Time Value of Money

Outline
 Meaning of Time Value
 Concept of Future Value and Compounding (FV)
 Concept of Present Value and Discounting (PV)
 Frequency of Compounding
 Present Value versus Future Value
 Determining the Interest rate (r)
 Determining the Time Period (n)
 Future Value and Present Value of Multiple Cash Flows
 Annuities and Perpetuities
Time Value of Money
 Basic Problem: How to determine value today of cash flows that are
expected in the future?
 Time value of money refers to the fact that a dollar in hand today is
worth more than a dollar promised at some time in the future
 Which would you rather have -- 1,000 today or 1,000 in 5 years.
 Obviously, Rs1,000 today.
 Money received sooner rather than later allows one to use the funds for
investment or consumption purposes. This concept is referred to as the
TIME VALUE OF MONEY
 TIME allows one the opportunity to postpone consumption and earn
INTEREST.
Future Value and Compounding
 Future value refers to the amount of money an investment will grow to over some length of time at
some given interest rate
 To determine the future value of a single cash flows, we need:
 present value of the cash flow (PV)
 interest rate (r), and
 time period (n)

 FVn = PV0 × (1 + r)n

 Future Value Interest Factor at ‘r’ rate of interest for ‘n’ time periods
 Examples on computation of future value of a single cash flow
Future Value (Graphic)

If you invested Rs 2,000 today in an account that

pays 6% interest, with interest compounded
annually, how much will be in the account at the
end of two years if there are no withdrawals?

0 1 2
6%
Rs2,000
FV
Future Value (Formula)

FV1 = PV (1+r)n
= 2,000 (1.06)2
= 2,247.20

FV = future value, a value at some future point in time

PV = present value, a value today which is usually designated as time 0
r = rate of interest per compounding period
n = number of compounding periods
Future Value (Example)

⚫ John wants to know how large his 5,000

deposit will become at an annual compound
interest rate of 8% at the end of 5 years.

0 1 2 3 4 5
8%
5,000
FV5
Future
 Value Solution

Calculation based on general formula:

FVn = PV (1+r)n
FV5 = 5,000 (1+ 0.08)5
= 7,346.64
⚫
Present Value and Discounting
 The current value of future cash flows discounted at the appropriate discount rate over
some length of time period
 Discounting is the process of translating a future value or a set of future cash flows into a
present value.
 To compute present value of a single cash flow, we need:
 Future value of the cash flow (FV)
 Interest rate (r) and
 Time Period (n)

 PV0 = FVn / (1 + r) n

 PVIF (r,n)
 Examples
Present Value (Graphic)

Assume that you need to have exactly 4,000 saved 10

years from now. How much must you deposit today in
an account that pays 6% interest, compounded annually,
so that you reach your goal of 4,000?

0 5 10
6%
4,000
PV0
Present Value (Formula)

PV0 = FV / (1+r)10
= 4,000 / (1.06)10
= 2,233.58

0 5 10
6%
4,000
PV0
Present Value Example

Joann needs to know how large of a deposit to make

today so that the money will grow to 2,500 in 5 years.
Assume today’s deposit will grow at a compound rate
of 4% annually.
0 1 2 3 4 5
4%
2,500
PV0
Present Value Solution

⚫ Calculation based on general formula:

PV0 = FVn / (1+r)n
PV0 = 2,500/(1.04)5
= 2,054.81
Frequency of
Compounding

General Formula:
FVn = PV0(1 + [r/m])mn

n: Number of Years
m: Compounding Periods per Year
r: Annual Interest Rate
FVn,m: FV at the end of Year n
PV0: PV of the Cash Flow today
 Frequency of Compounding Example

⚫ Suppose you deposit 1,000 in an account that pays

12% interest, compounded quarterly. How much will be
in the account after eight years if there are no
withdrawals?

PV = 1,000
r = 12%/4 = 3% per quarter
n = 8 x 4 = 32 quarters
 Solution based on formula:

FV= PV (1 + r)n
= 1,000(1.03)32

= 2,575.10
Present Value versus Future Value
 Present value factors are reciprocals of future value factors
 Interest rates and future value are positively related
 Interest rates and present value are negatively related
 Time period and future value are positively related
 Time period and present value are negatively related
Determining the Interest Rate (r)
 At what rate of interest should we invest our money today to
get a desired amount of money after a certain number of
years?
 Essentially, we are trying to determine the interest rate given
present value (PV), future value (FV), and time period (n)
 Examples
 The rate which money can be doubled/tripled
Determining the Time Period (n)
 For how long should we invest money today to get a desired
amount of money in the future at a given rate of interest
 Determining the time period (n) for which a current amount (PV)
needs to be invested to get a certain future value (FV) given a rate
of interest (r).
 Examples
 The time period needed to double/triple our current investment
Future Value of Multiple Uneven Cash
Flows
 Compute the future value of each single cash flow using
future value formula and add them up over all the cash flows
Present Value of Multiple Uneven Cash
Flows
 Compute the present value of each single cash flow using
present value formula and add them over all the cash flows
Annuities
 A series of level/even/equal sized cash flows that occur at
the end of each time period for a fixed time period
 Examples of Annuities:
 Car Loans
 House Mortgages
 Insurance Policies
 Some Lotteries
 Retirement Money
 Present Value of an Annuity
 Examples
 Computing Cash Flow per period in annuity
 Examples
Perpetuities
 A series of level/even/equal sized cash flows that occur at
the end of each period for an infinite time period
 Examples of Perpetuities:
 Consoles issued by British Government
 Preferred Stock

