Time Value of Money

The Time Value of Money

Would you prefer to have 1 million rupee now or 1 million rupee 10 years from now?

Of course, we would all prefer the money now!

This illustrates that there is an inherent monetary value attached to time.

The Interest Rate

Which would you prefer Rs.10,000 today or Rs.10,000 in 5 years? Obviously, Rs.10,000 today. You already recognize that there is

TIME VALUE TO MONEY!!

Why TIME?
Why is TIME such an important element in your decision? TIME allows you the opportunity to postpone consumption and earn INTEREST.

What is The Time Value of Money?

Money value today is worth more than received tomorrow

This is because a rupee received today can be invested to earn interest The amount of interest earned depends on the rate of return that can be earned on the investment

Time value of money quantifies the value of a rupee through time

Required Rate of Return

The time preference for money is generally expressed by an interest rate. This rate will be positive even in the absence of any risk. It may be therefore called the risk-free rate. An investor requires compensation for assuming risk, which is called risk premium. The investors required rate of return is: Risk-free rate + Risk premium

Time Value Adjustment

Two most common methods of adjusting cash flows for time value of money: Compounding the process of calculating future values of cash flows and Discounting the process of calculating present values of cash flows.

Uses of Time Value of Money

Time Value of Money, or TVM, is a concept that is used in all aspects of finance including:

Bond valuation Stock valuation Accept/reject decisions for project management Financial analysis of firms And many others!

Formulas

Common formulas that are used in TVM calculations:* Present value of a lump sum: PV = CFn / (1+i)n OR PV = FV / (1+i)n = PV (PVIFi,n( Future value of a lump sum: FV = CF0 * (1+i)n OR FV = PV * (1+i)n = FV (FVIFi,n( Present value of a cash flow stream:
n

PV = S [CFt / (1+i)t]
t=0

Formulas (continued)

Future value of a cash flow stream: FV = S [CFt * (1+i)t-n]

t=0 n

Present value of an annuity: PVA = A * {[(1+i)n - 1]/ [i (1+i)n]} = A ( PVIFAi,n) Future value of an annuity: FVA = A * {[(1+i)n - 1]/i} = A ( FVIFAi,n)

Annuity for the present value Loan Amortization or capital recovery A = PVA / {[(1+i)n - 1]/ [i (1+i)n]} Annuity for the future value Sinking Fund A = FVA / {[(1+i)n - 1]/i}

Effective Interest Rate = ( 1+i/m )nm 1 = A * {[(1+i/m)nm - 1]/i} 1

Present value of perpetuity or indefinite annuity = A/i

Variables

where

i = rate of return t = time period n = number of time periods A = Annuity CF = Cash flow (the subscripts t and 0 mean at time t and at time zero, respectively) PV = present value (PVA = present value of an annuity) FV = future value (FVA = future value of an annuity)

Basic Rules

The following are simple rules that you should always use no matter what type of TVM problem you are trying to solve: 1. Stop and think: Make sure you understand what the problem is asking. You will get the wrong answer if you are answering the wrong question. 2. Draw a representative timeline and label the cash flows and time periods appropriately. 3. Write out the complete formula using symbols first and then substitute the actual numbers to solve. 4. Check your answers using a calculator. While these may seem like trivial and time consuming tasks, they will significantly increase your understanding of the material and your accuracy rate.

The Time Value of Money

The Interest Rate Simple Interest Compound Interest Amortizing a Loan Compounding More Than Once per Year

Types of Interest

Simple Interest

Interest paid (earned) on only the original amount, or principal, borrowed (lent).

Compound

Interest

Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent).

Simple Interest Formula

Formula
SI: P0: i: n:

SI = P0(i)(n)
Simple Interest Deposit today (t=0) Interest Rate per Period Number of Time Periods

Simple Interest Example

Assume that you deposit Rs.1,000 in an account earning 7% simple interest for 2 years. What is the accumulated interest at the end of the 2nd year?

