CHAPTER 2

TIME VALUE OF MONEY

S. MARIA IMMANUVEL
Learning Objective

➢ Understand what is meant by "the time value of money."

➢ Understand the relationship between present and future value.
➢ Calculate the future and present value
➢ Calculate future and present value of annuity
➢ Build an “amortization schedule” for an installment-style loan.
Meaning
Time value of Money - Introduction

Would you prefer to

have 1 crore now or 1
crore 10 years from
now?
Time value of Money - Introduction

Reasons for Time Preference of Money

➢ Uncertain future

➢ Risk involvement

➢ Present needs

➢ Investment lost has opportunity cost – Return

➢ Inflation may increase and purchasing power decrease

A rupee today is worth more than rupee tomorrow

Time value of Money - Concepts

Present Value Future Value

To calculate present value of future To calculate future value of present

receiving receiving

Single Single Annuity

Annuity
amount amount
Time value of Money - Concepts

▪ Principal refers to the original amount of money invested or saved

▪ Simple interest is interest earned only on the principal investment.
▪ Compounding interest is defined as earning interest on interest.
▪ Annuity : Annuity means series of constant cash flows starting from
first year to nth year (say up to 5th year, 10 years etc.)
Time value of Money – Common notations

▪ PV = Present value
▪ FVn = Future value ‘n’ years hence
▪ Ct / PMT = Cash flow occurring at the end / beginning of year ‘t’
▪ r/ i = Interest rate
▪ n = No. of periods over which cash flow occurs
▪ g = Expected growth rate
▪m = number of compounding
Future value – Single amount
Future value – Single amount

▪ Assume that you deposit $1,000 at a compound interest rate of 7%

for
0 1 2
7%

$1,000
$1,070 $1,144.90 FV2

$1,000 (1.07) $1,070 (1.07)

Future value – Single amount

▪ Measuring value of an amount that is allowed to grow at a given

interest over a period of time
▪ Assuming that the worth of $1,000 needs to be calculated after 4
years at a 10% interest per year, we have

1st year……$1,000 X 1.10 = $1,100 Wealth grows at a

compound rate and
2nd year…...$1,100 X 1.10 = $1,210 the interest earned
3rd year……$1,210 X 1.10 = $1,331 is called compound
interest
4th year……$1,331 X 1.10 = $1,464
Future value – Single amount

▪ A generalized formula for Future Value:

Where
▪ FV = Future value
▪ PV = Present value
▪ i = Interest rate
▪ n = Number of periods;
▪ In the previous case, PV = $1,000, i = 10%, n = 4, hence;
FV = $1,000 (1.10)4 , or 1,000 * 1.464 = $1,464

Using the FV table

Future value – Single amount
n 1% 2% 3% 5% 6% 8% 10%

1 1.010 1.020 1.030 1.050 1.060 1.080 1.100

2 1.020 1.040 1.061 1.103 1.124 1.166 1.210 r = 10%
3 1.030 1.061 1.093 1.158 1.191 1.260 1.331 n=4
4 1.041 1.082 1.126 1.216 1.262 1.360 1.464
5 1.051 1.104 1.159 1.276 1.338 1.469 1.611

6 1.062 1.126 1.194 1.340 1.419 1.587 1.772

7 1.072 1.149 1.230 1.407 1.504 1.714 1.949
8 1.083 1.172 1.267 1.477 1.594 1.851 2.144
9 1.094 1.195 1.305 1.551 1.689 1.999 2.358
10 1.105 1.219 1.344 1.629 1.791 2.159 2.594

Value of FVIFr,n for various combinations

Future value – Single amount

▪ Exercise :
▪ Julie Wants to know how large her deposit of $10,000 will become at
an interest of 8% for 10 years. Compute the future value?

▪ FV = $10,000 (1.08)10 , or 10,000 * 2.159 = $21,590

Future value – Single amount – Rule 72 / 69

▪ How long does it take to double the amount at a particular interest

rate ?
▪ The Rule of 72 is a simple way to determine how long an investment
will take to double given a fixed annual rate of interest.
▪ Dividing 72 by the annual rate of return gives investors a rough
estimate of how many years it will take for the initial investment to
duplicate itself.

