Time Value of Money

By: Kiran Thapa

 Time Value of Money
 The most important concepts in finance
 Implies the value of a rupee received one year from
now is not the same as the value of a rupee received
today
 Money has a time value
 Can be clearly defined as the relationship between
time and value of money
 An Idea about Time Value of
Money
 You have the choice of receiving Rs 200 either now
or one year later
 Your choice would obviously go for the first
alternative because you can deposit it in your bank
account and earn interest
 If suppose interest rate of the bank is 10 percent,
one year later, the amount will be Rs 220 in your
bank account due to interest
 Therefore the current amount is more worth than the
future amount
 Reasons for Time Value of
Money

 Reinvestment opportunity
 Inflation
 Sacrifice of present consumption 
 Importance/Significance of
Time Value of Money

 Valuation of securities and other assets

 Capital budgeting
 Lease analysis
 Cost of capital
 Working capital
 Cash Flow Time Line
 A graphical representation
 Used to show the timing of cash flows
 The time line is a horizontal line divided into equal
periods such as days, months, or years 
 Each cash flow, such as a payment (outflow) or
receipt (inflow), is plotted along this line at the
beginning or end of the period in which it occurs
 … contd.

 Outflow is represented with negative sign and inflow

with positive sign extending downwards the time
line 
 Time line is the most important tool in time value
analysis
 Help to visualize what is happening in a particular
problem and then to help set up the problem for
solution
 … contd.

 Cash flows are placed directly below the tick marks,

and interest rates are shown directly above the time
line. Unknown cash flows, which you are trying to
find in the analysis, are indicated by question marks.
 … contd.

 Here the interest rate for each of the three periods is

7 percent; a single amount (or lump sum) cash
outflow is made at Time 0 Rs 100 and has minus
sign; and the Time 2 value is an unknown inflow.
 Since the Period 3 amount is an inflow, it does not
have a minus sign, which implies a plus sign. Note
that no cash flows occur at Times 1 and 2.
 Note also that we generally do not show rupee signs
on time lines to reduce clutter.
 … contd.

 Now consider a different situation, where a Rs. 100

cash outflow is made today, and we all receive an
unknown amount at the end of Time 2:
 
0 7% 1 10% 2

–100 ?

 Here the interest rate is 7% during the first period,

but it rises to 10 percent during the second period. If
the interest rate is constant in all periods, we show it
only in the first period, but if it changes, we show all
the relevant rates on the time line.
Types of Cash flows
 Single cash flows
 Annuity cash flows
 Perpetual cash flows
 Mix cash flows or uneven cash flows
 Future Value and
Compounding
 Future value is value of a sum after it is invested
over one or more periods
 The amount of money that will increase/grow within
a certain time period at a given interest rate in an
investment is called future value
 The future value is the sum of beginning amount and
interest earned
 … contd.

 The process of leaving money and any accumulated

interest in an investment for more than one period,
thereby reinvesting the interest, is called
compounding
 The arithmetic process of determining the final value
of a cash flow or series of cash flows when
compound interest is applied
 … contd.

 Most of financial decision making models are based

on present value
 The concept of present value itself is derived from
the notion of future value
 Its usefulness is confined to such things as finding
the terminal value of an investment, computing
amortization and sinking fund payments on debt
 Calculation of Future Value
i. Formula Method
FV = PV (1 + i)n
Where,
 n = number of periods invested
 FV = Future value
 PV = Present value
 i = Interest rate
 … contd.

ii. Tabular Method

The future value is also calculated by using future value
interest factor (FVIF). FVIF value are used from factor
table.

The equation is
FVn = PV ×FVIFi,n
 Present Value and
Discounting
 The present value of a rupee in that will be received
in the future is less than the value of a rupee in hand
today.
 The actual present value of a rupee depends on the
earnings opportunities of the recipient and the point
in time when the money is to be received.
 … contd.

