Time Value of Money

Prof. Sankersan Sarkar

 Orient Industries Ltd. has surplus cash of Rs. 50 lakh. It wants to invest this amount in a scheme which will provide a return of 12% per annum for 5 years. The company wants to know how much amount it will receive at the end of 5 years. Precision Instruments Ltd. wants to invest in a manufacturing plant after 4 years. The estimated money required to invest in the plant after 4 years is Rs. 5 crores. The company wants to know how much amount it should invest in a fixed deposit in State Bank of India now so that the required money will be accumulated at the end of 4 years. The fixed deposit at SBI will earn an interest of 8% p.a.

 There are cash flows at two different points of time First case: Present amount of cash flow is known and future amount of cash flow is to be computed Second case: Future amount of cash flow is known and present amount of cash flow is to be computed In between the two cash flows there is an investment opportunity

 Due to the presence of investment opportunity value of money differs at different points of time Because the investment opportunity provides returns which accumulate over time How will you compare money values at different times if there were no investment opportunity?

Four reasons why value of money should differ at different points of time: 1. Investment opportunities 2. Preference for consumption 3. Risk 4. Inflation
Given these factors how will you compare cash flows at different points of time?

 This gives rise to the concept of Time Value of Money To compare amounts of money at different times adjustments should be made for Time Value of Money. This adjustment is done by converting money amounts at different points of time to money amounts at a common point of time. The common point of time may be: Present (Now) or any point of time in Future.

Two types of adjustments: 1. Converting money amounts at present to money amounts in future : Compounding 2. Converting money amounts in future to money amounts at present (now): Discounting
Compounding gives Future Value of Money Discounting gives Present Value of Money Reverse processes

Compounding: Future Value of Money

F P x FVIF (r, n)
F = Future Value P = Present amount r = Rate of interest / return / opportunity cost of capital (% converted to decimal) n = No. of years (or other intervals of time) FVIF (r, n) is Future Value Interest Factor for (r & n)

FVIF(r, n) (1 r)

Discounting: Present Value of Money

P F x PVIF (r, n)
P = Present Value F = Future amount r = Rate of interest / return / discount rate / opportunity cost of funds (% converted to decimal) n = No. of years (or other intervals of time) PVIF (r, n) is Present Value Interest Factor for (r & n)

1 PVIF(r, n) n (1 r)

1. If you invest Rs. 10000 now in an investment scheme which offers an yield of 10% per annum what amount will you receive after 5 years? 2. An investment scheme promises a return of 20% per annum. How much amount should you invest now in order to get Rs. 50000 from the scheme after 5 years?

Doubling Period
Rule of 72: Tells the period in which an amount will be doubled at a given interest rate

Approx. doubling period =

72 Interest rate in percent

Future Value of Multiple Cash Flows

3. Amounts of Rs. 2000 and Rs. 3000 are to be invested at the end of 2 years and 4 years from now, at a return of 15%. Calculate the accumulated sum 6 years hence. 4. Amounts of Rs. 1000, Rs. 2000 and Rs. 3000 are to be invested at the beginning of year 2, year 3 and year 4 respectively. The yield earned is 20%. What is the accumulated value when the last amount is invested?

Present Value of Multiple Cash Flows

5. An investment scheme promises to provide returns of amounts Rs. 5000 two years hence, Rs. 6000 three years hence and Rs. 7000 four years hence. If the opportunity cost of your money is 15% then what is the worth of these cash flows to you now?

Annuity: An annuity consists of equal amounts of cash flows taking place at regular intervals of time for a specified no. of intervals. If the cash flows occur at the end of each time period it is called a Regular Annuity or simply Annuity. If the cash flows occur at the beginning of each time period it is called an Annuity Due.

Perpetuity: A perpetuity consists of equal amounts of cash flows taking place at regular intervals of time for infinite no. of intervals.

Future Value of Regular Annuity

F A FVIFA(r,n)
F = Future value of regular annuity A = Amount of each cash flow r and n have their usual meanings FVIFA(r, n) = Future Value Interest Factor of Regular Annuity

(1 r) n 1 FVIFA(r, n) r

Future Value of Annuity Due

F A FVIFA DUE (r, n)
F = Future value of annuity due A = Amount of each cash flow r and n have their usual meanings FVIFADUE(r, n) = Future Value Interest Factor of Annuity Due

FVIFA DUE (r, n) (1 r) FVIFA(r, n)

6.You are planning to invest Rs. 2000 at the end of every year for 8 years in a scheme that gives a return of 20%. The first cash flow occurs one year hence. What will be the future value of your investment? 7.You are planning to invest Rs. 2000 at the beginning of every year for 8 years in a scheme that gives a return of 20%. The first cash flow occurs as soon as you sign and accept the offer document. What will be the future value of your investment?

