Time Value of Money I

by
Vipul Mehta
Let’s enter into the world of
Time Value of Money
Rs 10,000 in year 1650
So what is the value of Taj Mahal now?

Rs 1,55,27,99,75,21,79,20,00,000

Or
Rs 15 billion billion

This is the power of compounding!!

Put Rs 1,00,000 in Fixed Deposit in the year 1994

How much would they have gotten by now?

Rs 11,02,626
Compound Interest Simple Interest

What are these??

Chintu & Pintu … and the curious case of Haldiram’s Bhujia
 People prefer current consumption over future
consumption

There is inflation in the economy – prices of goods/services

increase with time

Hence,
A Rupee Today is worth more than a Rupee Tomorrow
 This is called as Time Value of Money

 The value of money reduces with time

 Therefore it makes sense to eat your chocolates today! ;)

 But… if you do that, what happens to your

college fee?
So How Does Compounding work?
 What is compound interest?
 Investment amount: Principal

Interest rate, r = 7%
Year Investment Compound Simple
Interest Interest

2017 1000
2018
2019
2020
2021
 When working from Present to Future
Compounding

2017 2021
Rs 1,000 Rs 1,311
 Can we also work from Future to Present?
Discounting

2017 2021
Rs 1,000 Rs 1,311
 Let’s Welcome the Timeline!

0 1 2 3
7%
1000 FV = ?

Compounding: Finding FVs (moving to the right on a time line)

 Let’s Welcome the Timeline!

0 1 2 3
7%

PV = ? 1000

Discounting: Finding PVs (moving to the left on a time line)

 The Time Line
End of first End of second Start of
year year third year
Today

Year 1
t=0 t =1 t=2 t=3 t=4

Note:
The end of one year is the start of the next year.
Back to Compounding
 What happens if we increase the interest rate?

Year Investment Interest Investment Interest

r = 7% r = 10%
2017 1000 70 1000
2018 1070 74.9
2019 1144.9 80.1
2020 1225.0 85.8
2021 1310.8 91.8
How Does Compounding work?
 What happens if we increase the interest rate?

Year Investment Interest Investment Interest

r = 7% r = 10%
2017 1000 70 1000 100
2018 1070 74.9 1100 110
2019 1144.9 80.1 1210.0 121
2020 1225.0 85.8 1331.0 133.1
2021 1310.8 91.8 1464.1 146.4
 What do we Observe?
1. Compounding effect is greater with increasing
time
2. Compounding effect is greater with increasing
interest rate

Fundamental Investment Rules

1. Invest for a longer time

2. Invest in higher interest rates
Time Value of a Lump Sum

FVn = PV*(1+i)n
FVn = future value at time n
PV = present value right now
i = interest rate
n = time duration
Suppose you invest Rs. 100,000 @12% for 4 years. How much
money would you have after each of these 4 years?
FV = 100000 x (1.12)4 = Rs 157351.9

Year Investment (Rs)

2017 100000
2018
2019
2020
2021
Present Value

We know:
FV = PV*(1+i)n

Rearranging, we get
FV
PV =
(1 + i ) n
Suppose you want Rs. 100,000 in the year 2021. How much
money should you invest in each of these 4 years?
FV = 100000 / (1.12)4 = 63351.8

Year Investment (Rs)

2017
2018
2019
2020
2021 100000
Practice Questions
 Your sister has asked for a loan of Rs 12,500. She has promised to
repay the loan at the end of her education after 5 years.You would
normally get an interest of 6% in the market. How much would
you expect her to pay you after 5 years?
 Yash Chopra wants to invest some amount for his child’s MBA
scheduled to start 10 years from now which will cost Rs
10,00,000. Suppose the bank is giving him an interest of 8.3%pa.
How much should he invest now to have that amount?
 Abbas Mustan wants to earn money in the market. He finds a
mutual fund that has given a constant return of 15.6% since past 5
years. He wants to invest Rs 15,00,000 in the fund. How much
money will he get after 4 years from now?

Answers: 1) Rs 16,727.8; 2) Rs 450,521.4; 3) Rs 2,678,690.8

Let’s go a bit deep
 Series of Cash Flows
 Birla Sun Life Equity Fund is one of the top rated Mutual
Funds in its category industry. It has generated over 15%
annual returns year on year.
If you start putting Rs 10,000 every year (in SIP mode)
starting from 31 Dec 2017, how much money would you
have at the end of the year 2020?

