Chapter 2: Time Value

of Money
Concept & Relevance of TVM
• The concept of TVM is applicable and important for
every financial decision.
• Sound decision making requires that cash flows, which a
firm is expected to receive or give up over a period of
time should be logically comparable which requires
adjusting them for their timing and risk.
• It is applicable to individuals as well as to all forms of
business organisations.
• TVM or TPM is an individual’s preference for possession
of a given amount of money now, rather than having the
same amount at some future date.
• TVM is the rate of return which an investor can earn by
investing the money present at time period zero.
 Risk

Preference for Reasons

present Inflation
consumption for TVM

Investment
opportunities
 The Timeline
• Represents the timing of cash flows

• Helps in visualizing the problem

 Constructing the Timeline
Suppose you must pay tuition fee of Rs. 50,000
per year for the next two years. Your tuition
payments must be made in equal instalments at
the start of each semester. What is the timeline
of your tuition payments?
 Three rules of Time Travel
1. It is only possible to compare or
combine values at the same point in
time.
2. To move a cash flow forward in time,
you must compound it.
3. To move a cash flow backward in time,
you must discount it.
 The 1st Rule of Time Travel

• A rupee today and a rupee in one year are

not equivalent.
• It is only possible to compare or combine values
at the same point in time.
– Which would you prefer: A gift of Rs. 1,000
today or Rs. 1,210 at a later date?
– To answer this, you will have to compare the
alternatives to decide which is worth more.
One factor to consider: How long is “later?”
Example
• An Individual who is offered Rs.100 now and Rs.100
after one year

• A firm which purchases a machine for Rs.1 lakh

today is expected to receive a return of Rs 1.25
lakhs after one year.
Required rate of Return
• Time preference for money is generally expressed
by an interest rate which will be positive even in the
absence of risk. Justify why it will be positive even in
the absence of risk.
• It is known as the risk free rate.
• In reality, some degree of risk is always present.
• Therefore, an investor’s required rate of return will
be equal to:
Required Rate of return = Risk Free Rate + Risk Premium
• Use of Required Rate: It helps to convert cash flows occurring at
different time periods to comparable amounts in the present.
 The 2nd Rule of Time Travel
• To move a cash flow forward in time, you must
compound it.
– Suppose you have a choice between receiving Rs.
1,000 today or Rs. 1,210 in two years. You believe
you can earn 10% on the Rs. 1,000 today, but want
to know what the Rs. 1,000 will be worth in two
years.
 Compounding Example
Suppose you have a choice between
receiving Rs.5,000 today or Rs.10,000 in
five years. You believe you can earn 10%
on the Rs.5,000 today, but want to know
what the Rs.5,000 will be worth in five
years.
Future Value
• Future value of a single cash flow
• Rs 100 deposited in a bank at 5% p.a
F1 = 100 + (100 x 0.05)
=> 100 x (1 + 0.05) = 105
=> 100 + 5 = 105

F2 = 105 + (105 x 0.05)

=> [100 x (1 + 0.05)] + [{100 x (1 + 0.05)} x 0.05]
=> 100 x (1 + 0.05) x (1+0.05)
=> 100 x (1+0.05)2
=> 105 + 5.25 = 110.25
F3 = 110.25 + 110.25 x 0.05
=> [100 x (1+0.05)2] + [{100 x (1+.05)2} x 0.05]
=> 100 x (1+0.05)2 x (1+0.05)
=> 100 x (1+0.05)3
=> 100 x CVF(3,5%)

=> 110.25 + 5.51 = 115.76

Formula : PV ( 1+ r)n = FV
PV x CVF(n,r) = FV

• When compounding is involved we earn interest on both the principal and interest which has benn earned already i.e
interest earned keeps becoming a part of principal for calculating interest for the next period
• Simple Fact: Compounded value is directly proportional to the principal amount, rate of interest and time period
Future Value of an Annuity

Annuity is a fixed payment or receipt each time period

for a fixed no. of years.
Suppose Re.1 is deposited at the end of each year for 5
years at 10% p.a

=> Fn = A x {(1+r)n- 1}
r

=> F.V = A x CVFA/CVAF/FVAF/FVIAF/FVIFA(Compound value factor of an

annuity of Re.1)

Learn how to use tables and calculator to calculate CVFA

• Q) A firm deposits Rs.10000 at the end of each year for 6 years at
a) 7%.
b) 10%
c) 5%
Calculate the future value at the end of 6 years.

Solution
a) Fn = A x CVAF(n,r)
=> 10000 x CVAF(6,7%)
=> 10000 x 7.153 (see 6th period row & 7% column from the table)
=> Rs.71,530
Soln. Contd.
b) => 10000 x CVAF(6,10%)
=> 10000 x 7.716 (see 6th period row & 10% column from the table)
=> Rs.77,160

c) => 10000 x CVAF(6,5%)

=> 10000 x 6.802 (see 6th period row & 5% column from the table)
=> Rs.68,020
Sinking Fund
• It is a fund created out of fixed payments each period to accumulate
to a specified future sum after a specified period.

