Time Value of money

Abhishek Sinha FRM. Phd

Can you make your cash flow me travel? Yes, by using the concept of the me value of money.

The Value of money decreases over me hence the concept of interest / required rate of return may
be used to equate the cash flows at different points of me.

The first, thing to know are the types of cash flows we deal with.

The diagram captures the cash flows you will encounter.

Lump Sum – principal (PV) growing to become amount (FV) – (only two cash flows) at a given
interest rate (i%)

A sum of money PV growing for n years at i% to become FV.

Where PV is Present Value or (value in today’s term) and FV is Future Value n = me period i% =
Interest rate

We assume money grows at the compound interest rate. In other words, we are paid interest on
interest.

Formula for Amount in Compund Interest (CI) formula from your school days can be used.

𝐴 = (𝑃) ∗ (1 + 𝑖)
Let us call Amount (A)– “Future Value (FV)” and Principal (P) “Present Value (PV)” . Hence,

𝐹𝑉 = (𝑃𝑉) ∗ (1 + 𝑖)
Story Time:
Abhishek Panipuriwaala does not want to share the profits he has made at Abhishek Waterballs Pvt.
Ltd. with his wife. So, he decides to deposit in a bank in a clandes ne manner.

Abhishek Panipuiriwalla has earned Rs. 50,000 today he wants to know how much will it grow in 5
years at 10% p.a. Which formula to use

Steps involved

Step 1

Create a meline and map data given to the meline

. PV = FV =

50000

N= 5 years

Step 2

Iden fy the formula to be used in this case

𝐹𝑉 = (𝑃𝑉) ∗ (1 + 𝑖)
as

1. There are only two cash flows. I know the present value and need to find FV.

Step 3

Subs tute the values in the equa on.

FV = 50000*(1+10%)^5
𝐹𝑉 = (50000) ∗ (1 + 10%)
Step 4

Use the calculator to calculate the value. Answer – Rs. 80,525

Let us assume that Abhishek Panipuriwaala is not happy with Rs. 80525 and wants Rs. 100000 how
much should he deposit?

Hint: It is a lump sum, and we know the Future Value, however, we do not know the Present Value.
made at the beginning of the year. Here we can go back to what we already know.

𝐹𝑉 = (𝑃𝑉) ∗ (1 + 𝑖)

From there we can derive 𝑃𝑉 = (𝐹𝑉) ∗ (1 + 𝑖)

Assume Abhishek Panipuriwaala deposits his money in a bank which compounds the amount twice a
year. How would your account for the same?

Here i needs to be divided by the frequency of payment (m) and n needs to be mul plied by the
frequency of payments. Thus, we can have:

𝐹𝑉 = (𝑃𝑉) ∗ (1 + 𝑖/𝑚)
 𝑃𝑉 = (𝐹𝑉) ∗ (1 + 𝑖/𝑚)
∗
𝐹𝑉 = (50000) ∗ ((1 + 10%/2) )

𝐹𝑉 = (50000) ∗ ((1 + 5%) )

Here Abhishek Panipuriwaala can also calculate Effective Annual Rate from the annual rate (i) and m
is the number of payments made using the formula if the money is growing more than once in a year.
m referring to the number of payments he made in the year.
𝑖
𝐸𝐴𝑅 = 1 + −1
𝑚
∗
𝐸𝐴𝑅 = ((1 + 5%/2) )−1

𝐸𝐴𝑅 = ((1 + 2.5%) ) − 1

EAR = 5.06%
Abhishek Panipuriwaala wants to quickly know how much time it will take to double the money at a
given interest rate. He can use two approaches. There are two approaches here:
Rule of 72
𝑛 = 72/𝑖
Where i is the interest rate and n is the number of years. Hence, it will take approximately 72/5% =
14.4 years to double the money
Rule of 69
69
𝑛= + 0.35
𝑖
69
𝑛= + 0.35 = 14.15 𝑦𝑒𝑎𝑟𝑠
5
If you are the inquisitive kind, you can read this to compare Rule of 72 versus Rule of 69
Rule of 69 | Meaning, Benefits, Limita ons & More | eFinanceManagement

