Module 3: Time Value of Money

Topic 023: Time Value of Money-1

Module 3: Time Value of Money

Concept of Time Value of Money-1

• Concept of Value of Money

• Interest
• Future Value
• Present Value
Module 3: Time Value of Money

Concept of Time Value of Money-1

• Example:
• Would you like to have Rs. 100,000 now or
after one year?
• Would you like to have Rs. 100,000 now or
Rs. 110,000 after one year?
• Rs. 100,000 now is the present value
of money
• Rs. 110,000 after one year is the
future value of money
END
Module 3: Time Value of Money

Topic 024: Time Value of Money-2

Module 3: Time Value of Money

Concept of Time Value of Money-2

• What is the importance of Time?

• Time allows you to earn interest but you
have to defer the use of money
• What is Inflation?
• It is the gradual increase in the prices of
commodity and services
• How do we relate inflation to time
value of money?
• In time value of money we do not directly
incorporate inflation. Why?
 Module 3: Time Value of Money

Topic 025: Simple Interest and Compound

Interest
Module 3: Time Value of Money

Simple Interest

• Interest is the additional amount

an investor gets in the future by
foregoing his money today
• Interest is calculated by applying
a rate on an amount
• If the rate of interest is applied
on the original or principal
amount invested then it is called
Simple Interest
Module 3: Time Value of Money

Simple Interest

• Interest = Principal X Rate XTime

• I=Prt
Module 3: Time Value of Money
Compound Interest
• Compound interest is called the
interest on interest, as well as the
principal amount
• Compound interest is also charged
with a certain rate
• The difference between simple and
compound interest is that here the
rate is applied on the balance
amount i.e. principal plus previous
interest
• It is also calculated by multiplying
rate with amount available in the
balance
Module 3: Time Value of Money

Comparison of Simple and

Compound Interests

• As simple interest is charged on

the principal amount only, which
remains the same, and
compound interest on the
current balance, which keeps on
increasing every time when rate
is applied, so Compound interest
END
is always more than the simple
interest.
 Module 3: Time Value of Money

Topic 026: Present and Future Values using Simple

Interest-1
Present and Future Values using Simple Interest-1

Present Value
• Present value is the current value
i.e. the value of money at present
• The calculation of Present Value
is important with reference to
the Future Value
• If we are given an amount in the
future and we are asked to
calculate its present value then
we need to apply a formula to
get it.
Present and Future Values using Simple Interest-1

Future Value

• Future value is the value of

money in the future i.e. after a
year or a few years
• The calculation of Future Value is
important with reference to its
Present Value
• If we an amount today it will be
more in the future
Present and Future Values using Simple Interest-1

Present Value-PV and Future

Value-FV

• PV is the calculated by
subtracting interest from the
future value
• PV = FV - Interest
• FV is calculated by adding
interest in the present value
• FV = PV + Interest

END
 Module 3: Time Value of Money

Topic 027: Present and Future Values using Simple

Interest-2
Present and Future Values using Simple Interest-2

Future Value using Simple

Interest
• Example:
• An amount of Rs. 100,000 is
invested in a bank for one year @
10% per year for one year. What
will be the amount of interest? and
what will be the Future Value?
• Solution:
• Interest = 100,000 x 10% x 1 = Rs.
10,000
• FV = Principal + Interest = 100,000
+ 10,000 = 110,000
Present and Future Values using Simple Interest-2

Future Value using Simple

Interest
• Example: If interest is to be calculated
for two years what will be the amount
of interest and the future value:
• Solution:
• Interest = 100,000 x 10% x 2 = Rs.
20,000
• FV = Principal + Interest = 100,000
+ 20,000 = 120,000
Present and Future Values using Simple Interest-2

Present Value using Simple

Interest
• Example: If future value of an
amount is Rs. 110,000 after one year
what is the present value using simple
interest, given 10% rate of interest?
• Solution:
• PV = Principal - Interest = 110,000 - 10,000
= 10,000
• But the question is how do we know that
the interest is Rs. 10,000?
• The formula that we use for it is:
• PV = FV/(1+rt): Where ‘r’ is the rate and ‘t’
is the time
Present and Future Values using Simple Interest-2

Present Value using Simple

Interest
• Continuing with the example we will
calculate the PV as:
• PV = FV/(1+rt)
• PV = 110,000/(1+10%x1)
• PV = 110,000/1.1
• PV = 100,000
• This is the present value from where
we started earlier. If the FV is after two
years then the PV will be:
• PV = 120,000/(1+10%x2)
• PV = 120,000/1.2
• PV = 100,000
Present and Future Values using Simple Interest-2

Applications of Simple Interest

• Example: If the shelf price of an item is
Rs. 5,000 and 20% discount is offered
on it, what will be the discounted
price?
• Solution:
• Discount amount = 5,000 x 20% = 1,000
• Discounted price = 5,000 – 1,000 = 4,000

END
 Module 3: Time Value of Money

Topic 028: Future Value using Compound

Interest/Compounding-1
Future Value using Compound Interest/Compounding-1

Future Value using Compound

Interest
• Compounding is the process of
calculating future value of an amount
using compound interest
• Future value is calculated by
multiplying the present value with the
compounding factor i.e. (1+r)n
• Here ‘n’ is the number of
compounding periods
Future Value using Compound Interest/Compounding-1

