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Concepts of Value and Return

This document discusses concepts related to the time value of money including present and future values. It covers the following key points in 3 sentences: The chapter objectives are to understand what gives money its time value, explain methods to calculate present and future values, and highlight how present value technique is used in financial decisions. Individuals have a time preference for money due to risk, preference for current consumption, and investment opportunities, and this time preference is generally expressed as a required rate of return comprised of a risk-free rate plus a risk premium. The two most common methods to adjust cash flows for the time value of money are compounding, which calculates future values, and discounting, which calculates present values.

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Aditya Sngar
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40 views7 pages

Concepts of Value and Return

This document discusses concepts related to the time value of money including present and future values. It covers the following key points in 3 sentences: The chapter objectives are to understand what gives money its time value, explain methods to calculate present and future values, and highlight how present value technique is used in financial decisions. Individuals have a time preference for money due to risk, preference for current consumption, and investment opportunities, and this time preference is generally expressed as a required rate of return comprised of a risk-free rate plus a risk premium. The two most common methods to adjust cash flows for the time value of money are compounding, which calculates future values, and discounting, which calculates present values.

Uploaded by

Aditya Sngar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Concepts of Value and Return

Chapter Objectives
 Understand what gives money its time value.
 Explain the methods of calculating present and future
values.
 Highlight the use of present value technique
(discounting) in financial decisions.
 Introduce the concept of internal rate of return.

Time Preference for Money


 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
Required Rate of Return
 The time preference for money is generally expressed by
an interest rate. This rate will be positive even in the
absence of any risk. It may be therefore called the risk-
free rate.
 An investor requires compensation for assuming risk,
which is called risk premium.
 The investor’s required rate of return is: Risk-free
rate + Risk premium.

Time Value Adjustment


 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.
Future Value
 Compounding is the process of finding the future values of
cash flows by applying the concept of compound interest.
 Compound interest is the interest that is received on the
original amount (principal) as well as on any interest earned
but not withdrawn during earlier
periods.
 Simple interest is the interest that is calculated only on the
original amount (principal), and thus, no compounding of
interest takes place.

Future Value
 The general form of equation for calculating the future
value of a lump sum after n periods may, therefore, be
written as follows:
 The term (1 + i)n is the compound value factor (CVF) of
a lump sum of Re 1, and it always has a value greater
than 1 for positive i, indicating that CVF increases as i
and n increase.
n
n F =P(1+i)= CVF n n,i
Example
 If you deposited Rs 55,650 in a bank, which was paying a 15 per
cent rate of interest on a ten-year time deposit, how much would
the deposit grow at the end of ten years?
 We will first find out the compound value factor at 15 per cent for
10 years which is 4.046. Multiplying 4.046 by Rs 55,650, we get Rs
225,159.90 as the compound value:
10, 0.12 FV = 55,650 × CVF = 55,650´ 4.046 = Rs 225,159.90

Future Value of an Annuity


 Annuity is a fixed payment (or receipt) each year for a specified
number of years. If you rent a flat and promise to make a series of
payments over an agreed period, you have created an annuity.
 The term within brackets is the compound value factor for an
annuity of Re 1, which we shall refer as
Example
 Suppose that a firm deposits Rs 5,000 at the end of each year
for four years at 6 per cent rate of interest. How much would this
annuity accumulate at the end of the fourth year? We first find
CVFA which is 4.3746. If we multiply 4.375 by Rs 5,000, we
obtain a compound value of Rs 21,875: 4 4, 0.06 F = 5,000(CVFA ) =
5,000´ 4.3746 = Rs 21,873
Sinking Fund
 Sinking fund is a fund, which is created out of fixed payments
each period to accumulate to a future sum after a specified
period. For example, companies generally create sinking funds
to retire bonds (debentures) on maturity.
 The factor used to calculate the annuity for a given future sum
is called the sinking fund factor (SFF).
Present Value
 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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