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Time Value of Money

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Sanjib Das
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7 views33 pages

Time Value of Money

Uploaded by

Sanjib Das
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 33

Which would you prefer – Rs.

10,000
today or Rs. 10,000 in 5 years?

Obviously, Rs. 10,000 today.

You already recognize that there is


TIME VALUE TO MONEY!!

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 Time preference for money is an individual’s preference for
possession of a given amount of money now, rather than the
same amount at some future time.
 Three reasons may be attributed to the individual’s time
preference for money:
 risk
 preference for consumption
 investment opportunities

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TIME allows you the opportunity to
postpone consumption and earn INTEREST

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 Simple Interest
Interest paid (earned) on only the original
amount, or principal borrowed (lent).
 Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the principal
borrowed (lent).

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Future Value of a Single $1,000 Deposit
Future Value (U.S.

20000
10% Simple
15000 Interest
7% Compound
10000
Interest
Dollars)

5000 10% Compound


Interest
0
1st Year 10th 20th 30th
Year Year Year
 Two most common methods of adjusting cash flows for time
value of money:
 Compounding—the process of calculating future
values of cash flows and
 Discounting—the process of calculating present
values of cash flows.

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Compounding is the process of finding the future values of
cash flows by applying the concept of compound interest.

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 John wants to know how large his $10,000
deposit will become at an annual compound
interest rate of 10% at the end of 5 years.

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 Calculation based on general formula:
FVn = P0 (1+i)n
FV5 = $10,000 (1+ 0.10)5
= $16,105.10
 Calculation based on Table I:
FV5 = $10,000 (FVIF10%, 5)
= $10,000 (1.611)
= $16,110 [Due to Rounding]
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 Present value of a future cash flow (inflow or outflow) is the
amount of current cash that is of equivalent value to the
decision-maker.
 Discounting is the process of determining present value of a
series of future cash flows.
 The interest rate used for discounting cash flows is also called
the discount rate.

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Julie Miller wants to know how large of a
deposit to make so that the money will grow
to $10,000 in 5 years at a discount rate of
10%.
0 1 2 3 4 5

10%
$10,000
PV0
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 Calculation based on general formula:
PV0 = FVn / (1+i)n
PV0 = $10,000 / (1+ 0.10)5
= $6,209.21
 Calculation based on Table :
PV0 = $10,000 (PVIF10%, 5)
= $10,000 (.621)
= $6,210.00 [Due to Rounding]

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 AnAnnuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.
 Ordinary Annuity: Payments or receipts
occur at the end of each period.
 Annuity Due: Payments or receipts occur at
the beginning of each period.

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 Student Loan Payments
 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings

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 In most instances the firm receives a stream
of uneven cash flows. Thus, the present value
factors for an annuity cannot be used.
 The procedure is to calculate the present
value of each cash flow and aggregate all
present values.

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No. Compounding
Stated Annual Rate Periodic Rate Periods EAR
10%
monthly compounding 0.8333% 12 10.4713%
10%
quarterly compounding 2.5% 4 10.3813%
10%
semiannual compounding 5% 2 10.25%
10%
annual compounding 10% 1 10%

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Basket Wonders (BW) has a $1,000 CD at the
bank. The interest rate is 6% compounded
quarterly for 1 year. What is the Effective
Annual Interest Rate (EAR)?

EAR = ( 1 + 6% / 4 )4 - 1

= 1.0614 - 1 = .0614 or 6.14%!


Julie Miller is borrowing $10,000 at an annual
interest rate of 12%. Amortize the loan if
annual payments are made for 5 years.

PV0 = R (PVIFA i%,n)


$10,000 = R (PVIFA 12%,5)
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774
Quick! How long does it take to
double Rs.5,000 at a compound rate
of 12% per year (approx.)?

We will use the “Rule-of-72”.

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Quick! How long does it take to
double Rs. 5,000 at a compound rate
of 12% per year (approx.)?

Approx.Years to Double = 72 / i%
72 / 12% = 6 Years
[Actual Time is 6.12 Years]

33

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