Chapter – 3

Time Value of Money

 Time Value of Money

Which would you prefer – Rs 10,000 today

or Rs 10,000 in 5 years?
Obviously, Rs 10,000 today

Money received sooner rather than later allows one to use

the funds for investment or consumption purposes. This
concept is referred to as the TIME VALUE OF MONEY!!
MONEY
Reasons for Time Value of Money
 Individuals prefer current consumption to
future consumption.
 Capital can be employed productively to
generate positive returns.
 In an inflationary period a rupee today
represents a greater deal of purchasing
power than a rupee a year hence.
 Time Preference Rate & Required Rate
 The time value of money is generally expressed by
an interest rate. It is normally risk free rate.
 If risk is involved, risk premium is added to the
interest rate.
 Required Rate = Risk Free rate + Risk Premium
 The required rate of return may also be comparable
with the opportunity cost of capital.
 Compound Value
The ability of an asset to generate earnings, which are
then reinvested in order to generate their own earnings.
In other words, compounding refers to generating
earnings from previous earnings.
Also known as "compound interest".
Interest that accrues on the initial principal and the
accumulated interest of a principal deposit, loan or debt.
Compounding of interest allows a principal amount to
grow at a faster rate than simple interest, which is
calculated as a percentage of only the principal amount.
FVn = PV(1+ r)n
FV = Future or Compound Value
PV = Present Value
r = rate of interest
n = number of years
(1+ r)n = the future value interest factor

Simple Interest
FV = PV(1+n*r)
Compounding Graphically
Semi Annual & Other Compounding Periods
In case of semi-annual compounding there would be
two compounding periods within the year. Interest is
actually paid after every six months at a rate of one
half of the annual (stated) rate of interest.
Quarterly compounding means that there are four
compounding periods within the year. Instead of
paying the interest once a year, it is paid in four
equal installments after every three months.
A = P(1 + r/m)mn
where m is the no. of times per year compounding is
made.
Exercise:
1. Sachin deposited ₹ 1,00,000 in his bank for 2 years at simple interest of 6%.
How much interest would he earn ? How much would be the final value of
deposit?
(Ans: SI =12,000; A= 112000
2. Find the rate of interest if the amount owed after 6 months is ₹ 1050,
borrowed amount being ₹ 1000.
( Ans: 10%)
3. Simple interest on a certain sum for 4 years at 7%p.a. is more than simple
interest on the same sum for 2.5years at the same rate by 840. Find the
principal amount.
(Ans: P= ₹ 8000)
4. Rahul invested ₹ 70,000 in a bank at the rate of 6.5% p.a. simple interest
rate. He received ₹ 85,925 after the end term. Find out the period for which
sum was invested by Rahul.
(Ans : Time = 3.5yeas)
5. A simple interest of ₹ 3240 is received after 3 years on a certain principal at
the rate of 9% p.a. How much simple interest will be obtained after 5.5 years
from the same principal at the rate of 7% p.a ?
(Ans: P=12,000 ; SI = 4620)
 Future Value at the Beginning of the
Year @ 5%
Compound
Beginning Amount No. of years Interest
of Year Deposited compounded Factor Future Value

1 1000 5 1.28 1276.28

2 2000 4 1.22 2431.01
3 3000 3 1.16 3472.88
4 4000 2 1.10 4410.00
5 5000 1 1.05 5250.00
16840.17
 Future Value at the End of the Year @ 5%

Compound
End of No. of years Interest
Year Amount Deposited compounded Factor Future Value

1 1000 4 1.22 1215.51

2 2000 3 1.16 2315.25
3 3000 2 1.10 3307.50
4 4000 1 1.05 4200.00
5 5000 0 1.00 5000.00
16038.26
Exercise:

