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The Time

Value of
Money

4-1
Learning Objectives

 Understand the concept of Value of money.


 Understand various symbols used in Finance
 Distinguish between FV and PV
 Calculate present and future values of any set of
expected future cash flows.
 Calculate “n” and “r’ while other informations
are given

4-2
Chapter Outline
 Compounding concept
 Discounting concept
 Annuities and its types
 Loan Amortization schedule
 Saving and Retirement Plan

4-3
Focus on Principles
 Time Value of Money
 The value of a cash flow depends on when it
will occur.

4-4
4.2 Valuing Single Cash Flows
 In this section, we explain how time affects the
value of a cash flow.

4-5
Selected Notation
APR Annual Percentage Rate or nominal rate

PV Present Value
FV Future Value
r The discount rate per period
m The number of compounding periods per
year
n A time period

4-6
The Time Line
End of Start of
second year third year
Today

t=0 t =1 t=2 t=3 t=4


PV FV1 FV2 FV3 FV4

4-7
Future Value Formula
Let PV = Present Value
FV = Future Value at time n
r = interest rate (or discount rate) per period.

FV  PV (1  r ) n

4-8
Time value of money
Q#1: A person deposited Rs. 500,000 for one year
in account at 12%. How much he has in account
after one year?
Formula :
PV = Rs. 500,000 FV  PV (1  r ) n
r = 12% FV  500,000(1  0.12)1
n = 1 year FV  500,000(1.12)
FV = ? FV  560,000

4-9
Time value of money
Q#2: A person deposited Rs. 500,000 for two
years in account at 12%. How much he has in
account after two years?
Formula :
PV = Rs. 500,000 FV  PV (1  r ) n
r = 12%
FV  500,000(1  0.12) 2
n = 2 years
FV  500,000(1.2544)
FV = ?
FV  627,200

4-10
Future Value
Q#3: Suppose you invest Rs.1,000 at an expected
return of 10% per year. How much money do
you expect to have at the end of the 5 years?

PV = Rs. 1,000 Formula :


r = 10% FV  PV (1  r ) n
n = 5 years FV  1,000(1  0.1)5
FV = ? FV  1,000(1.6105)
FV  1,610.50

4-11
Present Value Formula
Let PV = Present Value
FV = Future Value at time n
r = interest rate (or discount rate) per period.

 1 
PV  FV  n 
 (1  r ) 

4-12
Time value of money
Q#4: A person required Rs. 110,000 after one
year in account while bank offered rate is 10%.
How much he should deposit today?

Formula :
FV = Rs. 110,000
 1 
n = 1 year PV  FV  n 
 (1  r ) 
r = 10%
 1 
PV = ? PV  110,000  1
 (1  0 . 1) 
PV  110,000(0.9091)
PV  100,000
4-13
Time value of money
Q#5: A person required Rs. 540,000 after three
years in account while bank offered rate is 12%.
How much he should deposit today?
Formula :
FV = Rs. 540,000  1 
n = 3 years PV  FV  n 
 (1  r ) 
r = 12%  1 
PV  540,000  5 
PV = ?  (1  0 . 12 ) 
PV  540,000(0.5674)
PV  306,396
4-14
Present Value
Q#6: You expect to receive Rs.10,000 six years
from today. If the required return is 9% per
year, what is the money worth today.

Formula :
FV = Rs. 10,000
 1 
n = 6 years PV  FV  n 
 (1  r ) 
r = 9%
PV = ?  1 
PV  10,000 6 
 (1  0.09) 
PV  5,962.67
4-15
Calculation of rate
Q#7: A person deposited Rs.100,000 today and
bank promised to pay Rs.126,000 after three
years. What rate offered by bank?

Formula :
PV = Rs. 100,000
FV  PV (1  r ) n
FV = Rs. 126,000 1/ n
 FV 
n = 3 years r   1
 PV 
r =? 1/ 3
 126,000 
r    1  8%
 100,000 
4-16
Time value of money
Q#8: A person deposited Rs.200,000 today and
bank promised to pay Rs.400,000 after five
years. What rate offered by bank?