SI

= P0(i)(n) = Rs.1,000(.07)(2) = Rs.140

Simple Interest (FV)

What is the Future Value (FV) of the deposit?

FV = P0 + SI = Rs.1,000 + Rs.140 = Rs.1,140 Future Value is the value at some future time of a present amount of money, or a series of payments, evaluated at a given interest rate.

Simple Interest (PV

What is the Present Value (PV) of the previous problem?

The Present Value is simply the Rs.1,000 you originally deposited. That is the value today! Present Value is the current value of a future amount of money, or a series of payments, evaluated at a given interest rate.

Why Compound Interest?

Future Value of a Single Rs.1,000 Deposit
20000 15000 10000 5000 0 1st Year 10th Year 20th Year 30th Year 10% Simple Interest 7% Compound Interest 10% Compound Interest

Future Value Single Deposit (Formula)

FV1 = P0 (1+i)1 =Rs.1,000(1.07) = Rs.1,070

Compound Interest You earned Rs.70 interest on your Rs.1,000 deposit over the first year. This is the same amount of interest you would earn under simple interest.

Future Value Single Deposit (Formula)

FV1 1st Year 2nd Year FV2 = P0 (1+i)1 = Rs.1,000 (1.07) = Rs.1,070 = Rs.1,140

= FV1 (1+i)1 = P0 (1+i)(1+i) = P0 (1+i)2 = Rs.1,000(1.07)(1.07) = Rs.1,000(1.07)2 = Rs.1,144.90

You earned an EXTRA Rs.4.90 in Year 2 with compound over simple interest.

General Future Value Formula

FV1 = P0(1+i)1 FV2 = P0(1+i)2 General Future Value Formula: FVn = P0 (1+i)n or FVn = P0 (FVIFi,n) -- See Table I

Valuation Using Table I

FVIFi,n is found on Table I at the end of the book

Period 1 2 3 4 5 6% 1.060 1.124 1.191 1.262 1.338 7% 1.070 1.145 1.225 1.311 1.403 8% 1.080 1.166 1.260 1.360 1.469

Using Future Value Tables

FV2 = Rs.1,000 (FVIF7%,2)=Rs.1,000 (1.145) =Rs.1,145 [Due to Rounding]

Period 1 2 3 4 5

6% 1.060 1.124 1.191 1.262 1.338

7% 1.070 1.145 1.225 1.311 1.403

8% 1.080 1.166 1.260 1.360 1.469

The Rule-of-72 and 69

Quick! How long does it take to double Rs.5,000 at a compound rate of 12% per year (approx.)? Approx. Years to Double = 72 / i% = 0.35 + 69 / i%
Approx. Years to Double = 72 / i% 72 / 12% = 6 Years [Actual Time is 6.12 Years]

Present Value Single Deposit (Formula)

PV0 = FV2 / (1+i)2 = FV2 / (1+i)2 = Rs.1,000 / (1.07)2 = Rs.873.44

General Present Value Formula

PV0 = FV1 / (1+i)1 PV0 = FV2 / (1+i)2

General Present Value Formula: PV0 = FVn / (1+i)n or PV0 = FVn (PVIFi,n) -- See Table II

Valuation Using Table II

PVIFi,n is found on Table II at the end of the book.

Period 1 2 3 4 5

6% .943 .890 .840 .792 .747

7% .935 .873 .816 .763 .713

8% .926 .857 .794 .735 .681

Types of Annuities

An Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods.

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

Ordinary Annuity -- FVA

FVAn = A(1+i)n-1 + A(1+i)n-2 + A(1+i)1 + A(1+i)0 ... +

Valuation Using Table III

FVAn FVA3

= A (FVIFAi%,n) = Rs.1,000 (FVIFA7%,3) = Rs.1,000 (3.215) = Rs.3,215

Period 1 2 3 4 5

6% 1.000 2.060 3.184 4.375 5.637

7% 1.000 2.070 3.215 4.440 5.751

8% 1.000 2.080 3.246 4.506 5.867

Annuity Due -- FVAD

FVADn = A(1+i)n + A(1+i)n-1 + A(1+i)2 + A(1+i)1 = FVAn (1+i) ... +

Example of an Annuity Due -- FVAD

FVAD3 = Rs.1,000(1.07)3 + Rs.1,000(1.07)2 + Rs.1,000(1.07)1 = Rs.1,225 + Rs.1,145 + Rs.1,070 = Rs.3,440