1.An amount of ₹ 15,000 is invested at 8% p.a., compounded annually. Calculate

1. Accumulated Amount after 3 years 2. Total compound interest in 3 years 3.
Interest in 3rd year.
[Ans: ₹ 18,896; ₹ 3,896; ₹ 1,400)
2. The accumulated value of a certain principal after 3 year is ₹ 6,655 and after 4
years, it becomes ₹ 7320.5. Find the rate of interest and the principal.
[Ans: 5,000]
3. Find the final amount of ₹ 10,000 at 9% p.a., in 3 years compounded half
yearly. [ Ans: 13023]
4. The difference between the simple interest and the compound interest on a
certain principal for 4 years at 8% p.a. is ₹ 648. Find the principal.
[ Ans: ₹ 16,000]
5. The simple and compound interest for 2 years on the same principal, at the
same rate are 3000 and 3120 respectively. Find the principal and the rate of
interest. [ Ans : Principal : ₹ 18750 , ROI = 8%]
6. Kanchan wanted to invest a certain amount in a bank at a certain rate of
compound interest. The bank promised to pay her ₹ 73,205, if she invested it for 4
years and ₹ 88,578.05, if she invested it for 6 years. Find the principal amount she
wanted to invest and the rate of compound interest. [Ans: 10%, P = ₹ 50,000].
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 values of a series of future cash flows.
The compound interest rate used for discounting
cash flows is also called the discount rate.
FVn = PV(1+ r)n
PV = FVn
-------------

(1+ r)n
Present Value of an Uneven Series

Present Value
End of the Factor @ Present
Year Cash Flows 10% Value
1 500 0.909 454.5
2 1000 0.826 826
3 1500 0.751 1126.5
4 2000 0.683 1366
5 2500 0.621 1552.5
5325.5
Multiple Cash Flows
• Consider an investment that pays $200 one year
from now, with cash flows increasing by $200 per
year through year 4. If the interest rate is 12%,
what is the present value of this stream of cash
flows?
• If the issuer offers this investment for $1,500,
should you purchase it?
Multiple Cash Flows
0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
1,432.93
Present Value < Cost → Do Not Purchase
Example
Your auto dealer gives you the choice to pay $15,500
cash now, or make three payments: $8,000 now and
$4,000 at the end of the following two years. If your
cost of money is 8%, which do you prefer?

Immediate payment 8,000.00

4 , 000
PV1  (1.08 )1
3,703.70
PV2  (14,.000
08 ) 2 3,429.36

Total PV $15,133.06
Present Values
$8,000

$4,000 $ 4,000

Present Value Year

0 1 2
Year 0
$8,000
4000/1.08 = $3,703.70
4000/1.082 = $3,429.36
Total = $15,133.06
Exercise:

1. Find the present value of ₹ 6,000 payable 2 years hence, if the interest is
compounded annually at 8%. [Ans : ₹ 5,144.03 ]
2. Omisha promised to give Priya ₹ 12,000 after 3 years. She also promised to
give her another ₹ 20,000 after 4 years. What is the present worth of both
these payments, if the interest is compounded at 9%p.a ? [ Ans: ₹ 23434.70]
3. If the present worth of a sum of ₹ 29,160 due after 2 years is ₹ 25,000, find
the ROI, compounded annually. [ Ans: 8%]
4. The price of a flat after 10 years will be ₹ 18,90,000 with 9% rate of
compound interest. Another flat will be worth ₹ 30,00,000 after 15 years with
8% appreciation. Find the present worth of both these flats. Also find the total
present worth of both the flats. [ Ans: 7,98,356.425; 9,45,725.115]
Net Present Value
The difference between present value of
cash inflows and the present value of cash
outflows. NPV is used in capital budgeting
to analyze the profitability of an investment
or project.
Net Present Value
$10,000
NPV  $9,500 
1.05
NPV  $9,500  $9,523.81
NPV $23.81
The present value of the cash inflow is greater
than the cost. In other words, the Net Present
Value is positive, so the investment should be
purchased.
Net Present Value
In the one-period case, the formula for NPV can be
written as:
NPV = PV –Cost

If we had not undertaken the positive NPV project

considered on the last slide, and instead invested our
$9,500 elsewhere at 5 percent, our FV would be less
than the $10,000 the investment promised, and we
would be worse off in FV terms :

$9,500×(1.05) = $9,975 < $10,000

 Compound Value of an Annuity

An annuity is an investment/ Borrowings that you make, either in a

single lump sum or through installments paid/ received over a certain
number of years, in return for which you receive/ pay back a specific
sum every year, every half-year or every month, either for life or for a
fixed number of years.