Future Value using Compound

Interest
• Example: What will be the future value
of Rs. 100,000 after one year using
compound interest at 10% interest
rate?
• Solution: The future value is calculated
as follows:
• FV = PV (1+r)n
• FV = 100,000 (1+10%)1
• FV = 100,000 (1.1) = 110,000
• Here if we compare it with the future
value using simple interest in our
earlier slides it is the same, why?
Future Value using Compound Interest/Compounding-1

Future Value using Compound

Interest
• Example 2: What will be the future
value of Rs. 100,000 after two years
using compound interest at 10%
interest rate?
• Solution: The future value is calculated
as follows:
• FV = PV (1+r)n
• FV = 100,000 (1+10%)2
• FV = 100,000 (1.21) = 121,000
• Here if we compare it with the future
value using simple interest in our
END
earlier slides it is more, why?
 Module 3: Time Value of Money

Topic 029: Future Value using Compound

Interest/Compounding-2
Future Value using Compound Interest/Compounding-2

Future Value using Compound

Interest
• The factor which is when multiplied
with an amount gives us the future
value is called Future Value Interest
Factor-FVIF.
• FVIF is always calculated with the value
of rate and time. So, it is written as
FVIFr,n
Future Value using Compound Interest/Compounding-2

Future Value using Compound

Interest
• When we compound an amount for a
very large number of years, let us say
30 years, the future value becomes
much higher than the simple interest.
• This is due to the fact that a lot of
interest is accumulated over time i.e.
even more than the principal and
when interest is calculated the next
years it gives a much higher value.
Future Value using Compound Interest/Compounding-2

Future Value Compounding

Factor
• When we have to calculate the
value after, let’s say 5-years the
factor will be multiplied by the
principal amount five times or its
power is taken as ‘5’.
• FV = PV (1+r)5 = PV (1+r)(1+r)
(1+r) (1+r) (1+r)
Future Value using Compound Interest/Compounding-2

Future Value Compounding

Factor
• After the first time when we
multiply the factor with the
principal we multiply it with the
previous value, that is not just the
principal amount but the principal
and the previous interest. So, we
always get a greater value than
simple interest

END
 Module 3: Time Value of Money

Topic 030: Present Value using Compound

Interest/Discounting-1
Present Value using Compound Interest/Discounting-1

PV Discounting Factor
• Discounting is the process of
calculating present value using
compound interest.
• While discounting we apply interest
rate and calculate the value after
subtracting the interest from the
future value.
• The discounting a Bill or a Note is
commonly used. Here the amount of
interest is deducted from a Bill or a
Note and the remaining amount is
paid.
Present Value using Compound Interest/Discounting-1

PV Discounting Factor
• The formula we use to calculate the
present value is similar to that of
future value but here instead of
multiplying the PV with the factor
we divide the FV with the factor.
• One divided by the compounding
factor is the Discounting Factor
• Discounting Factor = 1/ (1+r)n
OR
• Discounting Factor = (1+r)-n
Present Value using Compound Interest/Discounting-1

PV Discounting Factor
• Whenever we have to calculate
the present value of a future
amount we multiply it with the
discounting factor.
• Here ‘n’ is the years for which the
future amount is discounted or is
the value of discounting periods.
• The formula of present value is:
• PV = FV/ (1+r)n
OR
END
• PV = FV(1+r)-n
 Module 3: Time Value of Money

Topic 031: Present Value using Compound

Interest/Discounting-2
Present Value using Compound Interest/Discounting-1

PV Example 1
• If we will get Rs. 100,000 after
one year, given that interest rate
is 10% per annum, what is the
present value:
• Solution
• PV = 100,000(1+10%)-1
• PV = 100,000 (0.90909)
• PV = Rs. 90,909
Present Value using Compound Interest/Discounting-1

PV Example 2
• If we will get Rs. 100,000 after two
years, given that interest rate is
10% per annum, what is the
present value:
• Solution
• PV = 100,000(1+10%)-2
• PV = 100,000 (0.82645)
• PV = Rs. 82,645
• We may conclude from the two
examples that more is the number
of compounding periods less is the
present value.
Present Value using Compound Interest/Discounting-1

PV Example 3
• If we change the rate of interest
in Example-1 from 10% to 20%
what will be the present value:
• Solution
• PV = 100,000(1+20%)-1
• PV = 100,000 (0.833333)
• PV = Rs. 83,333
• From here we may conclude that
higher is the interest rate lesser is
the present value and vice versa.
END
 Module 3: Time Value of Money

Topic 032: Present Value and Future Value Interest

Factors: Use of Tables
Present Value and Future Value Interest Factors: Using Tables

PVIF and FVIF Tables

• For the ease of calculations
tables of future value interest
factors and present value interest
factors are available.
• Instead of applying the formula
of PV or FV we may just multiply
the amount with the factor to get
the result.
 Present Value and Future Value Interest Factors: Using Tables

Period 1% 2% 3% 4% 5% FVIF Table

1 1.010 1.020 1.030 1.040 1.050
• This is future value interest factor
2 1.020 1.040 1.061 1.082 1.103
table. Here all the values are of
3 1.030 1.061 1.093 1.125 1.158
4 1.041 1.082 1.126 1.170 1.216
FVIF with different rates and time
5 1.051 1.104 1.159 1.217 1.276
periods.
6 1.062 1.126 1.194 1.265 1.340 • To calculate the Future Value of
7 1.072 1.149 1.230 1.316 1.407 Rs. 100,000 at 3% interest rate
8 1.083 1.172 1.267 1.369 1.477 after 4-years we simply multiply
9 1.094 1.195 1.305 1.423 1.551 the amount with the FVIF (shown
10 1.105 1.219 1.344 1.480 1.629 in red color) as given below:
• FV = 100,000 x 1.126
• FV = Rs. 112,600
 Present Value and Future Value Interest Factors: Using Tables