Valuation Using Table III

FVADn = A (FVIFAi%,n)(1+i) FVAD3 = Rs.1,000 (FVIFA7%,3)(1.07) = Rs.1,000 (3.215)(1.07) = Rs.3,440

Period 1 2 3 4 5 6% 1.000 2.060 3.184 4.375 5.637 7% 1.000 2.070 3.215 4.440 5.751 8% 1.000 2.080 3.246 4.506 5.867

Overview of an Ordinary Annuity -- PVA

PVAn = A/(1+i)1 + A/(1+i)2 + ... + A/(1+i)n

Example of an Ordinary Annuity -- PVA

PVA3 =Rs.1,000/(1.07)1 + Rs.1,000/(1.07)2 + Rs.1,000/(1.07)3 = Rs.934.58 + Rs.873.44 + Rs.816.30 = Rs.2,624.32

Valuation Using Table IV

PVAn PVA3 = A (PVIFAi%,n) = Rs.1,000 (PVIFA7%,3) = Rs.1,000 (2.624) = Rs.2,624
6% 0.943 1.833 2.673 3.465 4.212 7% 0.935 1.808 2.624 3.387 4.100 8% 0.926 1.783 2.577 3.312 3.993

Period 1 2 3 4 5

Overview of an Annuity Due -- PVAD

PVADn = A/(1+i)0 + A/(1+i)1 + ... + A//(1+i)n-1 = PVAn (1+i)

Example of an Annuity Due -- PVAD

PVADn = Rs.1,000/(1.07)0 + Rs.1,000/(1.07)1 + Rs.1,000/(1.07)2 = Rs.2,808.02

Valuation Using Table IV

PVADn = A (PVIFAi%,n)(1+i) PVAD3 = Rs.1,000 (PVIFA7%,3)(1.07) = Rs.1,000 (2.624)(1.07) = Rs.2,808

Period 1 2 3 4 5 6% 0.943 1.833 2.673 3.465 4.212 7% 0.935 1.808 2.624 3.387 4.100 8% 0.926 1.783 2.577 3.312 3.993

How much will Rs.10,000 placed in a bank account paying 5% per year be worth compounded annually after 10 years?

FV= Rs.16,289

What will be the Present Value of Rs.10,000 placed in a bank account paying 8% per year be worth compounded annually after 10 years?

PV=Rs.4631.93

If you deposit Rs.50,000 today in a financial institute at the rate of 8 per cent in how many (roughly) years will this double using rule 72 and rule 69.

Solution. (a) DP = 72 / i = 72 / 8 = 9 years (b) DP = 0.35 + 69 / i = 0.35 + 69 / 8 = 8.975 years

Your 69-year old aunt has savings of Rs.35,000. She has made arrangements to enter a home for the aged on reaching the age of 80. Your aunt wants to decrease her savings by a constant amount each year for ten years, with a zero balance remaining. How much can she withdraw each year if she earns 6% annually on her savings? Her first withdrawal would be one year from today.

Rs.4,755.37

Someone you know is about to retire. His firm has given him the option of retiring with a lump sum of Rs.20,000 or an annuity of Rs.2,500 for ten years. Which is worth more now, if an interest rate of 7% is utilized for the annuity? Do not consider taxes.

You are considering the purchase of a Rs.50,000 machine, which is expected to generate Rs.11,511.19 annually for 8 years. What is the expected return on the investment?

A machine costs Rs.50,000 and is expected to yield a 16% annual rate of return on your investment, for 8 years. What is the annual income from the machine? Your banker tells you that a Rs.85,000 loan, for 30 years, has an annual payment of Rs.8,273.59. What must be the interest rate on the loan?