Time Value of Money

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 Time value of money
 Present and future value
 Doubling period
 Annuity
 Present and future value of ordinary annuity
 Present and future value of annuity due
 Multi-period Compounding

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Time value of money: Time value of money means that the
value of a unity of money is different in different time periods.

■ The sum of money received in future is less valuable than it

is today.

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An important financial principle is that the value of money is time dependent.

This principle is based on the following four reasons:

Inflation: Under inflationary conditions the value of money, expressed in terms of its
purchasing power over goods and services, declines.

Risk: Re. 1 now is certain, whereas Re. 1 receivable tomorrow is less certain. This ‘bird-in-
the-hand’ principle is extremely important in investment appraisal.

Personal Consumption Preference: Many individuals have a strong preference for

immediate rather than delayed consumption.

Investment Opportunities: Money like any other desirable commodity has a price, given
the choice of Rs. 100 now or the same amount in one year’s time, it is always preferable to
take the Rs. 100 now because it could be invested over the next year at (say) 18% interest
rate to produce Rs. 118 at the end of one year.

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 Rs. 100 (today) vs. Rs. 115 (1 yr from today)
(Considering 10% risk free interest rate on Rs. 100)

 Future Value (FV) of Rs. 100 after 1 yr = ??

 Present Value (PV) of Rs. 115 = ??

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 Compounding
 Discounting

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The process of investing money as well as reinvesting the interest
earned thereon is called compounding. The future value or
compounded value of an investment after n years when the interest
rate is r percent is :

(FV)n = PV(1 + r)n

(1 + r)^n is called the future value interest factor (FVIF) or simply the
future value factor.

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Future value of present money
Suppose you have invested rupees 1000 (single amount or lump sum) for five years at an
interest rate of 10% ( or inflation)
Year 0 Year 1 Year 2 Year 3 Year 4

Rs. 1000 Rs. 1100 Rs. 1210 Rs. 1331 Rs.1464.10

1100/1000
=1.1
1210/1000
=1.21
Future 1331/1000
value =1.331

factors 1464.10/1000
= 1.4641
(FVF)

(FVF) – Future value of present Rs.1

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The process of discounting, used for calculating the present
value, is simply the inverse of compounding.
The present value formula can be readily obtained by
manipulating the compounding formula:

PV = FVn / (1 + r)n

1/ (1 + r)n , is known as the discounting factor or the present

value interest factor (PVIF).

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Present value of future money

Year 0 Year 1 Year 2 Year 3 Year 4

Rs. 1000 Rs. 1100 Rs. 1210 Rs. 1331 Rs.1464.10

1000/1100
=0.9091
1000/1210
=0.8264
Present 1000/1331
value =0.7513

factors 1000/1464.10
= 0.6830
(PVF)

(PVF) – Present value of Future Rs.1 (discounted value or factor)

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Simple interest vs. Compound interest

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Doubling Period

 Rule of 72 (approx.)
 Rule of 69

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 Annuity

To be called annuity a series of payments (or receipts) must have following features:
■ Amount paid(or received) must be constant over the period of annuity and
■ Time interval between two consecutive payments (or receipts) must be the same.

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 Future of value of Ordinary Annuity
(OR)
Deferred Annuity (FVA)
It is a measure of how much a series of regular payments will be worth
at some point in the future, given a specified interest.
Future of value of Ordinary Annuity / Deferred Annuity (FVA)
Ordinary Annuity – series of payment made at the end of each period
Example – Assume you invest Rs. 1000 every year for next five years at 5 % interest rate

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Accumulated Amount

Rs. 1000 Rs. 1000 Rs. 1000 Rs. 1000 Rs. 1000 Accumulated Amount
1000 * (1.05^ 0) = 1000
1000 * (1.05 ^ 1) = 1050

1000 * (1.05 ^ 2) = 1102.50

1000 * (1.05 ^ 3) = 1157.63

1000 * (1.05 ^ 4) = 1215.51

Total Rs. 5525.64

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Future Value of ordinary Annuity Formula

(FV) ordinary annuity Example:

C = Rs. 1000
C = cash flow each period i=5%
i = interest rate n=5
n = number of periods or instalments
FV of ordinary annuity
FVIFA (i,n) = i.e. future value
=
interest factor of an annuity
=

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Example 1:
Suppose you have decided to deposit Rs.30,000 per year in your Public
Provident Fund Account for 30 years. What will be the accumulated amount
in your Public Provident Fund Account at the end of 30 years if the interest
rate is 8 percent?

