of Retirement Planning and Employee Benefits. This concept of is equally useful for Advance Financial Planning Exam. So, dont be lazy to remember this. Posted in TVM | Leave a Comment

Time Value of Money, Part-6

Posted by Prashant Shah on August 31, 2010 Mr. A plans to invest 10% of his yearly salary for next 25 years, salary increases by 5% p.a. The rate of return is 12% p.a. His current salary is Rs.2,00,000 p.a. and investments are made at the end of the year. This is the question of growing annuity where amount of investment is growing at 5% rate year on year and invested at 12% rate. We will have to use following equation as this question cannot be solved using pre-set formula of calculator. FV = A[(1+r)n (1+g)n]/(r-g) Where: FV = Future value A = Initial amount of investment r = Rate of return g = Growth rate n = Number of years So, in the above question amount of money Mr. A accumulates at the end of 25 years will be,
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FV = 20000[(1+0.12)25 (1+0.05)25]/(0.12-0.05) Hence, he will accumulate Rs.38,89,631 at the end of 25 years from now. Now lets assume that Mr. A starts investing from the beginning of the year, he will accumulate.. FV = A(1+r)[(1+r)n (1+g)n]/ r-g FV = 200001.12[(1+0.12)25 (1+0.05)25]/(0.12-0.05) Rs. 43,56,387 is the answer. This formula of growing annuity is useful when investments are growing at a constant rate. However in case where r=g, this formula is not useful, we may have to switch over to excel. Posted in TVM | Leave a Comment

Time Value of Money, Part-5

Posted by Prashant Shah on August 30, 2010 If you want 1crore rupees after 35 year, what amount of money will you have to invest from today? (Assume rate of return as 12% p.a.) This is the question of future value of annuity where we will have to find payments FV = 10000000 N = 35 i/y = 12 PMT =? (Begin mode) Answer: 20684 Let say you want to invest on monthly basis for the same amount, then FV = 10000000 N = 3512 = 420 i/y = 12/12 = 1 PMT =? (Begin mode) Answer: 1540

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Now another topic, let say you have taken a loan @ 12% for 10 years of Rs.10 lakh, what will be the EMI? This is the question of present value of annuity and we are finding payments here. PV = 1000000 (Inflow hence positive) N = 1012 = 120 i/y = 12/12 =1 PMT = ? Answer: 14347. Remember: EMIs are always paid at the end of the period, hence no need to assume begin mode. Present value of annuity is useful to find current value of all the future payments. Mr. A asks you to lend some money to him. He agrees to pay you Rs.1000 per month over a period of next 5 years. Prevailing rate of interest is 12% per annum. What amount of money should you lend him today? PMT = 1000 N = 512 = 60 i/y = 12/12 = 1 PV = ? Answer: 44955. Posted in TVM | Leave a Comment

Time Value of Money, Part-4

Posted by Prashant Shah on August 28, 2010 If Mr. A invests Rs.1000 per annum for next 10 years in a mutual fund which is earning 10% per annum. What amount of money will he receive after 10 years? This is the question of annuity. Annuity means a series of cash flows at equal interval. Payments of EMI, receipt of salary are a few of the examples of annuity. Annuity is of two types: Annuity Due: Where cash flow happens at the beginning of the period
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Annuity End: Where the cash flow happens at the end of the period Lets solve the above question considering Annuity End We dont get into formulae of the annuity and we will use a financial calculator PMT = -1000 N = 10 i/y = 10 FV = ? Answer: 15,937 Calculation for Annuity Due: PMT = -1000 (begin mode) N = 10 i/y = 10 FV = ? Answer = 17,531 Alternatively you can multiply the annuity end answer with rate of interest to get the answer. E.g. 15,937 1.1 = 17,531. Annuity can also be in monthly/quarterly or semi-annual intervals. In that case we will alter N and i/y as we did in the Part-3 of the time value of money learning. Mr. A has Rs.10,000 today and want to invest further Rs.1000 per year from today for next 10 years in a mutual fund earning 10% return. After 10 years he will get.. PV = -10000 PMT = -1000(begin mode) N = 10 i/y = 10 FV = ? Answer: 43,469.
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Important: Here initial value and annuity both are taken negative because both are outflows. Posted in TVM | Leave a Comment

