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Chapter 5

THE TIME VALUE OF MONEY The Magic of Compounding

Outline
Why Time Value
Future Value of a Single Amount
Future Value of an Annuity Present Value of a Single Amount Present Value of an Annuity

Why Time Value


A rupee today is more valuable than a rupee a year hence. Why ? Preference for current consumption over future consumption

Productivity of capital
Inflation Many financial problems involve cash flows occurring at different points of time. For evaluating such cash flows, an explicit consideration of time value of money is required.

Time Line
Part A 0 12% 1 12% 10,000 10,000 2 12% 10,000 3 12% 10,000 4 12% 10,000 5

Part B 0 12% 10,000 10,000 1 12% 2 12% 10,000 10,000 3 12% 10,000 4 12% 5

Notation
PV FVn : Present value : Future value n years hence

Ct
A r g n

: Cash flow occurring at the end of year t


: A stream of constant periodic cash flow over a given time : Interest rate or discount rate : Expected growth rate in cash flows : Number of periods over which the cash flows occur.

Future Value Of A Single Amount


Rs
First year: Principal at the beginning Interest for the year (Rs.1,000 x 0.10) 1,000 100

Principal at the end


Second year: Principal at the beginning Interest for the year

1,100
1,100

(Rs.1,100 x 0.10) Principal at the end


Third year: Principal at the beginning Interest for the year (Rs.1,210 x 0.10) Principal at the end Formula

110 1,210
1,210 121 1,331

Future value = Present value (1+r)n

Value Of FVr,n For Various Combinations Of r And n


n/r 2 4 6 8 10 6% 1.124 1.262 1.419 1.594 1.791 8% 1.166 1.361 1.587 1.851 2.518 10 % 1.210 1.464 1.772 2.144 2.594 12 % 1.254 1.574 1.974 2.476 3.106 14 % 1.300 1.689 2.195 2.853 3.707

Doubling Period
Thumb Rule : Rule of 72 72 Doubling period = Interest rate Interest rate : 15 percent 72 = 4.8 years Doubling period = 15 A more accurate thumb rule : Rule of 69
Doubling period = 0.35 +

69
Interest rate

Interest rate : 15 percent


Doubling period = 0.35 +

69 15

= 4.95 years

Future Value in Real Terms


So far we calculated the future value figures in nominal terms. To convert a nominal figure into a real figure, you have to adjust for the inflation factor. For example, if you earn a nominal rate of return of 15 percent on an investment of Rs. 100 for one year when the inflation rate is 6 percent, your investment grows as follows:
In Nominal Terms 100 (1.15) = Rs. 115 In Real Terms Rs. 108.49

=
100 1.15 1.06

In general, the future value in real terms is:


1 + Nominal rate Present value Note the following relationship: 1 + Inflation rate
n

1 + Nominal rate
1 + Real rate =

Put differently,
Real rate =

1 + Inflation rate Nominal rate Inflation rate 1 + Inflation rate

Present Value of A Single Amount


PV = FVn [1/ (1 + r)n] n/r 2 4 6% 0.890 0.792 8% 0.857 0.735 10% 0.826 0.683 12% 0.797 0.636 14% 0.770 0.592

6
8 10

0.705
0.626 0.558

0.630
0.540 0.463

0.565
0.467 0.386

0.507
0.404 0.322

0.456
0.351 0.270

12

0.497

0.397

0.319

0.257

0.208

Present Value Of An Uneven Series


A1
PVn = (1 + r) n t =1 + (1 + r)2 At (1 + r)t Cash Flow Rs. 1,000 2,000 2,000 3,000 3,000 4,000 4,000 5,000 PVIF12%,n 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 Present Value of Individual Cash Flow 893 1,594 1,424 1,908 1,701 2,028 1,808 2,020 13,376

A2
+ +

An
(1 + r)n

Year 1 2 3 4 5 6 7 8

Present Value of the Cash Flow Stream

Future Value Of An Annuity


An annuity is a series of periodic cash flows (payments and receipts ) of equal amounts
1 1,000 2 1,000 3 1,000 4 1,000 5 1,000 + 1,100

+ 1,210 + 1,331 +

1,464
Rs.6,105

Future value of an annuity = A [(1+r)n-1] r

What Lies In Store For You


Suppose you have decided to deposit Rs.30,000 per year in your Public Provident Fund Account for 30 years. What will be the accumulated amount in your Public Provident Fund Account at the end of 30 years if the interest rate is 11 percent ? The accumulated sum will be : Rs.30,000 (FVIFA11%,30yrs)

= Rs.30,000

(1.11)30 - 1
.11

= Rs.30,000 [ 199.02] = Rs.5,970,600

How Much Should You Save Annually?