Ordinary Annuity/Annuity regular : A series of fixed payments/

receipts made at the end of each period over a fixed amount of time.
FVn = C [(1+r)n - 1]
-------------------
r
Annuity Due / Annuity immediate: An annuity due requires
payments or receipts to be made at the beginning of the period.

FVn = C[(1+r)n - 1]
------------------* (1 + r)
r
Exercise:

1.What is the accumulated value after 4 years of an annuity of Rs. 8,000 p.a., the
rate of interest being 8%p.a.,? [Ans: Rs.36050]
2.Harsha opened a recurring deposit in a bank for 4 years with payments of Rs.
5,000, paid at the end of each year. Find the money obtained at the end of period
with 6% p.a.? [Ans: Rs. 21,873.075]
3.Jiya deposited Rs. 2,000 at the end of each year, for 2 years in a company and
received Rs. 4,200 as the accumulated value. Find rate of compound interest.
[Ans : 10%]
4.Diana deposits Rs. 1,650,at the end of each quarter for 3.5 years at 9% p.a.,
compound interest. Find the amount she will receive at the end of the period. [Ans
: 26803.33]
5. Manisha deposits Rs. 500 with 12% compound interest for 3 years. Find the
final amount if (i) Payment is at the end of each month (ii) Payment is at the end
of each quarter. [Ans: Monthly payment = 21,540; Quarterly payment = 7096.67 ]
6.Z invests Rs. 10,000 every year starting from today for next 10 years. Suppose
interest rate is 8% p.a., compounded annually . Calculate future value of that
annuity. [Ans: Rs. 1,56,454.875]
 Present Value of an Annuity
An investor may have an opportunity to receive a
constant periodic amount (an annuity) for a certain
number of years.
Annuity Due

PV
C
= r [1- 1 .
(1+r) t ] * (1+r)

Ordinary Annuity

PV =
C
r [ 1-
1 .
(1+r) t ]
 Value of an Annuity Due

An annuity whose payment is to be made immediately,

rather than at the end of the period. An annuity due
requires payments to be made at the beginning of the
period. For example, in many lease arrangements, the
first payment is due immediately and each successive
payment must be made at the beginning of the month.
Annuity
A constant stream of cash flows with a fixed maturity
C C C C

V

0 1 2 3 T

C C C C
PV   2
 3
 T
(1  r ) (1  r ) (1  r ) (1  r )
C 1 
PV  1  T 
r  (1  r ) 
Annuity: Example

If you can afford a $400 monthly car payment, how

much car can you afford if interest rates are 7% on
36-month loans?

$400 $400 $400 $400


V

0 1 2 3 36

$400  1 
PV  1  36 
$12,954.59
.07 / 12  (1  .07 12) 
 What is the present value of a four-year annuity of $100 per
year that makes its first payment two years from today if the
discount rate is 9%?
4
$100 $100 $100 $100 $100
PV1  t
 1
 2
 3
 4
$323.97
t 1 (1.09) (1.09) (1.09) (1.09) (1.09)

$297.22 $323.97 $100 $100 $100 $100

0 1 2 3 4 5
$327 .97
PV   $297 .22
0 1.09
Exercise:

