Time value of money

The time preference of money

An individual value the opportunity or receive money now higher than waiting for one or more periods, because Risk: he is not sure about the future cash receipts because of the uncertainty. Preference for consumption: money is the means by which we acquire most goods and services, we may prefer present consumption. Investment opportunities: the present can earn additional cash, so we wish to have opportunity to earn interest would lead us to prefer the money now rather than money a year hence.

Time value of money

Many financial problems involve cash flow occurring at different intervals. To evaluate the time value of money one has to understand Future value of single amount Future value of an annuity Present value of a single amount Present value of an annuity.

Future value of single amount

I year Principal at the beg

1000

Interest for the year (1000X.1) Principal at the end

II year Principal at the beg

100
1100 1100

Interest (1100X.1)
Principal at the end III yr Principal at the beg Interest (1210X.1) Principal at the end

110
1210 1210 121 1331

Formula for the future Value of single amount

FVn = PV (1+k)n

FVn PV
k n

Future value n years hence Cash today (present value) Interest rate per year No. of years compounding is done

Future value table

The factor (1+k)n is referred as the compounding factor or the future value of interest factor (FVIF k,n). This values are published in table showing this factor in various combinations of k and n. for eg.,
n/k
6% 8% 10% 12% 14%

2 4 6 8

1.124

1.166

1.210

1.254

1.300

1.262 1.419 1.594

1.360 1.587 1.851

1.464 1.772 2.144

1.574 1.974 2.476

1.689 2.195 2.853

DOUBLING PERIOD

To know the period it takes to double the amount of principal at a given interest rate, there is a rule of thumb called rule of 72. As per this rule the doubling period is obtained by dividing the interest rate by 72. i.e., if the interst rate is 8%, it takes (72/8) about 9 years to double the principal. There is another rule, which would be more accurate, called rule of 69. here the doubling period is equal to 0.35+69/k where k is the interest rate.

Shorter compounding period

I six mth

P @ beg

1000

If the compounding is done more than once in a year, interest is paid more frequently, for example if we deposit Rs.1000 with 12% interest, semiannually the sum grows like this.,

Int. for 6mth

(1000*.12/ 2)

60

P @ end

1060 1060

II six mth

P @ beg

Int. for 6mth

(1060*.12/ 2)

63.6

P @ end

1123.6

Formula for shorter compounding period

FV n = PV (1+k/m) mxn
Where m=number of times compounding is done during a year
n=number of years for which compounding is done.

Example

PV: 15000; Interest-12%p.a; n-5; quarterly compounding. What is the future value
4X5

FV= 15000(1+(.12/4)
Rs.27091

Effective versus nominal rate

We have seen above that Rs.1000 grows to Rs.1123.6 at the year end at the rate of 12% when compounding is done semiannually. That is 1000 grows at 12.36%, which is the effective rate of interest. Here 12% is the nominal rate and 12.36% is the effective rate.

Formula to find out the effective rate

r = (1+k/m)m -1

r = effective rate of interest k = nominal rate of interest m= frequency of compounding per year

Future value of an annuity

An annuity is a series of periodic cash flows (payments or receipts) of equal amount. The examples are insurance premium etc., Suppose we deposit Rs.1000 annually in a bank for 5 yrs, with the rate of 10%, the future value of such series of deposits would be like this:

1 1000

2 1000

3 1000

4 1000

5 1000

+ 1100 + 1210 + 1331 + 1464 6105

Future value of an annuity

FVA n = A(1+k) n-1+A(1+k)n-2+.+A
=A
1+k)n-1 k

Table for the future value annuity

The term (1+k)n -1

k Is referred as(FVIFA k,n) . This value is given as table for several combinations of k and n. for example,

n /k
2

6%
2.06

8%

10%

12% 14%
2.12 2.14

2.08 2.11

4
6

4.375
6.97

4.50 4.641 7
7.33 7.71

4.77 9
8.11

4.92
8.53

9.89

10.6 11.4

12.2

13.2

Annuity

If Ram invests 1500 at the end of first, second and third year, then it will be termed as annuity. The formula in such situations will be slightly different from FVIF. Let us now find the Future value of this annuity at the end of three years at an interest rate of 5%.

