REVIEW OF TIME VALUE OF MONEY

The concept that money has time value - the same amount of money flowing in or out of
the business at two different points of time has different value.
Significance
• Helps to know the present value of the cash inflow received in the future
• Helps to know the future value of the cash outflow spent at present.
• Makes cash flows (occurring at different point of time) comparable
• Very important in financial decision making

Some terms and notations

Cash flow – a payment or receipt of cash
Outflow – a payment, or disbursement, of cash for expenses, investments, and so on
Inflow – a receipt of cash from an investment, an employer, or other sources
Cash flow pattern – even cash flow (annuity due and ordinary) and uneven cash flow;
cash flow for finite period and perpetuities
Cash flow time line – a graphical representation that is used to show the timing of cash
flows.

0 1 2 3 4 5 Time

-1000 300 300 300 300 300Cash flows

PV = present value
i = interest rate the bank pays on the account per year. (it is paid at the end of each
year on the balance at the beginning of the year)
INT = rupee of interest earned during the year (beginning amount * i)
FVn = value at the end of n years in the future
n= numbers of periods interest is earned
PMT= an annuity

Future Value – the value of a present cash flow or a series of cash flows at any future
date. The process of finding out future value is known as compounding.

FV1 = PV + INT
= PV + PV (i)
= PV (1+i)

FV2 = PV1 (1+i)

= PV (1+i) (1+i)

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 = PV (1+i)2

In general,
FVn = PV (1+i)n (1)

Computing future value

• Numerical solution
• Tabular solution
• Financial calculator
• Spread sheet
Numerical solution
• Find out the multiple which is (1+i)n. Note, (1+i)n is also known as future value
interest factor (FVIF, i, n)
• Multiply the PV by the multiple calculated in step 1
Example 1
Find the future value for an initial value of Rs 500 compounded for 1, 2, 5 and 10 years at
6 percent.

Presenting the problem in cash flow time line

0 2 4 6 8 10

500 FV2=? FV4=? FV10=?

FVn = PV (1+i)n

For year 1, FV1 = PV (1+i)1

Rs 500(1.06) = Rs 530

For year 2, FV2 = PV (1+i)2

Rs 500(1.06)2 = Rs 561.8

For year 5, FV5 = PV (1+i)5

Rs 500(1.06)5 = Rs 669.11

For year 10, FV10 = PV (1+i)10

Rs 500(1.06)10 = Rs 1296.87

Tabular solution
Creating future value interest factor table

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 FVIFi,n = (1+i)n

Period (n) 1% 2% 5% 6% 10%

1 1.0600
2 1.1236
3
4
5 1.3382
10 1.7908

FVn = PV(FVIFi,n) (1. a)

For year 1, FV1 = PV (FVIF6%,1 period)

Rs 500(1.06) = Rs 530

For year 2, FV21 = PV (FVIF6%,2 period)

Rs 500(1.1236) = Rs 561.8

For year 5, FV5 = PV (FVIF6%,5 period)

Rs 500(1.3382) = Rs 669.11

For year 10, FV10 = PV (FVIF6%,10 period)

Rs 500(1.7908) = Rs 895.4

Exercise 1
Calculate future value of Rs 500 at 5%, 10% and 15% for 1, 2, 3 and 10 years; and plot
the values in graph

Graphical view of compounding process

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Note that FV increases with an increase in i and n.

Present Value – the value today of a future cash flow or series of cash flows. The
process of finding out present value of cash flow or series of cash flows is known as
discounting.
Cash flow time line

We know,
FVn = PV (1+i)n

Solving for PV, we get

PV = FVn/(1+i)n (2)

Example 2
Find the present value of Rs 669.11 receivable at the end of 5 years discounted at an
opportunity cost rate of 6 percent.

PV = FVn/(1+i)n
Rs 669.11/ (1.06)5 = Rs 500

Tabular solution
Creating present value interest factor table
PVIFi,n = 1/(1+i)n
Period (n) 1% 5% 6% 10%
1 .9434
2 .8900
3 .8396
4 .7921

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 5 .7473
10 .5584

PV = FVn (PVIFi,n) (2.a)

Rs 669.11(.7473) = Rs 500
Complete the graph
Graphical view of discounting process

Note that PV decreases with an increase in i and n.

ANNUITY
An annuity - a series of payment of fixed amount at each specified
interval of time for a given number of periods.
Ordinary annuity
Annuity due
Suppose, if an individual promises to pay Rs 1,000 at the end of each
of three years for amortization of a given amount of loan, then it is
called an ordinary annuity. If it were the annuity due, each payment
would be made at the beginning of each of the three years. It is
illustrated inTime 0
the following 2
1 line of cash
8% time flows: 3
Ordinary
annuity 1000 1000 1000

Time 0 8% 1 2 3

Annuity due 1000 1000 1000

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Future Value of an Ordinary Annuity
Suppose we invest Rs 1,000 each year for three years to invest in a
security paying 8 percent annual interest, how much would we have at
the end of three years?
The following time line gives an idea about compounding of each
annual payment and their future value at the end of year three.
Time 0 8% 1 2 3

Ordinary
annuity 1000 1000 1000
1000 × 1.08
1080
2
1000 × 1.08 1166.4
FVA3 = 3246.4