Period 1% 2% 3% 4% 5% PVIF Table

1 0.990 0.980 0.971 0.962 0.952
• This is present value interest
2 0.980 0.961 0.943 0.925 0.907
factor table. Here all the values
3 0.971 0.942 0.915 0.889 0.864
are of PVIF with different rates
4 0.961 0.924 0.888 0.855 0.823
and time periods.
5 0.951 0.906 0.863 0.822 0.784
• To calculate the present value of
6 0.942 0.888 0.837 0.790 0.746
Rs. 100,000 at 4% interest rate
7 0.933 0.871 0.813 0.760 0.711
for 5-years we simply multiply
8 0.923 0.853 0.789 0.731 0.677 the amount with the PVIF (shown
9 0.914 0.837 0.766 0.703 0.645 in red color) as given below:
10 0.905 0.820 0.744 0.676 0.614 • FV = 100,000 x 0.822
• FV = Rs. 82,200
 Module 3: Time Value of Money

Topic 033: Future Value of an Ordinary Annuity

Future Value of an Ordinary Annuity

Annuity
• An annuity is a series of payment
or receipts of equal amounts
after regular time periods.
• For example, if insurance
premium of Rs. 200,000 is paid
every year it will be an annuity.
• Similarly, if a person gets Rs.
40,000 interest per month on his
investment it is annuity.
 Future Value of an Ordinary Annuity

Ordinary Annuity
Year Amount
• An annuity where the payments
0 0
or receipts are at the end of the
1 5,000 year or the end of the period is
2 5,000 called an Ordinary Annuity or a
Deferred Annuity.
3 5,000 • For example, if insurance
4 5,000 premium of Rs. 200,000 is paid
on 31st December of every year
5 5,000 then it will be an ordinary
annuity.
Future Value of an Ordinary Annuity

Future Value of an Ordinary

Annuity
• To calculate the future value of
an ordinary annuity we apply the
following formula:
• FV = R[(1+r)n -1 ]
r
• Where:
• FV = future value of annuity
• R = the amount of installment
• r = the rate of interest
• n = number of installments
Future Value of an Ordinary Annuity

Future Value of an Ordinary

Annuity
• The factor, which is when
multiplied with the amount to
get future value of an annuity is
called Future Value Interest
Factory of an Annuity-FVIFA.
• The factor is given below:
• [(1+r)n -1 ]
r
Future Value of an Ordinary Annuity

Example of Future Value of an

Ordinary Annuity
• If Rs. 1,000 are paid at the end of
every year for 5-years what will
be the future value given that
10% per annum interest rate is
paid.
• Solution:
• FV = 1000[(1+10%)5 -1]
10%
• FV = 1000 [6.105]
• FV = Rs. 6,150
 Future Value of an Ordinary Annuity

Example of Future Value of an

Period 1% 2% 3% 4% 5% Ordinary Annuity using the Table
1 1.000 1.000 1.000 1.000 1.000 • We may use the FVIFA table to
calculate the future value, which
2 2.010 2.020 2.030 2.040 2.050 reduces our calculations.
• If Rs. 5,000 are paid at the end of
3 3.030 3.060 3.091 3.122 3.153 every year for 4-years what will be
the future value given that 2% per
4 4.060 4.122 4.184 4.246 4.310 annum interest rate is paid.
• Solution: Multiply the installment
5 5.101 5.204 5.309 5.416 5.526 amount with the FVIFA
• FV = 5000 [4.122]
• FV = Rs. 20,610
 Module 3: Time Value of Money

Topic 034: Present Value of an Ordinary Annuity

Present Value of an Ordinary Annuity

Present Value
• As an annuity is a series of
payments or receipts so like FV
we can also calculate its PV in
one go by using a formula.
• To calculate the present value of
an ordinary annuity we apply the
following formula:
• PV = R x [1-(1+r)-n ]
r
Present Value of an Ordinary Annuity

Example of Present Value of an

Ordinary Annuity
• If Rs. 3,000 are paid at the end of
every year for 7-years what will
be the present value of this
annuity given that 8% per annum
interest rate is paid.
• Solution:
• PV = 3000 x [1 - (1+8%)-7 ]
8%
• PV = 3000 [5.206]
• PV = Rs. 15,618
Present Value of an Ordinary Annuity

Present Value of an Ordinary

Annuity
• The factor, which is when
multiplied with the amount to
get the present value of an
ordinary annuity is called Present
Value Interest Factory of an
Annuity-PVIFA.
• The factor is given below:
• [1-(1+r)-n ]
r
END
 Module 3: Time Value of Money

Topic 035: Present and Future Values of Annuity Due

Present and Future Values of Annuity Due

Annuity Due
• An Annuity Due is a series of
payment or receipts of equal
amounts after regular time
periods. Here the amounts are at
the start of every time period
and not at the end like an
ordinary annuity.
• For example, if a person receives
his pension at the start of every
month, or a person pays his rent
at the beginning of every month.
Present and Future Values of Annuity Due

