TIME VALUE OF MONEY

In this session we shall

cover
Meaning of Time value of money
What
is
Compounding
and
Discounting?
Different patterns of Cash flows
and adjusting them for TVM
Multi
period
compounding/discounting
Use of TVM in finance

Time Value of Money

The basic principle in finance is
that
A rupee today is worth more than a
rupee tomorrow

Why?

 A rupee today is worth more than

a rupee tomorrow

because
the former can be invested to start
earning interest immediately

Example
If I have a Re1 today with me
and I can invest it at an interest
rate = 10% p.a. for 5 years, then
this Re1 shall grow to

Example
Rs 1.611 after 5 years.

How?

Example
Using the formula

P(1+r)n
where P is the principal amount
today, r is the rate of interest per
annum and n are the number of
years
= 1 (1+0.1)5 = 1.611

Example
This is to say that
A person would be indifferent between
receiving Re 1 today and receiving Rs
1.611 after 5 years if the opportunity
to earn a return is of 10% p.a.

COMPOUNDING
Present Value

COMPOUNDING
Future Value = Present Value (1+r) n

COMPOUNDING
Future Value = Present Value (1+r) n
The process of finding the future
value (FV), when the present value
(PV)
is
known
for
different
combinations of r and n is called
COMPOUNDING.

DISCOUNTING
Future value

DISCOUNTING
Present value = Future value
(1+r) n

DISCOUNTING
Present value = Future value
(1+r) n
The process of finding the present
value (PV), when the future value
(FV)
is
known
for
different
combinations of r and n is called
DISCOUNTING.

Example
Rs 50,000 is to be received after 15
years from now. What would be its
present value if the interest rate is
9% p.a.?

Rs 50,000 is to be received after 15 years from

now.
What would be its present value if the interest
rate is 9% p.a.?

PV = FV / (1+r)n
= 50,000 / (1+0.09)15
= Rs 13,750
This means that Rs 13,750 received
today or Rs 50,000 received after 15
years shall have the same value if
the opportunity to earn interest is 9%
p.a.

CVF and PVF Tables (Single

amounts)
CVF Table: provides the FV of Re 1 today
for various combinations of r and n
FV = PV * CVF (r%, n)

PVF Table: provides the PV of Re 1 in future

for various combinations of r and n
PV = FV * PVF (r%, n)

CVF and PVF Tables (Single

amounts)
Insert tables here

CVF and PVF Tables (Single

amounts)
Insert tables here

Rs 50,000 is to be received after 15 years from

now.
What would be its present value if the interest
rate is 9% p.a.?

PV= FV * PVF (9%, 15)

= 50,000 * 0.275
= Rs 13,750

Eg of FV of a Single amount
Rs 10,000 is being deposited in a
bank today for 5 years. What shall it
grow to after 5 years if interest rate
is 10% p.a.?

Rs 10,000 is being deposited in a bank today for 5 years.

What shall it grow to after 5 years if interest rate is 10%
p.a.?

FV = PV * CVF (r%, n)
= 10,000 * CVF (10%, 5)
= 10,000 * 1.464
= Rs 14,640
It means that Rs 10,000 of today and
Rs 14,640 after 5 years from now
carry the same value if the interest
rate is 10% p.a.

Different other forms of amounts

Multiple cash flows

Annuity
Perpetuity
Annuity due
Growing annuity
Growing perpetuity

Multiple cash flows

This refers to more than one amount
occurring (cash inflow) or having to
pay (cash outflow) at different points
of time in future

Eg of Multiple cash flows

An investment will pay Rs 100 after
one year, Rs 300 in the second year,
Rs 500 in the third year and Rs 1000
in the fourth year. If the interest rate
is 10%, what is the present value of
these multiple cash flows together?

Eg of Multiple cash flows

PV = 100/(1+0.1)1 + 300/(1+0.1)2 + 500/
(1+0.1)3 + 1000/(1+0.1)4
OR

= 100*PVF(10%,1)
+ 300*PVF(10%,2)
+ 500*PVF(10%,3)
+ 1000*PVF(10%,4)
= Rs 1397.91

Annuity
It refers to the same amount of cash
flow at regular intervals of time for a
specified period
This cash flow occurs at the end of
each year
If it occurs at the beginning of each
year, we call it Annuity due

Calculating PV of an Annuity
The PVs of Re1 annuities for different
combinations of n and r can be
had from PVAF Table
PV (any annuity amount)
= Annuity amount * PVAF (r%, n)

Example of Annuity
What would be the PV of Rs 900 to
be paid at the end of each year for 3
years from now at interest rate of
10%?

