Time Value of Money

PAPER 3A: COST ACCOUNTING CHAPTER 2

BY: CA KAPILESHWAR BHALLA

 Learning objectives
2

Understand the Concept of time value of money.

Understand the relationship between present and future value of

money and how interest rate is used to adjust the value of cash flows
in-order to arrive at present (discounting) or future (compounding)
values.

Understand how to calculate the present or future value of an

annuity?

Know how to use interest factor table’s in order to calculate the

present or future values?
 Simple Interest
3

 It may be defined as Interest that is calculated as a

simple percentage of the original principal amount.
 Compound Interest
4

 If interest is calculated on original principal amount

it is simple interest. When interest is calculated on
total of previously earned interest and the original
principal it compound interest.
 Example
5

Mr. X deposited Rs. 10,000 in a bank today for a

period of 5 years.
If the bank pays interest @ 10% p.a. annually
compounded, what is the maturity amount after a
period of 5 years?
 Solution
6

P{1+r} for n years

= 10000{1 + 0.1} compounded for 5 years
= 16105
 Conclusion
7

16105 i.e. FUTURE VALUE of a PRESENT AMOUNT

i.e. 10000
OR
10000 i.e. PRESENT VALUE of a FUTURE
AMOUNT i.e. 16105
 Section I (Part I)
8

FUTURE VALUE OF A PRESENT AMOUNT

(Table A1 and A2)
 Table A1 (FVIF)
9

Future value interest factor

This table gives us the MATURITY AMOUNT of Re

1 deposited TODAY

At a given rate of interest i.e. r

For a given period of time i.e. n

Note: This table is based on ANNUAL

Compounding.
 Extract of Table A1
10

Years Rate of Interest

10%
1 1.1
2 1.21
3 1.331
4 1.464
5 1.6105
 Issue
11

Can we use Table A1 in a situation where the

FREQUENCY of compounding is more than once in
a year.
 Answer
12

Yes, we can.

There are 2 approaches of doing this.

 Approach I
13

Calculate the effective rate of interest.

{1+ r/m} raise to power m

Where,
M = frequency of compounding in a year
 Example
14

Let us say Interest rate is 10% p.a. with six monthly

compounding.
Thus,
Frequency of compounding is 2.
Effective rate of interest is:
[{1 + 0.10/2} raise to power 2] - 1
= 10.25%
 Technique
15

 Now we can see Table A1 with the effective rate of

interest for a given no. of years
 Approach II
16

Change the ‘no of years’ and the ‘rate of interest’

RULE:
Divide rate of interest by frequency of compounding
in a year and multiply the no of years by the
frequency of compounding in a year
 Example
17

Let us take the same example,

10% p.a. six monthly compounding for 5 years.

You can see Table A1 with 10 years @ 5% rate of

interest
 Conclusion
18

10.25% for a period of 5 years

OR

5% for a period of 10 years.

Note: We will get same answer.

 Rule of 72
19

To calculate the doubling period

72/ rate of interest

Ex:
If rate of interest is 8%,
Money gets doubled in 9 years.
 Table A2 FVIFA

20

Future Value Interest

Factor for an Annuity

This table gives us the

MATURITY AMOUNT of

Re 1 deposited EVERY Year

END

At a given rate of interest

i.e. r

For a given period of time

i.e. n
 Extract of Table A2
21

Years Rate of Interest

10%
1 1
2 2.1
3 3.31
4 4.641
5 6.105
 Note:
22

 This table is also based on annual compounding.

 But remember the table considers that deposit is

made at EVERY YEAR END.
 Issue
23

Can we use Table A2 in a situation if the deposit is

made at the BEGINNING of each year?
 Answer
24

Yes, we can use Table A2 but each value of the table

needs to be multiplied by (1+r)
 Example
25

Mr. X wants Rs. 500000 at the end of 8 years from

now. Find the amount to be deposited each year in
an account offering 7% interest compounded per
annum.
 Solution
26

In this case we have to make use of future value annuity of

one rupee table i.e., table A2 since futue amount is given
and we need to calculate series of amount which shall
aggregate to Rs. 500000 at the end of 8 years.
Future value of annuity
= Equal payment x (CFAF 9r, n))
Rs. 500000 = Equal payment x 5.971
Equal payment = 500000 / 5.971
Equal payment = Rs. 83738.07
 Example
27