Future Value of Annuity Due

• Like an ordinary annuity we may
also calculate the FV and PV of an
annuity due.
• To calculate the future value of
an annuity due we use the
following formula:
• FV = R[(1+r)n - 1] x (1+r)
r
Present and Future Values of Annuity Due

Future Value of Annuity Due

• Where:
• FV = future value of annuity
• R = the amount of installment
• r = the rate of interest
• n = number of installments
Present and Future Values of Annuity Due

Present Value of Annuity Due

• Like a little variation in the FV
formula of ordinary annuity we can
calculate the FV of annuity due,
similarly we may also calculate the
PV of annuity due with a little
variation in the PV formula of
ordinary annuity.
• To calculate the present value of an
ordinary annuity we apply the
following formula:
END • PV = R[1-(1+r)-n+1 ]+R
r
 Module 3: Time Value of Money

Topic 036: Present and Future Values of Perpetuity

Present and Future Values of Perpetuity

Perpetuity
• Perpetuity is an annuity that
never ends or that ends at
infinity.
• This means that there are infinite
payments in a perpetuity.
• So theoretically we do not
calculate the FV of a perpetuity,
as it will be at infinity but we can
calculate the PV.
Present and Future Values of Perpetuity

Present Value of Perpetuity

• The reason of having a formula to
calculate the PV of perpetuity is
diminishing values of future
installments.
• The present value of every next
year’s installment is lesser and
lesser due to more discounting
periods, so after some years the
addition to the total present
value of perpetuity is negligible.
Present and Future Values of Perpetuity

Explanation of Present Value of

Perpetuity
• If we have perpetuity of Rs. 100
per year then the value of 40th
installment @ 20% p.a. will be
just Rs. 0.1, which will further
reduce with the passage of time.
• So, it is possible for us to
calculate the PV of a perpetuity
to two decimal places (i.e. up to
nearest Paisa)
Present and Future Values of Perpetuity

Formula of Present Value of

Perpetuity
• The formula that we use to
calculate the the PV of a
perpetuity is a reduced form of
the PV formula of an ordinary
annuity, where we put ‘n’ equal
to infinity.
• PV = R/r
• Where ‘R’ is the amount of
installment and ‘r’ is the
discounting rate.
Present and Future Values of Perpetuity

Example Present Value of

Perpetuity
• If we have perpetuity of Rs. 1,000
per year @ 10% p.a. what is the
present value.
• Solution:
• PV = 1,000 / 10%
• PV = Rs. 10,000

END
 Module 3: Time Value of Money

Topic 037: Discounting and Compounding Factors of Annuity:

Using Tables
Discounting and Compounding Factors of Annuity: Using Tables

Example of Future Value of an

Period 1% 2% 3% 4% 5% Ordinary Annuity using the Table
1 1.000 1.000 1.000 1.000 1.000
• We may use the FVIFA table to
calculate the future value, which
2 2.010 2.020 2.030 2.040 2.050 reduces our calculations.
• If Rs. 5,000 are paid at the end of every
3 3.030 3.060 3.091 3.122 3.153 year for 4-years what will be the future
value given that 2% per annum
4 4.060 4.122 4.184 4.246 4.310 interest rate is paid.
• Solution: Multiply the installment
5 5.101 5.204 5.309 5.416 5.526 amount with the FVIFA
• FV = 5000 [4.122]
• FV = Rs. 20,610
Discounting and Compounding Factors of Annuity: Using Tables

Example of Present Value of an

Period 1% 2% 3% 4% 5% Ordinary Annuity using the Table
• We may use the PVIFA table to
1 0.990 0.980 0.971 0.962 0.952 calculate the present value, which
reduces our calculations.
2 1.970 1.942 1.913 1.886 1.859 • If Rs. 7,000 are paid at the end of every
year for 5-years what will be the
3 2.941 2.884 2.829 2.775 2.723 present value given that 3% per annum
interest rate is paid.
4 3.902 3.808 3.717 3.630 3.546 • Solution: Multiply the installment
amount with the PVIFA as given below:
5 4.853 4.713 4.580 4.452 4.329 • FV = 7000 [4.580]
• FV = Rs. 32,060
Discounting and Compounding Factors of Annuity: Using Tables

Period 1% 2% 3% 4% 5% Present and Future Values of

1 0.990 0.980 0.971 0.962 0.952 Annuity Due using Tables
2 1.970 1.942 1.913 1.886 1.859 • We may use the FVIFA and PVIFA
3 2.941 2.884 2.829 2.775 2.723 tables to calculate the present and
4 3.902 3.808 3.717 3.630 3.546 future values, which reduces our
5 4.853 4.713 4.580 4.452 4.329 calculations.
Period 1% 2% 3% 4% 5% • To calculate the FV we need to
1 1.000 1.000 1.000 1.000 1.000 multiply the FVIFA with (1+r) and
2 2.010 2.020 2.030 2.040 2.050
in PV we need to take the value
3 3.030 3.060 3.091 3.122 3.153
4 4.060 4.122 4.184 4.246 4.310
of “n-1” and add amount of
5 5.101 5.204 5.309 5.416 5.526 installment ‘R’ in the value.
END
Module 3: Time Value of Money

Topic 038: Mixed Cash Flows-I

Mixed Cash Flows-I

Mixed Flows
• There are single amounts at present or
in the future and we can calculate
their FVs or PVs respectively.
• Similarly, there are series of amounts
called annuities and their FVs and PVs
could also be calculated using some
formulae.
• In addition to these, there are some
cash flow, which are neither single
amounts nor annuities called Mixed
Cash Flows.
 Mixed Cash Flows-I