8.You will retire from your service after 30 years and you are planning to accumulate Rs. 30 lakh by that time. An investment scheme requires you to invest a fixed amount at the end of every year for 30 years and offers a return of 15%. How much amount should you invest regularly in this scheme?

Solution to Que-8
Let the fixed amount to be invested at the end of every year be A. A represents a regular annuity over a period of 30 years. The accumulated value after 30 years should be 30 years. A x FVIFA(15%, 30) = 3000000 1 Or A 3000000 3000000
FVIFA (15 %,30 ) FVIFA (15 %,30 )

The reciprocal of FVIFA is called Sinking Fund Factor. A = Rs. 6901 (approx.)

Present Value of Regular Annuity

P A PVIFA(r,n)
P = Present value of annuity due A = Amount of each cash flow r and n have their usual meanings PVIFA(r, n) = Present Value Interest Factor of Regular Annuity

(1 r) 1 PVIFA(r, n) r(1 r) n
n

Present Value of Annuity Due

P A PVIFA DUE (r, n)
P = Present value of annuity due A = Amount of each cash flow r and n have their usual meanings PVIFADUE(r, n) = Present Value Interest Factor of Annuity Due

PVIFA DUE (r, n) (1 r) PVIFA(r, n)

9.An investment scheme requires you to invest upfront and promises to generate cash returns of Rs. 3000 at the end of every year for 20 years. If your opportunity cost of capital is 16% then what is the worth of the scheme to you? 10.An investment scheme requires you to invest upfront and promises to generate cash returns of Rs. 3000 at the beginning of every year for 20 years. If your opportunity cost of capital is 16% then what is the worth of the scheme to you?

11. You are planning to take a home loan of Rs. 20 lakh from SBI. As per the terms the loan will carry an interest rate of 12.25% and will be repayable in equated annual installments over a period of 20 years. These installments will cover both payments of principal and interest. Calculate the equated annual installments for retiring the loan.

Solution to Que-11
Let the amount of Equated Annual Installment be A. A represents a regular annuity over a period of 20 years. The present value of the annuity at 12.25% for 20 years should be Rs. 20 lakh. A x PVIFA(12.25%, 20) = 2000000 2000000 1 2000000 Or A =
PVIFA(12.2 5%,20) PVIFA(12.2 5%,20)

The reciprocal of PVIFA is called Capital Recovery Factor A = Rs. 271961 (approx.)

Present Value of Perpetuity

P A PVIFA(r,)
P = Present value A = Amount of each cash flow r = Discount rate / interest rate / opportunity cost No. of periods is infinity.
1 PVIFA(r,) Present Value Interest Factor of Perpetuity r

Nominal vs. Effective Interest Rates

Nominal interest rate is the stated interest rate in the loan contract Nominal rate may be compounded one or more times in a year If the nominal rate is compounded m times in a year then effective interest rate is that rate which will produce the same amount with annual compounding (compounding once in a year)

Nominal vs. Effective Interest Rates

r m i (1 ) 1 m
i = Effective interest rate with annual compounding r = Nominal interest rate compounded m times in a year (% converted to decimal) 12. If the nominal interest rate is 12% p.a. compounded 4 times in a year what is the effective interest rate?

13. Calculate the future value of Rs. 100000 after 5 years at 9% p.a. compounded annually, semiannually, quarterly & monthly. 14. Calculate the future value of an annuity of Rs. 1000 for 10 years at 12% p.a. compounded monthly. 15. Calculate the present value of annuity of Rs. 2000 for 5 years at 16% compounded quarterly. 16. Calculate the equated monthly installment (EMI) for a car loan of Rs. 4 lakh at 10.5% interest rate and one year period.

Homework
Textbook: Financial Management, Prasanna Chandra Ch.6: Time Value of Money: Problems: 6.4, 6.5, 6.6, 6.7, 6.8, 6.10, 6.11, 6.12, 6.13, 6.14, 6.15, 6.17, 6.18, 6.20, 6.22, 6.23, 6.24, 6.25, 6.26, 6.28, 6.29, 6.31 & other problems

Minimum Suggested Study Plan

Textbook: Financial Management, Prasanna Chandra Vital: Ch.6, p133-155 Desirable: Present value of a growing annuity

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