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Time Value of
Money
for present
consumption
Inflation
Risk
Why TIME?
Why is TIME such an important element
in your decision?
TIME allows you the opportunity to postpone
consumption and earn INTEREST
A rupee today represents a greater real
purchasing power than a rupee a year hence
Receiving a rupee a year hence is uncertain so
risk is involved
Types of Interest
Simple Interest
Interest paid (earned) on only the original
amount, or principal borrowed (lent).
Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).
SI = P0(i)(n)
SI:
Simple Interest
P0 :
i:
n:
SI
= P0(i)(n)
= Rs1,000(.07)(2)
= Rs140
= P0 + SI
= Rs1,000 + Rs140
= Rs 1,140
Future Value
Single Deposit
Assume that you deposit Rs 1,000
at a compound interest rate of 7%
for 2 years.
years
7%
Rs 1,000
FV2
Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1 = Rs 1,000 (1.07)
1,070
= Rs
General Future
Value Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.
FVn = P0 (FVIFi,n)
Problem
Reena wants to know how large her deposit of
Rs 10,000 today will become at a compound
annual interest rate of 10% for 5 years.
years
10%
Rs10,000
FV5
Solution
Problems
Your uncle deposits Rs. 10,000 into a 4 year FD that pays 5%
annual interest. You will receive the money in 4 years. What is the
FV after 4 years?
Variable compounding
Problems
Rs.1123.6
So,
Rs. 1000 grows @ 12.36% annually
Effective Rate of Interest
r = 1 + i/m
-1
Problem
Basket Wonders (BW) has a Rs1,000 CD at
the bank. The interest rate is 6%
compounded quarterly for 1 year. What is
the Effective Annual Interest Rate (EAR)?
EAR
EAR
= ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or
6.14%!
EIR
6 years
For accuracy use the Rule-of-69.
Doubling Period
=0.35 +(69 / Interest Rate)
6.1 years
General Present
Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
etc.
Present Value
Single Deposit
Assume that you need Rs 1,000 in 2 years.
Lets examine the process to determine
how much you need to deposit today at a
discount rate of 7% compounded annually.
7%
Rs 1,000
PV0
PV1
Present Value
Single Deposit (Formula)
PV0 = FV2 / (1+i)2
= FV2 / (1+i)2
0
7%
= Rs 1,000 / (1.07)2
= Rs 873.44
1
Rs 1,000
PV0
Problem
Reena wants to know how large of a
deposit to make so that the money will
grow to Rs 10,000 in 5 years at a discount
rate of 10%.
10%
5
Rs 10,000
PV0
Problem Solution
Problems
What is the PV of Rs.1000 receivable 6 years hence@
10% p.a.
PV0
10%
600
600
400
400 100
Solution
0
10%
600
600
400
400 100
545.45
495.87
300.53
273.21
62.09
5,000
10,000
10,000
3,000
2,000
Problems
30,000
20,000
10,000
10,000
Types of Annuities
Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period.
Annuity Due:
Due Payments or receipts
occur at the beginning of each period.
Examples of Annuities
Insurance Premiums
Retirement Savings
FV of Annuity
FV of an annuity due =
Parts of an Annuity
(Ordinary Annuity)
End of
Period 1
1
Rs 100
Today
End of
Period 2
End of
Period 3
2
Rs 100
3
Rs 100
Parts of an Annuity
(Annuity Due)
Beginning of
Period 1
Beginning of
Period 2
Rs 100
Today
Beginning of
Period 3
Rs 100
Rs 100
. . .
i%
A
A = Periodic
Cash Flow
n-2
FVAn
n+1
Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
7%
Rs1,000
Rs1,000
Rs1,000
Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
7%
Rs1,000
Rs1,000
Rs1,000
Rs1,070
Rs1,145
FVA3 = 1,000(1.07)2 +
1,000(1.07)1 + 1,000(1.07)0
= 1,145 + 1,070 + 1,000
= Rs 3,215
Rs3,215 =
FVA3
FVAn A(1 i )
n 1
A(1 i )
(1 i ) 1
A
n2
... A
i%
R
. . .
n-1
FVADn
Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
7%
1,000
1,000
1,000
1,070
Rs1,145
Rs1,225
FVAD3 = 1,000(1.07)3 +
1,000(1.07)2 + 1,000(1.07)1
= 1,225 + 1,145 + 1,070
= Rs 3,440
Rs 3,440 =
FVAD3
FV of Annuity
n+1
. . .
i%
R
R
R = Periodic
Cash Flow
PVAn
Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
7%
Rs1,000
Rs1,000
Rs1,000
Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
7%
934.58
873.44
816.30
Rs1,000
Rs 2,624.32 = PVA3
Rs1,000
PVA3 =
Rs1,000
1,000/(1.07)1 +
1,000/(1.07)2 +
1,000/(1.07)3
...
2
n
(1 i ) (1 i )
(1 i )
(1 i ) n 1
A
n
i (1 i )
PVADn
. . .
i%
R
n-1
R: Periodic
Cash Flow
Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
7%
1,000.00
934.58
873.44
1,000
1,000
2,808.02 = PVADn
Problems
Example
Reena has Rs1,000 to invest for 1 year
at an annual interest rate of 12%.
Annual
FV
= 1,000(1+
[.12/1])(1)(1)
1,000
= 1,120
Semi
FV
= 1,000(1+
[.12/2])(2)(1)
1,000
= 1,123.6
Perpetuity
A perpetuity is an annuity with an infinite number
rate =A/i
The present value of cash flows occurring in the
Present Value of a
Perpetuity
A
A
A
PVAn
...
2
n
(1 i ) (1 i )
(1 i )
When n=
PVperpetuity =
[A/(1+i)]
[1-1/(1+i)]
= A(1/i) = A/i
Present Value of a
Perpetuity
What is the present value of a perpetuity of
Rs270 per year if the interest rate is 12% per
year?
A
PV
perpetuity
i
Rs270 Rs 2250
0.12
Problems
2.
3.
4.
5.
Usefulness of Amortization
1. Determine Interest Expense -Interest expenses may reduce
taxable income of the firm.
2.
= A(PVIFA i%,n)
Payment
Interest
Principal
Ending
Balance
Rs2,774
Interest Principal
--Rs1,200
--Rs1,574
Ending
Balance
Rs10,000
8,426
2
3
4
5
Interest Principal
---
---
Ending
Balance
Rs10,000
Rs2,774
Rs1,200
Rs1,574
8,426
2,774
1,011
1,763
6,663
2,774
800
1,974
4,689
2,774
563
2,211
2,478
2,775
297
2,478
Rs13,871
Rs3,871 Rs10,000
EXERCISE
Ashish
recently obtained a
Rs.50,000 loan. The loan carries
an 8% annual interest. Amortize
the loan if annual payments are
made for 5 years.
SOLUTION
50000
0.08
12523
TIME
PAYMENT INTERESTPRINCIPAL
0
1
2
3
4
5
12523
12523
12523
12523
12522
4000
3318
2582
1786
928
AMOUNT
OUTSTANDING
50000
8523
41477
9205
32272
9941
22331
10737
11594
11594
0
EXERCISE
Compute
Solution
Cash flows occur at the end of the period
. . .
i%
100
200
100
100
200
th
Till 5 year
248.70
763.05
1011.75
1228.9
15
. . .
200