Number of Years to Double = 72 ÷ Interest Rate (%)

Number of Years to Double = .35 + (69 ÷ Interest Rate %)

Future value – Single amount – Rule 72 / 69

▪ Example : Doubling period at 10% interest rate

▪ a) 72 / 10 = 7. 2 years
▪ b) 0.35 + (69/ 10) = 7. 25 years

Number of Years to Double = 72 ÷ Interest Rate (%)

Number of Years to Double = .35 + (69 ÷ Interest Rate %)

Number of Years to Triple = 115 ÷ Interest Rate %

Compound Annual Growth Rate
(CAGR)
Application : Finding the growth Rate

▪ The sales revenues of Infosys

Limited have grown from ₹
47,300 crores in 2014-15 to
₹ 121,641 crores in 2021-22.
What is the compounded annual
growth rate (CAGR) ?

47,300 ( 1+g)7 = 121,641

( 1+ g )7 = 2.5717
g = 0.1445 or 14.45%

CAGR = 14.45%
Application : Finding the growth Rate

▪ The sales revenue of Avenue

Supermart (Dmart) has grown
from ₹ 8583 crores in 2015-16
to ₹ 30,976 crores in 2021-
22. What is the compounded
annual growth rate ?

8,583 ( 1+g)6 = 30,976

( 1+ g )6 = 3.6090
g = 0.2385 or 23.85%

CAGR = 23.85%
Application : Finding the growth Rate

▪ You invested $10,000 in a portfolio

with the returns outlined below:
▪ From Jan. 1, 2018, to Jan. 1, 2019,
your portfolio grew to $13,000 (or
30% in year one).
▪ On Jan. 1, 2020, the portfolio was
$14,000 (or 7.69% from January
2019 to January 2020).
▪ On Jan. 1, 2021, the portfolio ended
with $19,000 (or 35.71% from
January 2020 to January 2021).
▪ Compute CAGR
Application : Finding the growth Rate

▪ an investor bought 55 shares of

Amazon.com (AMZN) stock in
December 2017 at $1,180 per
share, for a total investment of
$64,900.
▪ After three years, in December
2020, the stock has risen to
$3,200 per share, and the
investor’s investment is now
worth $176,000.1 What is the
CAGR?
Present Value – Single amount
 Present Value – Single amount

▪ A sum payable in the future is worth less today than the stated
amount
▪ Discounting is the inverse of compounding
▪ Assume that you need $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% compounded
0
annually. 1 2
7%
$1,000
$1,000 / (1.07)2
PV0

$873.44
Present Value – Single amount
Present Value - Single amount

n 1% 2% 3% 5% 6% 8% 10%

1 0.990 0.980 0.971 0.952 0.943 0.926 0.909

2 0.980 0.961 0.943 0.907 0.890 0.857 0.826
3 0.971 0.942 0.915 0.864 0.840 0.794 0.751
4 0.961 0.924 0.888 0.823 0.792 0.735 0.683
5 0.951 0.906 0.863 0.784 0.747 0.681 0.621

6 0.942 0.888 0.837 0.746 0.705 0.630 0.564

7 0.933 0.871 0.813 0.711 0.665 0.583 0.513
8 0.923 0.853 0.789 0.677 0.627 0.540 0.467
9 0.914 0.837 0.766 0.645 0.592 0.500 0.424
10 0.905 0.820 0.744 0.614 0.558 0.463 0.386
Value of PVIFr,n for various combinations
Present Value – Single amount

▪ How much would you be willing to

pay today for the right to receive
$1,000 five years from now, given
you wish to earn 6% on your
investment

