238141Fm05 Time Value2

5-1
WELCOME TO
CHAPTER 5
TIME VALUE OF MONEY
Copyright © by R. S. Pradhan. All rights reserved.

5-2
CHAPTER 5: TIME VALUE OF MONEY
 A rupee received today is worth more
than a rupee expected in the future.
 Financial managers must have clear
understanding of the time value of
money.
 Of all the concepts in finance, none is
more important than time value of
money.
 Also called discounted cash flow
analysis.
5-3
Time value of money: It is concerned with:
1. Future value (Value at a future date?)
2. Present value (Value today?)
3. Rates of interest or return: ‘i’ or ‘r’=?
4. Finding time (No. of time periods):‘n’ or ‘t’ =?
Four ways to find:
1. Solve the equation with a regular calculator.
2. Use financial tables.
A1: PVIF (Present value interest factor) values
A2: PVIFA (Present value interest factor of
annuity) values
A3: FVIF (Future value interest factor) values
A4: FVIFA (Future value interest factor of annuity)
values
3. Use a financial calculator.
4. Use a spreadsheet.
5-4
1. FUTURE VALUE (FV)
Amount of money / investment that will grow to
over a period of time at some given interest rate.
Finding FV is called compounding.
What is the FV of an initial Rs.1000 after 3 years
if i = 10%? We need Rs.1331 at least.
0 1 2 3
i = 10%
PV= -1000 FV = ?
Finding FV means moving to the right.
How much do we get at t=3 on simple &
compound interest basis?
FVn = PV(1 + i)n 5-5
After 3 years
FV3 = PV(1 + i)3 = Rs.1000(1.10)3 = 1000 x 1.331 =
1331.0. OR Using the FVIF (Future Value of Interest
Factor) Table. Table A3 Page 438):
FV3 = PV x FVIF10%,3rd yr = Rs.1000 x 1.331 = 1331.0
Higher the ‘i’, higher would be FV or vice versa (See
Fig 5.1 in page 131).
Table A4: How to use FVIFA (Future Value Interest
Factor of Annuity) table?
What is the FV of a 3-year ordinary annuity of Rs.1000
at 10%? Is it Rs.3310?
0 1 2 3
10%
1000 1000 1000

5-6
0 1 2 3
10%
1000 1000 1000

1100
1210
FV = 3310

5-7
Table method:
 What is the FV of a 3-year ordinary annuity of
Rs.1000 at 10 percent?
Yr. Cash Flow FVIF@10%FV
(A3:Page 438)
1 1000 1.21 1210
2 1000 1.1 1100
3 1000 1 1000
Total 3.31 3310
(Future Value Interest Factor of Annuity : Table
A4 Page 441):
 FV = PMT x FVIFA10%3yrs
 FV = Rs.1000 x 3.31 = Rs. 3310
 How do we find FV if the cash flows are not
even? Change CFs in the above table.
5-8
 Effect of compounding is not great over short

time periods but it is huge over long time
periods.
 If one of our ancestors had invested Rs.10 for
us at a 10 percent interest rate 150 years ago,
how much we would have today?
 FV150 = PV(1 + i)150 = ?

5-9
 FV = Rs. 16,177,178.
 We would have become a millionaire.

5 - 10
2. PRESENT VALUES (PV)
 PV is the current value of future cash flows
discounted at the appropriate rate.
 Discounting is the process of finding out
present value of some future amount.
 Finding PV is the discounting which is the
reverse of compounding.
 What is the PV of Rs.1000 due in 3 years if
i=10%?
0 1 2 3
i = 10% t = 3 yrs.
PV = ? FV=1000
5 - 11
We know, FVn = PV(1 + i )n
n
FVn  1 
PV = n = FVn  
 1+ i
1+ i
1 3
 
PV = Rs.1000   =1000*0.7513 =751.3
1.10 
PVIF (Table A1: Present Value Interest Factor -
Page 432).
PV =FV*PVIF10%3rd yr=Rs.1000(0.7513) =Rs.751.3.
Higher the discount rate, lower would be PV or
vice versa (Figure 5.2 in page 135).
5 - 12
Table A2: How to use PVIFA (Present Value
Interest Factor of Annuity) table?
What is the PV of this ordinary annuity?
0 1 2 3
10%
100 100 100