The accumulated sum will be:

Rs.30,000 (FVIFA 8% 30yrs)

= Rs.30,000 []

= Rs.30,000 [ 113.283]

= Rs.3,398,490

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Example 2:
You want to buy a house after 5 years when it is expected to cost Rs.2
million. How much should you save annually if your savings earn a
return of 12 percent?

The future value interest factor for a 5 year annuity,

given an interest rate of 12 percent is,
FVIFAn=5, r=12% = = 6.353
The annual savings should be :
= Rs.314,812

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 Example 3:
You want to take up a trip to the moon which costs Rs 1 million. You
can save annually Rs 50000. how long you have to wait if your savings
earn an interest of 12%
The future value of an annuity of Rs.50,000 that earns 12 percent is equated to Rs.1,000,000.
50,000 x FVIFAn=?, r=12% = 1,000,000
50,000 x = 1,000,000
=
= x 0.12 = 2.4
= 2.4 + 1 = 3.4
n log 1.12 = log 3.4
n = 10.8 years
You will have to wait for about 11 years.

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 Present of value of Ordinary Annuity
(OR)
Deferred Annuity (FVA)

Present value calculation of ordinary annuity tells how much

money would be required now to produce a series of payments in
the future, again assuming a set of interest rate.

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 Five instalments of Rs. 1000 each to be made over a period of five years, how
much money you should need today to settle the future payments.
(Provided money is invested at an Interest rate of 5%)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Amount Required Rs. 1000 Rs. 1000 Rs. 1000 Rs. 1000 Rs. 1000
1000/(1.05^1)=952.38
1000/(1.05^2)=907.03

1000/(1.05^3)=863.84

1000/(1.05^4)=822.70

1000/(1.05^5)=783.53

Rs. 4329.48 Total

Rs. 4.329.58 invested at 5% interest would be sufficient to produce those five

instalments /payments of each Rs. 1000
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Present Value of ordinary Annuity Formula

(PV) ordinary annuity Example:

C = Rs. 1000
C = cash flow each period i=5%
i = interest rate n=5
n = number of periods or instalments
FV of ordinary annuity
PVIFA (i, n) = i.e. Present value
=
interest factor of an annuity
=

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Interest rate
= 10 %

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Example 4:
After reviewing your budget, you have determined that you can afford to pay
Rs.12,000 per month for 3 years toward a new car. You call a finance company
and learn that the going rate of interest on car finance is 1.5 percent per month
for 36 months. How much can you borrow?
To determine how much you can borrow, we have to calculate the present value of
Rs. 12,000 per month for 36 months at 1.5 percent per month.
Since the loan payments are an ordinary annuity, the present value interest factor of
annuity is:
PVIFA r, n = = = 27.66
Hence the present value of 36 payments of Rs.12,000 each is:
Present value = Rs.12,000 x 27.66 = Rs.331,920
You can, therefore, borrow Rs.331,920 to buy the car.

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Example 5:
You want to borrow Rs 10,80,000 to buy a flat. You approach a housing finance
company which charges 12.5% interest. You can pay Rs. 1,80,000 per year toward
loan amortisation. What should be the maturity period of the loan.

