Week 2 – Time value of Money
1. Future Value (FV)
Meaning:
Future Value refers to the worth of today’s money at a specific point in the future, assuming it
earns interest or investment returns over time. It captures the idea that money grows when it
is invested.
● If you deposit ₹1,000 in a savings account today, in one year it will be more than
₹1,000 because the bank pays you interest.
● The higher the interest rate or the longer the period, the greater the future value.
Types:
● Single Cash Flow: A one-time investment made today grows into a larger amount in
the future.
● Series of Cash Flows (Annuity): Regular contributions (monthly, yearly) accumulate to
a larger future value.
Practical Finance Relevance:
● Helps investors forecast the maturity value of FDs, SIPs, or retirement funds.
● Used in setting financial goals (e.g., how much today will become in 10 years).
2. Present Value (PV)
Meaning:
Present Value is the current worth of a sum of money that is expected in the future,
discounted at a given rate of return. It represents the principle that a rupee today is more
valuable than a rupee tomorrow because today’s rupee can be invested.
● Example: If you are promised ₹10,000 after 5 years, you may ask: “How much is that
worth today if my required return is 8%?”
Types:
● Single Cash Flow: Value today of a one-time payment in the future.
● Series of Cash Flows (Annuity): Value today of regular payments received in the future
(like pensions or lease payments).
Practical Finance Relevance:
● Used in investment appraisal, bond pricing, and project evaluation.
● Helps compare different opportunities by bringing all values to “today’s terms.”
3. Loan Amortization (PMT, IPMT, PPMT Concepts)
Meaning:
Loan amortization refers to the process of repaying a loan through fixed, periodic payments
over time. Each payment consists of two parts:
1. Interest portion – payment for using borrowed funds.
2. Principal portion – reduction in the outstanding loan balance.
Key Characteristics:
● At the beginning, the interest component is higher since the outstanding loan is large.
● As time passes, the principal portion increases and interest decreases.
Practical Finance Relevance:
● Used by banks to structure home loans, car loans, and business loans.
● Helps borrowers understand how much of their EMI goes toward interest vs principal.
● Provides a complete amortization schedule, showing balance reduction over time.
4. Perpetuity
Meaning:
A perpetuity is a series of equal cash flows that continue indefinitely (forever). Unlike an
annuity, which ends after a fixed time, a perpetuity has no maturity.
Examples:
● Preferred shares that pay a fixed dividend forever.
● Endowment funds that provide annual scholarships indefinitely.
Key Idea:
The value of a perpetuity depends on the size of the payment and the required rate of return.
Practical Finance Relevance:
● Useful in valuing certain financial securities like perpetual bonds.
● Applied in financial planning where indefinite support (like charity funds) is expected.
5. Growing Annuity
Meaning:
A growing annuity is a series of periodic payments that increase at a constant growth rate for
a fixed period. Unlike a normal annuity (where each payment is equal), here each payment is
larger than the previous one.
Example:
● A company pays dividends that grow by 5% every year for the next 10 years.
● An employee’s salary increases by 4% every year for a contract period of 5 years.
Key Idea:
The present value of a growing annuity considers both the time value of money and the
growth factor in payments.
Practical Finance Relevance:
● Widely used in stock valuation (Dividend Discount Models).
● Useful in forecasting project cash flows that grow over time.
● Helps in personal finance to value pension or salary streams that increase yearly.
1. Future Value (FV) – Single and Series of Cash Flows
(a) Single Cash Flow
Formula (manual):
FV = PV × (1 + r)^n
● PV = Present Value (initial investment)
● r = Interest rate per period
● n = Number of periods
Excel Formula:
=FV(rate, nper, pmt, [pv], [type])
● rate → interest rate per period
● nper → number of periods
● pmt → periodic payment (0 if not used)
● pv → present value (entered as negative if it’s an outflow)
● type → 0 (end of period, default) or 1 (beginning of period)
Example:
Investment of 10,000 at 8% annual interest for 5 years:
FV = 10000 × (1 + 0.08)^5 = 14,693
Excel: =FV(8%,5,0,-10000) → 14,693
(b) Future Value of a Series (Annuity)
Formula (manual):
FV = PMT × [((1 + r)^n – 1) / r]
Example:
Deposit 1,000 every year for 5 years at 10%:
FV = 1000 × [(1.10^5 – 1) / 0.10] = 6,105
Excel: =FV(10%,5,-1000,0,0) → 6,105
💡 Used for SIPs, recurring deposits, pension savings.
2. Present Value (PV) – Single and Series of Cash Flows
(a) Single Cash Flow
Formula (manual):
PV = FV ÷ (1 + r)^n
Excel Formula:
=PV(rate, nper, pmt, [fv], [type])
Example:
Future cash inflow of 20,000 after 4 years, discount rate = 10%:
PV = 20000 ÷ (1.10^4) = 13,660
Excel: =PV(10%,4,0,-20000,0) → 13,660
(b) Present Value of a Series (Annuity)
Formula (manual):
PV = PMT × [1 – (1 + r)^(-n)] / r
Example:
Receive 5,000 every year for 6 years at 12% discount rate:
PV = 5000 × [1 – (1.12)^(-6)] / 0.12 = 21,239
Excel: =PV(12%,6,5000,0,0) → 21,239
💡 Used for pension valuation, bond pricing, lease agreements.
3. Loan Amortization (PMT, IPMT, PPMT)
Excel Functions
1. PMT → Payment amount
=PMT(rate, nper, pv, [fv], [type])
2. IPMT → Interest portion in a given period
=IPMT(rate, per, nper, pv, [fv], [type])
3. PPMT → Principal portion in a given period
=PPMT(rate, per, nper, pv, [fv], [type])
Example
Loan: 5,00,000 at 12% annual rate, tenure = 5 years, monthly installments
● Monthly rate = 12% / 12 = 1%
● Periods = 5 × 12 = 60
1. EMI = =PMT(12%/12, 60, -500000) → 11,122
2. Interest (1st month) = =IPMT(12%/12, 1, 60, -500000) → -5,000
3. Principal (1st month) = =PPMT(12%/12, 1, 60, -500000) → -6,122
Amortization schedule = build table for each period with IPMT & PPMT.
💡 Used for home loans, car loans, business loans.
4. Perpetuity and Growing Annuity
(a) Perpetuity
Formula (manual):
PV = C / r
● C = annual cash flow
● r = discount rate
Example:
Perpetual bond paying 100 annually, discount rate = 5%
PV = 100 / 0.05 = 2,000
💡 Used for valuing perpetual bonds, preferred shares.
(b) Growing Annuity
Formula (manual):
PV = PMT × [1 – ((1 + g) / (1 + r))^n] / (r – g)
● PMT = first payment
● g = growth rate
● r = discount rate
● n = number of periods
Example:
Payment starts at 100, grows at 4% per year, discount rate = 10%, duration = 10 years
PV = 100 × [1 – ((1.04 / 1.10)^10)] / (0.10 – 0.04) = 772
💡 Used in dividend discount models, project appraisals, salary forecasting.