 The process of finding the present value of a cash

flow or a series of cash flows; discounting is the
reverse of compounding.
 Present value or discounting cash flows is a financial
technique that is used extensively in the appraisal of
investment decisions, so it is a concept which is of
fundamental importance in financial management.
Calculation Of Present Value

i. Formula Method
FV n
PV =
(1+ i)n

where,
n = number of periods
 … contd.

ii. Tabular Method

The present value is also calculated by using present
value interest factor (PVIF). The equation is
PV = FVn × PVIFi,n
Where, PVIFi,n = Present value interest factor at i% for
n years.
 Finding Out Discount Rate
(Interest Rate)
 Discount rate plays a vital role in time value of
money.
 If there is zero discount rate present value and future
value are always equal.
 There are only four parts to this equation: the
present value (PV), the future value (FVn), the
discount rate (i), and the life (n).
 Given any three of these, we can always find the
Calculation of Discount Rate

i. Formual Method
FVn
PV= n
(1+ i)
 … contd.

ii. Tabular Method

This problem can be solve by using present value
interest factor (PVIF) or future value interest factor
(FVIF) table. Let us start with present value interest
factor (PVIF) table.
Using PVIF table (present value table)
PV = FVn (PVIFi,n)
Note: To achieve the exact rate of return (discount rate)
we must use following equation.

Factor at low rate - Exact factor

Discount rate = LR + ´ (Difference in rate)
Factor at lower rate - Factor at high rate
 Finding Out Number of
Periods
We can use the present value and future value formula
to calculate the number of periods.

 The number of period can be find out by using numerical as

well as table method.

i. Numerical Solution
FV
Present value (PV) =
(1+ i)n
 … contd.

ii. Tabular solution

Using PVIF table
We have,
PV = FVn ´ PVIF i, n
Note: To find the actual number of years, the following equation is used.
Factor at low year - Exact factor
n=Minimum year+ ´ (Difference in rate)
Factor at low year - Factor at high year

Both method provides the same results but due to rounding error there is
slightly different results occur.
Problems
1. If you deposit Rs 1,000 in a bank account that pays 10%
interest per year. How much money would you have in 5 year?
Ans: Rs 1,610.51.
2. What is the present value of a security that promises to pay you
Rs 10,000 in 2 year? Assume that interest rate is 10%.
Ans: Rs 8,264.4628
3. At 7% interest rate, how long does it take to double your
money? Ans: 10.24 years
4. Your parents are planning to retire in 10 years. They currently
have Rs 250,000, and they would like to have Rs 1,000,000
when they retire. What must be the interest rate? Ans: 14.87%
 Annuity

 An annuity is a special cash flow pattern in

which a constant annual amount is to be paid
or received over a defined number of periods.
 Annuity is of two types:
 ordinary annuity and
 annuity due
 Ordinary Annuity

 In ordinary annuity, it is assumed that the

cash flows occur at the end of the period.
 Ordinary annuity is also known as deferred
annuity.
 For example, a person promises to pay Rs
5,000 at the end of each of 3 years for loan,
then it is ordinary annuities.
 Annuity Due
 An annuity due is one in which cash flows occur at
the beginning of each period.
 For example, if a person pay Rs 5,000 at the
beginning of each of 3 years instead of the end of
each of 3 years, then it is annuity due. Interest rate
on loan assumed to be 10 percent annually.
 Difference between ordinary annuity and annuity due
is each cash flow occurs one period earlier in the
annuity due than ordinary annuity.
 … contd.

 Ordinary annuities are much more common than

annuities due and from now on, unless otherwise
stated, we will assume we are dealing with ordinary
annuities.
 Difference between ordinary annuity and annuity due
is each cash flow occurs one period earlier in the
annuity due than ordinary annuity.
 Future Value of An Ordinary
Annuity

The future value of an annuity (FVAn) is the total sum

of annuity will be worth at the end of the annuity term,
when a constant annual amount is invested each period
and retained until the end of the annuity term.
 Calculation Of Future Value
Of An Ordinary Annuity
i. Formula Method
é(1+ i)n - 1ù
FVAn= PMT ´ ê ú
ë i û
Where,
FVAn = Future value annuity for n
PMT = Constant payment or cash flow
i = The rate of interest ( or discount rate)
n= Number of years of the annuity
FVIFAi,n = Future value interest factor annuity for i and n
 … contd.