1.Find the present value of an ordinary annuity of Rs. 10,000p.a., for 4 years at
9% p.a., [Ans : 32,400]
2.Karthik purchased a TV set and paid Rs. 5000 immediately, another Rs.
5000 after a year and Rs. 5000, after 2 years and thus became debt free. Find
the price of TV set if the compound interest charged was 3.5% p.a.
[ Ans : Rs.14500].
3. Mr. Vohra purchased an LCD TV worth Rs. 70,000 with a down payment of
Rs. 10,000 and quarterly instalments of equal amount for one year. What is the
quarterly instalment if the company wishes to get 12%p.a., compounded
interest? [Ans: Rs.16,158]
4. Mr. Kulkarni bought a one ton AC with cash payment of Rs. 5,000 and 4
monthly instalments of Rs. 2500 each. What is the cost of AC if the company
charges 12% interest, compounded annually?
5. Suppose your mom decides to gift you Rs.10,000 every year starting from
today for next five years. You deposit this amount in a bank as and when you
receive and get 10%p.a., interest compounded annually . What is the present
value of this annuity? [Ans: 41698.70]
Effective versus Stated Rate
The annual rate of interest that does not account
for compounding occurring within the year. For
e.g. rate of interest on fixed deposit is 8%.
(Stated rate)
An investment's annual rate of interest when
compounding occurs more often than once a
year calculated as the following:
 Mr. Bhat deposits a certain amount at the end of every year for 4 years
in a bank. The rate of interest is 9% p.a., compounded half yearly.
Find the effective rate of interest.

Let i=9% = 0.09 and n = 2 periods in a year

Effective rate = (1 + 0.09/2) 2 – 1

= (1 + 0.045) 2 – 1
= 1.092025 – 1 = 0.092025
Effective rate = 9.2025% and stated Rate is only 9%.

Exercise:
Mr. Joshi deposits Rs. 8000 at the end of every year for 5 years in a bank. The bank
charges the rate as 8% p.a., compounded quarterly. Find the effective rate of
interest p.a., Also find the accumulated value. [ Ans : Effective rate = 8.24%;
Accumulated value = 47160.9084
 EQUATED MONTHLY INSTALMENTS (EMI)
The Loan taken from banks or any financial institutions is repayed in equal
monthly instalments over the time period of loan. The instalment is known as
EMI. EMI consists of 2 parts, one representing interest on the outstanding
balance loan and the other representing part of the principal to be repaid.

Loan Amortisation schedule:

Loan Amount : Rs. 80,000
Repaid in 2 years
Rate of Interest : 12% p.a.
Calculate EMI

r = 0.12/12 = 0.01; n= 2* 12 = 24 months; 1/(1+r) = 1/(1.01) = 0.9901; C = ?

C 1 
PV  1 
r  (1  r )T 

80000 = C [ 1- (0.9901) 24 ] / 0.01

C = 3766.47
 Loan Amortisation Schedule:

Month Principal EMI Interest part (1% Principal Outstanding

of Principal) part Principal
1 80,000 3766 800 2966 77034
2 77034 3766 770 2995 74038
3 74038 3766 740 3026 71012
4 71012 3766 710 3056 67956

Exercise:

Mihir took a loan of Rs. 50,000 from a company for a period of 1 year at
12%p.a. Find the EMI, using reducing balance method. Find the interest
component and the principal component for first two months.
[Ans : C = 4444; First year Principal = 3944; Interest = 500; Second year
Principal = 3983.44; Interest = 460.56]
 Sinking Fund
Sinking fund provision is really just a pool of money
set aside by a corporation to help repay a bond issue.
FV = A(CVAFn,r)
A= FV
(CVAFn,r)
A = FV( r/(1+r)n -1)
It helps in determining the annual amount to be put in
a fund to repay bonds or debentures at the end of a
specified period.
[ CVAF = compounded value of annuity factor ]
CVAF = (1+r)n - 1)
-------------------
r
 LEASING

Leasing is a financial arrangement under which the owner of the asset (lessor)
allows the user of the asset (lessee) to use the asset for a definite period of time
(lease period) for a consideration (lease rental) payable over a given period of time.