 1 
PV = $1000  5 
 (1.06) 
= $1000(.747 )
= $747
Present Value – Single amount

▪ Present value of Rs 1000 ▪ Present value of Rs 1000

receivable 6 years hence; receivable after 10 years ;
Discounting rate = 10% Discounting rate = 8%
▪ PV = 1000 x PVIF10%, 6 ▪ PV = 1000 x PVIF8%, 10
▪ = 1000 x 0.564 ▪ = 1000 x 0.463
▪ = 564 ▪ = 463
Future value of an Annuity
Future value of an Annuity

▪ Annuity: A series of consecutive payments or receipts of equal

amount at the end of each period for a specified number of 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
▪ Calculated by compounding each individual payment into the future
and then adding up all of these payments
▪ Examples: Student Loan Payments ; Car Loan Payments ; Insurance
Premiums ; Mortgage Payments ; Retirement Savings
Future value of an Annuity – Ordinary (End)

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3
0 1 2 3

$100 $100 $100

Today Equal Cash Flows

Each 1 Period Apart
Future value of an Annuity – Ordinary (End)

Cash flows occur at the end of the period

0 1 2 n n+1
i% . . .
R R R
R = Periodic
Cash Flow

FVAn = R(1 + i)n-1 + R(1 + i)n-2 + FVAn

... + R(1 + i)1 + R(1 + i)0
Future value of an Annuity – Ordinary (End)

Cash flows occur at the end of the period

0 1 2 3 4
7%

$1,000 $1,000 $1,000

$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000(1.07)0 $3,215 = FVA3
= $1,145 + $1,070 + $1,000
= $3,215
Future value of an Annuity - beginning

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows

Each 1 Period Apart
Future value of an Annuity - beginning

Cash flows occur at the beginning of the period

0 1 2 3 n–1 n
i% . . .
R R R R R

FVADn = R(1 + i)n + R(1 + i)n-1 + FVADn

... + R(1 + i)2 + R(1 + i)1
= FVAn (1 + i)
Future value of an Annuity - beginning

Cash flows occur at the beginning of the period

0 1 2 3 4
7%
$1,000 $1,000 $1,000 $1,070

$1,145
$1,225

FVAD3 = $1,000(1.07)3 + $3,440 = FVAD3

2
$1,000(1.07) + $1,000(1.07) 1

= $1,225 + $1,145 + $1,070

= $3,440
 Future value of an Annuity

Y1 Y2 Y3
Example: Suppose $100 $100 $100
you invest $100 at the
end of each year for Compounds for 0 years:
the next 3 years and $100(1.08)0 = $100.00
earn 8% per year on
your investments. Compounds for 1 year:
How much would you $100(1.08)1 = $108.00
be worth at the end of
the 3rd year? Compounds for 2 years:
$100(1.08)2 = $116.64
______
Future Value of the Annuity $324.64
Future value of an Annuity

FV3 = $100(1.08)2 + $100(1.08)1 +$100(1.08)0

= $100[(1.08)2 + (1.08)1 + (1.08)0]
= $100[Future value of an annuity of $1
factor for i = 8% and n = 3.]

= $100(3.246)
= $324.60
Future value of an Annuity

▪ What is the future value of

$20,000 paid at the end of each
of the following 5 years, assuming
your investment returns 8% per
year?

 (1 + .08)5 − 1
FV = 20,000  
 .08 
= $117,332
Future value of an Annuity

▪ If you invest $1,000 at the end of each year for the next 12 years
and earn 14% per year, how much would you have at the end of 12
years?
▪ r = 14% and n = 12

FV1 2 = $1000(27.2 71) given i = 14% and n = 12

= $27,271

From FVIFA
table
Future value of an Annuity - Table

n 1% 2% 3% 5% 6% 8% 10% 12% 14%

1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000

2 2.010 2.020 2.030 2.050 2.060 2.080 2.100 2.120 2.140
3 3.030 3.060 3.091 3.153 3.184 3.246 3.310 3.374 3.440
4 4.060 4.122 4.184 4.310 4.375 4.506 4.641 4.779 4.921
5 5.101 5.204 5.309 5.526 5.637 5.867 6.105 6.353 6.610