Types of Mixed Cash Flows

• As mixed cashflows are series of
amounts after regular intervals but
the amounts are not the same and
in some cases the time periods may
also vary, so it is difficult to
calculate the PVs and FVs.
• Like annuities and single amounts
we do not have any specific formula
for mixed cash flows but we need to
improvise to calculate their PVs and
END FVs.
Module 3: Time Value of Money

Topic 039: Mixed Cash Flows-II

 Mixed Cash Flows-II

Year Amount Amount Amount

Types of Mixed Cash Flows
Rs. Rs. Rs. • Mixed cash flows may be of the
1 1,000 1,000 1,000 following types:
2 2,000 1,000 1,000 • All different amounts
3 3,000 1,000 1,000 • Two or more annuities
4 4,000 2,000 1,000 • Annuities and different amounts
5 5,000 2,000 4,000 • There is no given method to solve
6 6,000 2,000 5,000 these as the number of amounts of
7 7,000 2,000 7,000
cashflows and the sequence are
8 8,000 3,000 8,000
different.
9 9,000 3,000 8,000
• The key to solve such a problem is
10 10,000 3,000 8,000
minimize the calculations i.e. with
minimum applications of formulas the
value should be calculated.
 Mixed Cash Flows-II

PVs and FVs of Mixed Flows

• To calculate the PVs or FVs we need
to analyze mixed cash flows in
components.
• PV or FV of each component is
separately calculated and then all
the values are summed up to get
the total PV or the FV.
• So the process is to first calculate
the present value and further
discount it OR calculate the present
value and further compound it.
END
 Module 3: Time Value of Money

Topic 040: Present Values of Mixed Cash Flows

 Present Values of Mixed Cash Flows

Year Amount
Calculating PV of a Mixed Cash Flow
Rs. • Let us take this example. Here we have
1 1,000 three annuities. If interest rate is 10%
2 1,000 p.a. the shortest way will be to calculate
3 1,000
the PVs of all the three annuities one by
4 2,000
one.
5 2,000 • PV1 = 1000 x [1 - (1+10%)-3 ] = Rs. 2,487
6 2,000 10%
7 2,000 • PV2 = 2000 x [1 - (1+10%)-4 ] = Rs. 6,340(1.1)-3 = 4,761
8 3,000 10%
• PV3 = 3000 x [1 - (1+10%)-3 ] = Rs. 7,461(1.1)-7 = 3,828
9 3,000 10%
10 3,000 • PV = PV1+PV2+PV3
• PV = 2487 + 4761 + 3828 = Rs.
11,076
 Present Values of Mixed Cash Flows

Year Amount
Example 2
Rs. • Let us take another example. Here we
1 1,000 have three annuities. If interest rate is
2 1,000 10% p.a. the shortest way will be to
3 1,000
calculate the PVs of all this cash flow will
4 1,000
be as given under.
5 1,000 • PV1 = 1000 x [1 - (1+10%)-8 ] = Rs. 5,335
6 1,000 10%
7 1,000 • PV2 = 3000 (1+10%)-9 = Rs. 1,272
8 1,000
• PV3 = 5000 (1+10%)-10 = Rs. 1,930
9 3,000
10 5,000 • PV = PV1+PV2+PV3
• PV = 5335 + 1272 + 1930 = Rs. 8,537
END
 Module 3: Time Value of Money

Topic 041: Future Values of Mixed Cash Flows

 Future Values of Mixed Cash Flows

Year Amount
Calculating FV of a Mixed Cash Flow
Rs. • Let us take the same example and now
1 1,000 calculate its FV. If interest rate is 10%
2 1,000 p.a. and again the shortest way will be
3 1,000
to calculate the FVs of all the three
4 2,000
annuities one by one.
5 2,000 • FV1 = 1000 x [(1+10%)3 - 1] = 3,310(1.1)7 = 6,451
6 2,000 10%
7 2,000 • FV2 = 2000 x [(1+10%)4 - 1] = 9,282(1.1)3 = 12,354
8 3,000 10%
• FV3 = 3000 x [(1+10%)3 - 1] = 9,930
9 3,000 10%
10 3,000 • FV = FV1 + FV2 + FV3
• FV = 6451 + 12354 + 9930 = Rs. 28,735
 Future Values of Mixed Cash Flows

Year Amount
Example 2
Rs. • Let us take another example. Here we
1 1,000 have three annuities. If interest rate is
2 1,000 10% p.a. the shortest way will be to
3 1,000
calculate the PVs of all this cash flow will
4 1,000
be as given under.
5 1,000 • FV1 = 1000 x [(1+10%)8 - 1] = 11,436(1.1)2 = Rs.13,838
6 1,000 10%
7 1,000 • FV2 = 3000 (1+10%)1 = Rs. 3,333
8 1,000
• FV3 = 5000 = Rs. 5,000
9 3,000
10 5,000 • FV = FV1 + FV2 + FV3
• FV = 13838 + 3333 + 5000 = Rs. 22,171
 Module 3: Time Value of Money

Topic 042: Shorter Period Compounding

Shorter Period Compounding

Concept of Shorter Period

Compounding
• Generally rate of interest is given as
per cent per annum.
• This means that a certain amount
per hundred will be paid after one
year.
• For example if we say that interest
rate is 10% per annum, this means
Rs. 10 per every Rs. 100 will be paid
after one year.
• This means the rate will be applied
on the amount once in a year.
Shorter Period Compounding