90.9
82.6
75.1
248.6 = PV
5 - 13
Table method: What is the PV of a 3-year
ordinary annuity of Rs.100 at 10 percent?
Year Cash Flow PVIF@10% PV
Page 432
1 100 0.909 90.9
2 100 0.826 82.6
3 100 0.751 75.1
Total 2.486 248.6
Using PVIFA table (Table A2: Page 435):
PV = (PVIFAi%,n yrs) PMT
= PVIFA (10%, 3 yrs)100 =(2.487)100 = 248.7
 How do we find PV if the cash flows are not
even? (Change CFs in the above table).
5 - 14
3. Finding discount rate or rates of return:
Suppose we would like to retire in 40 years as a

millionaire. If we have Rs.20,000 today, what rate
of return do we need to earn?
FV=PV(1+i)n
Or Rs.1000,000=Rs.20,000(1+i)40
Or Rs.20,000 (1+i)40 = Rs.1000,000
Or (1+i)40 = 50 OR (1+i) = 501/40 =50.025 Or i=10.2%
Using Table method: FV = PV (FVIFi, n yrs)
FVIFi,40 = 50 Orig.value - LR value
10% = 45.259 i =LR + ----------------------------- Diff. in rates
? = 50 HR value - LR value
11% = 65.001
i = 10.24%
5 - 15
Orig.value - LR value
i =LR + ------------------------------- Diff. in rates
HR value - LR value
50 - 45.259
i =10 + --------------------------- (11-10)
65.001 - 45.259
i = 10.24 =10.24%

5 - 16
4. Finding the Time (t or n?)
How long does it take to double Rs.1 million, if the
appropriate interest rate is 10 percent?
0 i = 10% 1 2 t=? ?
-Rs. 1m Rs.2m
FV= PV(1 + i)n
Or Rs.2m = Rs.1m(1 + 0.10)n
Or Rs.1m(1 + 0.10)n =Rs.2m
(1.1)n = Rs. 2m / Rs. 1m = 2
Or n ln (1.1) = ln (2)
Or n = ln (2) / ln (1.1)
Or n =©0.693
Copyright / 0.0953
by R. S. Pradhan. = reserved.
All rights 7.3 yrs.
Using Table Method: FV = PV (FVIFi, n yr) 5 - 17
Or (FVIFi, n yr) = FV / PV
Or FVIF10%, n =2m/1m = 2.
Or Find ‘n’ for ‘2’ in 10% column.
It lies between 7 & 8 years.
Value of 7 year = 1.9487

?= 2
Value of 8 year = 2.1436
By interpolation,
Orig. Value - LY Value
LY+ -------------------------------- (Diff. in yrs)
HY Value - LY Value
= 7.3 years
5 - 18
What’s the difference between an ordinary

annuity and an annuity due?
Ordinary Annuity (end of the year)

0 1 2 3
i%
PMT PMT PMT

Annuity Due (beginning of the year)
0 1 2 3
i%
PMT PMT PMT

PV
FV
5 - 19
What is the FVA & PVA if the interest rate is 5%,
PMT = Rs.100, & t = 3 years?
 Assume payment has to be made at the
beginning of the year.
FVADue = PMT (FVIFA5%,3yrs) x 1.05
FVADue = Rs.100 x 3.1525 x1.05 = Rs.331
PVADue = PMT (PVIFA5%, 3yrs) x 1.05
= Rs. 100 x 2.7232 x 1.05 = Rs. 285.9
 If you have to receive, negotiate for beginning of
the period payment.
 If you have to pay, negotiate for end of the
period payment.
 Since ordinary annuities are more common, we
confine to payment at the end of each period.
5 - 20
More Frequent compounding?
(P.137 last para)
Will the FV of a lump sum be larger or