=> Fn = A x CVAF(n,r)
=> A = Fn / CVAF(n,r)
• => A = Fn x 1/CVAF(n,r)
Þ SFF (Sinking Fund Factor) = 1/ CVAF(n,r)
• Q) How much amount should be deposited each year to accumulate
the following amounts after 6 years:
a) Rs.71,530 at 7%
b) Rs.77,160 at 10%
c) Rs.68,020 at 5%

Solution
a) => A = Fn / CVAF(n,r)
=> Rs.71,530 x 1/ CVAF(n,r)
=> Rs.71,530 x 1/7.153
=> Rs.71,530 x 0.13980114818957081
=> Rs.10,000
For part (b) & (c) apply the same method
Q) If Mr. Amit has decided to deposit Rs.1 lakh in his PPF A/C for 30
years. How much will be the accumulated amount after 25 years at
9% interest rate?

Q) Sahara Finance advertises that it will pay Rs.8000 at the end of 6

years to investors who deposit Rs.1000 annually for 6 years?
Solution
Þ 8000 = 1000 x CVAF(6,r)
Þ 8000/1000 = CVAF(6,r)
Þ 8 = CVAF(6,r)
• By looking at the CVAF table in the row for 6th period the value 8 lies
between 11% and 12% column so we can conclude that the interest
rate is slightly above 11% and slightly below 12%
• We can calculate the exact value by interpolation
• show it on the board
Q) One day Nitesh decided to take a to and fro trip to Mars as he was
firmly determined to prove that men are from Mars. The trip will cost
him Rs.10,00,000. He starts saving Rs.50,000 every year which will
earn an interest of 12%. How long will he have to wait to fulfill his
desire?
Solution
=> 50,000 x {(1+0.12)n- 1} = 10,00,000
0.12
=> 50,000 x {(1.12n- 1)/0.12} = 10,00,000
=> {(1.12n- 1)/0.12} = 10,00,000/50,000
=> 1.12n- 1 = 20 x 0.12
Þ 1.12n = 1 +2.4
Þ 1.12n = 3.4
Þ taking log we get n x log 1.12 = log 3.4
Þ n x 0.0492 = 0.5315
Þ n = 0.5315/ 0.0492
Þ n = 10.8028 years = 11 years approximately
• Doubling Period
 How long would it take to double the amount at the given rate of
interest?
• There are three ways to calculate it:
 From the table
 Rule of 72
 Rule of 69

• Rule of 72 = 72/interest rate

• Rule of 69 = 0.35 + 69/interest rate

Q) How long would it take to double the amount at 12%?

Soln.
• From the CVF (not CVAF) table by looking at the 12% column = about 6
years
• Rule of 72: 72/12 = about 6 years
• Rule of 69: 0.35 + 69/12 = 6.1 years
• Finding the Growth Rate
Q) A company has 5000 employees and the workforce is
expected to grow at 5% per year. How many employees
will the company have after 10 years?

Solution
=> 5000 x (1+ 0.05)10
=> 5000 x (1.05)10
=> 5000 x 1.629
=> 8145
Q) RIL had revenues of Rs.100 million in in 1990. It increased to Rs.1000
million in 2000. Calculate the compound annual growth rate of RIL.
Solution
Let the compound growth rate be = g
=> 100 (1+ g)10 = 1000
=> (1+ g)10 = 1000/100
=> (1+ g)10 = 10
=> (1+ g) = 101/10
=> g = 101/10 -1
Taking log of 101/10
=> (1/10 x log10)
=>1/10 x1
Þ AL 0.1= 1.2589 (substituting the value of 101/10 = 1.2589 in the Eq.)
Þ g = 1.2589-1
Þ g = 0.2589= 25.89%
Non-annual Compounding
• Adjustments are to be made in the rate of interest (r) and time period of
compounding (n).
• Adjusted r is equal to r/m where m is the no. of times compounding is done in one
year
• Adjusted n is equal to m x n = mn
• Adjusted formula: Formula : FV = PV (1+ r/m)mn
• Faster the interest is compounded faster the FV grows.
Q) An amount of Rs.1000 is deposited at 12% p.a compounded
half yearly for 1 year. Find out the future value and the effective annual rate of
interest.
Solution
Þ 1000 (1+ 0.12/2)2x1
Þ 1000 (1.06)2
Þ1000 (1.124)value from the table
Þ 1124 (approximate amount as the value in the table was upto 3 decimal places
whereas the exact value of CVF will be 1.1236 and hence the answer will be
Rs.1123.60 )
ÞEffective rate of interest is: (FV – PV)/PV = (1124 – 1000)/1000
Þ0.124 = 12.4%
• Effective rate of interest (re) is the rate of interest compounded
annually which is equal to the rate of interest p.a compounded more
than once per year.