6 6.152 6.308 6.468 6.802 6.975 7.336 7.716 8.115 8.536

7 7.214 7.434 7.662 8.142 8.394 8.923 9.487 10.089 10.730
8 8.286 8.583 8.892 9.549 9.897 10.637 11.436 12.300 13.233
9 9.369 9.755 10.159 11.027 11.491 12.488 13.579 14.776 16.085
10 10.462 10.950 11.464 12.578 13.181 14.487 15.937 17.549 19.337

11 11.567 12.169 12.808 14.207 14.972 16.645 18.531 20.655 23.045

12 12.683 13.412 14.192 15.917 16.870 18.977 21.384 24.133 27.271

Value of FVIFAr, n for various combinations r = 14% , n = 12

 Future value of an Annuity

▪ Futura Ltd has an obligation to ▪ Suppose you have decided to

redeem Rs 500 million bonds 6 deposit Rs 30,000 per year in PPF
years hence. How much should account for 20 years. What is the
the company deposit annually in value on maturity (PPF interest
a sinking fund a/c wherein it being 8%).
earns 14% interest to cumulate
Rs 500 million in 6 years.

FVAn = A { FVIFA 14%, 6} FVAn = A { FVIFA 8%, 20 }

500 = A x 8.536 = 30,000 x 45.762
A = 500/ 8.536 = 58.575 = Rs. 13,72,860
million
Future value of an Annuity – Finding Interest Rate

▪ A Finance company advertises that it will pay Rs 8000 at the end of 6

years to investors who pay Rs 1000 annually for 6 years. What is
the interest offered?

FVAn = A { FVIFA r%, 6 }

8000 = 1000 x FVIFA
FVIFA = 8.00
From the tables r = between 10 & 12%
Present value of an Annuity
Present value of annuity (PVIFA)

▪ Calculated by discounting each individual payment back to the present and then
adding up all of these payments
▪ For multiple periods we have the discounted cash flow (DCF) formula

PV0 = C1
(1+ r )1 + (1+ r ) 2 + .... + (1+ r )t
C2 Ct
Present value of annuity (PVIFA)

Cash flows occur at the end of the period

0 1 2 n n+1
i% . . .
R R R

R = Periodic
Cash Flow
PVAn
PVAn = R/(1 + i)1 + R/(1 + i)2
+ ... + R/(1 + i)n
Present value of annuity (PVIFA)

Cash flows occur at the end of the period

0 1 2 3 4
7%

$1,000 $1,000 $1,000

$934.58
$873.44
$816.30
$2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 +
$1,000/(1.07)2 +
$1,000/(1.07)3
= $934.58 + $873.44 + $816.30
= $2,624.32
Present value of annuity (PVIFA)

Cash flows occur at the beginning of the period

0 1 2 n–1 n
i% . . .
R R R R

R: Periodic
PVADn Cash Flow

PVADn = R/(1 + i)0 + R/(1 + i)1 + ... + R/(1 + i)n–1

= PVAn (1 + i)
Present value of annuity (PVIFA)

Cash flows occur at the beginning of the period

0 1 2 3 4
7%

$1,000.00 $1,000 $1,000

$ 934.58
$ 873.44
$2,808.02 = PVADn

PVADn = $1,000/(1.07)0 + $1,000/(1.07)1 +

$1,000/(1.07)2 = $2,808.02
Present value of annuity (PVIFA)

▪ Suppose you can invest in a project that will return $100 at the end of
each year for the next 3 years. How much should you be willing to
invest today, given you wish to earn an 8% annual rate of return on
your investment?
T0 T1 T2 T3
$100 $100 $100
Discounted back 1 year:
$100[1/(1.08)1] = $92.59
Discounted back 2 years:
$100[1/(1.08)2] = $85.73
Discounted back 3 years:
$100[1/(1.08)3] = $79.38
PV of the Annuity = $257.70
Present value of annuity (PVIFA)

PV = $100[1 /(1.08)11 ] + $100[1 /(1.082) 2 ] + $100[1 /(1.083) 3 ]