smaller if we compound more often,
holding the stated i% constant? Why?
LARGER? SMALLER?
If compounding is more frequent than
once a year - for example, semiannually,
quarterly, or daily - interest is earned on
interest more often.
5 - 21
0 1 2 3
10%
100 133.10
Annually: FV3 = Rs.100(1.10)3 = 133.10.
0 1 2 3
0 1 2 3 4 5 6
5%
100 134.01
Semiannually: FV6= Rs.100(1.05)6 =134.01
(Divide rate by 2 and multiply ‘t’ by 2.)
5 - 22
By using Table:
Annual basis:
FV3 = FVIF(10%, 3yrs.)Rs.100 = 1.331x100 = 133.1
Semiannual basis:
FV6 = FVIF(5%, 6pds) Rs.100 =1.3401x100 =134.01
(Again, divide rate by 2 and multiply ‘t’ by 2)
Comparison of different types of interest rates:

(P.131)
People in finance often work with three types of
interest rates:
iNom = Nominal/ stated/ quoted rate per year.
iPer = Periodic rate.
EAR (EFF%) = Effective annual rate.
5 - 23
Nominal or quoted rate:
The rate quoted by the banks, brokers and other
fin. insts. Also known as annual percentage rate
(APR).
Periodic rate:
The rate charged by a lender or paid by a
borrower each period. It can be a rate per year
or per quarter or per month, etc.
Effective Annual Rate (EAR = EFF%)

The annual rate which causes PV to grow to the
same FV as under multi-period compounding.

5 - 24
How do we find EFF% for a nominal rate

of 10%, compounded semiannually?
( ) -1
nm
iNom
EFF% = 1 +
m
= (1 + 0.10) - 1.0
1x2
2
= (1.05)2 - 1.0
= 0.1025 = 10.25%.
m = no. of periods
5 - 25
EAR = EFF% of 10%

EARAnnual = 10%.
EARS = (1 + 0.10/2)1x2 - 1 = 10.25%.
EARQ = (1 + 0.10/4)1x4 - 1 = 10.38%.
EARM = (1 + 0.10/12)1x12 - 1 = 10.47%.
EARD(360) = (1 + 0.10/360)1x360- 1= 10.52%.

5 - 26
Amortization
Construct an amortization schedule for a
Rs.1,000, 10% annual rate 3 year loan with 3
equal payments.
PV of annuity
Annual pmt = --------------------------
PVIFA(10%, 3 yrs)
= Rs.1000/2.4869 = Rs.402
Year Payment Interest Prin. pmt. End Bal.
1 402 100 302 698
2 402 70 332 366
3 402 37 366 -
Total 1206 206 1000
5 - 27
Solve Problems
Chapter 5: Time Value of Money
 Self-test problems: Page 144: SP6 to 8, & 13 to
15.
 Problems: Page 147
P5, P7, P9, P10, P12 to P15, & P18.
 Quiz
Thanking you

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5-1

Copyright © by R. S. Pradhan. All rights reserved.

1000 1000 1000

1000 1000 1000

Copyright © by R. S. Pradhan. All rights reserved.

 Effect of compounding is not great over short

Copyright © by R. S. Pradhan. All rights reserved.

Copyright © by R. S. Pradhan. All rights reserved.

100 100 100

Suppose we would like to retire in 40 years as a

Copyright © by R. S. Pradhan. All rights reserved.

Value of 7 year = 1.9487

What’s the difference between an ordinary

Ordinary Annuity (end of the year)

PMT PMT PMT

PMT PMT PMT

Will the FV of a lump sum be larger or

Comparison of different types of interest rates:

Effective Annual Rate (EAR = EFF%)

Copyright © by R. S. Pradhan. All rights reserved.

How do we find EFF% for a nominal rate

EAR = EFF% of 10%

EARS = (1 + 0.10/2)1x2 - 1 = 10.25%.

EARQ = (1 + 0.10/4)1x4 - 1 = 10.38%.

EARM = (1 + 0.10/12)1x12 - 1 = 10.47%.

EARD(360) = (1 + 0.10/360)1x360- 1= 10.52%.

Copyright © by R. S. Pradhan. All rights reserved.

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