PV = Rs. 200,000 Formula :


1/ n
FV = Rs. 400,000  FV 
r   1
n = 5 years  PV 
1/ 5
r =?  400,000 
r    1  14.87%
 200,000 

4-17
Concept of Effective Annual rate
Annual Percentage Rate (APR) = 10%
Compounding Intervals (m) = Half yearly (2)
Deposited Amount = Rs.100

0 6 months 1 year

100 100 105


(5%) 5 5.25
(5%)
105 110.25

4-18
Concept of Effective Annual rate
Annual Percentage Rate (APR) = 10%
Compounding Intervals (m) = Quarterly (4)
Deposited Amount = Rs.100
0 3m 6m 9m 1y

100 100 102.5 105.06 107.69


(2.5%) 2.5 2.56 2.63 2.69
102.5 105.06 107.69 110.38

4-19
Concept of Effective Annual rate

Compounding m

Yearly 1

Half Yearly 2

Quarterly 4

Monthly 12

Daily 365

4-20
Concept of Effective Annual rate
Consider an APR of 10% with half yearly
compounding. What is the EAR?

m 2
 APR   0.10 
EAR  1    1  1   1
 m   2 

EAR  0.1025  10.25%

4-21
Concept of Effective Annual rate
Consider an APR of 10% with quarterly
compounding. What is the EAR?

m 4
 APR   0.10 
EAR  1    1  1   1
 m   4 

EAR  0.1038  10.38%

4-22
Concept of Effective Annual rate
Consider an APR of 10% with monthly
compounding. What is the EAR?

m 12
 APR   0.10 
EAR  1    1  1   1
 m   12 

EAR  0.1047  10.47%

4-23
Concept of Effective Annual rate

Compounding m APR EAR

Yearly 1 10% 10%

Half Yearly 2 10% 10.25%

Quarterly 4 10% 10.38%

Monthly 12 10% 10.47%

Daily 365 10% 10.52%

4-24
From EAR to APR
 This topic you will cover in Tutorial class
by calculating it yourself.
 EAR will always be higher than APR
 As compounding intervals within a year
increasing, EAR will be much higher than
APR

4-25
Question
Bank compounding quarterly, how much we
will have after 3 years after depositing
Rs.1,000 at the rate of 15%?
Data: Using: nm
PV = Rs.1,000  r
FV  PV 1  
r = 15%  m
3*4
n = 3 years  0.15 
m = 4 FV  10001  
 4 
FV = ?
FV  1,555.45
4-26
Valuing Annuities
 An annuity is a series of equal periodic
cash flows.
 It must have defined time limit

4-27
Annuity example
 A person deposited Rs.5000 per year for 4
years.
 Isit Annuity?
 YES
 Reason
 Fixed installment Rs.5000
 Time interval is fixed one year
 Time limit defined 4 years

4-28
Annuities
 An annuity is a series of identical cash flows that
are expected to occur each period for a specified
number of periods.

 Thus, CF1 = CF2 = CF3 = CF4 = ... = CFN

 Examples of annuities:
 Installment loans (car loans, mortgages).
 Rent payment on your apartment.

4-29
Is this Annuity?
Q) What will be the future value of following cash
flows at year 5. Offered rate is 10%.
0 1 2 3 4 5

800 900 850 700 600


No
Because cash flows are different.

4-30
Is this Annuity?
Q) What will be the future value of following cash
flows at year 5. Offered rate is 10%.
0 1 2 3 4 5

800 800 800


No
Because cash flows are not in series, the cash
flows of year 2 and 5 are missing.
4-31
Is this Annuity?
Q) What will be the future value of following cash
flows at year 5. Offered rate is 10%.
0 1 2 3 4 …..... N

800 800 800 800 ……….


No
Because no time limit defined.