1.ABC Ltd. wants to lease out an asset costing Rs. 3,60,000 for a five year period. It
has fixed a rental of Rs.1,05,000 p.a., payable annually starting from the end of first
year. Suppose rate of interest is 14% p.a., compounded annually on which money
can be invested by the company. Is this agreement favourable to the company?
2.A company is considering proposal of purchasing a machine either by making full
payment of Rs.4000 or by leasing it for four years at an annual rate of Rs. 1250.
Which course of action is preferable if the company can borrow money at 14%
compounded annually?
Capital Expenditure (investment decision):

Capital Expenditure means purchasing an asset (which results in outflows of

money) today in anticipation of benefits ( cash inflow) which would flow across
the life of investment .

1. A machine can be purchased for Rs. 50,000. Machine will contribute Rs.
12,000 per year for next 5 years. Assuming borrowing cost is 10% p.a.,
compounded annually. Determine whether machine should be purchased or
not.
2. A machine with useful life of seven years costs Rs. 10,000 while another
machine with useful life of 5 years costs Rs. 8,000. The first machine saves
labour expenses of Rs. 1900 annually and second one saves labour
expenses of Rs. 2200 annually . Determine the preferred course of action.
Assuming cost of borrowing as 10% compounded p.a.,
Valuation of Bond:

A bond is a security in which the issuer owes the holder a debt and is obliged to
repay the principal and interest. Bonds are generally issued for a fixed term
longer than one year.

1.An investor intends purchasing a three year Rs. 1,000 par value bond having
nominal interest rate of 10%. At what price the bond may be purchased now if it
matures at par and the investor requires a rate of return of 14%?
Present Value of an Perpetuity
Perpetuity is an annuity that occurs indefinitely.
P= A
-----
r
Present Value of a Growing Annuity
PV = A
------( 1 – (1+ r) ^-n/ r)
1+g
Where r = (1-g)/(1+g)
Perpetuity
A constant stream of cash flows that lasts forever
C C C
…
0 1 2 3

C C C
PV   2
 3

(1  r ) (1  r ) (1  r )
C
PV 
r
Perpetuity:

1.Ramesh wants to retire and receive Rs. 3,000 a month. He wants to pass
this monthly payment to future generations after his death. He can earn an
interest of 8% compounded annually. How much will he need to set aside to
achieve his perpetuity goal?
C= Rs. 3,000
r= 8%p.a., = 0.08/12 = 0.00667 (monthly)
PV = C/r = 3000/0.00667 = Rs. 4,49,775

If he wanted the payments to start today, he must increase the size

of the funds to handle the first payment. This is achieved by depositing Rs.
4,52,775 (449775 + 3000) .
Growing Perpetuity
A growing stream of cash flows that lasts forever

C C×(1+g) C ×(1+g)2
…
0 1 2 3
2
C C (1  g ) C (1  g )
PV   2
 3

(1  r ) (1  r ) (1  r )
C
PV 
r g
Growing Perpetuity: Example

The expected dividend next year is $1.30, and

dividends are expected to grow at 5% forever.
If the discount rate is 10%, what is the value of
this promised dividend stream?
$1.30 $1.30×(1.05) $1.30 ×(1.05)2
…
0 1 2 3
$1.30
PV  $26.00
.10  .05
Growing Annuity
A growing stream of cash flows with a fixed maturity
C C×(1+g) C ×(1+g)2 C×(1+g)T-1

V

0 1 2 3 T
T1
C C (1  g ) C (1  g )
PV   2
  T
(1  r ) (1  r ) (1  r )

C  
T
 1 g 
PV  1    
r g   (1  r )  

Growing Annuity: Example

A defined-benefit retirement plan offers to pay $20,000

per year for 40 years and increase the annual payment by
three-percent each year. What is the present value at
retirement if the discount rate is 10 percent?

$20,000 $20,000×(1.03) $20,000×(1.03)39


V

0 1 2 40

$20,000  
40
 1.03 
PV  1     $265,121.57
.10  .03   1.10  