finance

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finance

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- Finance Chapter 9 Questions and Solutions
- Chapter 4 Solutions
- Tutorial Chap 1
- lesson plan - deferred annuities
- Time Value of Money
- Solved Problems in Engineering Economy & Accounting
- EBOOK MATERI TIME VALUE OF MONEY.pdf
- Assignment2 Solution
- Fa4e Sm Ch09
- Assignment #1
- Bus Math
- THE CONCEPT OF INDEX NUMBER_VISHNU
- 00-15
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- CHPT02
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Richa Kumar

shareholders wealth which depends on value of firm

Value of firm depends upon the opinions of investors

about the future benefits from investment ( returns)

Investors form their opinion about the firm on the

basis of information about amount of returns and

time when the returns will be received.

Thus, valuation of a firm should not only depend

upon the amount of returns but also on the time value

of money

Richa Kumar

different points in time.

Typical investment projects incur costs upfront and

receive benefits in the future.

How do we account for this time difference when

valuing a project?

Richa Kumar

than a rupee to be received tomorrow

That is because todays one rupee can be invested

so that we have more than one rupee tomorrow

Richa Kumar

cash flows:

Cost: Rs.100,000 today

Benefit: Rs. 105,000 in one year

In general, money today is not the same as money in one

year.

If you have Re. 1 today, you can invest it (for example,

in a bank account) and end up with more than Re.1 in

one year.

We call the difference in value between money today and

money in the future the time value of money.

Richa Kumar

because..

(earning power).

Money has a time value because its

purchasing power changes over

time (inflation).

Individuals generally prefer current

consumption to future

consumption.

terms of interest rate.

Interest is the cost of moneya cost

to the borrower and an earning to

the lender

Richa Kumar

time period

Present Value - An amount of money today, or the

current value of a future cash flow

Period - A length of time (often a year, but can be a

month, week, day, hour, etc.)

Interest Rate - The compensation paid to a lender

for the use of funds expressed as a percentage for a

period (normally expressed as an annual rate)

Richa Kumar

Abbreviations

PV - Present value

FV - Future value

Pmt - Per period payment amount/ Installment

N - Either the total number of cash flows or

the number of a specific period

i - The interest rate per period

Richa Kumar

Timelines

A timeline is a graphical device used to clarify the

timing of the cash flows for an investment

Each tick represents one time period

PV

0

Today

FV

1

3

Richa Kumar

5

9

you wish to invest for one year. If you can earn 10%

per year on your investment, how much will you have

after one year?

-10,000

0

FV1=10,000(1+0.10)=11,000

Richa Kumar

10

extend the investment for a second year. How much

will you have accumulated at the end of year 2?

10000

0

?

1

FV2=10000(1+0.10)(1+0.10) = 12100

or

FV2=10000(1+0.10)2 = 12100

Interest= 12100-10000=2100

Richa Kumar

11

generalize the future value calculations as follows:

FV3 = 10000(1+0.10)3 = 13310

Interest= 13310-10000=3310

Richa Kumar

12

Compound Interest

increasing at an increasing rate

In other words, the amount of interest earned each

year is increasing

Year 1: Rs. 1000

Year 2: Rs. 1100 (2100-1000)

Year 3: Rs. 1210 (3310-1100-1000)

The reason for the increase is that each year you are

earning interest on the interest that was earned in

previous years in addition to the interest on the

original principle amount

Richa Kumar

13

Compound Interest

charging an interest rate to an initial

sum and to any previously

accumulated interest that has not

been withdrawn.

Richa Kumar

14

Compound Interest

P = Principal

i = Interest

rate

N = Number of

interest

periods

Example:

P = 10,000

i = 10%

N = 3 years

End of Beginning

Year

Balance

Interest

earned

Ending

Balance

10,000

10,000

$1000

$11,000

11,000

$1100

12100

12,100

1210

13,310

Richa Kumar

15

13,310

2

3

10,000

FV=10000(1+0.10

)3

FV=13,310

Richa Kumar

16

4000

3833.76

3500

5%

3000

10%

15%

Future Value

2500

20%

2000

1636.65

1500

1000

672.75

500

265.33

0

0

10

11

12

13

14

15

16

17

18

19

20

Years

Richa Kumar

17

years, if the rate of interest is 10%

Rs.54,562,898,811,973,500

Thats about 54,563 Trillion Rupees!

Richa Kumar

18

FVN = PV(1+i)N

Computation by this formula can become time

consuming if the number of years become larger, say

15 years.