• Relationship between r and re

=> PV (1 + re )n = PV (1+ r/m)mn
=> (1 + re ) = (1+ r/m)m
Substituting the values in the above equation from the previous
question we get:
Þ (1 + re ) = (1 + 0.12/2)2
Þ (1 + re ) = (1 + 0.06)2
Þ (1 + re ) = 1.1236 (1.124 as per the table)
Þ re = 1.1236 – 1
Þ re = 0.1236 = 12.36%
Q) A deposit of Rs.10000 is to be made by Mr. Ronit in
a bank for one year. There are two bank with the
following schemes:
a) ICICI Bank -12.25% p.a compounded monthly or
b) Federal Bank-12.9% p.a compounded quarterly
Which scheme is better for Mr. Ronit? Advise

Federal= ((1+0.129/4)^4)-1=((1+0.03225)^4) -
1=1.1353-1=13.53% p.a compounded annually
ICICI= ((1+0.1225/12)^12)-1 =12.96% p.a
compounded annually
 The 3 Rule of Time Travel
rd

• To move a cash flow backward in time, you must

discount it.
– Suppose you have a choice between receiving Rs.
1,000 today or Rs. 1,210 in two years. You believe
you can earn 10% on the Rs. 1,000 today, but want
to know what the Rs. 1,210 will be worth now.
 Exercise

You are considering investing in a savings bond

that will pay Rs. 15,000 in 10 years. If the
competitive market interest rate is fixed at 6%
p.a., what is the bond worth today?
 Example
You need money to buy a new car. Your uncle will
lend you the money so long as you agree to pay him
back within 4 years. You offer to pay him the rate of
interest that he would otherwise get by putting his
money in a savings account (6%). Based on your
earnings and living expenses, you think you will be
able to pay him Rs. 50,000 in one year and then Rs.
80,000 each year for next three years. How much
can you borrow from him?
Present Value (PV)
• PV of a future cash flow (inflow or outflow) is the
amount of cash today (current) that is equivalent to the
decision maker.
• The process of determining the PV of the future cash
flows is called discounting and the rate of interest used is
called the discounting rate which is the same interest
rate used for compounding as that is the required rate
given.
Þ FV = PV ( 1+ r)n
Þ FV/ ( 1+ r)n = PV
Þ FV x 1/( 1+ r)n = PV
Þ FV x PVF(n,r) = PV
Þ Using the PVF table is same as using the CVF table
Present Value of Single Cash Flow
• Solve by using tables and calculators
• Calculate the present value of Rs 1 lakh received after 15 years at:
a) 10%
b) 12%
c) 13%
Q) Calculate the present value of Rs 1 lakh at 10 % received after :
d) 10 years
e) 15 years
f) 20 years
Solve by using tables and calculators
• By plotting the answers on a graph, we can comment about the
relationship between the PV, time period, rate of interest and the
FV.
• So what are you waiting for? Just do it and find out the direction
of relationship.
• Present Value of an Annuity
• Annuity is a fixed payment or receipt each year for a
fixed no. of years.
• Suppose Re.1 is received at the end of each year for
5 years at 10% p.a

=> PV = A x [1 - {1/(1+r)} n]
r

=> P.V = A x PVFA(Present value factor of an annuity of Re.1)

• Learn how to use tables and calculator to calculate

CVFA
Q) What will be PV of a stream of receipts of Rs.1000 received for 3
years annually at the end of each year at 10% interest rate?