Shorter Period Compounding

• Now if the rate of interest remains
the same but it is applied for more
than once in a year it gives greater
future value or lesser present value.
• Future value increases because
applying the rate more than once.
For example if it is applied twice
then the first time the rate will be
applied on the principal amount for
six months and the second time on
the principal plus the interest of first
six months.
Shorter Period Compounding

Shorter Period Compounding

• Now let us see how it works. If Rs.
1,000 are invested for one year @
10% per annum what will be the
future value? If the compounding is
done bi-annually, what will be the
future value then?
Shorter Period Compounding

Shorter Period Compounding

• Solution:
• 1000 (1+10%)1 = Rs. 1,100

• 1000 x 10% x 6 = 50,

12
FV = 1000 + 50 = Rs. 1,050

• 1050 x 10% x 6 = 52.5

12
FV=1050 + 52.5 = Rs.
1,102.5
 Shorter Period Compounding

How to Calculate FV or PV using

formulas in Case of Shorter
Period Compounding
• Shorter period compounding
actually increases the
effectiveness of rate of interest.
• So, a formula is devised to
calculate the future values or
present values using short period
compounding.
• This formula is referred to
END Effective Rate of Interest formula,
which we will discuss in detail.
 Module 3: Time Value of Money

Topic 043: Shorter Period Discounting

Shorter Period Discounting

Shorter Period Discounting

• As we have discussed shorter
period compounding, similarly
there is shorter period
discounting.
• This means that as applying
interest rate more than once in
a year increases the future
value, similarly applying the rate
more than once also changes
the present value.
Shorter Period Discounting

Shorter Period Discounting

Continued

• Why shorter period discounting

gives us a different present value.
• When we apply the rate once in a
year to get the present value it
deducts the interest of full one
year from the total future value.
• Nevertheless, when we apply the
rate twice in a year then the first
time it is applied on the future
value and then on a lesser value.
Shorter Period Discounting

Shorter Period Discounting

Continued
• If discounting is done twice a
year, in the first half interest is
applied on the future value
after one year and in the second
half of the year the interest is
deducted from the future value
which is six months from now,
(which is less than the future
value after one year).
• Hence, we get a greater present
value.
Shorter Period Discounting

Shorter Period Discounting

• Now let us try to understand
with an example. If Rs. 1,000
are given one year from now
and we have to calculate its
PV @ 10% per annum what
will be the PV? And if the
discounting is done bi-
annually, what will be the PV
then?
Shorter Period Discounting

Shorter Period Discounting

Example Continued
• Solution:
• 1000 (1+10%)-1 = Rs. 9,900

• 1000 x 10% x 6 = Rs. 50

12
PV = 1000 – 50 = Rs. 9,950

• 9950 x 10% x 6 = Rs. 49.75

12
PV=9950 - 49.75 = Rs.
9900.25
 Shorter Period Discounting

Shorter Period Discounting

Formula
• Like shorter period
compounding the formula of
effective rate of interest is
also used to calculate present
values, which will be
discussed in the next lectures.

END
 Module 3: Time Value of Money

Topic 044: Continuous Compounding and Discounting

Continuous Compounding and Discounting

The Concept of Continuous

Compounding
• We have discussed the shorter
period compounding and shorter
period discounting where the
compounding or discounting
periods are reduced from one
year.
• Now if the compounding or
discounting periods are reduced
to two or four or twelve or fifty
two or 365 the effect will be
higher and higher.
Continuous Compounding and Discounting

Continuous Compounding or
Discounting
• If we keep on reducing the
compounding or discounting
period from a year to half a year,
a month, a week, a day, an hour,
a minute, a second or even
lesser, it becomes a case of
continuous compounding or
discounting.
Continuous Compounding and Discounting

The Formula for Continuous

Compounding or Discounting
• The formula for future value with
continuous compounding is:
• FVn = PV (e)rxn
• Where:
• FVn = Future Value after ‘n’ years
• PV = Present Value
• e = Exponential Constant = 2.718
• The formula for the present value
is given under:
• PV = FV (e)-rxn
Continuous Compounding and Discounting

Example of FV Continuous
Compounding
• If Rs. 1,000 are continuously
compounded @10% per
annum for two years, what will
be the future value?
• FVn = PV (e)rxn
• FV2 = 1,000 (2.718)0.1x2
• FV = 1,000 (2.718)0.1x2
• FV = Rs. 1,221.38
Continuous Compounding and Discounting

Example of FV Continuous
Discounting
• If Rs. 1,000 are continuously
discounted @10% per annum
for two years, what will be the
present value?
• PVn = FV (e)-rxn
• PV2 = 1,000 (2.718)-0.1x2
• PV = 1,000 (2.718)-0.1x2
• PV = Rs. 818.75
END
 Module 3: Time Value of Money

Topic 045: Effective Rate of Interest

Effective Rate of Interest

Effective Rate of Interest-ERI

• We have discussed that shorter
period compounding increases
the future value of an amount.
• We may put it in other words that
when a rate of interest is applied
for shorter periods it increases
the effectiveness of the rate, that
is the same rate of interest gives a
higher future value called
Effective Rate of Interest-ERI.
• The rate which is not adjusted for
shorter period compounding is
called Nominal Rate.
Effective Rate of Interest