Till now we have covered

1. What is lump sum payment?

a. Only two cash flows
i. PV
ii. FV

2. What is future value of lump sum payment?

a. 𝐹𝑉 = (𝑃𝑉) ∗ (1 + 𝑖)

3. What is present value of lump sum payment?

a. 𝑃𝑉 = (𝐹𝑉) ∗ (1 + 𝑖)

4. What happens if the money compounds for more than once a year. What is Effec ve
rate/effec ve annual rate
a. 𝐸𝐴𝑅 = 1 + −1
 5. How much me does it take to double the money.
a. Rule of 72
𝑛 = 72/𝑖
b. Rule of 69
69
𝑛= + 0.35
𝑖
Annuity payments
Annuity payments refer to equal payments made at equal intervals when the interest rate is given and
the time period is known.
Assume Abhishek Panipuriwaala does not have Rs. 50000 immediately hence he plans to deposit Rs.
5000 every year for 10 years star ng at the end of the year.

This is how the meline would appear

50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000

Interest rate 5% No. of years = 10 years

In such cases, we can use the concept of annuity.

There are two things we can do here.

A. We can find the value of all the payments a er 10 years. We can find the value at the end of
10 years by using the Future Value of Annuity (FVA) formula.
𝑃𝑀𝑇
𝐹𝑉𝐴 = ∗ ((1 + 𝑖) − 1)
𝑖

Where PMT refers to the equal payments made at equal intervals, in this case, INR 50,000 is the PMT.
i is the interest rate at 5% p.a. and n is the me period.
50000
𝐹𝑉𝐴 = ∗ ((1 + 0.05) − 1)
5%
We can find the value at the end of 10 years by using the Future Value of Annuity (FVA) formula.

Where can Abhishek Panipuriwaala use this concept?

This concept is applicable when:

1. Abhishek Panipuriwaala is planning his re rement, and he wants to know how much FVA (
remember sum of money at the end on n years is called FVA) he will accumulate if we
deposit a PMT of equal value at equal intervals given the interest rate.
2. We want to know how much Abhishek Panipuriwaala will accumulate a er n years at i%
interest rate if we deposit PMT at the end of each year to meet our kids educa on needs.
 3. Addi onally, he can also calculate the PMT or amount he need to deposit at equal intervals
in order to replace a machine if he has all the other variables involved in the equa on.
𝐹𝑉𝐴 ∗ 𝑖
𝑃𝑀𝑇 =
((1 + 𝑖) − 1)
For example, we want to replace a machine a er n years, and we know the price of the
machine.
Abhishek Panipuriwaala has following doubts in mind what if
A. Abhishek Panipuriwaala deposits the first tranche at the beginning of the year instead of
at the end of the year then what? Let us help him. This is how the meline would appear.

50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000

FVA = ?
What we observe is - there is an addi onal payment at the beginning of the year. Such a
stream of cash flow is called annuity due. In this case the following formula should be
used.
𝑃𝑀𝑇
𝐹𝑉𝐴 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑑𝑢𝑒 = ( ) ∗ ((1 + 𝑖) − 1)) ∗ (1 + 𝑖)
𝑖
Note, everything remains the same we have just mul plied FVA formula with 1+I
because of the addi onal payment.

B. Abhishek Panipuriwalla deposits 50000 at the end of every month instead of every year.
Hint: We need to adjust the interest and me period for the effect of periodic interest.
Following is how your FVA formula change.