Example of Annuity
What would be the PV of Rs 900 to
be paid at the end of each year for 3
years from now at interest rate of
10%?
PV of Rs 900 of annuity is to be
calculated

Example of Annuity
What would be the PV of Rs 900 to
be paid at the end of each year for 3
years from now at interest rate of
10%?
PV of Rs 900 of annuity is to be
calculated
PV (any annuity amount)
= Annuity amount * PVAF (r%, n)

Example of Annuity
What would be the PV of Rs 900 to
be paid at the end of each year for 3
years from now at interest rate of
10%?
PV of Rs 900 of annuity is to be
calculated
PV (any annuity amount)
= Annuity amount * PVAF (r%, n)
PV (Rs 900 annuity) = 900 * PVAF
(10%, 3)

Example of Annuity
What would be the PV of Rs 900 to
be paid at the end of each year for 3
years from now at interest rate of
10%?
PV of Rs 900 of annuity is to be
calculated
PV (any annuity amount)
= Annuity amount * PVAF (r%, n)
PV (Rs 900 annuity) = 900 * PVAF
(10%, 3)

Example of Annuity
What would be the PV of Rs 900 to
be paid at the end of each year for 3
years from now at interest rate of
10%?
PV (Rs 900 annuity) = 900 * PVAF
(10%, 3)
= 900 * 2.487 = Rs
2,238

Perpetuity
It is the same amount of cash flow
occurring at regular intervals of time
for an infinite time in future
This also occurs at the end of each
year

Calculating present value of

Perpetuity
PV (Perpetuity) = Annual amount / r

Example of Perpetuity
Find out the PV of an investment
which is expected to give a return of
Rs 2500 p.a. infinitely and the rate of
interest is 12% p.a.

Example of Perpetuity
Find out the PV of an investment
which is expected to give a return of
Rs 2500 p.a. infinitely and the rate of
interest is 12% p.a.
PV of (perpetuity=2500) = 2500/0.12
= Rs 20,833.33

Multi period Compounding /

Discounting
The compounding / discounting may
take place more than once a year i.e.
monthly, quarterly, semi annually,
etc.
In that case an adjustment would be
required in r and n in the formula
of PV and FV, all else remaining the
same

Multi period Compounding /

Discounting
The compounding / discounting may
take place more than once a year i.e.
monthly, quarterly, semi annually, etc.
In that case an adjustment would be
required in r and n in the formula of
PV and FV, all else remaining the same
r% p.a. : (r/x) % per period of
compounding / discounting

Multi period Compounding /

Discounting
The compounding / discounting may take
place more than once a year i.e. monthly,
quarterly, semi annually, etc.
in that case an adjustment would be
required in r and n in the formula of PV
and FV, all else remaining the same
r% p.a. : (r/x) % per period of
compounding / discounting
n : n x periods of compounding /
discounting

Multi period Compounding /

Discounting
The compounding / discounting may take place
more than once a year i.e. monthly, quarterly,
semi annually, etc.
in that case an adjustment would be required in
r and n in the formula of PV and FV, all else
remaining the same
r% p.a. : (r/x) % per period of compounding /
discounting
n : n x periods of compounding / discounting
Here x are the number of times compounding /
discounting takes place in a year

Example of Multi period discounting

Calculate PV of Rs 1000 to be
received after 2 years at interest =
12% p.a. if discounted :
Annually
Semi annually
Quarterly
Monthly

Solution
If discounted annually:
r = 12%, n = 2
Then,
PV = 1000 * PVF (12%, 2)
= 797

Solution
If discounted semi-annually:
r = 6%, n = 4
Then,
PV = 1000 * PVF (6%,4)
= 792

Solution
If discounted quarterly,
r = 3%, n = 8
Then,
PV = 1000 * PVF (3%,8)
= 789

Solution
If discounted monthly,
r = 1%, n = 24
Then,
PV = 1000 * PVF (1%, 24)
= 780

How shall it be used in

finance?
Implicit rate of return
Determination of time period
Accept / Reject Capital budgeting
decisions
Bond valuation
Stock valuation
Financial analysis of firm
.. and many more!!!