In such cases, compound value table can be used. The

table gives the compounded value of Re 1 after n

years for a wide range of i and n

Richa Kumar

19

P=10000

N=3

i= 10% (0.10)

Compounding factor as per table = 1.331

Thus, FV=1.331*10,000= Rs. 13310

Interest = 13,310-10,000=Rs. 3,310

Richa Kumar

20

Year

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

1%

1.01

1.02

1.03

1.041

1.051

1.062

1.072

1.083

1.094

1.105

1.116

1.127

1.138

1.149

1.161

1.173

1.184

1.196

1.208

1.22

2%

1.02

1.04

1.061

1.082

1.104

1.126

1.149

1.172

1.195

1.219

1.243

1.268

1.294

1.319

1.346

1.373

1.4

1.428

1.457

1.486

3%

1.03

1.061

1.093

1.126

1.159

1.194

1.23

1.267

1.305

1.344

1.384

1.426

1.469

1.513

1.558

1.605

1.653

1.702

1.754

1.806

4%

1.04

1.082

1.125

1.17

1.217

1.265

1.316

1.369

1.423

1.48

1.539

1.601

1.665

1.732

1.801

1.873

1.948

2.026

2.107

2.191

5%

1.05

1.103

1.158

1.216

1.276

1.34

1.407

1.477

1.551

1.629

1.71

1.796

1.886

1.98

2.079

2.183

2.292

2.407

2.527

2.653

Richa Kumar

6%

1.06

1.124

1.191

1.262

1.338

1.419

1.504

1.594

1.689

1.791

1.898

2.012

2.133

2.261

2.397

2.54

2.693

2.854

3.026

3.207

7%

1.07

1.145

1.225

1.311

1.403

1.501

1.606

1.718

1.838

1.967

2.105

2.252

2.41

2.579

2.759

2.952

3.159

3.38

3.617

3.87

8%

1.08

1.166

1.26

1.36

1.469

1.587

1.714

1.851

1.999

2.159

2.332

2.518

2.72

2.937

3.172

3.426

3.7

3.996

4.316

4.661

9%

1.09

1.188

1.295

1.412

1.539

1.677

1.828

1.993

2.172

2.367

2.58

2.813

3.066

3.342

3.642

3.97

4.328

4.717

5.142

5.604

10%

1.1

1.21

1.331

1.464

1.611

1.772

1.949

2.144

2.358

2.594

2.853

3.138

3.452

3.797

4.177

4.595

5.054

5.56

6.116

6.727

21

say, it is done once in an year.

However, interest may be paid and thus

compounding may be done twice a year ( semiannually), four times a year ( quarterly) or n times in

an year.

For the purpose of computation, semi annual

compounding means that there are two periods of six

months in one year. Similarly, quarterly compounding

means that there are 4 periods of 3 months each in

one year.

Richa Kumar

22

An example

P=1000

N=3 years

i= 10% p.a.

For finding the FV using semi-annual compounding,

we convert the period (N) into number of half years

( 3X2=6) and convert rate of interest from annual

(p.a) to half year ( 10%/2=5%)

FV= 1000(1+0.05)6

FV=1000(1.34)=1340

Richa Kumar

23

flows over time.

In other words, an asset may give certain cash flow

at the end of each year. Alternatively, an investor may

invest on more than one occasion. For example, a

depositor may deposit every year some amount in

the bank.

Thus, the investor may be interested in finding the

value at the end of the series of investment.

Richa Kumar

24

Example

the end of 2nd year and Rs. 2000 at the end of 3rd

year. What will be the future value of the investment

at the end of 3 years, if the rate of interest is 10% p.a.

compounded annually.

Next Table shows how FV will be calculated in this

case.

Richa Kumar

25

End

of

Year

Amount

Deposit

ed (2)

No of

Compound

years

interest

compound factor (4)

ed

F. V

(2)x(4)

500

1.210

605

1000

1.100

1100

2000

1.000

2000

Total

3705

Richa Kumar

26

Compounding Annuities

intervals. In the previous example if the depositor had

deposited an equal installment of Rs. 1000, it could

be termed as annuity

The time interval in annuity need not be one year; it

can be one month. Thus, the period of annuity could

be a month, a quarter or any other period

For calculating FV of annuity, in that case, we can

change the amounts to 1000 each; as shown in next

slide

Richa Kumar

27

End

of

Year

Amount

Deposit

ed (2)

1000

No of

Compound

years

interest

compound factor (4)

ed

F. V

(2)x(4)

1.210

1210

1000

1.100

1100

1000

1.000

1000

Total

3310

of annuity.

Richa Kumar

28

Annuity Tables

annuity of Re 1 for n years at i rates

Thus, we can select the appropriate annuity factor

from Future Value Annuity Table and multiply it with

the annuity amount (viz. Rs. 1000, in this case)

For 3 years at 10% interest, the future value annuity

table gives 3.310 value

Thus, the FV of the annuity is

FV= 1000 X 3.310 = 3310

Remember that you are using Future value Annuity

Table and NOT Present value annuity table

Richa Kumar

29

Richa Kumar

30

annuity

of an annuity immediately after payment of the

installment. In other words, it gives the compound

value of an annuity at the point where the last

installment is paid. This effectively means that annuity

involving x number of payments will occur over a

period of x-1 years.

It may be noted from the previous example that the

number of years compounded was 0 in the case of

last installment, as the payment was made

immediately after the last installment was paid, thus

last installments money was lent for 0 year.

