MODULE 2

TIME VALUE OF MONEY 08 Hours

Compounding, Continuous Compounding, Effective Rate of Interest, Discounting – Single Cash Flows &
Series of Cash Flows, Annuity – Future Value and Present Value, Present Value of Growing Annuity,
Perpetuity – Present Value, Growing Perpetuity – Present Value, Equated Annual Instalments.
Time value of money
‘A rupee today is worth more than a rupee tomorrow’. the value of a unit of money is different in
different time periods.
Reasons Why Money in the Future is Worth Less Than Similar Money Today
There are three reasons why money can be more valuable today than in the future.
(i) Preference for Present Consumption: Individuals have a preference for current
consumption in comparison to future consumption. In order to forego the present consumption
for a future one, they need a strong incentive. Say for example, if the individual’s present
preference is very strong then he has to be offered a very high incentive to forego it like a higher
rate of interest and vice versa.
(ii) Inflation: Inflation means when prices of things rise faster than they actually should.
When there is inflation, the value of currency decreases over time. If the inflation is more, then
the gap between the value of money today to the value of money in future is more. So, greater
the inflation, greater is the gap and vice versa.
(iii) Risk: Risk of uncertainty in the future lowers the value of money. Say for example, non-
receipt of payment, uncertainty of investor’s life or any other contingency which may result in
non-payment or reduction in payment.
Time value of money results from the concept of interest.
Compounding and Discounting
Compounding is the process of calculating future values of cash flows where discounting means
finding present value of cash flows.
COMPOUNDING TECHNIQUE/FUTURE VALUE TECHNIQUE
Future value is the value at some future time of a present amount of money, or a series of payments,
evaluated at a given interest rate.
A. FUTURE VALUE/ COMPOUNDED VALUE OF SINGLE AMOUNT
1. Calculate compound amount of Rs. 1,00,000 at the rate of 15% per annum for 3 years.
2. Calculate future value of Rs. 1,00,000 at the rate of 18% per annum for 5 years.

B. FUTURE VALUE/ COMPOUNDED VALUE OF SINGLE AMOUNT (INTEREST

COMPOUNDED MORE THAN ONCE IN A YEAR)
1. Calculate interest on Rs. 1,00,000 at the rate of 12% per annum for one year, if interest is
compounded quarterly.
2. Rs. 1,000 today is equivalent to how much at the end of 4 years assuming interest at the rate of
(a) 15% and (b) 20%. Show the calculations if the interest is compounded annually, half yearly,
quarterly and monthly.
3. 2,000 is invested at annual rate of interest of 10%. What is the amount after 2 years if the
compounding is done?
(a) Annually? (b) Semiannually? (c) Monthly? (d) Daily? (Continuous compounding)
C. FUTURE VALUE/ COMPOUNDED VALUE OF SERIES OF CASHFLOWS

1. Suppose Mr.X deposits each year Rs.500, Rs,1000, Rs.1500, Rs.2000 and Rs.2,500 in his savings
bank account for 5 years, interest rate – 5%, assuming deposits are made at the end of each year
calculate the future value of his deposits at the end of 5th year. Also calculate the future value
assuming deposits are made at the beginning of the year.
2. Suppose Mr.Z deposits each year Rs.1,500, Rs,2,500, Rs.3,500 in his savings bank account for 3
years, interest rate – 8%, assuming deposits are made at the end of each year calculate the future
value of his deposits at the end of 3rd year.

D. FUTURE VALUE/ COMPOUNDED VALUE OF AN ANNUITY

ANNUITY is a series of equal payments or receipts occurring over a specified number of periods or in
other words it refers to stream of equal annual cashflows.
1. An investor deposits Rs. 1,000 in a saving institution. Each payment is made at the end of the year.
If the payments deposited earn 6% interest compounded annually, how much amount will he receive
at the end of 10 years?
2. An individual plan investing Rs. 100 per year in savings plan that earns 5% interest compounded
annually. Calculate the sum of annuity payments at the end of 10 years.
3. Find the amount of an annuity if payment of Rs.500 is made annually for 7 years at interest rate of
14% compounded annually.
4. Rs. 200 is invested at the end of each month in an account paying interest 6% per year compounded
monthly. What is the amount of this annuity after 10th payment?