PV = $100[1 /(1.08) ] + $100[1 /(1.08) ] + $100[1 /(1.08) ]
= $100[1 /(1.08)11 + 1 /(1.08)2 2 + 1 /(1.083) 3 ]
= $100[1 /(1.08) + 1 /(1.08) + 1 /(1.08) ]
= $100[Prese nt value of an annuity of $1 factor for i = 8% and n = 3]
= $100[Prese an annuity of $1 factor for i = 8% and n = 3]
nt value ofD.)
(See Appendix
(See Appendix
= $100(2.577 ) D.)
= $100(2.577
$257.70 )
= $257.70
PV of an annuity of $1 factor in general terms :
1
− an annuity
PV1of of $1 factor in general terms :
(1 + i )
n

1 (useful with non - financial calculator s)

1− i
(1 + i )
n
(useful with non - financial calculator s)
Present value of annuity (PVIFA)

▪ Tiburon Autos offers you “easy payments” of $5,000 per year, at the
end of each year for 5 years. If interest rates are 7%, per year, what is
the cost of the car?
5,000 5,000 5,000 5,000 5,000
Year
Present Value 0 1 2 3 4 5
at year 0
5,000 / 1.07 = 4,673
5,000 / (1.07) = 4,367
2

5,000 / (1.07) = 4,081

3

5,000 / (1.07) = 3,814

4

5,000 / (1.07) = 3,565

5

Total NPV = 20,501

Present value of annuity (PVIFA)

 1 1 
Lottery value = 19.683  − 30 
 .036 .036(1 + .036) 
Value = $357.5 million
Present value of annuity (PVIFA)
n 1% 2% 3% 5% 6% 8% 10%

1 0.990 0.980 0.971 0.952 0.943 0.926 0.909

2 1.970 1.942 1.913 1.859 1.833 1.783 1.736
3 2.941 2.884 2.829 2.723 2.673 2.577 2.487
4 3.902 3.808 3.717 3.546 3.465 3.312 3.170
5 4.853 4.713 4.580 4.329 4.212 3.993 3.791

6 5.795 5.601 5.417 5.076 4.917 4.623 4.355

7 6.728 6.472 6.230 5.786 5.582 5.206 4.868
8 7.652 7.325 7.020 6.463 6.210 5.747 5.335
9 8.566 8.162 7.786 7.108 6.802 6.247 5.759
10 9.471 8.983 8.530 7.722 7.360 6.710 6.145
Value of PVIFA r,n for various combinations
 Present value of annuity (PVIFA)

▪ Suppose you won a state lottery ▪ After reviewing your budget, you
in the amount of $10,000,000 to have determined that you can
be paid in 20 equal annual pay Rs 12,000 per month for 3
payments commencing at the end years towards a new car. You
of next year. What is the present learn that the going interest rate
value (ignoring taxes) of this is 1% p.m. for 30 months (for car
annuity if the discount rate is finance). How much can you
9%? borrow?

PV = $500,000(9 .129) given i = 9% and n = 20 PVAn = A { PVIFA 1%, 30 }

= 12,000 x
= $4,564,500 25.808
= Rs 309,696
 Present value of annuity (PVIFA)

▪ X deposits Rs 300,000 on
retirement in a bank which pays
10% annual interest. How much
can be withdrawn annually for a
period of 10 years?

PVA n = A { PVIFA 10%, 10 }

300,000 = A x 6.145
A = 300,000 / 6.145
= Rs 48,819
Present value of annuity (PVIFA) – Finding Interest rates

▪ Suppose a Finance Company ▪ Suppose a Finance Company

offers the financial contract – offers the financial contract –
▪ If you deposit ₹ 15,000 with it, ▪ If you deposit Rs 10,000 with it,
the Company promises to pay the Company promises to pay Rs
₹ 5000 annually for 4 years. 2500 annually for 6 years.
▪ What is the interest rate ? ▪ What is the interest rate ?

