Time Value of Money We say that money has a time value because that money can be invested with

the expectation of earning a positive rate of return. In other words, a rupee received today is worth more than a rupee to be received tomorrow. That is because todays rupee can be invested so that we have more than one dollar tomorrow The Terminology of Time Value Present Value - An amount of money today, or the current value of a future cash flow

Future Value - An amount of money at some future time period 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 (or saver) for the use of funds expressed as a percentage for a period (normally expressed as an annual rate) Abbreviations PV - Present value FV - Future value Pmt - Per period payment amount N - Either the total number of cash flows or the number of a specific period i - The interest rate per period Time Value of Money (TVM) is an important concept in financial management. It can be used to compare

investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities. There are two types of interest: a.Simple interest b.Compound Interest Simple Interest: Simple interest is calculated on the original principalonly. Accumulated interest from prior periods is not used in calculations for the following periods. Simple Interest = Principal *interest rate *time /100..1 Ex. Mr. X borrowed Rs.100000 for 5 years at 10% p.a. simple interest. How much interest he will have to pay after 5 years? Sol: Simple interest = 100000*10*5/100 = 50000

Compound Interest:Compound interest is paid on the original principal and on the accumulated past interest FVn = PV (1 + r)n .2 Ex. Mr. X invested Rs.20000 in a scheme that gives interest 12% p.a. compounding annually. Calculate the maturity amount after 10 years? Sol:FVn = PV (1 + r)n Accumulated amount = 20000*(1.12)10 = Rs.62117 By using formulae 2, we can calculate the PV, r, and n. Continuous Compounding: Compounding of interest using the shortest possible interval of time. Although continuous compounding sounds impressive, in practice it results in virtually the same effective yield as daily compounding.

FV = PVert3 Ex. An amount of Rs.2,340.00 is deposited in a bank at an annual interest rate of 8%, compounded continuously. Find the balance after 3 years. Sol. Use FV = PVert e stands for the Napier's number (base of the natural logarithm) which is approximately 2.7183. FV = 2340e.08(3) = 2974.72 So, the balance after 3 years is approximately 2,974.72. NOMINAL RATE OF INTEREST:Nominal rate of interest refers to the rate of interest before adjustment for inflation (in contrast with the real interest rate); or, for interest rates "as stated" without adjustment for the full effect of compounding (also referred to as the nominal annual rate). An interest rate is called nominal if the frequency of compounding (e.g. a month) is not

identical to the basic time unit (normally a year). For example: 12% p.a. compounding monthly Or 8% p.a. compounded quarterly EFFECTIVE RATE OF INTEREST: The effective interest rate is the interest rate on a loan or deposits restated from the nominal interest rate as an interest rate with single periodlcompound interest. The above examples (of nominal rate) may be expressed as effective rates as follows: 1% p.m. or 2% per quarter These rates may be expressed an annual as per formula below: The effective interest rate is always calculated as if compounded annually. The effective rate is calculated in the

following way, where r is the effective rate, i the nominal rate (as a decimal, e.g. 12% = 0.12), and n the number of compounding periods per year (for example, 12 for monthly compounding): .4 12% p.a. compounding monthly r = (1.01)12 -1 = 0.1268 = 12.68% p.a. compounding annually 8% p.a. compounded quarterly r = (1.02)4 1 = 0.0824 = 8.24% p.a. compounding annually It may be seen that formula 4 can be appropriately used to convert effective interest into nominal interest if required. ANNUITY: A series of payments made at successive periods ( intervals ) of time is called an annuity. Example: 1.life insurance premium 2.Loan EMIs

TYPES OF ANNUITY: 1.Ordinary Annuity or Immediate Annuity or Annuity in Arrears 2.Annuity Due 3.Annuity in perpetuity Ordinary Annuity or Immediate Annuity or Annuity in Arrears: An annuity where the payments are made at the end of every period. Ex 1. Mr. Sharma is depositing Rs.500 at the end of every year for 10 years. Ex 2. Mr. X has purchased an immediate annuity plan in which he is getting Rs.3000 at the end of every month. We are often interested in computing the future value of an annuity ( ex. 5 years SIP in a mutual fund ) . The same can be computed easily using the following formula : Future value of ordinary annuity (Sn) = A [(1 + r)n - 1] / r 5

Ex.1 Mr. X saves Rs.1000 p.m. in the end of every month for 5 years at 12% p.a. Calculate the future value? Ans. Using formula (Sn) = A [{(1 + r)n 1} / r] = 1000[{(1+.12/12)5*12} / .01 ] = 81670 Using formula 2 & 5, we can derive PV of ordinary annuity. Calculation of annuity (regular installment): The required annual saving = amount to be accumulated /future value of ordinary annuity (Sn)of rupee 1 Annuity Due: An annuity where savings or withdrawal are made in the beginning of every period Formula Future value of annuity Due (Sn ) = Future value of ordinary annuity (Sn) * (1+r)

( 1+r )

= A [(1 + r)n - 1] / r 6

Calculation of Present Value of Annuity Due: Present value of annuity due (an ) = Present value of ordinary annuity (an) * (1+r) = A [{1 (1/1 + r)n} / r] * (1+r) ..7 Calculation of annuity (regular installment): The required annual saving = Amount to be accumulated / (Sn ) n of rupee 1 Annuity in Perpetuity Perpetuity is an annuity of infinite duration. The present value of a perpetuity commencing at the end of every period = Annuity required per period / rate of interest compounding each period

PV = A/r .8 The present value of a perpetuity commencing in the beginning of every period PV = A/r * (1+r) 9