EFFECTIVE RATE OF INTEREST

It is the actual equivalent annual rate of interest at which an investment grows in value when
interest is credited more often than once a year.
1. If the interest is 10% payable quarterly, find the effective rate of interest.
2. What is the effective rate of interest, if the rate of interest is 12 per cent per annum, when
compounding is done annually, semiannually, and quarterly?
3. What is the effective rate of interest if the rate of interest is 18 per cent per annum, when
compounding is done annually, semiannually, quarterly and monthly?
DISCOUNTING TECHNIQUE/ PRESENT VALUE TECHNIQUE

“Present Value” is the current value of a “Future Amount”. It can also be defined as the amount
to be invested today (Present Value) at a given rate over specified period to equal the “Future
Amount”.
If we reverse the flow by saying that we expect a fixed amount after n number of years, and we
also know the current prevailing interest rate, then by discounting the future amount, at the
given interest rate, we will get the present value of investment to be made.
Discounting future amount converts it into present value amount. Similarly, compounding
converts present value amount into future value amount.
Therefore, we can say that the present value of a sum of money to be received at a future date
is determined by discounting the future value at the interest rate that the money could earn over
the period. This process is known as Discounting.
The present value interest rate or the future value interest rate is known as the discount rate.
This discount rate is the rate with which the present value or the future value is traded off. A
higher discount rate will result in a lower value for the amount in the future. This rate also
represents the opportunity cost as it captures the returns that an individual would have made on
the next best opportunity.
 I. PRESENT VALUE/ DISCOUNTED VALUE OF SINGLE AMOUNT

1. What is the present value of Rs.1 to be received after 2 years compounded annually at
10%?
2. Find the present value of Rs.10,000 to be required after 5 years if the interest rate be 9 per
cent. Given that (1.09)5 = 1.5386
3. Find out the present value of Rs. 2,000 received after 10 years if discount rate is 8%.
4. What is the present value of Rs.50,000 to be received after 10 years at 10 per cent
compounded annually?
5. What is the present value of Rs. 1,00,000 received after 2 years, at a discount rate of 10%?
6. Find the present value of Rs. 1,00,000 received at the end of 2 years at a discount rate of
10%, if discounting is made half yearly.
7. Calculate the present value of following cash flows:
a. Rs. 2,000 to be received at the end of 2 years @ 10% compounded annually.
b. Rs. 5,000 to be received at the end of 1 year at 9% compounded quarterly.
c. Rs. 1,000 to be received at the end of 6 months @ 8% compounded monthly.
d. Rs. 4,000 to be received at the end of 3 years at 12% compounded monthly.
II. PRESENT VALUE/ DISCOUNTED VALUE OF SERIES OF CASHFLOWS
1. A company is considering the purchase of a machine that is expected to provide cash inflows as
follows:
YEAR 1 2 3 4 5 6 7
Cash
Inflows 1200 1800 2000 1900 1700 1700 1700
If the appropriate discount rate is 12%, what is the present value?

2. Calculate present value of following streams of payment assuming discount rate of 8%, 12%
and 15%.
YEAR 1 2 3 4 5
Cash Inflows (Rs.) 200 300 400 600 800

III. PRESENT VALUE/ DISCOUNTED VALUE OF AN ANNUITY

1. Calculate the present value of Re. 1 per year for 3 years at 6%.
2. A project offers an annual return of Rs. 2,50,000 for 5 years. If the cost of money is 15%,
calculate the present value of the project?
3. Determine the present value of receiving Rs.100 per year for 10 years with interest rate of
10%.
4. Calculate the present value of the following annuities at the discount rate of 9%.
(a) Rs. 1,500 per year for 6 years.
(b) Rs. 2,000 per year for 8 years.