𝑃𝑀𝑇
𝐹𝑉𝐴 = ∗ ((1 + 𝑖/𝑚) − 1)
𝑖/𝑚

What have we learnt about annuity ll now:

1. What is annuity?
Annuity represents equal cash flow at equal intervals of me.
2. What is PMT?
PMT represents equal payments at equal intervals.
3. What is FVA?
Future Value of Annuity (FVA) represents the sum of PMTs (star ng at the end of first
year) at equal intervals of me a er adjus ng for me value of money, when the interest
rate is known and the me period is known.
4. What is FVA Annuity Due ?
If the PMT starts at the beginning of the year instead of the end of the year it is called
FVA Annuity Due.

𝑃𝑀𝑇
𝐹𝑉𝐴 = ∗ ((1 + 𝑖) − 1)
𝑖

Till now we have looked at situa ons where Abhishek Panipuriwaala is interested in
calcula ng the sum of PMTs (a er adjus ng for me value of money) in the future. What
 would Abhishek Panipuriwaala do if he wants to find the present value of cash flows
(a er adjus ng for me value of money)? He could resort to Present Value of Annuity
(PVA).
Let us assume, Abhishek Waterballs Pvt. Ltd. Is planning to buy a second hand sugarcane
juice extrac ng machine which will generate a cashflow of Rs. 50,000 every year for 10
years. How much should he pay for the machine?

𝑃𝑉𝐴 = ∗ (1 − (1 + 𝑖) )
C. This is how the meline would appear.

50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000
PVA = ?

This concept is useful for Abhishek Panipuri Waala when

A. He values Abhishek Waterballs Pvt Ltd.
a. Here it should be noted that most companies do not have constant
cashflows. It is expected that Abhishek Waterballs Pvt. Ltd. has cashflows
which beats its previous cash flows.
b. Hence, what if cashflows grow at constant rate let us assume 10%. Can we
find the present value of such cash flows.

Yes. We can.
𝑃𝑉𝐴 = ∗ (1 − ((1 + 𝑔)/(1 + 𝑖)) )
Where g is the growth rate. It is important to note that growth rate cannot be equal to or
more than i. (This formula is not in your syllabus but is important for valua on concept.
B. When he issues a bond he can value the bond by combining the PVA and PV concept.
This would be dealt in detail in bond chapter.
C. The value of any asset with equal cash flows at equal interval can be valued using
this formula.
D. For calcula ng the amount of loan he takes the formula can be used given the EMI
the interest rate and the dura on of the loan.
a. What if the interest is paid monthly as is the case.
𝑃𝑉𝐴 =
/
∗ (1 − (1 + 𝑖) )

b. He can also use the Present Value of Annuity due to calculate the value if the first
EMI is payment at the beginning of the period. Assumed payments are made at the
beginning of the year
𝑃𝑉𝐴 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑑𝑢𝑒 = ∗ ((1 − (1 + 𝑖) ))*(1+i)

What have we learnt about PVA

What is PVA?
Present value of annuity is the applica on of me value of money to calculate the
present value of series of PMT (equal payment at equal me).
What is PVA annuity due?
Present value of annuity due is the applica on of me value of money to calculate
the present value of series of PMT (equal payment at equal me) when the first
payment is made at the beginning of the year.

Abhishek Panipuriwaala is wondering how can he calculate the value of the following
A. He has promised to fund a prize of Rs. 5000 every year upto eternity at his alma
mater. What is the amount he should keep aside today.
Here the concept of perpetuity may be used PVAperpetuity = PMT/I as the value
of (1 − (1 + 𝑖) ) may be ignored when the me tends to infinity.
B. He has calculated the value of his company using the PVA for 10 years. However,
he knows the company last forever and hence he also wants to find the value
a er 10 years ll perpetuity and add it to the value he has already got. He
es mates in the 10th year he will earn INR 10 lakhs in cash . However, he
assumes the amount will grow at 10%.
Here he can use the following formula.
1+𝑔
𝑃𝑉𝐴(𝑔𝑟𝑜𝑤𝑖𝑛𝑔 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦) = 𝑃𝑀𝑇 ∗ ( )
𝑖−𝑔