Richa Kumar

31

installment annuity of Rs. 5000 at 9% p.a. interest.

The annuity payment begins in year 6. How will we

calculate Future Value in such case?

The fact that payment will begin from 6th year is

immaterial for computing Future Value

Thus, FV=5000(4.573)=22,365

Richa Kumar

32

Or

Discounting future cash flows

Richa Kumar

33

Present value of future cash flows

of timeline, future value of a given amount increases.

What will happen, we have a future value amount and

we wish to find out present value of a future amount.

In other words, we want to move from right side of the

timeline and want to find value on the left side of

timeline.

We know that value of an amount x received in future

will be less than x received today. In other word, the

present value (PV) of a given future amount (FV) is

less than the future amount(FV)

Richa Kumar

34

of an investment

But we can turn this around to find the amount that

needs to be invested to achieve some desired future

value:

FV formula

using cross-multiplication

Richa Kumar

35

Birthday(which is 6 years from now) with a lot of

fanfare. After some research, you estimate that you will

need about Rs. 100,000 for that kind of celebration. If

you can earn 10% per year on your investments in fixed

deposit for 6 years in a bank, how much do you need to

invest today to achieve your goal?

PV6=(100000)/(1.10)6 , Or

100000 X (1/(1.10)6 )= 100000 X 0.56447=56,447)..See

PV Table)

Richa Kumar

36

Present Value of Re 1

37

cash flows is called discounting

The discounting process is exactly the opposite of

compounding process.

In compounding, we calculate the future value (FV)

given present value. In discounting, we find out PV

given the FV.

In compounding, we use interest rate. The rate we

use in case of discounting is called discounting rate

Richa Kumar

38

asset are spread over a period of time.

A manager would like to know whether it is

worthwhile to invest in that asset or not.

For this purpose, the manager would like to compare

the present value of a stream/series of cash inflows

from the asset, with the cost of the asset. If the

present value of series of cash inflows is higher than

the cost of asset, the asset may be worth considering

for investment. Otherwise, it is not desirable to invest

in that asset.

39

Example

discount), find the present value of the following

series of cash flows:

Year Cash

Flows( Rs.)

1

1000

2000

3000

4000

Richa Kumar

40

Year

(1)

Cash

Flows

(2)

1000

2000

3000

4000

Tota 10,00

Present

value

Factor

(3)

PV Table

Value

Present

Value

(2 )X (3)

1/

(1.10)1

1/

(1.10)2

1/

(1.10)3

1/

(1.10)4

0.909

909

0.826

1652

0.751

2253

0.683

2732

Richa Kumar

7546

41

series of cash flow

alternatives for calculating the present value factor.

We can use the factor 1/(1+i)N each year or simply

look at the Present Value Table of locate this factor

corresponding to the given rate of discount (i) and

year (N)

The series of cash flow totaling Rs. 10,000 over a

period of 4 years is worth only Rs. 7546 only today.

Richa Kumar

42

Annuities

values and each year the amount of cash flow was

different.

When there is equal amount of cash flows spaced at

equal time intervals, we call it annuity.

Annuities are very common: Rent, Home/Car Loan

Repayments, Interest on Debentures

annuity

100

100

100

100

100

Richa Kumar

43

10% per year, we find that the present value is:

62.0

68.3

9

75.1

0

82.6

3

90.9

4

1

379.0

8

100

100

100

100

100

Richa Kumar

44

Year

(1)

Cash

Present PV Table

Flows

value

Value

(2)

Factor

(3)

500

500

500

500

1/

(1.10)1

1/

(1.10)2

1/

(1.10)3

1/

(1.10)4

Richa Kumar

Present

Value

(2 )X (3)

0.909

454.50

0.826

413.00

0.751

375.50

0.683

341.50

45

each cash flow separately

We can use a closed-form of the PVA equation

instead:

Richa Kumar

46

For example we can use this equation to find the present value of

Rs.100 of 5 year annuity at 10% discount rate as follows: Pmt

=100,i=10%, N= 5

regardless of the number of payments

Alternatively, we can use Annuity Tables

Richa Kumar

47

48

PV of Perpetual Annuity

Some investments are such that the cash flow are unending (i.e. perpetual) and we get the cash flow for

infinite number of periods. Unlike the ordinary annuity

where the cash flow are received for a fixed number of

years, in perpetual annuity, cash flows are received

year after year, forever.

For example, a donor may like to institute a

scholarship for students of an Institute and prefer an

annuity that is perpetual so that scholarship amount

could be given every year, for indefinite period of time.

Richa Kumar

49

very simple

PV of P. Annuity= A/i

For example: If the donor wants to find out how much

amount should be invested in a perpetual annuity so

the scholarship amount of Rs. 5,000 pa can be paid,

for ever. Given the rate of interest being 10%, the

amount to be invested shall be as follows:

PV of P. Annuity= A/I = 5,000/0.10= Rs. 50,000

Richa Kumar

50

51

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