PVA n = A { PVIFA r%, 6 } PVA n = A { PVIFA r%, 6 }

15,000 = 5000 x PVIFA 10,000 = 2500 x PVIFA
PVIFA = 3.00 PVIFA = 4.0
Referring to tables r = 12% (approx) Referring to tables r = 13% (approx)
Finding Interest Rate

▪ You can buy a security now for Using Table

$1000 and it will pay you $1,191 ▪ FVn = PV0 (FVIFi,n)
three years from now. What ▪ FVIF i,n = FVn / PV0
annual rate of return are you ▪ FVIF i,3 = 1191 / 1000
earning? ▪ =1.191
▪ From the Table FVIF at n=3 we find that
the interest rate that yield 1.191 FVIF is
6%
OR
PV0 = FVn (PVIFi,n)
PVIFi,n =PV0 / FVn
PVIFi,3 = 1000/1191
0.8396
From the PVIF at n=3 we find that the interest
rate that yield 0.8396 PVIF is 6%
i = 0.06
Finding Interest Rate

▪ Suppose you can buy a security Using Table

at a price of Rs.78.35 that will pay ▪ FVn = PV0 (FVIFi,n)
you Rs.100 after five years. What ▪ FVIF i,n = FVn / PV0
annual rate of return will you earn ▪ FVIF i,5 = 100 / 78.35
if you purchase the security? ▪ =1.276
▪ From the Table FVIF at n=5 we find that
the interest rate that yield 1.276 FVIF is
5%
OR
PV0 = FVn (PVIFi,n)
PVIFi,n =PV0 / FVn
PVIFi,3 = 78.35/100
0.7835
From the PVIF at n=5 we find that the interest
i = 0.05 or 5% rate that yield 0.7835 PVIF is 5%
Finding for N (Years)

▪ Your friend deposits $100,000 into an account paying 8% per year.

She wants to know how long it will take before the interest makes her
a millionaire.
Finding for N (Years)

▪ Your friend deposits $100,000 into an account paying 8% per year.

She wants to know how long it will take before the interest makes her
a millionaire. (FVIF Table)
Finding for N (Years)

▪ Your friend deposits $100,000 into an account paying 8% per year.

She wants to know how long it will take before the interest makes her
a millionaire. (PVIF table)
Finding for N (Years)

▪ Suppose you know that a security will provide a return of 10 percent

per year, it will cost Rs.68.30 to purchase and you want to keep it
grows to a value of Rs.100. How long it will take the investment to
grow to Rs.100?
▪ PV : Rs.68.30 , FV: Rs. 100, i = 10%

n = 3.99 or 4 years
Finding for N (Years)

▪ By Table ▪ By Table
▪ FVn = PV0(FVIFi,n) ▪ PV0 = FVn(PVIFi,n)
▪ FVIFi,n = FVn / PV0 ▪ PVIFi,n = PV0 / FVn
▪ FVIF10,n = 100 / 68.30 ▪ PVIF10,n = 68.30 / 100
▪ FVIF10,n = 1.464 ▪ PVIF10,n = 0.683
▪ From the table FVIF, i = 10% we find that ▪ From the table PVIF, i = 10% we find that
the number of periods that yield 1.464 is the number of periods that yield 0.683 is
4 years 4 years
Loan Amortisation
 Present value of annuity (PVIFA) – Loan Amortisation

▪ Suppose a Firm borrows Rs 10 lakhs at interest rate of 14% and loan

is to be repaid in 5 equal instalments payable at the end of each of
the next 5 years. What is the amount payable annually ?

Begin Principal
Year Instal Interest Balance
Amount repayment
1 10,00,000 2,91,290 1,40,000 1,51,290 8,48,710
PVA n = A { PVIFA 14%, 5
2 8,48,710 2,91,290 1,18,819 1,72,471 6,76,239
}
10,00,000 = A x 3.433 3 6,76,239 2,91,290 94,674 1,96,616 4,79,623
A = Rs
291,290 4 4,79,623 2,91,290 67,147 2,24,143 2,55,480
5 2,55,480 2,91,290 35,767 2,55,523
 Present value of annuity (PVIFA) – Loan Amortisation

▪ You borrow Rs.10,000 today and will repay the loan amount in equal
installments at the end of the next 4 years. How much is your annual
payment if the interest rate is 9%?