Effective Rate of Interest-ERI

Formula
• We use a formula to convert a
certain rate of interest in effective
rate. The following is the formula:
• ERI = {[1+ (r/m)]m -1} x 100
• Where ‘m’ is the number of
compounding periods in a year, ‘r’
is the nominal rate, and ERI is the
effective rate . As generally rate of
interest is given as per year or per
annum.
Effective Rate of Interest

EFI formula Explanation

• If rate of interest is not given as
per year (which is not very
common) then ‘m’ is the number
of compounding periods in the
period for which the rate is given
(why ?).
• For example if rate is annual and
compounding is done quarterly
then m = 4 (four quarters in a
year). If compounding is done
monthly then m = 12.
Effective Rate of Interest

ERI Formula Explanation

Continued
• If rate of interest is given as per
semi-year (i.e. half yearly rate)
then ‘m’ is the number of
compounding periods in a semi-
year.
Effective Rate of Interest

ERI Formula Explanation

Continued
• For example if rate is semi-annual
and compounding is done
quarterly then m = 2 (there are
two quarters in a semi-year). If
compounding is done monthly
then m = 6 (6 months in a semi-
year).
 Effective Rate of Interest

Application of the Formula of ERI

• Example: If the nominal rate of
interest is 12% per annum and is
to be converted to semi-annual
rate, what will be the value? If to
quarterly rate and monthly rate?
• Solution:
• ERI = {[1+ (r/m)]m -1} x 100
• ERI = {[1+ (12%/2)]2 -1} x100
• ERI = 12.36%
• ERI = {[1+ (12%/4)]4 -1} x100
END • ERI = 12.55%
 Module 3: Time Value of Money

Topic 046: Equivalent Rate of Interest

Equivalent Rate of Interest

Equivalent Rate of Interest

• Shorter period compounding
increases the effectiveness of
interest rate and hence we
calculate effective rate of interest.
• What if we want to apply a
nominal rate for shorter period
keeping its effectiveness the
same, that is reducing the rate to
the extent that with shorter
period compounding it gives the
same future value.
Equivalent Rate of Interest

Equivalent Rate of Interest

• One way to convert an annual
rate to equivalent rate for a
shorter period that seems
workable is dividing the nominal
rate by the number of periods in a
year, that is for semi-annual two
and for quarterly four, as under:
• Eq. Rate = 12%/2 = 6%
• Unfortunately, this is wrong
calculation.
Equivalent Rate of Interest

Formula to Calculate Equivalent

Rate of Interest
• The formula to calculate the
equivalent rate of interest is given
under:
Eq Rate = [(1+r)1/n – 1] x 100
• Where:
• r = nominal annual rate of
interest
• n = number of compounding
periods in one year (if nominal
rate is annual)
Equivalent Rate of Interest

Example of Equivalent Rate of

Interest
• We are given 12% per annum
nominal interest rate. This rate is
to be applied on quarterly basis.
What is the equivalent
percentage rate?
• Solution:
Eq Rate = [(1+r)1/n – 1] x 100
Eq Rate = [(1+12%)1/4 – 1] x 100
Eq Rate = 2.8737%
 Equivalent Rate of Interest

Analysis of Equivalent Rate of

Interest
• In the example the calculated
equivalent interest rate is 2.8737,
whereas if we divide 12% by 4 we
get 3%.
• To verify the equivalent rate let us
calculate the future value of Rs.
1,000 after three years using the
two rates:
• FV = 1,000 (1+12%)3 = 1,404.92
• FV = 1,000 (1+2.8737%)12 = 1404.92
END • FV = 1,000 (1+3%)12 = 1425.76
 Module 3: Time Value of Money

Topic 047: Loan Amortization: Calculating Installments

Loan Amortization: Calculating Installments

Loan Amortization
• Time Value of Money has
several applications.
• Loan amortization is a process
of repaying a loan in
installments over a period of
time.
• Each installment contains some
principal repayment and
interest.
Loan Amortization: Calculating Installments

Loan Amortization Schedule

• The process of loan
amortization is carried out by
making a loan amortization
schedule.
• Loan amortization schedule is a
table in which we have:
• The regular installment amount
• The principal repaid in each
installment
• Amount of interest in each
installment
• The remaining balance
Loan Amortization: Calculating Installments

Calculating the Installment

• The first step in making a loan
amortization schedule is to
calculate the amount of loan
installment.
• This is done by considering the
following:
1. Amount of loan
2. Rate of interest
3. Time period for which loan is
taken
Loan Amortization: Calculating Installments

Calculating the Installment

• We use the present value of an
ordinary annuity formula to
calculate the amount of
installment, as given under:
• PV = R x [1-(1+r)-n ]
r
• Here: PV is taken as the
amount of loan, ‘R’ as the
amount of loan installment, ‘r’
as the rate of interest, and ‘n’
as the number of installments.
Loan Amortization: Calculating Installments

Example of Calculating the

Installment
• If we borrow Rs. 100,000 for a
period of 5-years @ 10% per
annum interest rate, what will
be the amount of installment?
• Solution:
• PV = R x [1-(1+r)-n ]
r
• 100,000 = R x [1-(1+10%)-5 ]
10%
END • R = 26,379.75
 Module 3: Time Value of Money