IV. PRESENT VALUE OF GROWING ANNUITY

A series of payments or receipts occurring over a specified number of periods that increase each
period at a constant percentage. In a growing ordinary annuity, payments or receipts occur at the
end of each period; in a growing annuity due, payments or receipts occur at the beginning of each
period.

1. You have invested Rs. 1,00,000 in a project from which the returns at the end of first year is Rs.
10,000. The returns increase each year by 10%. If the investment is for a period of 4 years,
what is the present value of the returns? What will be the present value of returns, if
the investment is for a period of 10 years? Assume a discount rate of 14%.
 2. Suppose you have a rights to a gold mine for the next 20 years, over which period you plan to
extract 5,000 ounces of gold every year. The current price per ounce is Rs.3000, but it is expected
to increase 3% a year. the appropriate discount rate is 10%. Estimate its present value.

V. PRESENT VALUE OF PERPETUITY

Perpetuity is an annuity in which the periodic payments or receipts begin on a fixed date and
continue indefinitely or perpetually. Fixed coupon payments on permanently invested
(irredeemable) sums of money are prime examples of perpetuities.
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?
2. What is the present value of Rs. 5 per year forever at 6% discount rate?

3. Find the present value of Rs. 1,000 received per year forever at a discount rate of 10%.

4. Calculate Present Value of Rs. 1000 received from the end of year 3 forever at a discount rate of
12%.

5. Calculate Present Value of Rs. 10,000 received from the end of year 7 forever at a discount rate
of 15%.

VI. PRESENT VALUE OF GROWING PERPETUITY

A stream of cash flows that grows at a constant rate forever is known as growing perpetuity.
1. Assuming that the discount rate is 7% per annum, how much would you pay to receive Rs.
50, growing at 5%, annually, forever?
2. Calculate present value from the following information: Cash Flow at the end of year One – Rs.
10,000. Growth rate – 8%
Period – Infinity Discount rate – 12%.
3. Calculate the present value from the following information:
Cash inflows at the end of Year Six – Rs. 2,00,000. Growth rate
– 10% forever.
Discount Rate – 15%.

Equated Annual Instalment

1. A company has raised a loan of Rs. 5,00,000 from a financial institution at 8% per annum rate
of interest. The amount has to be paid back in 5 equal annual instalments. What shall be the size
of instalment?
2. Find out the loan payments per annum for the following: Cost of
Equipment: Rs. 50 Lakhs.
Borrowing rate: 15%
Term of Loan: 5 years
a. Principal is payable in equal investment over the period of five years.
b. Amount of loan is payable equally over the period of five years.
3. Your father deposits Rs. 3,00,000 on retirement in a bank which pays 10 per cent annual
interest. How much can be withdrawn annually for a period of 5 years?
Z plans to receive an annuity of ` 5,000 semi-annually for 10 years after he retires in 18 years.
Money is worth 9% compounded semi-annually.
(a) How much amount is required to finance the annuity?
(b) What amount of single deposit made now would provide the funds for the annuity?
(c) How much will Mr. Z receive from the annuity?

ABCL Company has issued debentures of ` 50 lakhs to be repaid after 7 years. How much
should the company invest in a sinking fund earning 12 percent in order to be able to repay
debentures?

How much amount is required to be invested every year so as to accumulate Rs. 3,00,000 at the end
of 10 years if the interest is compounded annually at 10%?
ABCL Company has issued debentures of Rs. 50 lakhs to be repaid after 7 years. How much
should the company invest in a sinking fund earning 12 percent in order to be able to repay
debentures?
Suppose you have borrowed a 3 year loan of Rs.1,00,000 at 9 per cent from your employer to buy
a motorcycle. If your employer requires three equal end-of-year repayments, then what will be
the annual installment amount?