PVA n = A { PVIFA 9%, 4 }

10,000 = A x 3.240
A = Rs
3086.42
Present value of annuity (PVIFA) – Loan Amortisation

▪ A mortgage loan $80,000 to be repaid over 20 years at 8% interest:

Present value of annuity (PVIFA) – Period of Loan amortisation

▪ Suppose you want to borrow Rs 10,84,000 to buy a flat. A Housing

Finance Company offers loan at 12% interest. You can pay Rs
175,000 per year towards loan amortisation. What would be the
maturity period of loan?

PVA n = A { PVIFA 12%, n }

10,84,000 = 175,000 x PVIFA
PVIFA = 6.194
Referring to tables n = 12 years
Present value of perpetuity
Present Value of perpetuity
Present Value of perpetuity

▪ Perpetuity is an annuity that ▪ If an amount is to grow at a

occurs indefinitely constant rate for ever it is called
a growing perpetuity.
▪ Perpetuities are not very common
in financial decision making
PV of growing perpetuity = Perpetuity /
▪ Example: Interest rate – growth rate

▪ Irredeemable preference shares,

the company is expected to pay
preference dividend perpetually
PV of perpetuity = Perpetuity / Interest rate ▪ A = annuity
▪ g = growth rate
Present Value of perpetuity

▪ Example: Perpetuity of ₹ ▪ Assume that an investor expects

10,00,000 per year is proposed a perpetual sum of Rs.500
for funding research in an annually from his investment.
University. If 10% is the interest What is the present value of this
rate, what should be the amount perpetuity if interest rate is 10%,
that should be set aside today

PVA = A * (1/r) PVA = A * (1/r)

= 10,00,000 / 0.1 = 500 / 0.1
= ₹ 1,00,00,000 = ₹ 5,000
Present Value of perpetuity

▪ Suppose a mutual fund promises

to pay you Rs.1000 every year
with a 2% growth for all the time
to come and the applicable
discount rate is 8%. How much is
the value of this stream?
Growing perpetuity = 1000 / (0.08 – 0.02)

Growing perpetuity = 16666.67

Multiple Compounding
Multiple Compounding / Intra-year compounding

▪ Compounding interest more than

once a year is called "intra-year
compounding".
▪ Interest may be compounded on
a semi-annual, quarterly, monthly,
daily, or even continuous basis.
▪ When interest is compounded
more than once a year, this
affects both future and present-
value calculations
Multiple Compounding - Effective vs Nominal rates

▪ Nominal / Stated Rate: ▪ Effective rate:

▪ This interest works according to ▪ It caters the compounding
the simple interest and does not periods during a payment plan. It
take into account the is used to compare the annual
compounding periods. interest between loans with
different compounding periods
like week, month, year etc. In
general stated or nominal interest
rate is less than the effective one
Multiple Compounding - Effective vs Nominal rates

▪ Suppose you invest Rs.100 now in a bank, interest rate being 10% a
year and that the bank will compound interest semi-annually (twice a
year). How much amount will you get after a year?

For first six months:

Interest = 100 * 10% * ½ = Rs.5
Effective interest rate :

EIR = (5+5.25) / 100

For next six months: = 10.25 %
Interest = 105 * 10% * ½ = Rs.5.25
Multiple Compounding - Effective vs Stated rates

▪ i = annual nominal rate of return

▪ m = number of compounding per year
▪ n = number of years

Frequency Nominal Rate (%) M Effective interest rate

Annual 13% 1 13%
Semi annual 13% 2 13.42%
Quarterly 13% 4 13.65%
Monthly 13% 12 13.80%
weekly 13% 52 13.86%
Multiple Compounding

▪ A company pays 15% interest, compounded quarterly, on a 3 year

public deposit of Rs1000, then the total amount compounded after 3
years is how much?
Multiple Compounding

