Session II

Time
Time Value
Value
Of
Of
Money
Money
Which would you prefer -- Rs10,000 today or
Rs10,000 in 5 years?
years

Obviously, Rs10,000 today.

today

You already recognize that there is TIME

VALUE TO MONEY!!
MONEY
 Why
Why TIME?
TIME?

Why is TIME such an important element in

your decision?

TIME allows you the opportunity to postpone

consumption and earn INTEREST.
INTEREST
 The
The Time
Time Value
Value of
of Money
Money
 The value of money received today is different
from the value of money received after some time
in future
 The reasons for this are
1. Inflation
2. Risk
3. Personal consumption preference
4. Investment opportunities
 Present Value is the current value of a future amount of money, or a series of payments,
evaluated at a given interest rate.

 Future Value is the value at some future time of a present amount of money.

 Compounding is the process of finding the future value of the present stream of cash
flows

 Discounting is the process of finding out the present value of the future stream of cash
flows.

 The principal is the amount borrowed.

 Interest is the compensation for the opportunity cost of funds and the uncertainty of
repayment of the amount borrowed; that is, it represents both the price of time and the
price of risk. The price of time is compensation for the opportunity cost of funds and the
price of risk is compensation for bearing risk.
Future value
 Types
Types of
of Interest
Interest

 Simple Interest
Interest paid (earned) on only the original amount, or
principal, borrowed (lent).

 Compound Interest
Interest paid (earned) on any previous interest earned,
as well as on the principal borrowed (lent).
 Simple
Simple Interest
Interest Formula
Formula

Formula SI = P0(i)(n)

SI: Simple Interest

P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
 Simple
Simple Interest
Interest Example
Example

 Assume that you deposit Rs 1,000 in an account earning 7%

simple interest for 2 years. What is the accumulated interest
at the end of the 2nd year?

 SI = P0(i)(n)
= 1,000(.07)(2)
= 140
 Simple
Simple Interest
Interest (FV)
(FV)

 What is the Future Value (FV)

FV of the deposit?

FV = P0 + SI
= Rs1,000 + Rs140
= Rs1,140
 Compound Interest

 If interest for one period is added to the principal for the

next period, it is called compound interest
 The time period for compounding the interest may be
annual, semi- annual or any other regular period of time.


A= P(1+i)n
A = amount at the end of ‘n’ period
i= rate of interest per payment period
n = no. of payment periods
 Valuation
Valuation Using
Using Table
Table II

FVIFi,n is found on Table I

at the end of the book.

Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
 Using
Using Future
Future Value
Value Tables
Tables

FV2 = Rs1,000 (FVIF7%,2)

= Rs1,000 (1.145)
= Rs 1,145 [Due to Rounding]

Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
 Double
Double Your
Your Money!!!
Money!!!

Quick! How long does it take to double Rs

5,000 at a compound rate of 12% per year
(approx.)?

We will use the “Rule-of-72”.

 The
The “Rule-of-72”
“Rule-of-72”

Quick! How long does it take to double

$5,000 at a compound rate of 12% per year
(approx.)?

Approx. Years to Double = 72 / i%

72 / 12% = 6 Years
[Actual Time is 6.12 Years]
 Frequency
Frequency of
of Compounding
Compounding

General Formula:
FVn = PV0(1 + [i/m])mn
n: Number of Years m:
Compounding Periods per Year
i: Annual Interest Rate FVn,m:
FV at the end of Year n
PV0: PV of the Cash Flow today
 Impact
Impact of
of Frequency
Frequency

Julie Miller has Rs1,000 to invest for 2 Years at an

annual interest rate of 12%.

Annual FV2 = 1,000(1+

1,000 [.12/1])(1)(2)
= 1,254.40
Semi FV2 = 1,000(1+
1,000 [.12/2])(2)(2)
= 1,262.48
 Impact
Impact of
of Frequency
Frequency

Qrtly FV2 = 1,000(1+

1,000 [.12/4])(4)(2) =
1,266.77

Monthly FV2 = 1,000(1+

1,000 [.12/12])(12)(2)
= 1,269.73

Daily FV2 = 1,000(1+[.12/365])

1,000 (365)(2)

= 1,271.20
 Sinking Fund

 Sinking fund is a fund, which is created out of fixed payments

each period to accumulate to a future sum after a specified
period.

 Companies generally create sinking fund to retire bonds on

maturity.

 Fn = A * CVIFA n,i
A = Fn * 1/CVIFAn,i
A = Fn * SFFn,i
SFF n,i = sinking fund factor
 Present Value
 Translating a value to the present is referred to as discounting.