4-32
Two Types of Annuities
 Ordinary Annuity:
 An annuity with end-of-period cash flows, beginning
one period from today.
 For example, a car loan

 Annuity Due:
 An annuity with beginning-of-period cash flows.
 For example, an apartment lease

4-33
Ordinary Annuity
Q) Suppose you save Rs.1,000 per year at the end
of each year for 4 years and earn 10% interest per
year. How much will you have at the end of 4 years?
0 1 2 3 4

End

1000 1000 1000 1000

4-34
Annuity Due
Q) Suppose you save Rs.1,000 per year at the
beginning of each year for 4 years and earn 10%
interest per year. How much will you have at the
end of 4 years?
0 1 2 3 4

Beginning

1000 1000 1000 1000

4-35
Future Value of an Ordinary
Annuity
FV of Rs.2,000 per year for 5 years, at 10% per year:
Future value calculated by compounding forward one period at a time
Future value calculated by compounding each cash flow separately
0 1 2 3 4 5
Time
(years)
2,000 2,000 2,000 2,000 2,000
x 1.1 2,200.0
x 1.12 2,420.0
x 1.13 2,662.0
x 1.14 2,928.2
Total future value Rs.12,210.2
4-36
Ordinary Annuity

 Future Value:
 (1  r ) n  1 
FVAn  PMT 
 r 

 Present Value:
 1  (1  r )  n 
PVAn  PMT 
 r 

4-37
Annuity Due

 Future Value:
 (1  r ) n  1 
FVAn  PMT  * (1  r )
 r 

 Present Value:
 1  (1  r )  n 
PVAn  PMT  * (1  r )
 r 

4-38
Question
Suppose you save Rs.4,000 per year at the end of
each year for 3 years and earn 5% interest per
year. How much will you have at the end of 3
years? Using:
 (1  r ) n  1 
Data: FVAn  PMT 
PMT = Rs.4,000  r 
 (1  0.05) 3  1 
n = 3 years FVAn  4,000 
 0.05 
r = 5%
FVAn  4,0003.1525
FV = ?
FVAn  Rs.12,610
4-39
Question
Suppose you save Rs.4,000 per year at the end of
each year for 10 years and earn 8.5% interest per
year. How much will you have at the end of 10
years? Using:
 (1  r ) n  1 
Data: FVAn  PMT 
PMT = Rs.4,000  r 
 (1  0.085)10  1 
n = 10 years FVAn  4,000 
 0.085 
r = 8.5%
FVAn  4,00014.8351
FV = ?
FVAn  Rs.59,340
4-40
Question
Suppose you save Rs.4,000 per year at the end of
each year for 3 years and earn 5% interest per
year. What will be the present value of your
savings? Using:
 1  (1  r )  n 
Data: PVAn  PMT 
PMT = Rs.4,000  r 
 1  (1  0.05) 3 
n = 3 years PVAn  4,000 
r = 5%  0.05 
PVAn  4,0002.7232
PV = ?
PVAn  Rs.10,893
4-41
Question
Suppose you save Rs.4,000 per year at the end of
each year for 10 years and earn 8.5% interest per
year. What will be the present value of your
savings? Using:
 1  (1  r ) n