ii. Tabular Solution

The future value of annuity can be calculated by

using the tabular solution as follows:

FVAn = PMT (FVIFA )

i, n
 Future Value of Annuity Due
 If the payments or receipts are made at the
beginning of the years, it is called an annuity due.
 In this case, one compounding period is more than
ordinary annuity.
 The value of annuity due is relatively higher than the
value of ordinary annuity.
Calculation Of Future Value
Of Annuity Due

i. Formula Method
é
ê(1+ i)n - 1ùú
FVAn(due) = PMT ´ ê ú (1 + i)
ë i û

ii. Tabular Method

Future value of annuity due can be calculated by
using the tabulation solution as follows:
FVAn(due) = PMT (FVIFA i, n) ( 1 + i)
Present Value of an Ordinary
Annuity
 Present value of an annuity is similar to the future
value of an annuity.
 The present value of an annuity is a concept widely
employed in the evaluation of many financial
decisions, corporate as well as personal.
 Many financial products in the financial services
market, such as pension plans, insurance policies all
involve, in one fashion or another, the determination
of the present value of annuity.
 Calculation
i. Formula Method
é1- 1 ù
PVAn = PMT
ê (1+ i) ú
n

ë i û
Where,
PVAn = Present value of annuity at time n
PMT = Constant payment or cash flow
i = The rate of interest ( or discount rate)
n = Number of years of the annuity
PVIFAi,n = Present value interest factor annuity for i
and n
 … contd.

ii. Tabular Method

Present value of ordinary annuity can be calculated by
using the tabulation solution as follows:

PVAn = PMT (PVIFA )

i, n
Present Value of Annuity Due
 If the payments or receipts are made at the
beginning of the years, it is called an annuity due.
 In this case, one compounding period is more than
ordinary annuity.
 So the present value of annuity due is relatively
higher than the value of ordinary annuity.
Calculation of : Present Value
of Annuity Due

i. Formula Method
é 1 ù
ê1- (1+ i)n ú
PVA(due) = PMT ´ ê ú (1+ i)
ë i û
ii. Tabular Method

PVA (due) = PMT (PVIFA i, n) (1 + i)

 Finding Out Discount rate and
Number of Periods in Annuity

The discount rate or interest rate and number

of periods is calculated in annuity as same as
single cash flows
Problem 1
Consider the following annuity
Rs 400 per year for 10 years at 10%
(a) Calculate the present value and future
value of annuity.
(b) Redo part (a) assuming annuity due.
(c) Redo part (a) and (b) if interest rate is
0%.
Problem 2
 A 5 year security has a price of Rs
1,300. the security pays Rs 400 at the
end of each of the next 5 years. What is
the expected return of this investment
to that investor?
 Ans: 16.324%
Problem 3
 Ram was a student at PU, he borrowed
Rs 10,000 in student loans at an annual
interest rate of 9%. If Ram repays Rs
1,000 per year, what is the required
time to pay the loan?
 Ans: n = 26.7193 years
Problem 4
 Sohan wants to buy car that costs Rs
12,000. He has arranged to borrow the
total purchase price of the car from
bank at 12% annual rate. The loan
requires quarterly payments for a
period of 3 years. What is the quarterly
payment?
 Ans: PMT = Rs 1,205.55
 Perpetuity

 Perpetuity is also known as perpetual annuity.

 In a simple annuity, the time period and cash
flows of amount are specified.
 But some annuities have infinite life and
payment should be made forever.
 This is called perpetuity.
 Computing Perpetuity
The present value of a perpetual can be
determined by utilizing the following formula:
PMT PMT PMT
PV (perpetuity) = + +...+
(1+i)1 (1+i)2 (1+i) ¥

PMT
=
i
Where,
PV = Present value of perpetuity
PMT = Amount of cash flow per year
i = Discount rate (opportunity cost)