Dec 31 Dec 31 Dec 31 Dec 31

Jan 2 17
17 18 19 20

10000 10000 10000 10000

 Series of Cash Flows contd.
Dec 31 Dec 31 Dec 31 Dec 31
Jan 1 17
17 18 19 20

10000 10000 10000 10000

10000

10000 (1.15)

10000 (1.15)2

10000 (1.15)3
∑
Rs 49,933.8
 If you invests the same amount till the year 2035, how much
would you get?
 Such computations are cumbersome and are handled by
considering cash flows as “annuities”
Annuities
 Annuity is a stream of constant cash flows occurring at
uniform intervals of time
 Examples: Insurance premium, EMIs
 When cash flows occur at the end of each period it is
termed as regular or ordinary annuity
 Cash flow map of an Annuity

0 1 2 3 4

100 100 100 100

Ordinary Annuity for 3 years

Future Value of an Annuity
FV of Annuity is given as
FV = A(1+i)n-1 + A(1+i)n-2 + …. + A

FVannuity = A x (1+i)n - 1
i

A = equal installments
FV Annuity Factor
i= interest rate
FVIFA
n = no of periods
Let’s Solve a Problem
 Yash Chopra wants to invest some amount for his child’s
MBA to start 10 years from now which will cost Rs
10,00,000. Suppose the bank is giving him an interest of
9%pa. How much should he invest each year for the next 10
years to have that amount?
(Ans: 65,820)
Present Value of an Annuity
 Recollect that FV = PV * (1+i)n
and from our annuity case, we know
(1+i)n - 1
FVannuity = A x
i
Therefore, we can rearrange terms to get PV

PVannuity = A x (1+i)n - 1
i (1+i)n
A = equal installments
i= interest rate PV Annuity Factor
n = no of periods PVIFA
The Clever Warren Buffet Case
 Mr Warren Buffet, the second richest man in the world
decided to donate 85% of his $44bn fortune to Tata Trust in
equal installments of $1.5bn for next 25 years. Assume Tata
Trust invests the money at 8% pa, what amount will Tata
Trust get at the end of 25 years?
 Mr Warren Buffet, the second richest man in the world
decided to donate 85% of his $44bn fortune to Tata Trust in
equal installments of $1.5bn for next 25 years. Mr Buffet is a
shrewd businessman and you think he has not really donated
85% of his wealth. What %age of his wealth he has donated
assuming he earns 8% on his wealth?
{Ans: 1) $109.36bn, 2) 36.39%}
 Mr Warren Buffet, the second richest man in the world
decided to donate 85% of his $44bn fortune to Tata Trust in
equal annual installments for next 25 years. What would the
installments be if Tata Trust earns 8% on his wealth?
Ans: $3.5bn
Let’s Try Multiple Choice
 As winner of a spot the alphabet on Coke bottle cap
competition, you can chose one of the following:
 100,000 now
 200,000 at the end of five years
 21,000 each year for 10 years
If the interets rate is 10% which alternative will you choose?

Ans: C
Annuity Types
 Recall that the Annuity we are studying also called Regular or
Ordinary Annuity
 Now we will study another type of Annuity known as
Annuity Due
Ordinary Annuity
0 1 2 3 4

100 100 100 100

Annuity Due
0 1 2 3 4

100 100 100 100

Annuity Due
 Since now the money is coming one year before, the Annuity
can be invested earlier and hence will get more interest.
 Series of Cash Flows
 Assume today is 1 Jan 2012 and Mr Aftab Shivdasani deposits
Rs 10,000 in a bank account on 1st January every year for
four years, till 2015. How much money will he get at the
beginning of year five if he gets 10% return on an annual
basis.
Jan 1 13 Jan 1 14 Jan 1 15 Jan 1 16
Jan 1 12

10000 10000 10000 10000

 Series of Cash Flows contd.
Dec 31 Dec 31 Dec 31 Dec 31
Jan 1 12
12 13 14 15

10000 10000 10000 10000

10000 (1.1)

10000 (1.1)2

10000 (1.1)3
10000 (1.1)4

∑
51,051
 FV and PV in Annuity Due
 Since cash flow occur one period before, FV and PV are
increased by a factor of (1+i). We observe that:

Ordinary Annuity Annuity Due

Future Value A[(1+i)n – 1]/i A{[(1+i)n – 1]/i}.(1+i)

• A*FVIFA*(1+i)
Present Value A[(1+i)n – 1]/i.(1+i)n A{ [(1+i)n – 1]/i(1+i)n}.(1+i)
• A*PVIFA*(1+i)
Annuity Due Example
 You feel that you have grown up and want to save money for
your child’s education to start 10 years from now.You save Rs
12,000 every year starting from today. How much will you
get after 10 years if you get 9% on your saving?
 2 step process:
1. Calculate the PV or FV as though it were an ordinary annuity
2. Multiply your answer by (1+i)
Ans: 198,723/-
Perpetuity
 A perpetuity is a stream of regular payments that goes on forever
 An infinite annuity
 Future value of a perpetuity
 There can be no future value since annuity goes on forever
 Present value of a perpetuity
 A
PV =  
i
 An Government bond, if purchased, promises to pay Rs 10,000
every year indefinitely to the buyer. At what price will the bond
sell if government bonds trade at 5% pa.