Course No.

ET ZC414

Project Appraisal
BITS Pilani
Hyderabad Campus

Module : selection 1 Session 8

S. Hanumantharao Date : 2/8/2015

Total ppt :41

BITS Pilani
Hyderabad Campus

Chapter 7
Time value of money

Objectives
1. Calculate the future value and present
value of a single amount.
2. Calculate the future value and present
value of an annuity.
3. Compute the present value of a growing
annuity.
4. Show the impact of compounding
frequency on the effective rate of interest.
BITS Pilani, Hyderabad Campus

Money has time value.

A rupee today is more valuable than a rupee a year hence.
Why?
There are several reasons:
Individuals, in general, prefer current consumption to future
consumption.
Capital can be employed productively to generate positive
returns. An investment of one rupee today would grow to (1 + r)
a year hence (r is the rate of return earned on the investment).
In an inflationary period a rupee today represents a greater real
purchasing power than a rupee a year hence.

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 Most financial problems involve cash flows occurring at

different points of time next month, next year and so on
These cash flows have to be brought to the same point of
time for purposes of comparison and aggregation.
Hence you should understand the tools of compounding and
discounting which underlie most of what we do in finance
from valuing securities to analyzing projects,
from determining lease rentals to choosing the right financing
instruments,
from setting up the loan amortization schedules to valuing
companies,
so on and so forth.

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End of period

Beginning of period.

Part A: cash flow at the end of period

Part B cash flow at the beginning of period.
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Notations
We will use the following notation:
PV: Present value
FVn: Future value n years hence
Ct: Cash flow occurring at the end of year t
A : A stream of constant periodic cash flows over a given
time
r :Interest rate or discount rate
g: Expected growth rate in cash flows
n: Number of periods over which the cash flows occur.

BITS Pilani, Hyderabad Campus

Future Value
Suppose you deposit Rs.1,000 today in a bank which pays
10 percent interest compounded annually, how much will
the deposit grow to after 8 years and 12 years?
Rs.1,000(1.10)^8 = Rs.1,000 (2.144)
= Rs.2,144
The future value, 12 years hence, will be:
Rs.1,000 (1.10)^12= Rs.1,000 (3.138)
=Rs. 3138
This means todays 1000
Is worth 2144 after eight years
And 3138 after 12 years
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Simple Cash Flows

A simple cash flow is a single cash flow in a specified future
time period.
Cash Flow: CFt
______________________________________|
Time Period: t
The present value of this cash flow isPV of Simple Cash Flow = CF t / (1+r)t
The future value of a cash flow is FV of Simple Cash Flow = CF0 (1+ r)t
t can be days, weeks, months, quarterly or half yearly

Interest rate or discount rate per t

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Future Value Investment Factor

Table

While tables are easy to use they have a limitation as they contain
values only for a small number of interest rates. So often you may have
to use a calculator.
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Graphic view of compounding

4.5000
4.0000
3.5000
3.0000

2%
4%
6%
8%
10%
12&

2.5000
2.0000
1.5000
1.0000
0.5000
0.0000

10

12

14
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BITS Pilani, Hyderabad Campus

Power of compounding
We've seen compounding referred to as "the most powerful
force in the universe," "the royal road to riches," and "the
greatest mathematical discovery in human history."
Albert Einstein called compounding the eighth wonder of
the world.
At end
of Year

5%

10%

15%

20%

Rs105

Rs110

Rs115

Rs120

Rs128

Rs161

Rs201

Rs249

10

Rs163

Rs259

Rs405

Rs619

15

Rs208

Rs418

Rs814 Rs1541

25

Rs339 Rs1,083 Rs3,292 Rs9,540

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Rule of 72
Investors usually ask the question: How long
would it take to double the amount at a given
rate of interest?
Rule of thumb: 72/interest rate
10 percent
15 percent