You want to buy a house after 5 years when it is expected to cost Rs.2 million. How much should you save annually if your savings earn a compound return of 12 percent ? The future value interest factor for a 5 year annuity, given an interest rate of 12 percent, is :

(1+0.12)5 - 1
FVIFA n=5, r=12% = 0.12 = 6.353

The annual savings should be : Rs.2000,000 = Rs.314,812 6.353

Annual Deposit In A Sinking Fund


Futura Limited has an obligation to redeem Rs.500 million bonds 6 years hence. How much should the company deposit annually in a sinking fund account wherein it earns 14 percent interest to cumulate Rs.500 million in 6 years time ?
The future value interest factor for a 6 year annuity, given an interest rate of 14 percent is : FVIFAn=6, r=14% = (1+0.14)6 1 0.14 The annual sinking fund deposit should be : Rs.500 million = Rs.58.575 million 8.536 = Rs. 58.575 = 8.536

Finding The Interest Rate


A finance company advertises that it will pay a lump sum of Rs.8,000 at the end of 6 years to investors who deposit annually Rs.1,000 for 6 years. What interest rate is implicit in this offer?
The interest rate may be calculated in two steps : 1. Find the FVIFAr,6 for this contract as follows : Rs.8,000 = Rs.1,000 x FVIFAr,6 FVIFAr,6 2. = Rs.8,000 Rs.1,000 Look at the FVIFAr,n table and read the row corresponding to = 8.000

6 years until you find a value close to 8.000. Doing so, we find that FVIFA12%,6 is 8.115. So, we conclude that the interest rate is slightly below 12 percent.

How Long Should You Wait


You want to take up a trip to the moon which costs Rs.1,000,000 . The cost is expected to remain unchanged in nominal terms. You can save annually Rs.50,000 to fulfill your desire. How long will you have to wait if your savings earn an interest of 12 percent ? The future value of an annuity of Rs.50,000 that earns 12 percent is equated to Rs.1,000,000.
50,000 x FVIFAn=?,12% = 1,000,000 50,000 x 1.12n 1 = 1,000,000 0.12

1.12n - 1 =
1.12n n log 1.12 n = = =

1,000,000 x 0.12 = 2.4


50,000 2.4 + 1 = 3.4 log 3.4 0.5315

n x 0.0492 = 0.0492

0.5315 = 10.8 years

You will have to wait for about 11 years.

Present Value Of an Annuity


1Present value of an annuity = A
1 (1+r)n
r

Value of PVIFAr,n for Various Combinations of r and n


n/r 6 % 2 4 6 1.833 3.465 4.917 8% 1.783 3.312 4.623 10 % 1.737 3.170 4.355 12 % 1.690 3.037 4.111 14 % 1.647 2.914 3.889

6.210

5.747

5.335
6.145 6.814

4.968
5.650 6.194

4.639
5.216 5.660

10 7.360 6.710 12 8.384 7.536

Loan Amortisation Schedule


Loan : 1,000,000 r = 15%, n = 5 years
1,000,000 = A x PVIFAn =5, r =15% = A x 3.3522

A = 298,312
Year Beginning Annual Amount (1) 1 2 3 4 5 a Instalment (2) (3) 150,000 127,753 102,169 72,748 38,913 Interest Principal Remaining Repayment Balance (2)-(3) = (4) (1)-(4) = (5) 148,312 170,559 196,143 225,564 259,399 851,688 681,129 484,986 259,422 23*

1,000,000 298,312 851,688 298,312 681,129 298,312 484,986 298,312 259,422 298,312

Interest is calculated by multiplying the beginning loan balance by the interest rate.

b. Principal repayment is equal to annual instalment minus interest. * Due to rounding off error a small balance is shown

Equated Monthly Installment


Loan = 1,000,000, Interest = 1% p.m, Repayment period = 180 months

A x 1-1/(0.01)180

1,000,000 =
A

0.01

= Rs.12,002

Housing Industry Practice


The periodic loan installment is simply the value of A in the following equation. P = A [1-(1/1+r)n] / r (5.6)

This means,
A=

Pxr
(5.6a) [1 (1/1+r)n]

In the housing finance industry, it is equivalently expressed as: (1+r)n A = P x r x (1+r)n 1 Note that the formula in Eq (5.6b) is equivalent to the formula in Eq because 1 1 (1+r)n 1
1

(5.6b) (5.6a)

(1+r)

(1+r)n = = 1 (1+r)n (1+r)n - 1

Finding The Interest Rate


Suppose someone offers you the following financial contract: If you deposit Rs.10,000 with him he promises to pay Rs.2,500 annually for 6 years. What interest rate do you earn on this deposit? The interest rate may be calculated in two steps: Step 1 Find the PVIFAr,6 for this contract by dividing Rs.10,000 by Rs.2,500 Rs.10,000 PVIFAr,6 = = 4.000 Rs.2,500 Step 2 Look at the PVIFA table and read the row corresponding to 6 years until you find a value close to 4.000. Doing so, you find that PVIFA13%,6 is 3.998 Since 4.000 is very close to 3.998, the interest rate is 13 percent.

