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Time Value of Money

This is a basic Finance concept, known as the Time Value of Money, accounting for various things like inflation, risk, risk free return etc.

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Rishab Kapur
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© © All Rights Reserved
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Download as PPTX, PDF, TXT or read online on Scribd
59 views

Time Value of Money

This is a basic Finance concept, known as the Time Value of Money, accounting for various things like inflation, risk, risk free return etc.

Uploaded by

Rishab Kapur
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Money has time value.

A rupee today is more valuable than a rupee a


year hence. Why?

A rupee today is more valuable than a rupee a


year hence. Why?
Individuals, in general, prefer current
consumption to future consumption.
Capital can be employed productively to generate
positive returns.
An investment of one rupee today would grow to (1 + r)
a year hence (r is the rate of return earned on the
investment).

What about inflation?


Does it not erode the value of rupee?
Time value is over and above inflation or vice versa

Future Value
Suppose you deposit Rs.1,OOO today in a bank
which pays 10 percent interest compounded
annually, how much will the deposit grow to after
8 years and 12 years?
Rs.1,OOO(1.10)^8 = Rs.1,OOO(2.144)
= Rs.2,144
The future value, 12 years hence, will be:
Rs.1,OOO(1.10)^12= Rs.1,OOO (3.138)
=Rs. 3138

Simple Cash Flows


A simple cash flow is a single cash flow in a specified
future time period.
Cash Flow:
CFt
______________________________________|
Time Period:
t
The present value of this cash flow isPV of Simple Cash Flow = CFt / (1+r)t
The future value of a cash flow is FV of Simple Cash Flow = CF0 (1+ r)t
t can be days, weeks, months, quarterly or half yearly

Part A: cash flow at the end of period


Part B cash flow at the beginning of period.

Power of compounding

Power of compounding
We've seen
compounding referred to
as "the most powerful
force in the universe,"
"the royal road to
riches," and "the
greatest mathematical
discovery in human
history."
Albert Einstein called
compounding the eighth
wonder of the world.

At end
of Year

5%

10%

15%

20%

Rs105

Rs110

Rs115

Rs120

Rs128

Rs161

Rs201

Rs249

10

Rs163

Rs259

Rs405

Rs619

15

Rs208

Rs418

Rs814 Rs1541

25

Rs339 Rs1,083 Rs3,292 Rs9,540

Rule of 72
Investors usually ask the question: How long would it take to double the
amount at a given rate of interest?

Rule of thumb: 72/interest rate


10 percent
15 percent

72/10 = 7.2 years


72/15 = 4.8 years

10 percent
15 percent

0.35+69/10 = 7.25 years


0.35+69/15 = 4.95 years

Present value

751.3148009

Discounting
The process of discounting, used for
calculating the present value, is simply the
inverse of compounding. The present value
formula can be readily obtained by
manipulating the compounding formula:
FVn = PV (1 + r)^n
Dividing both the sides by (1 + r)^n, we get:
PV = FVn (1/(1 + r^n))
The factor 1/(1 + r)^n is the discounting factor

Annuities
Suppose you deposit Rs.1,000 annually in a bank for 5
years and your deposits earn a compound interest rate
of 10 percent. What will be the value of this series of
deposits (an annuity) at the end of 5 years? Assume
that each deposit occurs at the end of the year.

1
1
(1 + r)n
PV of an Annuity = PV(A,r, n) = A

The present value of a series of payments, whether the


payments are the same or not, is

When the periodic payments or dividends are all the same,


this is considered a geometric series. By using the geometric
series formula, the formula can be rewritten as

multiply it by (1+r)/(1+r)

Shorter Discounting Periods


Sometimes cash flows have to be discounted more
frequently than once a year - semi-annually, quarterly,
monthly, or daily.
As in the case of intra-year compounding, the shorter
discounting period implies that (i) the number of
periods in the analysis increases and (ii) the discount
rate' applicable per period decreases.
The general formula for calculating the present value in
the case of shorter discounting period is:

Net Present Value


Sum of the PVs of all cash flows
n

NPV =

t=0

CFt
(1 + R)t
NOTE: t=0

Initial cost often is CF0 and is an outflow.


n

NPV =

t=1

CFt
(1 + R)t

- CF0

Period
0
1
2
3
4
5

values
-1000000
200000
200000
300000
300000
350000

NPV - 5,271.62

PV
-1,000,000.00
181818.1818
165289.2562
225394.4403
204904.0366
217322.4631
-5,271.62
NPV(10%,B3:B7)+B2

Net Present Value Profile

Trial and error


Cash flow (100,000) 30,000 30,000, 40000 and 45000. The IRR
is the value of r which satisfies the following equation:
100 000 = 30,000/(1+r)+ 30,000/(1+r)^2+ 40,000/(1+r)^3+
45,000/(1+r)^4
Try r=15, we get npv= 100,802-100,000 = 801
Try r= 16, we get npv = 98,641-100000 =1364
So r will be close to 15+ 801/(801+1364) = 15.37
0
1
2
3
4
IRR

-100000
0.15
0.16
30000 -100000 -100000
30000 26086.96 25862.07
40000 22684.31 22294.89
45000 26300.65 25626.31
15.37% 25728.9 24853.1
800.8119 -1363.64

Assumptions of IRR
1. The investment is held till maturity.
2. All intermediate cash flows are re-invested at
IRR
3. The cash flows should be periodic i.e. the time
interval between two cash flows are equal.
IRR is sometimes called the discounted cash
flow rate of return, rate of return, and effective
interest rate. The internal term signifies the
rate is independent of outside interest rates.

Internal Rate of Return (IRR)


IRR is the discount rate that forces PV of inflows
equal to cost, and the NPV = 0:

CFt
0
t
(
1

IRR
)
t 0
n

NPV vs. IRR


NPV: Enter r, solve for NPV
n
CFt
NPV

t
t 0 (1 R )
IRR: Enter NPV = 0, solve for IRR.
n

CFt
0

t
t 0 (1 IRR )

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