Time Value of Money

Prof. Sayantan Kundu

IIM Ranchi
 Topics
The One-Period Case
The Multiperiod Case
Compounding Periods
Simplifications
Investment Decision Making
 The One-Period Case: Future Value
In the one-period case, the formula for FV can be written as:
FV = C0×(1 + r)

Where C0 is cash flow at date 0 and r is the

appropriate interest rate.

C0×(1 + r)
C0 = $10,000 FV = $10,500
$10,000  1.05

Year 0 1
 The One-Period Case: Future Value
In the one-period case, the formula for FV can be written as:
FV = C0×(1 + r)

Where C0 is cash flow at date 0 and r is the

appropriate interest rate.

C0×(1 + r)
C0 = $10,000 FV = $10,500
$10,000  1.05

Year 0 1

This process is called compounding

The One-Period Case: Present Value
What is the current worth (present value) of $10000 that
you will receive 1 year from now?
C1
PV 
1 r
Where C1 is cash flow at date 1 and r is the appropriate interest
rate.

C1/(1 + r)
PV = $9,523.81 C1 = $10,000
$10,000/1.05

Year 0 1

This process is called discounting

 The One-Period Case: Net Present Value
Suppose an investment that promises to pay $10,000 in one year
is offered for sale for $9,500. Your interest rate is 5%. Should you
buy?
The Net Present Value (NPV) of an investment is the present
value of the expected cash flows, less the cost of the investment.
+10000
t=0

t=1
-9500

$10,000
NPV  $9,500 
1.05
NPVt  Cost0  PV0t
NPV  $9,500  $9,523.81
NPV  $23.81
 Multi-Period Case: FV

$1.10  (1.40)5
$1.10  (1.40) 4

$1.10  (1.40) 3

$1.10  (1.40) 2
$1.10  (1.40)

$1.10 $1.54 $2.16 $3.02 $4.23 $5.92

0 1 2 3 4 5
 Multi-Period Case: FV PV & NPV
+130 +190 +80 +60
t=0 FV
PV t=1 t=2 t=3 t=4 t=5
-250

𝑃𝑉𝐶𝑎𝑠ℎ𝑂𝑢𝑡𝑓𝑙𝑜𝑤 = −250
130 190 80 60
𝑃𝑉𝐶𝑎𝑠ℎ𝐼𝑛𝑓𝑙𝑜𝑤 = + + +
(1+0.1)1 (1+0.1)2 (1+0.1)3 (1+0.1)4

𝐹𝑉𝐶𝑎𝑠ℎ𝐼𝑛𝑓𝑙𝑜𝑤 = 130(1 + 0.1)4 + 190(1 + 0.1)3 + 80(1 + 0.1)2 + 60(1 + 0.1)1

𝐹𝑉𝐶𝑎𝑠ℎ𝑂𝑢𝑡𝑓𝑙𝑜𝑤 = −250(1 + 0.1)5

NPVt  Cost0  PV0t

IRR or “Internal Rate of Return” is the RATE at which NPV =0

 Equivalent Interest Rate

mT cT
 r  i
 C0  e 
rc T
FV  C0  1    C 0  1  
 m  c

Interest rate for different compounding period

can be made equivalent in sense that they yield
same FV from same PV in certain time.
 Annuity
C C C C


0 1 2 3 T

C C C C
PV    
(1  r ) (1  r ) (1  r )
2 3
(1  r ) n

Growing Annuity
n 1
C C (1  g ) C (1  g ) 2
C (1  g )
PV    
(1  r ) (1  r ) 2
(1  r ) 3
(1  r ) n
 Perpetuity- Special Case
C C C

…
0 1 2 3

C
PV 
r

Growing Perpetuity

C
PV 
rg
Equivalent Annual Equal Cash Flow
C0 C1 C2 C3

…
0 1 2 3

Equivalent Annual Equal Cash Flow of an

uneven cash flow of the same duration
A A A A

…
0 1 2 3
 Investment Decision Making
C0 C1 C2 C3

…
0 1 2 3

A A A A

…
0 1 2 3

• If NPV > 0 then DO THE PROJECT Else DO NOT

• If IRR > r* then DO THE PROJECT Else DO NOT
Thank You