Mr. X is planning for his retirement. He is 50 years

old today, and would like to have Rs. 500000 when
he attains the age of 65 years. He intends to deposit a
constant amount of money in a bank account
offering 12 percent rate of interest per annum every
year. How much should Mr. X invest at the end of
each year for next 15 years to obtain Rs. 500000 at
the end of that period?
 Solution
28

Given
Required sum in future Rs. 500000
Period of investment (years) 15
Interest rate 12%
Future value factor of annuity at 12% for 15 years
37.28 (using table A2)
Let ‘R’ be the amount deposited every year for the
given period, therefore, we have
R x (37.28) = 500000
R = 500000 / 37.28 = Rs. 13412.01
 Section II (Part I)
29

Present Value of a Future Amount

(Table A3 and A4)
 Part I (PVIF)
30

Present Value Interest factor

This table gives us the discounted or present value

Of an amount which is to be received after ‘n’ no of

years

If received TODAY

Discounted at a given rate of interest i.e. r

 Table A3 Extract
31

Years Rate of Interest

10%
1 0.909
2 0.826
3 0.751
4 0.683
5 0.621
 Notes
32

This table is basically INVERSE of Table A1.

FV = PV (1+r)
Thus,
PV = FV x 1/(1+r)
 Example
33

If we have to receive Rs. 10000 after 5 years from

Mr. Y, if it is received today:

Taking a discount/interest rate 10%,

We will receive 10000 x 0.621= 6210
 Example II
34

Find the present value of Rs. 8000, in following cases :

Received today

Received three year from now.

Received five years from now

Received nine years from now.

Received twelve years from now.

Given required rate of 12%.

 Solution
35

In the above cases, we shall make use of table A3 i.e., present value of one rupee.

Rs. 8000 received is equivalent to Rs. 8000.

Present value of Rs. 8000 received at the end of three years from now

= Rs. 8000 x PVF (12%, 3 years)

= Rs. 8000 x 0.712 = 5696

Present value of Rs. 8000 received at the end of five years from now

= Rs. 8000 x 0.567 = 4536

Present value of Rs. 8000 received at the end of nine years from now

= Rs. 8000 x 0.361 = 2888

Present value of Rs. 8000 received at the end of twelve years from now

= Rs. 8000x 0.257 = 2056

 Part II (PVIFA)
36

Present Value Interest Factor for an Annuity

This table gives us PRESENT VALUE

Of amount to be received at the end of every year

If received TODAY

Discounted at a rate of interest ‘r’

 Table A4 Extract
37

Years Rate of interest

10%
1 0.909
2 1.735
3 2.486
4 3.169
5 3.791
 Example
38

If we receive Rs. 10,000 every year end for the next 5

years,
If the entire money is received today,
using a discount rate of 10%,
We will receive 10,000 x 3.791
= 37910
 Example
39

Mr. X is planning to retire this year. He is given

two choices. His company can either pay him a
lump sum retirement payment of Rs. 400000 or
Rs. 60000 life time annuity. Mr. X is in good
health and expects to live for at least 20 more
years. If he has opportunity to earn interest at the
rate of 12% p.a., which alternative should be
choose? Would his decision change, if he has
opportunity to earn interest rate of 14% p.a.
 Solution
40

Payment (presently) = 400000

Annuity = Rs. 60000
Period of annuity 20 years
If he has opportunity to earn interest rate of 12%,
Present value of annuity = 60000 x PVAF (12%, 20 years) (using table A4)
60000 x 7.469 = 448140
If he has opportunity to earn interest rate of 14%,
Present value of annuity = 60000 x PVAF (14%, 20 years) (using table A4)
60000 x 6.623 = 397380
Mr. X should choose annuity payment of R. 60000 if he has
opportunity to earn return of 12% p.a. However, he shall opt for lump
sum payment if he has opportunity to earn return of 14% p.a.
 Example
41

A company is extending a loan facility of Rs.

5,00,000 for five years at the rate of 12% p.a., on
compounding basis which is to be paid back in the
form of five equal installments. Find the size of each
installment.
 Solution
42

Annual amount = Total amount of loan to be repaid

/ PVF (r, n)
Annual Installment = 5,00,000 / 3.605
(Use Table A4)
Annual Installment = Rs. 1,38,696.26.
 Present Value of Annuity till Perpetuity
43
Without growth With growth

A/r A/r-g

Where, Where,
A= Annuity A= Annuity
R= rate of interest R= rate of interest
G= growth rate
 Lesson Summary
44

Concept of Future Value

Concept of Present Value

Concept of Annuity

Practical application
 Thank you
45

All the best ………