180,000 x PVIFAn , r = 1,080,000

180,000 PVIFAn =? , r=12.5% = 1,080,000
180,000 x = 1.080,000
Given this equality the value of n is calculated as follows:
= =6

= 0.25
=4
n= 11.76
You can perhaps request for a maturity of 12 years

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Future of value of Annuity Due

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Future of value of Annuity Due

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Future of value of Annuity Due
Annuity Due – series of payment made at the beginning of each period
Example – Assume you invest Rs. 1000 every year for next five years at 5 % interest rate

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Accumulated Amount

Rs. 1000 Rs. 1000 Rs. 1000 Rs. 1000 Rs. 1000 Accumulated Amount

1000 * (1.05 ^ 1) = 1050

1000 * (1.05 ^ 2) = 1102.50

1000 * (1.05 ^ 3) = 1157.63

1000 * (1.05 ^ 4) = 1215.51

1000 * (1.05 ^ 5) = 1276.28

Total Rs. 5801.92

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 Future value of annuity due

= C (1+ i) + C(1+i)2 + C(1+i)3 + ----------------+ C(1+i)n

= C (1+ i) [ ]

(Future value)Annuity due = C (1+ i) [ ]

(Future value)Annuity due = (1+ i) (Future value)Ordinary Annuity

Example – Assume you invest Rs. 1000 every year for next five years at 5 % interest rate

(Future value)Annuity due = C (1+ i) [ ] = 1000 (1+0.05) * = Rs.5801.92

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Example 6:
A company wants to invest $3,500 every six months for four years to purchase a delivery truck. The
investment will be compounded at an annual interest rate of 12% per annum. The initial investment
will be made now, and thereafter, at the beginning of every six months. What is the future value of the
cash flow payments?

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Present value of Annuity Due

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 Considering 5 % interest rate and payment of Rs.1000 made ate the beginning of each year for five years

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Amount Required Rs. 1000 Rs. 1000 Rs. 1000 Rs. 1000 Rs. 1000
1000
1000/(1.05^1)=952.38

1000/(1.05^2)=907.03

1000/(1.05^3)=863.84

1000/(1.05^4)=822.70

Rs. 4545.95 Total

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 Present value of annuity due

= C + + + ----------------+

= (1+ i)

(Present value)Annuity due = C (1+ i)

(Present value)Annuity due = (1+ i) (Present value)Ordinary Annuity

(Future value)Annuity due = (1+ i)n (Present value) Annuity Due

Example – Considering 5 % interest rate and payment of Rs.1000 made at the beginning of
each year for five years
(Present value)Annuity due = C (1+ i) [ ] = 1000 (1+0.05) * = Rs. 4545.95
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Example 7:
An individual makes rental payments of $1,200 per month and wants to know the present value of
their annual rentals over a 12-month period. The payments are made at the start of each month. The
current interest rate is 8% per annum.

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 Multi-Period Compounding

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 Multi-Period Compounding

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 Multi-Period Compounding

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 Multi-Period Compounding

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 Multi-Period Compounding

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 Multi-Period Compounding

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 Multi-Period Compounding

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 Multi-Period Compounding

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Example
• Suppose you invest $1000 at an annual rate of 8% with interest
compounded a) annually, b) semi-annually, c) quarterly, and d) daily.
How much would you have at the end of 4 years?

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 Continuous Compounding

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Example 8:
Tina invested $3000 in a bank that pays an annual interest rate of 7% compounded continuously. What is
the amount she can get after 5 years from the bank? Round your answer to the nearest integer.

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Example 9:
What should be the rate of interest for the amount of $5,300 to become double in 8 years if the amount
is compounding continuously? Round your answer to the nearest tenths.

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Sinking Fund
• It is a kind of reserve by which a provision is made to reduce a liability,
e.g., redemption of debentures or repayment of a loan. A sinking fund
is a form of specific reserve set aside for the redemption of a long-
term debt. The main purpose of creating a sinking fund is to have a
certain sum of money accumulated for a future date by setting aside a
certain sum of money every year.
• It is a kind of specific reserve. Whatever the object or the method of
creating such a reserve may be, every year a certain sum of money is
invested in such a way that with compound interest, the exact
amount to wipe off the liability or replace the wasting asset or to
meet the loss, will be available.
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Example 10:
A machine costs Rs. 3,00,000 and its effective life is estimated to be 6 years. A sinking fund is created for replacing the
machine at the end of its effective life time when its scrap realizes a sum of Rs. 20,000 only. Calculate to the nearest
hundreds of rupees, the amount which should be provided, every year, for the sinking if it accumulates at 8% p.a.
compounded annually.

FV = Machine Cost – Scrap Cost

(FV) ordinary annuity

C = Rs 38168

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