1500 FVIFA (5%, 3) = 1500 ((1+.05)3-1)/.05 = 1500 x 3.1525 = Rs 4,728.75.

Here the cash flows occur at the end of each period. Such an annuity is termed as regular or deferred annuity. But if the annuity payments are made at the beginning of each period then it is termed as annuity due and in such a situation the formula for Future Value annuity will be: FVIFA (due) = (1+k) FVIFA (for regular annuity).

Suppose in the above example Ram invests Rs 1,500 at the beginning of the first, second and third year, then the accumulated value that he will get at the end of three years will be: = 1500 FVIFA (due) = 1500 (1+k) FVIFA (for regular annuity). From the previous example, FVIFA (for regular annuity) = 3.1525. = 1500 (1+.05) 3.1525 = Rs 4,965.19

Sinking Fund Factor: It helps in computing the amount that has to be invested at the end of every year for a period of n years at the rate of interest k in order to accumulate Rs. 1 at the end of the period. If S is the amount that one wants to accumulate at the end of n years then the amount A to be deposited at the end of each period can be computed as: A=S X k/((1+k)n-1) The term k/((1+k)n-1) is called Sinking Fund factor

Ltd. has to repay Rs. 55,000 worth debentures at the end of 5 years from now. How much should the firm deposit each year at an interest rate of 5% so that it grows to Rs 55, 000 at the end of the fifth year

5500X0.05/(1+0.05)5-1 = Rs 9,954.

Compounded annual growth rate

A bank offers you to deposit Rs.1000 and promises to pay Rs.1762 after 5 years. What is the interest rate? FV=1762; PV-1000; n=5 CAGR (1/n) (Ending value/ beginning value) -1

Present value of a single amount

Suppose someone promises you to give your Rs.1000, three years hence, what is the present value of this at the rate of 10%?
Value three year hence= 1000 Value two year hence =1000(1/1.1) Value one year hence =1000(1/1.1)(1/1.1) Value now (present) =1000(1/1.1) (1/1.1) (1/1.1)

Formula for the present value of single amount

The process of discounting, used for calculating the present value, is the inverse of compounding. Thus, n PV= FV n 1
1+k the factor, highlighted is called the discounting factor of the present value of interest factor. It is available in the table as

(PVIF k,n)

An investor wants to know the present value of Rs.50000 to be received after 15 years if the interest rate is 9% FV=50000;n=15;i=9% FV*PVFA 15,9%= 50000*0.275=13750

Present value of an annuity

Suppose we expect to receive Rs.1000 annually for 3 years, each receipt occuring at the end of the year, what is the present value of the stream of the benefits?
2 3

1000

1 1.1

+1000

1 1.1

+ 1000 1 1.1

1 1000

2 1000

3 1000

901.1

826.4 751.3 2478.8

PVIFA (Present Value Investment Factor of an Annuity) = ((1 + k)n-1)/[k(1 + k)n] (or) 1-(1/1+k)n/ k

A person wants to receive Rs.5000 every year for the next four years. How much he should invest now at 10%? A= 5000; n=4; i=10%; PV=? Using table D or formula 5000XPVFA 10%,4 = 5000*3.170=15850

Capital recovery factor

Capital recovery is an annuity from an investment made for a specified time at a given rate of interest It is the reciprocal of present value investment factor for annuity. It is particularly used in preparation of a loan amortization schedule.

Capital recovery factor =k(1+k)n/(1+k)n-1

problem

Ananya borrowed a loan of Rs 14,000 at a rate of 9% for a period of three years. Prepare a loan amortization schedule using the given data

The annual installment for a loan of Rs. 14,000 at a rate of 9% can be computed using the capital recovery factor. k(1+k)n Annual installment 14,000 x (1+k)n - 1 = 14,000 x = 14,000 x 0.3951 = Rs. 5531

End of Year

Annual installment

Interest

Principal Outstanding Balance

1 2 3

5531 5531 5531

1260 876 457

4271 4655 5074

9729 5074 0

Present Value of Perpetuity

Perpetuity is an annuity of infinite duration. The present value of perpetuity is computed as:

where, A is the constant annual payment

PAST QUESTIONS
1.

Calculate the following:

1.

2.

Compound value of Rs.10000 at the end of 3 years @12% rate, when interest is calculated on (a) yearly (b) half yearly (c)quarterly basis If you deposit Rs.5000 today @ 6% rate, in how many years the amount will double.(7)

2. 3.

What is meant by time value of money(3) How is the concept of :present value related to the time value of money?