72/10 = 7.2 years

72/15 = 4.8 years

10 percent
15 percent

0.35+69/10 = 7.25 years

0.35+69/15 = 4.95 years

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Growth rate

BITS Pilani, Hyderabad Campus

Growth Rate
Phoenix Limited had revenues of Rs.100 million in 2000
which increased to Rs. 1000 million in 2010. What was
the compound growth rate in revenues?
The compound growth rate may be calculated as follows:
100 (1 + g)^10 = 1,000
(1 + g)^10 = 1000/100 = 10
(1 + g) = 10 ^1/10
g = 10^1/10-1
= 1.26 - 1 = 0.26 or 26 percent

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Present value

751.3148009
BITS Pilani, Hyderabad Campus

Discounting
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
rewriting the compounding formula:
FVn = PV (1 + r)^n
Dividing both the sides by (1 + r)^n, we get:
PV = FVn (1/(1 + r^n))
The factor 1/(1 + r)^n is the discounting factor

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II. Annuities
An annuity is a constant cash flow that occurs at regular
intervals for a fixed period of time. Defining A to be the
annuity,
For a cash flow to be an

annuity, it has to be
A A A A
1.The same amount in each
| | | |
period
2.The periods have to remain
0 1 2 3 4
fixed (monthly, annual)
The present value of an annuity can be calculated by
taking each cash flow and discounting it back to the
present, and adding up the present values

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Annuities
Suppose you deposit Rs.1,000 annually in a bank for 5
years and your deposits earn a compound interest rate
of 10 percent. What will be the value of this series of
deposits (an annuity) at the end of 5 years? Assume that
each deposit occurs at the end of the year.

[(1.1)^5-1]/0.1 = 6.1501, this multiplied by 1000 = 6150.1

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

III. Growing Annuity

A growing annuity is a cash flow growing at a constant rate
for a specified period of time. If A is the current cash flow,
and g is the expected growth rate, the time line for a
growing annuity looks as follows

Figure3.8:AGrowingAnnuity
A(1+g)
0

A(1+g)2
2

A(1+g)3
3

...........

A(1+g)n
n

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Present Value of a Growing

Annuity

The present value of a growing annuity can be estimated

in all cases, but one - where the growth rate is equal to
the discount rate, using the following model:

(1
+
g)
1

(1 + r)
PVofanAnnuity = PV(A,r, g,n) = A(1 + g)

(r

g)

In that specific case, the present value is equal to the

nominal sums of the annuities over the period, without
the growth effect.
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BITS Pilani, Hyderabad Campus

IV. Perpetuity
A perpetuity is a constant cash flow at regular intervals
forever. The present value of a perpetuity isThe best way to think about a perpetuity is not as forever
but as a very long time.. The present value of an annuity
that last 50 or 60 years converges on this value
A
PVofPerpetuity =
r

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

V. Growing Perpetuities
A growing perpetuity is a cash flow that is expected to grow at a
constant rate forever. The present value of a growing
perpetuity is -

CF1
PVofGrowingPerpetuity =
(r g)

where
CF1 is the expected cash flow next year,
g is the constant growth rate and
r is the discount rate.

This is a cash flow growing at a constant rate forever. Here, g<r.

Since the growth rate is forever, it is constrained to be less
than or equal to the growth rate of the economy. If we allow for
that constraint, g will always be less than r.
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INTRA-YEAR COMPOUNDING AND

DISCOUNTING

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Effective versus Stated

Rate
Rs.1,OOOgrows to Rs.1,123.6 at the end of a year if the
stated rate of interest is 12 percent and compounding is
done semiannually.
This means that Rs.1,OOOgrows at the rate of 12.36
percent per annum.
The figure of 12.36 percent is called the effective interest
rate - the rate of interest under annual compounding
which produces the same result as that produced by an
interest rate of 12 percent under semi-annual
compounding.

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

When compounding becomes continuous, the effective

interest rate is expressed as follows:
Effective interest rate =
where e is the base of natural logarithm, and r is the stated
interest rate.

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Shorter Discounting
Periods
Sometimes cash flows have to be discounted more
frequently than once a year - semi-annually, quarterly,
monthly, or daily.
As in the case of intra-year compounding, the shorter
discounting period implies that (i) the number of periods
in the analysis increases and (ii) the discount rate'
applicable per period decreases.
The general formula for calculating the present value in the
case of shorter discounting period is:

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus