Shareholder Value Network

Creating Shareholder Value

Cash Flow from Discount

Debt
Operation Rate
Value Drivers

Value Sales Growth WC Investment

Cost of
Growth OPM Fixed Capital
Capital
Duration Tax Rate Investment
Decisions
Mgt.

Operating Investment Financing

3-1
3-2
 Time Value of Money
The Interest Rate
Simple Interest
Compound Interest
Amortizing A Loan
3-3
 The Interest Rate

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!!
3-4
 Importance of Time Value in
Finance
Most financial decisions involve costs
& benefits that are spread out over
time.
Time value of money allows
comparison of cash flows from
different periods.

3-5
 Risk and Uncertainty :
Future is always uncertain and risky. Outflow of
cash is in our control as payments to parties are
made by us.

There is no certainty for future cash inflows.

Cash inflows is dependent out on our Creditor,

Bank etc.

As an individual or firm is not certain about

future cash receipts, it prefers receiving cash
now.
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 Inflation:
In an inflationary economy, the money
received today, has more purchasing
power than the money to be received in
future.

In other words, a rupee today represents

a greater real purchasing power than a
rupee a year hence.

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 Consumption:
Individuals generally prefer current
consumption to future consumption.

Investment opportunities:

An investor can profitably employ a

rupee received today, to give him a higher
value to be received tomorrow or after a
certain period of time.

3-8
 Time Value of Money (Purchasing Power
-Inflation) and Interest Rate.

Nominal or Market Interest

Rate is the Combination of.
3-9
 How Do You Take Care of
TVM ?

3-10
 Computational Aids

3-11
 Types of Interest
Simple Interest
Interest paid (earned) on only the
original amount, or principal
borrowed.
Compound Interest
Interest paid (earned) on any
previous interest earned, as well
as on the principal borrowed.
3-12
 Simple Interest Formula

Formula SI = P0(i)(n)
SI: Simple Interest
P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods

3-13
 Simple Interest Example
 Assume that you deposit Rs.1,000 in an
account earning 7% simple interest for 2
years. What is the accumulated interest at
the end of the 2nd year?

SI = P0(i)(n) = Rs.1,000(.07)(2)

= Rs.140

3-14
 Simple Interest (FV)
What is the Future Value (FV) of the
deposit?
FV = P0 + SI
= Rs.1,000 + Rs.140
= Rs.1,140
What is Future Value :
Is the value at some future time of a
present amount of money, or a series of
payments, evaluated at a given interest rate.
3-15
 Simple Interest (PV)
Q: What is the Present Value (PV) of the
previous problem ?
The Present Value is simply the Rs.1,000 you
originally deposited. That is the value today!

Present Value
is the current value of a future amount of
money, or a series of payments, evaluated at
a given interest rate.
3-16
 Why Compound Interest?

Future Value of a Single Rs.1,000 Deposit

20000
10% Simple
15000 Interest
Future Value (Rs. )

10000 7% Compound
Interest
5000 10% Compound
Interest
0
1st Year 10th 20th 30th
Year Year Year
3-17
 Future Value of Single Flow Graphic
Assume that you deposit Rs.1,000 at a
compound interest rate of 7% for 2 years.

0 1 2
7%
Rs.1,000
FV2

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Future Value of Single Flow (Formula)

FV1 = P0 (1+i)1 = Rs.1,000 (1.07) = Rs.1,070

Compound Interest
You earned Rs.70 interest on your
Rs. 1,000 deposit over the first year.

This is the same interest you would

earn under simple interest.
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Future Value of Single Flow (Formula)
FV1 = P0 (1+i)1 = Rs. 1,000 (1.07)
= Rs. 1,070

FV2 = FV1 (1+i)1 = P0 (1+i)(1+i)

=1,000 (1.07)(1.07)= P0 (1+i)2
= 1,000(1.07)2= 1,144.90

You earned an EXTRA Rs. 74.90 in Year 2

with compound over simple interest.

3-20
 General Future Value Formula
FV1 = P0(1+i)1 FV2 = P0(1+i)2

General Future Value Formula:

FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n) -- See Table I

FVn = Future Value of the initial

flow n years hence.
P0 = Initial cash flow n = Life of investment
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i = Annual Interest Rate.
 Valuation Using Table I

Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469

FVIFi,n is found on Table

3-22
 Using Future Value Tables
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
FV2 = Rs.1,000 (FVIF7%,2)
= Rs.1,000 (1.145)
= Rs.1,145 [Due to Rounding]
3-23
 Story Problem Example
X wants to know how large his Rs.10,000 deposit
will become at a compound interest rate of 10%
for 5 years.

0 1 2 3 4 5
10%
Rs.10,000
FV5
3-24
 Story Problem Solution
 Calculation based on general formula:
FVn = P0 (1+i)n
FV5 = Rs. 10,000 (1+.10)5
= Rs. 16,105.10

 Calculationbased on Table I:
FV5 = Rs. 10,000 (FVIF10%, 5)
= Rs. 10,000 (1.611)
= Rs. 16,110 [Due to Rounding]

3-25
 Double Your Money!!!
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”.

3-26
 The “Rule-of-72”
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]
3-27
 Rule of 69
However, an accurate way
of calculating doubling
period is the “rule of 69”
= 0.35 + (69/Interest Rate)

3-28
 Increased Frequency of
Compounding
Suppose you bought a scheme where
compounding is done more frequently.
For example, assume you deposit Rs.
10,000 in bank which offers 10% interest
per annum compounded semi-annually
which means that interest is paid every
six months.
Beginning amount = Rs.10,000
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 Increased Frequency of Compounding
Beginning amount = Rs.10,000
Interest @10% p.a for first 6 months: 10,000 * (0.1/2)
Rs. 500

Interest @10% p.a for second 6 months: 10,500 * (0.1/2)

Rs.525

Amount at the end of the year: Rs. 11,025

3-30
 Frequency of Compounding

General Formula:
FVn = PV0(1 + [i/m])m n
n:Number of Years
m:Compounding Periods per Year
i:Annual Interest Rate
FVn,m: FV at the end of Year n
PV0: PV of the Cash Flow today

3-31
 Impact of Frequency
You have Rs.1,000 to invest for 2 Years
at an annual interest rate of 12%.

Annual FV2 = 1,000 (1+ [.12/1])(1) (2)

= 1,254.40

Semi FV2 = 1,000(1+ [.12/2])(2) (2)

= 1,262.48
3-32
 Impact of Frequency
Qtrly FV2 = 1,000 (1+ [.12 / 4])(4) (2)

= 1,266.77
Monthly FV2 = 1,000(1+ [.12 /12]) (12) (2)

= 1,269.73

Daily FV2 = 1,000 (1+[.12 / 365 ]) (365) (2)

= 1,271.20

3-33
 Effective vs. Nominal Rate of Interest:
Effective rate of interest which is the rate of
interest per annum under compounding that
produces the same effect as that produced by
an interest rate under semi-annual
compounding.
m
r = 1 + (k/m) -1
r = Effective rate of interest. k = Nominal
rate of interest. m = Frequency of
compounding per year.
3-34
 Effective Annual Interest Rate
RIL has a Rs.1,000 CD at the bank. The
interest rate is 6% compounded quarterly
for 1 year.
Q: What is the Effective Annual Interest
Rate (EAR)?

EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or 6.14%!
3-35
 How Do You find out the Compounded
Growth Rate for a given series ?
Example:
Years 1989 1990 1991 1992 1993 1994
Profits 95 105 140 160 165 170
Ans: The ratio of profits for 1994 to 1989 is to
be determined. 170 / 95 = 1.79
FVIFk,n table is to be looked at. Look at a value
which is close to 1.79 for the row for 5 years.
The value close to 1.79 is 1.762 and the interest
rate corresponding to this is 12%. Therefore,.
The
3-36
compound growth rate is 12%.
 Present Value of Single Flow (Graphic)

Assume that you need Rs.1,000 in 2 years. Let’s

examine the process to determine how much you
need to deposit today at a discount rate of 7%.

0 1 2
7%
Rs.1,000
PV0 PV1

3-37
 Present Value of Single Flow (Formula)

PV0 = FV2 / (1+i)2 = Rs.1,000 / (1.07)2

= FV2 / (1+i)2 = Rs. 873.44

0 1 2
7%
Rs.1,000
PV0
3-38
 General Present Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2

General Present Value Formula:

PV0 = FVn / (1+i)n
or PV0 = FVn (PVIFi,n) --See Table

3-39
 Using Present Value Tables
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
PV2 = Rs.1,000 (PVIF7%,2)
= Rs.1,000 (.873)
3-40
= Rs.873 [Due to Rounding]
 Story Problem Example
X wants to know how large of a deposit to
make so that the money will grow to
Rs.10,000 in 5 years at a discount rate of
10%.
0 1 2 3 4 5
10%
Rs.10,000
PV0
3-41
 Story Problem Solution
 Calculation based
on general formula:
PV0 = FVn / (1+i)n
PV0 = Rs.10,000 / (1+ 0.10)5
= Rs.6,209.21

 Calculation basedon Table I:

PV0 = Rs.10,000 (PVIF10%, 5)
= Rs.10,000 (.621)
= Rs. 6,210.00
3-42
 Types of Annuities
 An Annuity
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

3-43 each period.
 Annuity
An annuity due will always be greater than an
otherwise equivalent ordinary annuity because
interest will compound for an additional
period.

3-44
 Annuities

3-45
 Examples of Annuities

 Student Loan Payments

 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings

3-46
 Future Value of an Ordinary Annuity

Using the FVIFA Tables

 Annuity = Equal Annual Series of Cash Flows

 Example: How much will your deposits grow to

if you deposit Rs. 100 at the end of each year at
5% interest for three years.

3-47
 Future Value of an Ordinary Annuity

Using the FVIFA Tables

FVA = 100(FVIFA,5%,3) = Rs. 315.25

3-48
 Example of an FV of an Ordinary Annuity – (FVA)

End of Year
0 1 2 3 4
7%
Rs. 1,000 Rs.1,000 Rs.1,000
Rs.1,070
Rs.1,145

Rs. 3,215 = FVA3

FVA3 = Rs. 1,000(1.07)2 + Rs.1,000 (1.07)1
+ Rs.1,000(1.07)0 = Rs.1,145 + Rs.1,070
3-49 +Rs.1,000 = Rs.3,215
 Present Value of an Ordinary Annuity

 Annuity = Equal Annual Series of Cash Flows

 Example: How much could you borrow if you

could afford annual payments of Rs. 2,000 (which
includes both principal and interest) at the end of
each year for three years at 10% interest?

3-50
 Present Value of an Ordinary
Annuity
Using PVIFA Tables

PVA = 2,000(PVIFA,10%,3)
=2000 * 2.487 = Rs. 4,973.70
3-51
 Example of an Ordinary Annuity -- PVA

End of Year
0 1 2 3 4
7%
Rs.1,000 Rs.1,000 Rs.1,000
Rs.934.58
Rs.873.44
Rs.816.30
PVA3 = Rs.1,000/(1.07)1 +
Rs.1,000/(1.07)2 +
Rs.2,624.32 = PVA3
Rs.1,000/(1.07)3
= Rs.934.58 + Rs.873.44 +
Rs.816.30 = Rs.2,624.32
3-52
 Valuation Using Table

Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
PVAn = Rs. (PVIFAi%,n)
PVA3 = Rs.1,000 (PVIFA7%,3)
= Rs.1,000 (2.624) = Rs.2,624
3-53
 Future Value of an Annuity
Due
 Annuity = Equal Annual Series of Cash Flows

 Example: How much will your deposits grow to

if you deposit Rs. 100 at the beginning of each
year at 5% interest for three years.

3-54
 Future Value of an Annuity Due

Using the FVIFA Tables

FVA = 100(FVIFA,5%,3)(1+k) = Rs. 330.96

FVA = 100(3.152)(1.05) = Rs. 330.96

3-55
 Valuation Using Table
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867

FVAn = Rs. (FVIFAi%,n)

FVA3 = Rs.1,000 (FVIFA7%,3)
= Rs.1,000 (3.215) = Rs.3,215
3-56
 Example of an Annuity Due -- FVAD
Beginning of Year
0 1 2 3 4
7%
Rs.1,000 Rs.1,000 Rs.1,000 Rs.1,070

Rs.1,145
Rs.1,225
FVAD3 = Rs.3,440

FVAD3 = Rs.1,000(1.07)3 + Rs.1,000(1.07)2 +

Rs.1,000(1.07)1 = Rs.1,225 + Rs.1,145 +Rs.1,070
=Rs.3,440
3-57
 Valuation Using Table
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867

FVADn = Rs. (FVIFAi%,n)(1+i)

FVAD3 = Rs.1,000 (FVIFA7%,3)(107)
= Rs.1,000 (3.215)(1.07) = Rs.3,440
3-58
 Example of an Annuity Due -- PVAD
Beginning of Year
0 1 2 3 4
7%
Rs.1,000.00 Rs.1,000 Rs.1,000
Rs. 934.58
Rs. 873.44

PVADn=Rs. 2,808.02

PVAD3 = Rs.1,000/(1.07)2 + Rs.1,000/(1.07)1 +

Rs.1,000/(1.07)0 = Rs.2,808.02
3-59
 Valuation Using Table
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993

PVADn = Rs. (PVIFAi%,n)(1+i) PVAD3

= Rs.1,000 (PVIFA7%,3)(1.07) =
Rs.1,000 (2.624)(1.07) = Rs.2,808

3-60
 Steps to Amortizing a Loan
Calculate the payment per period.
Determine the interest in Period t.
( Loan Balance at t-1) x (i% / m)
Compute principal payment in Period t.
( Payment - Interest from Step 2)
Determine ending balance in Period t.
(Balance - principal payment from Step
3)
Start again at Step 2 and repeat.
3-61
 Amortizing a Loan Example
Julie Miller is borrowing Rs.10,000 at an
annual interest rate of 12%. Amortize the
loan if annual payments are made for 5
years.
Step 1: Payment
PV0 = R (PVIFA i%, n )
Rs. 10,000 = R (PVIFA 12%, 5 )
Rs.10,000 = R (3.605)
R = Rs.10,000 / 3.605 = Rs. 2,774
3-62
 Amortizing a Loan Example
End of Payment Interest Principal Ending
Year Balance
0 --- --- --- $10,000
1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000

[Last Payment Slightly Higher Due to Rounding]

3-63
 Usefulness of Amortization
1. Interest Expense -- Interest expenses
may reduce taxable income of the
firm.

2. Debt Outstanding -- The quantity of

outstanding debt may be used in day-to-
day activities of the firm.

3-64