▪ $10,000 investment earns 15% interest over the next year. The
following examples show the ending value of the investment when the
interest is compounded annually, semiannually, quarterly, monthly.
▪ Annual Compounding: FV = $10,000 x (1 + (15% / 1)) (1 x 1) =
$11,500
▪ Semi-Annual Compounding: FV = $10,000 x (1 + (15% / 2)) (2 x 1) =
$11,556.25
▪ Quarterly Compounding: FV = $10,000 x (1 + (15% / 4)) (4 x 1) =
$11,586.50
▪ Monthly Compounding: FV = $10,000 x (1 + (15% / 12)) (12 x 1) =
$11,607.55
Continuous Compounding
Continuous Compounding and Discounting

▪ Compound interest is usually ▪ The continuous compounding

calculated on a daily, weekly, formula should be used when
monthly, quarterly, half-yearly, or they mention specifically that the
annual basis. In each of these amount is "compounded
cases, the number of times it is continuously" in a problem.
compounding is different and is
finite. ▪ This formula involves the
mathematical constant "e"
▪ In continuous compounding
number of times by which
compounding occurs is tending
to infinity.

i = interest rates, n = number of years

e = 2.7183
Continuous Compounding and Discounting

▪ Tina invested $3000 in a bank ▪ Jim invested $5000 in a bank that

that pays an annual interest rate pays an annual interest rate of
of 7% compounded 9% compounded continuously.
continuously. What is the amount What is the amount he can get
she can get after 5 years from the after 15 years from the bank?
bank?
Continuous Compounding and Discounting

▪ What should be the rate of interest for the amount of $5,300 to

become double in 8 years if the amount is compounding
continuously?
▪ F = 2(5300) = 10600
Inflation, Nominal Vs Real Interest rate
Inflation : Nominal Vs Real Interest rate

▪ Inflation is an increase in the average price level of many goods and

services.
▪ When the inflation rate goes up, it indicates that the prices of many
goods and services are going up—your rupees will then buy less than
they did before.
▪ In other words, the purchasing power of your money goes down when
the inflation rate goes up.
▪ Inflation matters when making decisions related to interest rates on
savings accounts and other financial assets.
Inflation : Nominal Vs Real Interest rate

▪ Inflation changes the purchasing power of money.

▪ When talking about interest rates, the terms “real” and “nominal” are
used to distinguish between rates that do and don’t take inflation into
account.
▪ A “nominal interest rate” is the rate that banks and financial
institutions quote or state. It does not consider inflation. It is the
actual rate paid. For example, the interest rate paid to you on a
savings account is a nominal interest rate.
▪ A “real interest rate” is an interest rate that has been adjusted for
inflation. To calculate a real interest rate, you subtract the inflation
rate from the nominal interest rate.
Inflation : Nominal Vs Real Interest rate
Inflation
Inflation : Nominal Vs Real Interest rate

▪ An investor purchases a stock on January 1 of a given year for $75,000. At

the end of the year, on December 31, the investor sells the stock for
$90,000. During the course of the year, the investor received $2,500 in
dividends. At the beginning of the year, the Consumer Price Index (CPI) was
at 700. On December 31, the CPI was at a level of 721. Calculate the
inflation Adjusted return.
▪ Return = (Ending price - Beginning price + Dividends) / (Beginning price) =
($90,000 - $75,000 + $2,500) / $75,000 = 23.3% percent.
▪ Inflation = (Ending CPI level - Beginning CPI level) / Beginning CPI level =
(721 - 700) / 700 = 3 percent
▪ Inflation-adjusted return = (1 + Stock Return) / (1 + Inflation) - 1 = (1.233 /
1.03) - 1 = 19.7 percent
Formula Summary
Assignments

▪ Jewellery shop monthly savings for buying jewellery in the future-

▪ Online purchase zero EMI and Regular EMI
▪ Credit card – Zero interest
▪ Any financial products like retirements plans / Pension plans / life insurance / of
Bank / Insurance / - How are they using the TVM
▪ Physical purchase EMI options like Bajaj Finance /
▪ Mobile recharge plans / advance recharge for longer period
Chapter End