Time Value of Money, Part-3

Posted by Prashant Shah on August 27, 2010 How to use future value and present value concepts when compounding is not annual? Lets first of all understand the concept of simple interest and compound interest. Simple Interest: I invested Rs.100 for 3 years at simple interest of 10% per annum. In this case interest = 10010% = Rs.10 So Rs.10 will be paid over a period of 3 years and Rs.100 will be paid back as maturity value. Year 1 2 3 Amt Rs. 10 10 10+100

Now instead, I invested Rs.100 for 3 years at compound interest of 10% per annum There will be no intermittent cash inflows to me and whatever interest is accrued will be reinvested at 10% and I will get a lump sum at the end of 3 years. Year 1 2 3 Amt Rs. at the end of year 100+10(interest @10%) = 110 110+11(interest @10%) = 121 121+12.1(interest @10%) = 133.1

Hence I will get Rs.133.1 at the end of 3 years. This is the concept of compound interest and it differs from simple interest. Practically majority of the investment products follow the concept of compound interest. Normally compounding can be made on monthly/quarterly/semi-annually/annual basis. Semi-annual compounding: Mr. A invested Rs.1000 in National Saving Certificate. Maturity is 6 years and rate of interest is 8% compounded semi-annually. What amount he will receive at maturity? Solution: PV = -1000
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i/y = 8/2 = 4 (as compounding is semi-annual) N = 62 = 12 (as compounding is semi-annual) FV = ? Answer: Rs.1601 Quarterly compounding: Mr. A invested Rs.1000 in bank fixed deposit. Maturity is 5 years and rate of interest is 8% compounded quarterly. What amount he will receive at maturity? PV = -1000 i/y = 8/4 = 2 (as compounding is quarterly) N = 54 = 20 (as compounding is quarterly) FV = ? Answer: Rs.1486. Monthly Compounding: Mr. A invested Rs.1000 in company fixed deposit. Maturity is 5 years and rate of interest is 12% compounded monthly. What amount he will receive at maturity? PV = -1000 i/y = 12/12 = 1 (as compounding is monthly) N = 512 = 60 (as compounding is monthly) FV = ? Answer: Rs.1817. Note: Practice questions will be published soon. Posted in TVM | Leave a Comment

Time Value of Money, Part-2

Posted by Prashant Shah on August 26, 2010 If somebody says that he will give you Rs.1000 after 5 years at an interest rate of 10%. What amount of money you will be willing to pay him now?

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Solution: FV = 1000 N=5 i/y = 10 PV = ? If the same person says that you pay me Rs.500 today and I will give you Rs.1000 after 5 years. What rate of return will you realized from this? Solution: PV = -500 N=5 FV = 1000 i/y = ? The concept of present value and future value are very important for evaluating various investment options. Important: When asked to find i/y or rate of return on calculator you may get answer as error. Reason is either of PV or FV is to be assumed negative while solving on calculator or on excel. So lets make a rule that when outflow is given we will assume it negative and inflow will be assumed positive Posted in TVM | Leave a Comment

Time Value of Money, Part-1

Posted by Prashant Shah on August 26, 2010 We know that receiving Rs.100 today is more than receiving the same amount one year hence. The simplest reason behind this is opportunity cost. We could have earned interest on the amount if saved. To understand in a proper way lets begin with Future Value concept I assume that you are using a financial calculator Example : If I am investing Rs.100 today in a bank deposit which pays me 8% interest, what amount of money will I receive at the end of 1 year? Solution: PV =100
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N=1 i/y = 8 FV = ? Let investment period be 10 years in the above illustration, the amount receivable will be Solution: PV =100 N=10 i/y = 8 FV = ? This is how future value of the money invested can be found. Important: Make sure that you clear the values entered in the calculator before entering the new values.

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