Data: PVAn  PMT 
PMT = Rs.4,000  r 
 1  (1  0.085) 10 
n = 10 years PVAn  4,000 
r = 8.5%  0.085 
PVAn  4,0006.5614
PV = ?
PVAn  Rs.26,245
4-42
Question
Suppose you save Rs.4,000 per year at the
beginning of each year for 3 years and earn 5%
interest per year. How much will you have at the
end of 3 years? Using:
Data:  (1  r ) n
1 
FVAn  PMT  * (1  r )
 r 
PMT = Rs.4,000
 (1  0.05) 3  1 
FVAn  4,000  * 1  0.05
n = 3 years  0.05 
r = 5% FVAn  4,0003.1525* 1.05
FV = ? FVAn  Rs.13,240.5
4-43
Question
Suppose you save Rs.4,000 per year at the
beginning of each year for 10 years and earn 8.5%
interest per year. How much will you have at the
end of 10 years? Using:
Data:  (1  r ) n
1 
FVAn  PMT  * (1  r )
 r 
PMT = Rs.4,000
 (1  0.085)10  1 
 * 1  0.085
n = 10 years FVAn  4,000 0.085 
r = 8.5% FVAn  4,00014.8351* 1.085
FV = ?
FVAn  Rs.64,384
4-44
Question
Suppose you save Rs.4,000 per year at the
beginning of each year for 3 years and earn 5%
interest per year. What will be the present value of
your savings? Using:
 1  (1  r )  n 
Data: PVAn  PMT  * 1  r 
 r 
PMT = Rs.4,000  1  (1  0.05) 3 
PVAn  4,000  * 1  0.05
n = 3 years  0.05 
r = 5% PVAn  4,0002.7232* 1.05
PV = ? PVAn  Rs.11,438
4-45
Question
Suppose you save Rs.4,000 per year at the
beginning of each year for 10 years and earn 8.5%
interest per year. What will be the present value of
your savings? Using:
   n

Data:  * 1  r 
1 (1 r )
PVAn  PMT
PMT = Rs.4,000  r 
 1  (1  0.085) 10 
n = 10 years PVAn  4,000  * 1  0.085
 0.085 
PVAn  4,0006.5614* 1.085
r = 8.5%
PV = ?
PVAn  Rs.28,476
4-46
Loan Amortization
Q) What are the annual payments for a 4-year
Rs.4,000 loan if the interest rate is 9% per year?
How much the total amount of interest will be paid
against the loan? Make an amortization schedule.
Data:
PV = Rs.4,000
r = 9%
n = 4 years
PMT = ?
4-47
Calculation of PMT and Interest Payment

For PMT (using formula):


1− 1+𝑟 −𝑛
PV=PMT
𝑟

−4
1− 1 + 0.09
4,000=PMT
0.09

PMT = Rs.1,235

4-48
Calculation of PMT and Interest Payment

Each Payment (PMT) against the Loan consists on


the following two components;

PMT = Principal Payment + Interest Payment

 Principal Payment:
Each payment (PMT) reduces the principal loan
balance.
 Interest Payment:
The income of bank against loan payment.

4-49
Calculation of PMT and Interest Payment

For Interest Payment:


Total Interest = Total Payment – Loan Payment

For Total Payment:


= PMT x no. of years
= Rs.1,235 x 4 = Rs.4,940

Total Interest = Rs.4,940 – Rs.4,000


= Rs.940

4-50
Amortization Schedule
Loan
Year Pmt Interest Principal
Balance
0 minus
9% of loan balance 4,000.00
1 1,235 360.00 874.67 ?
3,125.33
2 1,235 281.28 953.40 2171.93
3 1,235 195.47 1,039.20 1,132.73
4 1,235 101.95 1,132.73 -

4-51
Practice Questions
You need Rs.30,750 at the end of eight years,
bank is offering you 12 percent interest on your
deposit (compounded annually). How much
amount should you deposit each year?

Using Formula:
 (1  r ) n  1 
FVAn  PMT 
 r 
PMT = Rs.2,500

4-52
Practice Questions
You borrowed Rs.50,000 at the rate of 12 percent
interest for eight years. How much amount will you
pay each year to pay off this borrowing in eight
years?