It is noted that the future value of

perpetuity can not be calculated.
Problem 1
What is the present value of a
perpetuity of Rs 100 per year if the
appropriate discount rate is 7 percent?
If interest rates in general were to
double and the appropriate discount
rate rose to 14 percent, what would
happen to the present value of the
perpetuity? Ans: 1,428.5714 & 714.2857
 Uneven Cash Flows
 If the cash flow are not constant over the periods or
differs in each period, then cash flow is said to be
uneven cash flow.
 Unlike an annuity, there is no particular pattern to
the cash flows over time; rather, the receipts differ
from year to year.
 We will use cash flow (CF) to denote the cash flows
in general, which indicates uneven cash flows.
 Calculation of PV of Uneven
Cash Flow
The present value of an uneven cash flow stream is
found as the sum of the present values of the
individual cash flows of the stream.
i. Formula Method
CF1 CF2 CF3 CFn
PV = + + + …+
(1 + i)1 (1 + i)2 (1 + i)3 (1 + i)n

ii. Tabular Method

Year CF PVIF at i% PV
1 . . .
2 . . .
. . . .
. . . .

Present value = ….
 Calculation of FV of Uneven
Cash Flow
 The future value of an uneven cash flow stream
(sometimes called the terminal value) is found by
compounding each payment to the end of the stream
and then summing the future values
i. Formula Method

FVn = CF1 (1+ i)n – 1 + CF2 (1+ i)n – 2 + …+

CFn (1+ i) n - n

ii. Tabular Method

Year CF FVIF at i% PV
1 . . .
. . . .
. . . .
. . . .
. . . .
Future value = ….
Problem
 Calculate the present and future value
of following cash flows at 10 percent
interest rate.
 Year 1 = Rs 100
 Year 2 = Rs 200
 Year 3 = Rs 300
 Year 4 = Rs 400
 Compounding Periods
General formula to calculate the future value of
the various compounding is as follows:
æ i öm ´ n
FVmn = PV ç1+ m÷
è ø
Where,
m = compounding periods
n = Number of years
Other Compounding Periods
Generally compounding is classified as
follows:
Annual compounding: FVn = PV ( 1 + i)n
æ i ö2´n
ç
Semi annual compounding: FVn = PV ç1+
÷
è 2÷ø
æ i ö4´ n
ç
Quarterly compounding: FVn = PV ç1+ 4÷
÷
è ø
æ i ö12 ´ n
ç
Monthly compounding: FVn = PV ç1+
÷
è 12 ÷
ø
æ i ö52 ´ n
ç
Weekly compounding: FVn = PV ç1+
÷
è 52 ÷
ø
Continuous compounding: FVn = PV (ei ´ n)
Where,
e = The exponential function, which has a value of 2.7183
Problem
 Suppose you deposit Rs 10,000 in a
bank paying 12 percent annual interest
rate. Calculate the future value at the
end of 3 years if bank compounds
interest
a. Annual; b. Semiannual, c. Quarterly,
d. Monthly, e. Weekly, f. Daily, g.
Continuously.
 Nominal or Simple or Quoted
Interest Rate
 Nominal interest rate is the rate that is quoted by
borrowers and lenders.
 Practitioners in the stock, bond, mortgage, commercial
loan, consumer loan, banking, and other markets
express all financial contracts in terms of nominal rates.
 Nominal rate is the general rate that is use in practice
while making borrowing and lending contracts. However,
to be meaningful, the simple interest rate must also
include the number of compounding periods per year.
 For example, a bank might offer 6 percent nominal
interest rate, compounded annually or semiannually, or
quarterly or monthly etc.
 Periodic Rate
 The periodic rate is the rate charged by a lender or
paid by a borrower each period.
 It can be a stated rate per year, per 6-month, per
quarter, per month, or per day and so on.
 This rate is calculated by dividing the nominal
interest rate by number of period in a year.
Calculation of Periodic Rate
i N om
Periodic rate (i PER ) =
m
Where,
iNom = the nominal annual rate
m= the number of compounding periods per year.
Above equation implies that if periodic rate is multiplied
by the number of compounding period during the year
then the this rate is stated approximately or known as
approximate annual rate and it is expressed as follows:

Nominal annual rate = iNom = Periodic rate  m

 … contd.

