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The Time Value of Money

Richa Kumar

Valuation and Time Value of Money

The primary objective of firm is to maximize


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

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Timing of Cost and Benefits

For most financial decisions, costs and benefits occur at


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?

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What is Time Value of Money?

In other words, a rupee received today is worth more


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

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The Time Value of Money

Consider an investment opportunity with the following


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.
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Money has a time value


because..

It can earn more money over time


(earning power).
Money has a time value because its
purchasing power changes over
time (inflation).
Individuals generally prefer current
consumption to future
consumption.

Time value of money is measured in


terms of interest rate.
Interest is the cost of moneya cost
to the borrower and an earning to
the lender
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The Terminology of Time Value

Future Value - An amount of money at some future


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)

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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

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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
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Calculating the Future Value

Suppose that you have an extra Rs. 10000 today that


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

Interest = 11000-10000=Rs. 1000


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Calculating the Future Value (cont.)

Suppose that at the end of year 1 you decide to


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
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Generalizing the Future Value

Recognizing the pattern that is developing, we can


generalize the future value calculations as follows:

If you extended the period to 3 years


FV3 = 10000(1+0.10)3 = 13310

Interest= 13310-10000=3310

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Compound Interest

Note from the example that the future value is


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
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Compound Interest

Compound interest: the practice of


charging an interest rate to an initial
sum and to any previously
accumulated interest that has not
been withdrawn.

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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

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13,310

2
3

10,000

FV=10000(1+0.10
)3
FV=13,310
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Compound Interest Graphically


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

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The Magic of Compounding

How much will be the future value of Rs. 24 after 371


years, if the rate of interest is 10%

Rs.54,562,898,811,973,500
Thats about 54,563 Trillion Rupees!

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Using Compound Interest Tables

The FV formula using compounding is:

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

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Using Compound Interest Table

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

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Compound Interest Table


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

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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

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Multiple Compounding Periods

Generally, compounding is done annually. That is to


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.
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Semi Annual Compounding:


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
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FV of series of cash flows

Most of the time, assets generate a series of cash


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.

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FV of series of cash flows: An


Example

A invests Rs. 500 at the end of 1st year, Rs. 1000 at


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.

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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
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Compounding Annuities

Annuity is series of equal payments/receipts at equal


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

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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

However, we have a quicker way to calculate FV


of annuity.
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Calculating FV of Annuity using


Annuity Tables

Annuity Table give the compounded valued of an


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
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Ordinary Annuity or End of Year


annuity

The ordinary annuity table gives the compound value


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.
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Annuity starting in future

Let us suppose that a depositor deposits a 4


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

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Calculating Present Value


Or
Discounting future cash flows

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The concept of Discounting or


Present value of future cash flows

We noticed in earlier that as we move on the right side


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)
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Calculating the Present Value

So far, we have seen how to calculate the future value


of an investment
But we can turn this around to find the amount that
needs to be invested to achieve some desired future
value:

We can also derive this formula from the


FV formula
using cross-multiplication
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Present Value: An Example

Suppose that you have decided to celebrate your 25th


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)
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Present Value of Re 1

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Discounting and Compounding

The process of calculating present value of future


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

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PV of Series of Cash Flows

It is quite common that benefits received from an


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.

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PV of Series of Cash Flow: An


Example

Given the time value of money being 10% ( rate of


discount), find the present value of the following
series of cash flows:
Year Cash
Flows( Rs.)
1

1000

2000

3000

4000
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Present Value of Cash Flows


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

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7546

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Interpretation of Present Value of


series of cash flow

The previous table shows that we have two


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.

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Annuities

In the previous example, there was a mixed stream of


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

The timeline shows an example of a 5-year, Rs. 100


annuity

100

100

100

100

100

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Present Value of an Annuity

Using the example, and assuming a discount rate of


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

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Present Value of an Annuity


Year
(1)

(PVA=500, N=4, i=10%)


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

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Present
Value
(2 )X (3)

0.909

454.50

0.826

413.00

0.751

375.50

0.683

341.50
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Present Value of an Annuity (cont.)

Actually, there is no need to take the present value of


each cash flow separately
We can use a closed-form of the PVA equation
instead:

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Present Value of an Annuity (cont.)

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

This equation works for all regular annuities,


regardless of the number of payments
Alternatively, we can use Annuity Tables
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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.
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PV of Perpetual Annuity (conti)

Computing the present value of perpetual annuity is


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

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