Using Formula:
 1  (1  r )  n 
PVAn  PMT 
 r 
PMT = Rs.10,065

4-53
Retirement
You wish to retire in 40 years and planning to save
Rs.5,000 per year to accumulate enough amount
in order to live comfortably after retirement. How
much money will you have saved upon retirement,
If the interest rate is 6 percent.
Saving Period

0 …………….……….………………………………………………….. 40
PMT = 5,000
FV=?
r = 6%
4-54
Practice Questions
Using Formula:
 (1  r ) n  1 
FVAn  PMT 
 r 
 (1  0.06) 40  1 
FVAn  5,000 
 0.06 

FVAn  Rs.773,810

4-55
Practice Questions
You believe you will need to have saved
Rs.500,000 by the time you retire in 40 years in
order to live comfortably after retirement. If the
interest rate is 6 percent, how much must you save
each year to meet your retirement goal?
Saving Period

0 …………….……….………………………………………………….. 40
PMT = ? r = 6% FV=500,000

4-56
Practice Questions
Using Formula:
 (1  r ) n  1 
FVAn  PMT 
 r 
 (1  0.06) 40  1 
500,000  PMT 
 0.06 

PMT  Rs.3,230.77

4-57
Practice Questions
You have retired after 40 years and saved
Rs.500,000 in your account. How much amount
you will receive per year from the bank for 15
years to spend in your retired life, if the interest
rate is 10 percent.
Saving Period Spending Period

…………….……….. Period after retirement


0 40 65
PV=500,000 PMT = ?
r = 10%
4-58 =Principal Amount + Interest Amount
Practice Questions
Using Formula:
 1  (1  r )  n 
PVAn  PMT 
 r 
 1  (1  0.10) 15 
500,000  PMT 
 0.10 

PMT  Rs.65,737

4-59
Practice Questions
You believe you will need to spend Rs.50,000 a
year for 20 years after retirement at the age of 60
years. How much amount you will need to have in
your bank account to fulfill your retirement goal, if
the interest rate is 8 percent.
Saving Period Spending Period

…………….…….. Period after retirement


0 60 80
PV=? PMT = 50,000
r = 8%
4-60
Practice Questions
Using Formula:
 1  (1  r )  n 
PVAn  PMT 
 r 
 1  (1  0.08) 20 
PVAn  50,000 
 0.08 

PV  Rs.490,907

4-61
Perpetuity
 A perpetuity is an annuity with an infinite number
of cash flows.

 The present value of cash flows occurring in the


distant future is very close to zero.
 At 10% interest, the PV of Rs.100 cash flow occurring
50 years from today is Rs.0.85!
 The PV of Rs.100 cash flow occurring 100 years from
today is less than one penny!

4-62
Present Value of a Perpetuity
0 1 2 3 4 5 6 ………………n

PV 100 100 100 100 100 100 ……………100

PMT
Formula: PV 
r
4-63
Present Value of a Perpetuity
Q) Find the present value of a perpetuity of
Rs.25,000 per year if the interest rate is 8% per
year.
PMT
PV 
r
$25,000
PV   $312,500
0.08
4-64
Nominal, Inflation & Real Rate
Formula:
1  Nominal Rate
1  Real Rate 
1  Inflation Rate
Where;
 Nominal Rate
 Generally called “quoted rate”
 Used in business transactions and in financial
activities
 Includes Inflation rate.

4-65
Nominal, Inflation & Real Rate
Q) If the nominal rate is 10 percent, what will be
the real interest rate, if the inflation rate is 8
percent?
1  Nominal Rate
1  Real Rate 
1  Inflation Rate
1  0.10 1.10
1  Real Rate  
1  0.08 1.08
Real Rate  1.02  1  0.02
Real Rate  2%
4-66
Nominal, Inflation & Real Rate
Q) If the nominal rate is 10 percent, what will be
the real interest rate, if the inflation rate is 12
percent?
1  Nominal Rate
1  Real Rate 
1  Inflation Rate
1  0.10 1.10
1  Real Rate  
1  0.12 1.12
Real Rate  0.98  1  0.02
Real Rate  2%
4-67
Nominal, Inflation & Real Rate
Q) If the nominal rate is 10 percent, what will be
the real interest rate, if the inflation rate is 0
percent?
1  Nominal Rate
1  Real Rate 
1  Inflation Rate
1  0.10 1.10
1  Real Rate  
1 0 1
Real Rate  1.1  1  0.1
Real Rate  10%
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