 Present value = PV = FV / (1 + i) n
Where:
PV = present value (today's value),
FV = future value (a value or cash flow sometime in the future),
i = interest rate per period, and
n = number of compounding periods
And [(1 + i) n] is the compound factor.
 Annuity
 An Annuity represents a series of equal payments (or receipts)
occurring over a specified number of equidistant periods.

 The word annuity in a broader sense includes payment which can

be annual, semiannual, quarterly or any other fixed length of
time.

 It does not necessarily mean payment taken to be one year.

 Types
Types of
of Annuities
Annuities

 Ordinary Annuity:
Annuity Payments or receipts occur at
the end of each period.

 Annuity Due:
Due Payments or receipts occur at the
beginning of each period.
 Examples of Annuities

 Student Loan Payments

 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings
 Parts
Parts of
of an
an Annuity
Annuity

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

Rs100 Rs100 Rs 100

Today
 Parts
Parts of
of an
an Annuity
Annuity
(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

Rs100 Rs100 Rs100

 Hint on Annuity Valuation

The future value of an ordinary annuity

can be viewed as occurring at the end
of the last cash flow period, whereas
the future value of an annuity due can
be viewed as occurring at the
beginning of the last cash flow period.
 Valuation
Valuation Using
Using Table
Table III
III
FVAn = R (FVIFAi%,n)
FVA3 = Rs1,000 (FVIFA7%,3)
= Rs1,000 (3.215)
= Rs3,215
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
 Valuation
Valuation Using
Using Table
Table III
III

FVADn = R (FVIFAi%,n)(1+i)
FVAD3 = Rs1,000 (FVIFA7%,3)(1.07)
= Rs1,000 (3.215)(1.07) = Rs3,440

Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
 Hint on Annuity Valuation

The present value of an ordinary annuity can

be viewed as occurring at the beginning of the
first cash flow period, whereas the future
value of an annuity due can be viewed as
occurring at the end of the first cash flow
period.
 Valuation
Valuation Using
Using Table
Table IV
IV

PVAn = R (PVIFAi%,n) PVA3

= Rs1,000 (PVIFA7%,3)
= Rs1,000 (2.624) = Rs2,624
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
 Valuation
Valuation Using
Using Table
Table IV
IV

PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = Rs1,000 (PVIFA7%,3)(1.07)
= Rs1,000 (2.624)(1.07) = Rs2,808

Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
 Effective
Effective Annual
Annual
Interest
Interest Rate
Rate

Effective Annual Interest Rate

The actual rate of interest earned (paid) after
adjusting the nominal rate for factors such as
the number of compounding periods per year.

(1 + [ i / m ] )m - 1
 Effective
Effective Annual
Annual Interest
Interest Rate
Rate

Baskin Wonders (BW) has a Rs1,000 CD at the bank. The

interest rate is 6% compounded quarterly for 1 year.
What is the Effective Annual Interest Rate (EAR)?
EAR

EAR = ( 1 + 6% / 4 )4 - 1 =
1.0614 - 1 = .0614 or 6.14%!
 Steps
Steps to
to Amortizing
Amortizing aa Loan
Loan

1. Calculate the payment per period.

2. Determine the interest in Period t. (Loan Balance at t-1) x

(i% / m)

3. Compute principal payment in Period t. (Payment -

Interest from Step 2)

4. Determine ending balance in Period t. (Balance -

principal payment from Step 3)

5. Start again at Step 2 and repeat.

 Amortizing
Amortizing aa Loan
Loan Example
Example

Julie Miller is borrowing $10,000 at a compound annual

interest rate of 12%. Amortize the loan if annual payments
are made for 5 years.

Step 1: Payment
PV0 = R (PVIFA i%,n)
$10,000 = R (PVIFA 12%,5)
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774
 Amortizing
Amortizing aa Loan
Loan Example
Example

End of Payment Interest Principal Ending

Year Balance
0 --- --- --- $10,000
1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000

[Last Payment Slightly Higher Due to Rounding]

 Usefulness of Amortization

1. Determine Interest Expense -- Interest expenses may

reduce taxable income of the firm.

2. Calculate Debt Outstanding -- The quantity of

outstanding debt may be used in financing the day-
to-day activities of the firm.
 Perpetuities
 Perpetuity is a cash flow without a fixed time horizon.
 For example if someone were promised that they would receive a cash flow of
Rs400 per year until they died, that would be perpetuity.
 PV of Perpetuity Formula
 PV = C

R
 C = cash payment
 R = interest rate
 Example

If someone were promised a cash flow of Rs 400 per year until they died and they
could earn 6% on other investments of similar quality, in present value terms
the perpetuity would be worth Rs 6,666.67. (Rs 400 / .06 = Rs 6,666.67)