Solution
Þ 1000 x PVFA(3,10%)
Þ 1000 x 2.487 ( from the PVFA table) = Rs.2487
 a

Q) Mr. A wants to borrow Rs. 10,80,00 0 to buy a car. He approaches SBI for a loan which
charges 12.5% interest. He can afford to pay Rs.1,80,000/year towards loan repayment.
Calculate the maturity period of the loan which Mr. A should ask the from the respective bank
manager?
Solution
ÞA x PVAF(n,r)=Loan
ÞA x CVAF(n,12.5%)= Loan x CVF(n,12.5%)
=> 1,80,000 x [1 – {1/(1+0.125)n}] = 10,80,000
0.125
=> [1 – {1/1.125n}] = 10,80,000
0.125 1,80,000
Þ 1 – (1/1.125n) = 6 x 0.125
Þ 1 – {1/1.125n )= 0.75
Þ 1 – 0.75 = 1/1.125n
Þ 0.25 = 1/1.125n
Þ 1.125n = 1/0.25
Þ1.125n = 4
Þ Taking log on both sides we get log1.125n = log 4
Þ n log1.125 = log 4
Þ n x 0.0511 = 0.6021
Þn = 0.6021/ 0.0511
Þ n = 11.76 years = 12 years
• Q) A firm borrows Rs.10 lakhs at 15% and it is to be
repaid in 5 equal installments at the end of each
year. Calculate the installment?
• Q) If Mr. B deposits Rs.3 lakhs in a bank at 10%. How
much can be withdrawn annually for a period of 10
years?
• Q) If A deposits Rs.10,000 in HDFC bank, it will pay
Rs.2500/year for 6 years. What interest rate does B
earn on this deposit?
• Q) Mr. R will receive an annuity of Rs.50,000 once
every 2 years stretching over a period of 30 years. If
the annual interest rate is 8%, what is the present
value of annuity?
 Q) Ravi wants to save for the college education of
his son. He estimates that the college education
expenses will be Rs.10 lakhs per year for 4 years
when his son reaches college in 16 years (after 16
years). The expenses will be payable at the
beginning of each year. How much should he save
every year for next 15 years at 8% if his son is born
today to cover up his son’s college education
expenses?
Present value of Growing Annuity

• Growing annuity represents cash flows which are

expected to grow at a constant rate. Example :
dividends, salaries, prices etc.
Formula:
Q) Rakesh takes a part-time job for 5 years. His
employer agrees to pay him a salary of
Rs.1000/Year with an annual increment of 10%. Find
out the PV if his required rate of return is 12%.?

Ans. Rs.4307

Q) A company paid a dividend of Rs.60 last year which

is expected to grow at 10% p.a for 15 years and then
end. What is the present value of the expected
series if the discount rate is 21%?

Ans. Rs.456.36
Q) Mr. Ashish has the right to harvest teak plantation
for 20 years and he expects to get 1 lakh cubic feet
of teak every year which is currently priced at
Rs.500/cubic feet. The price is expected to grow at
8%/year. The required rate of return for Mr. Ashish
is 15%. Advise whether he should invest in the
plantation if he has to pay Rs.52 crores to get the
teak plantation harvesting rights.
Ans. Rs.55,17,36,683
Q) Ramesh has borrowed a 3 year loan of Rs.9000
from his employer at 9 %. If the employer requires
3 equal end of the year repayments, what will be
the yearly installment to be paid by Ramesh? Also
show the loan amortisation schedule.
Can you calculate the PV of uneven cash flows?
Annuity Due
a) FV of Annuity Due : All the annuity amounts earn
interest for an extra year.
Formula : FV of ordinary annuity x (1+r)
=> A x CVAF(n,r) x (1+r)

b) PV of Annuity Due : All the annuity amounts will

be discounted for one year less.
Formula : PV of ordinary annuity x (1+r)
=> A x PVAF(n,r) x (1+r)
Continuous Compounding

• It is also known as daily compounding

• Formula: Fn = P.ein
=> Fn = P.ex

Where e = 2.7183

• Present value in case of continuous compounding

• Formula: Fn = PV.ein
=> Fn /ein= PV
=> Fn .e-in = PV
Q) Find out the compound value of Rs.1000 compounded
continuously at 12% for 2 years.
Ans) Rs.1271.30
Present Value of Perpetuity
• Formula: PV = Perpetuity amount/r
Q) Indian Govt. issued irredeemable bonds that will pay
an yearly interest of Rs.1000 for ever at 10%. What
should be the price of the bond.

Present Value of Growing Perpetuity

• Formula: PV = Perpetuity amount/(r – g)

• If an office premise is expected to generate a rental of

Rs.1 lakh every year which is expected to grow at 5%
every year for indefinite period of time. Calculate the
present value of the rental stream at 10% discounting
rate.
 Question
• Mr. X has inherited Rs.200000 from his father. He works at Infosys and has a
salary of Rs.100000/annum. He plans to purchase a car which will cost him
Rs.1000000. He approaches SBI for a 5 year loan at 12% p.a with annual loan
installments. He will retire after 20 years. He needs to buy a house after
retirement, the estimated cost of which is Rs.50 lakhs. He will receive Rs.20
lakhs as PF amount at the time of retirement. The housing loan rate is
estimated to be 10% after 20 years. He also will need Rs. 10 lakhs to send his
daughter to LSE after 20 years for her Masters in Finance. The interest rate is
10%. How much should he save every year to fulfill all his obligations and also
ensure a pension like perpetuity of Rs.20000/year after retirement for meeting
his living expenses. Prepare an excel schedule showing the matching of savings
and expenses from Year 1 to Year 20 as a verification of the value calculated as
savings required in every year. Also suggest ways to ensure that Mr. X is able to
fulfill all his financial obligations on time with respect to the given information
regarding his salary.
Thank You