Formula method
FVAn = (3)
Where,
FVA n = future value of an ordinary annuity for ‘n’ years.
PMT = annual amount of equal payment. = Rs 1000
n = number of compounding period = 3 years
i = annual rate of interest at which each payment is
compounded= 8% or 0.08
Substituting the respective values the future value of Rs 1,000 ordinary
annuity for three years compounded at 8 percent annual rate is given
by:
FVA3 = = Rs 3246.4
Tabular method
By using future value interest factor of annuity table, we can calculate
the future value of an ordinary annuity as follows.
FVAn = PMT [FVIFAi,n ] (3. a)
FVA3 = PMT [FVIFA i,n]
= Rs 1000 [FVIFA8, 3]
= Rs 1000 x 3.2464 = Rs 3246.4
Future Value of an Annuity Due

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 If the Rs 1000 annuity is the annuity due such that each payment
occurs at the beginning of each of the three year, it look like as follows
in cash flow
Time time line:
8% 1 2 3
0

Annuity Due
1000 1000 1000
1000 × 1.08
1080
2
1000 × 1.08 1166.4
1000 × 1.083
1259.71
FVA3 = 3506.11

Formula method
FVAn (due) = (1+i) (4)
FVA3 (due) = (1+0.08) = Rs 3246.4 (1.08) = Rs 3506.11

Tabular Solution
By using future value interest factor of annuity table, we can calculate
the future value of an annuity due as follows:
FVAn (due) = PMT [FVIFAi,n] (1+i) (4. a)
FVA3 (due) = PMT [FVIFAi, n] (1+i)
= Rs 1000 [FVIFA8, 3] (1+0.08)
= Rs 1000 x 3.2464 x 1.08 = Rs 3506.11
Present Value of an Ordinary Annuity
PVAn = PMT (5)
If the cost of funds is 10 percent, the present value of three-year
annuity of Rs 1000 each year is given by:
PVA3 = Rs 1000
= Rs 1000 x 2.4868 = Rs 2486.8

Tabular Solution
PVAn = PMT [PVIFAi, n] (5. a)
PVA3 = Rs 1000 [PVIFA 10, 3]
= Rs 1000 x 2.4868 = Rs 2486.8
Present Value of an Annuity Due
PVAn (due) = PMT (1+i) (6)

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In the previous example, if Rs 1000 annual payment is made at the
beginning of each of three years, the present value of annuity due is
given by:
PVAn (due) = Rs 1000 (1+0.1)
= Rs 1000 x 2.4868 x 1.10 = Rs 2735.48
Tabular Solution
PVAn = PMT [PVIFA i, n] (1+i) (6. a)
PVA3 = Rs 1000 [PVIFA 10, 3] (1+0.1)
= Rs 1000 x 2.4868 x 1.10 = Rs 2735.48
UNEVEN CASH FLOW STREAMS
In our previous section we noted that annuities call for a stream of
equal payment over the time. However in many cases, in a stream of
cash flow, the cash flow in each period may differ from period to
period. Such cash flows are called uneven streams of cash flows. In
case of uneven stream of cash flows the calculation process of present
value and future value is discussed below:
Present Value of Uneven Cash Flow Stream

PV = + + + …….+ (7)
Suppose a security provides the following stream of cash flows till its
maturity in five years.
End of 1 2 3 4 5
Year
Cash Flow 10 15 20 25 40
(Rs ) 0 0 0 0 0
If appropriate discount rate is 10 percent, the present value of this
uneven stream of cash flows is calculated as follows:

Yea Cash 10%PV PV

r Flows IF
1 Rs 100 0.9091 Rs
90.91
2 150 0.8264 123.96
3 200 0.7513 150.26
4 250 0.6830 170.75
5 400 0.6209 248.36

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 PV of uneven CF streams Rs
784.24

Future Value of Uneven Cash Flow Streams

FVn = CF1(1+i)n-1 + CF2(1+i)n-2 + CF3(1+i)n-3 + . . . +

CFn(1+i)0 (8)
Let us consider the same cash flow stream as above and a 10 percent
rate of compounding. The future value is computed as follows:
Year Cash 10%FVIF FV
Flows
1 Rs 100 (1.1)4 = Rs
1.4641 146.41
2 150 (1.1)3 = 199.65
1.3310
3 200 (1.1)2 = 242.00
1.2100
4 250 (1.1)1 = 275.00
1.1000
5 400 (1.1)0 = 400.00
1.0000
FV of Uneven Streams Rs
CF 1263.06

AMORTIZED LOANS
Amortized loan refers to the loan that is to be repaid in equal
periodic installments including both principal and interest. The concept
of present value and compound interest rate is used to amortize a loan
over the time in equal installments.
Let us suppose a loan of Rs 10,000 is to be repaid in 4 equal
installments including principal and 10 percent interest per annum. We
apply the following steps to set up an amortization schedule of the
loan.
Determining annual payment
The annual amount of installments to be paid off that includes both
principal and interest amount is calculated as follows:
PMT = (9)
=

9
 =
= Rs 3154.67
Setting loan amortization schedule
Once the annual amount of installment is determined, the loan
amortization schedule could be set up as follows:
Ye Beginni Payme Interest Repaym Ending
ar ng nt (4) = ent of Balance
(1) Amount (3) (2) x Principa (6) =
(2) 0.10 l (2) – (5)
(5) =
(3) – (4)
1 Rs Rs Rs Rs Rs
10000.00 3154.67 1000.00 2154.67 7845.33
2 7845.30 3154.67 784.53 2370.14 5475.16
3 5475.16 3154.67 547.52 2607.15 2868.01
4 2868.01 3154.67 *286.66 2868.01 -

• Interest payment in the 4th year has been rounded to make the sum of principal
plus interest equal to the annual payment of Rs 3154.67.

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