 This nominal annual rate also known as annual

percentage rate (APR).
 If there is one payment per year, then the periodic
rate is equal with the nominal interest rate.
 If there is more payments during the year, then the
periodic interest rate is different from nominal
interest rate.
 The APR never is used in actual calculations; it is
simply reported to borrowers.
 Effective Annual Rate (EAR)

The effective annual interest rate is the interest rate

compounded annually that provides the same annual
interest as the nominal rate does when compounded on
times per year.
æ
ç i S IM PLEö÷m
Effective annual interest rate = ç1+ – 1.0
è m ÷ ø

Where,
iSIMPLE = The simple, or quoted, interest rate
m = The number of compounding periods per year
 … contd.

 The EAR rate generally is not used in calculations.

 The EAR is useful in comparing securities with
different compounding periods.
 Some banks and savings and loans even pay interest
compounded continuously.
 The maximum effective annual rate for a given
nominal annual rate occurs when interest is
compounded continuously.
 The effective annual rate for continuously
compounding can be found by using the following
equation:
Effective annual interest rate = ei – 1
Problem
 Suppose a bank provide nominal annual
interest rate of 10 percent. Calculate
the effective annual interest rate if bank
compounds
a.Annual, b. Semiannual, c. Quarterly,
d. Monthly, e. Weekly, f. Daily, g.
Continuously
 Amortized Loans
 The word amortized comes from the Latin word mors,
meaning ‘death’,
 An amortized loan is one that is “killed off” over time.
 The term loan amortization refers to the determination
of the equal annual loan payments necessary to
provide lender with a specified interest return and
repay loan principal over a specified period.
 … contd.

 The loan amortization process involves finding the

future payments whose present value at the loan
interest rate equals the amount of initial principal
borrowed.
 Lenders use a long amortization schedule to determine
these payment amounts and the allocation of each
payment to interest and principal.
 Amortization schedule are widely used for home
mortgages, loans, retirement plans etc.
 … contd.

 Amortizing a loan actually involves creating an

annuity out of a present amount
 This relationship is given by the following equation.

PVAn = PMT  (PVIFAi,n)

 To find the equal annual payment required to
amortize the loan
PVAn
PMT =
PVIFAi, n
 Preparing Amortized
Schedule
Step 1: Find the Annual Payment (PMT) using the
PVIFA table
Step 2: Find the interest paid in Year 1
Interest = Beginning balance  Interest rate

Step 3: Find the principal repaid in Year 1

Principal = Payment – Interest = XXX
Step 4: Find the ending balance after year 1
Ending balance = Beginning balance – Principal
 … contd.

Step 5: Construct an amortization table

Year Payment Interest Principal Loan Balannce

0
1
2
3

Repeat steps 2 to 4 until end of loan

Problem
Consider the loan amount of Rs 100, for 3
years at 10 percent interest rate.
a Prepare the amortization schedule.
b.Redo part a assuming payment is
payable in advance.
Problem
You opened an account in Nabil Bank Limited. The bank pays interest rate of 4
percent per annum and compounds quarterly.
a. If you deposit Rs 50,000 now, how much shall it grow at the end of 5 years?
b. What rate will you earn if the money deposited in the bank account doubles in 5
year?
c. How long will it take to grow Rs 50,000 to Rs 110,000 if the bank pays interest
at 4 percent per annum compounded annually?
d. Assume that you deposit Rs 50,000 at the end of each quarter for 4 years. What
will be the balance in your account at the end of 4 year if the bank pays interest
4 percent per annum compounded quarterly?
e. What is the relationship between discounting and compounding? What is the
present value of a Rs 1,000 perpetuity discounted back to the present at 8
percent?
f. You have just borrowed Rs 100,000, and you agree to pay it back over the next
25 years in 25 equal end of year annual payments that include the principal
payments plus 10 percent compound interest on the unpaid balance. What will
be the size of these payments?

 
 Ans: a. Rs 1,010; b. 14.104%; c.
20.1035 years; d. Rs 862,893.20; e.
12,500; f. Rs 11,016.8072
 Any queries?

?
Thank You