Valuing an Infrequent Annuity


Raghavan will receive an annuity of Rs. 50,000, payable once every two years. The payments will stretch out over 30 years. The first payment will be received at the end of two years. If the annual interest rate is 8 percent, what is the present value of the annuity? The interest rate over a two-year period is.

(1.08) x (1.08) 1 = 16.64 percent


This means that Rs. 100 invested over two years will yield Rs. 116.64. We have to calculate the present value of a Rs.50,000 annuity over 15 periods, with an interest rate of 16.64 percent per period. This works out to: Rs. 50,000 [{ 1 (1/1.1664)15 }] / 0.1664 = Rs. 270,620

Equating Present Value of Two Annuities


Ravi wants to save for the college education of his son, Deepak. Ravi estimates that the college education expenses will be rupees one million per year for four years when his son reaches college in 16 years the expenses will be payable at the beginning of the years. He expects the annual interest rate of 8 percent over the next two decades. How much money should he deposit in the bank each year for the next 15 years (assume that the deposit is made at the end of the year) to take care of his sons college education expenses? The time line for this problem is as follows: 0 Now 1 1st deposit 2 -----2nd deposit 15th deposit 1st expense 4th expense 15 16 17 18 19

The present value of college education expenses when his son becomes 15 years old is: Rs. 1,000,000 x PVIFA (4 years, 8%) = Rs. 1,000,000 x 3.312 = Rs. 3,312,000 The annual deposit to be made so that the future value of the deposits at the end of 15 years is Rs.3,312,000 is: Rs.3,312,000 Rs. 3,312,000 A= = FVIFA (15 years, 8%) 27.152 = Rs. 121,980

Present Value Of A Growing Annuity


A cash flow that grows at a constant rate for a specified period of time is a growing annuity. The time line of a growing annuity is shown below:
A(1 + g) 0 1 A(1 + g)2 2 3 A(1 + g)n n

The present value of a growing annuity can be determined using the following formula :
1

(1 + g)n

(1 + r)n
PV of a Growing Annuity = A (1 + g) rg The above formula can be used when the growth rate is less than the discount rate (g < r) as well as when the growth rate is more than the discount rate (g > r). However, it does not work when the growth rate is equal to the discount rate (g = r) in this case, the present value is simply equal to n A.

Present Value Of A Growing Annuity


For example, suppose you have the right to harvest a teak plantation for the next 20 years over which you expect to get 100,000 cubic feet of teak per year. The current price per cubic foot of teak is Rs 500, but it is expected to increase at a rate of 8 percent per year. The discount rate is 15 percent. The present value of the teak that you can harvest from the teak forest can be determined as follows:
1.0820 1 1.1520 PV of teak = Rs 500 x 100,000 (1.08) 0.15 0.08 = Rs.551,736,683

Annuity Due
Ordinary annuity

A 0 1 A

A 2 A

A n1

A n

Annuity due

n1

Thus, Annuity due value = Ordinary annuity value (1 + r) This applies to both present and future values

Present Value Of A Growing Perpetuity


A Present value of perpetuity = r

Shorter Compounding Period


Future value = Present value 1+
r mxn

Where r = nominal annual interest rate m = number of times compounding is done in a year n = number of years over which compounding is done Example : Rs.5000, 12 percent, 4 times a year, 6 years 5000(1+ 0.12/4)4x6 = 5000 (1.03)24 = Rs.10,164

Effective Versus Nominal Rate


r = (1+k/m)m 1 r = effective rate of interest

k = nominal rate of interest


m = frequency of compounding per year Example : k = 8 percent, m=4 r = (1+.08/4)4 1 = 0.0824 = 8.24 percent
Nominal and Effective Rates of Interest
Effective Rate % Nominal Rate % 8 12 Annual Compounding 8.00 12.00 Semi-annual Compounding 8.16 12.36 Quarterly Compounding 8.24 12.55 Monthly Compounding 8.30 12.68

Continuous Compounding
When compounding becomes continuous, the effective interest rate is : Effective interest rate =er-1

Summing Up

Money has time value. A rupee today is more valuable than a rupee a year hence. The general formula for the future value of a single amount is :Future value = Present value (1+r)n The value of the compounding factor, (1+r)n, depends on the interest rate (r) and the life of the investment (n).

According to the rule of 72, the doubling period is


obtained by dividing 72 by the interest rate. The general formula for the future value of a single cash amount when compounding is done more frequently than annually is: Future value = Present value [1+r/m]m*n

An annuity is a series of periodic cash flows (payments and

receipts) of equal amounts. The future value of an


annuity is Future value of an annuity = Constant periodic flow [(1+r)n 1)/r] The process of discounting, used for calculating the present value, is simply the inverse of compounding. The present value of a single amount is: Present value = Future value x 1/(1+r)n The present value of an annuity is: Present value of an annuity = Constant periodic flow [1 1/ (1+r)n] /r A perpetuity is an annuity of infinite duration. In general terms: Present value of a perpetuity = Constant periodic flow [1/r]