Topic 048: Loan Amortization Schedule-1

 Loan Amortization Schedule-1

Year
Installmen
Interest Principal Balance
Example of Loan Amortization
t
Schedule
0 0.00 0.00 0.00 100000 • Continuing with the example
with loan amount of Rs.
1 26379.75 10000.00 16379.75 83620.25
100,000, loan period of 5-years
2 26379.75 8362.03 18017.72 65602.53 @ 10% per annum interest
rate, and the amount of
3 26379.75 6560.25 19819.50 45783.03
installment Rs. 26,379.75, let us
4 26379.75 4578.30 21801.45 23981.58 make loan amortization
Schedule
5 26379.75 2398.17 23981.58 0.00
 Module 3: Time Value of Money

Topic 049: Loan Amortization Schedule-2

Loan Amortization Schedule-2

Example of Loan Amortization

Schedule
• Continuing with the example
with loan amount of Rs.
100,000, loan period of 5-years
@ 10% per annum interest rate
but will payments will be made
at the start of the year.
 Loan Amortization Schedule-2
Example of Loan Amortization
Year Installment Interest Principal Balance Schedule
• PV = R x [1-(1+r)-n+1 ] + R
1 23981.59 0.00 23981.59 76018.41 r
• 100,000 = R x [1-(1+10%)-5+1 ] +R
2 23981.59 7601.84 16379.75 59638.66 10%
• R = 23,981.59
3 23981.59 5963.87 18017.72 41620.94

4 23981.59 4162.10 19819.49 21801.45

5 23981.59 2180.15 21801.45 0.00

Module 3: Time Value of Money

Topic 050: Sinking Fund-1

Sinking Fund-1

Sinking Fund
• A sinking fund comprises of is
an amount set aside regularly
for some future payments.
• These payments may be related
to bonds retirement or
payment of some other liability
• Sinking funds may also be
created for replacement of
assets in the future
Sinking Fund-1

Sinking Fund: What is Needed

• A sinking fund is like a savings
account where the sum
accumulates and interest is
earned.
• To make a sinking fund we need
to know the following:
• The future amount required
• The rate of interest
• The time period and frequency
of payment
• The amount of each installment
Sinking Fund-1

How to Calculate the Installment

• To make a sinking fund the
information that we have is the
amount needed in the future,
the rate of interest and time.
• The amount of installment to
get a certain amount in the
future at the given rate of
interest is calculated by using
the Future Value of Annuity
formula.
• FV = R x [(1+r)n - 1]
r
Sinking Fund-1

Sinking Fund: Example

• To calculate the amount of
installment let’s assume we need
Rs. 100,000 after 5-years. Interest
rate is 10% per annum and
amounts will be deposited at the
end of every year.
• FV = R x [(1+r)n - 1]
r
• 100,000 = R x [(1+10%)5 - 1]
10%
• R = 100,000/6.1051
• R = 16,379.75 (Installment)
 Sinking Fund-1
Example of Sinking Fund
Sinking Fund
• To make a complete sinking
Years Installment interest Balance fund let us assume the
1 819 819 following data:
• Time to accumulate the
2 819 81.9 1719.9 amount is 5-years
• Amount to be accumulated
3 819 172 2710.9
is Rs. 5,000
4 819 271 3800.9 • Interest rate is 10%
• Installment = FV/FVIFA
5 819 380 4999.9
= 5,000/6.105
= 819
Module 3: Time Value of Money

Topic 051: Sinking Fund-2

Sinking Fund-2

Sinking Fund with Annuity Due

• If a sinking fund is created with
deposits at the start of a year
then it will form an annuity
due.
• This will earn more interest and
so less amounts will be
deposited i.e. the amount of
installment will be less.
Sinking Fund-2

Formula of Future Value of

Annuity Due
• In a sinking fund we need to
accumulate an amount in the
future so we used the FV
formula
• The FV formula of an annuity
due is:
• FV = R[(1+r)n - 1] x (1+r)
r
Sinking Fund-2

How to Calculate the Installment

in a Sinking Fund of Annuity Due
• Let us apply the formula of FV
of annuity due. If the FV
required is Rs. 100,000, rate of
interest is 10%, time is five
years.
• FV = R x [(1+r)n - 1] (1+r)
r
• 100,000 = R x [(1+10%)5 - 1] (1+10%)
10%
• R = 100,000/6.71561
• R = 14890.68
 Sinking Fund-2

Sinking Fund
Example of Sinking Fund
• To make a complete sinking
Years Installment interest Balance
fund let us assume the
0 14890.68 0 14890.68
following data:
1 14890.68 1489.07 31270.43 • Time to accumulate the
2 14890.68 3127.04 49288.15 amount is 5-years
• Amount to be accumulated
3 14890.68 4928.82 69107.65
is Rs. 5,000
4 14890.68 6910.77 90909.1 • Interest rate is 10%
5 0 9090.91 100000 • Installment = FV/FVIFA
= 5,000/6.105
= 819
 Module 3: Time Value of Money

Topic 052: Key Elements of Time Value of Money

Key Elements of Time Value of Money

Key Elements of TVM

• There are several elements and

applications of Time value of
money that we have discussed.
• This module provides a
summary of the discussion of
Time Value of Money.
Key Elements of Time Value of Money

Key Elements

• Interest
• Simple and Compound Interest
• Future and Present Values
• Deferred Annuity
• Annuity Due
• Perpetuity
• Shorter Period Compounding
• Continuous Compounding
Key Elements of Time Value of Money

Key Elements Continued

• Effective Rate of Interest

• Equivalent Rate of Interest
• Mixed Cash Flows
• Loan Amortization Schedule
• Sinking Funds

END