 Present Value of a Perpetuity

Effective Annual Rate
 Compounding other than annual
Present Value
 It can be seen that PV of future money depends on
three variables
 Rate of interest
 Future Value
 Time period
 There can be an almost infinite combinations of these
variables However Mathematicians on the line of
compound value tables have also calculated the values
of factor1/(1+r)n .
 For different combinations of two variables r and n
.These values are known as present values of future sum
of money for a given rate of interest and time period and
is denoted as PVF(r,n) These values have been given in
table A-3 in appendix II The figure given at the
intersection of a particular rate of interest r and time
period n when multiplied with future amount will give
the PV of that amount for the given combination or r &
n Therefore the formula for
 PV=FV×PVF(r, n )
 You are required to calculate PV of Rs 1500 receivable
after 3 years and rate of interest after 10%
 Solution
 PV=FV×PVF(r, n )
 =1500×.751
 =1,126.50
PV of a series of equal cash flows or
annuity
 You are required to calculate the Present value in the given
case Mr. X paid an amount of Rs,900 p.a for Three years with
10% rate of interest
 Solu:
 PV=Annuity amount×PVAF(r,n)
 =900×2.487
 =2,238
 A student is awarded a scholarship and two options are
placed before him:
 To receive Rs1,100 now
 To receive Rs100 pm at the end of next 12 months
 Which option be chosen if rate of intrest is 12%?
Option 1:The amount of Rs 11,00 receivable now is expressed in present money
and therefore does not require any adjustment.
Option2:There is an annuity of Rs,100 for a period of next 12 months. The rate of
interest is 12% p.a .The position can also be expressed as an annuity of 12
periods at rate of interest 1%.On the basis of value given in Table A -4 for PVAF
which is 11.255, the present value of annuity is Rs100×11.255=Rs1,125.50.
Since PV in option II is higher than the PV in option I, The student should choose
option II.
Perpetuity
 A Perpetuity may be defined as an infinite series of equal cash flows
occurring at regular intervals. It has indefinitely long life. If a deposit of
Rs 1,000 is made in a savings bank account at 3 ½% for indefinite
period then the yearly interest of Rs 35 is a perpetuity of interest
income so long as initial deposit of Rs1,000 is kept unchanged .In order
to find out the PV of perpetuity the present value of each of infinite
number of cash flow should be added .if the first occurrence of the
perpetuity takes place after 1 year from today then present value of
perpetuity may be calculated with the help of following equation .
 PV=Cash Flow÷(1+r)1+ Cash Flow ÷(1+r)2+..................................+
Cash Flow ÷(1+r)n
 Conceptually it is difficult or rather impossible to find out PV of
perpetuity. However ,Mathematically it is easiest stream of the cash
flow to value ,Mathematically,Infinite summation adds up to the simple
version
 PVp=Annual Cash Flow/r
 Find out the present value of an investment which is expected to give a
return of Rs,2500p.a.indefinately and rate of interest is 12%p.a
 Using the equation
 PVp=Annual Cash flow/r
 2500/0.12=20,833.33
Valuation of securities
 Valuation analysis is a process to estimate the
approximate value or worth of an asset, whether its a
business, equity, fixed income security, commodity,
real estate, or other assets. The analyst may use
different approaches to valuation analysis for different
types of assets, but the common thread will be looking
at the underlying fundamentals of the asset.
 Valuation is the analytical process of determining the current (or
projected) worth of an asset or a company. There are many techniques
used for doing a valuation. An analyst placing a value on a company
looks at the business's management, the composition of its capital
structure, the prospect of future earnings, and the market value of its
assets, among other metrics.
 Fundamental analysis is often employed in valuation, although several
other methods may be employed such as the capital asset pricing model
(CAPM) or the dividend discount model (DDM).
 A number of concepts of valuation have been used in
the literature .These different concepts of valuation
discussed here have specific issues and purpose and
therefore the same assets may be valued differently by
different persons with different perspective.
 Book Value : The BV of an assets is an accounting concept based on
the historical data given in the balance sheet or can be ascertained on
the basis of figures contained in the balance sheet.

Market Value: The MV of an assets is defined as the price for which the
assets can be sold .The MV of a financial assets refers to the price
prevailing at stock exchange.

Going concern Value: The GV refers to the value of the business as an

operating, performing, and running business unit. This is the value
which a prospective buyer of a business may be ready to pay.
 Liquidating value: The LV refers to the net realise able value is equal to the
difference between the value of assets and the sum total of external liabilities.
This net difference belongs to the owners/shareholders and is known as the LV.
 Capitalized value: The CV of a financial assets is defined as the sum of present
value of cash flow from an assets in order to find out CV.The future expected
benefits are discounted for the time value of money in the valuation of financial
asset. The CV is also known as economic value.
 The suitability of CV method of valuation of financial assets can be substantiated
in the terms of the following.
 Cash Flows
 Timing
 The Risk
Required Rate of Return

 The application of the concept of CV requires in the first instance , the

determination of discount rate or the required rate of return of the investors for a
specific security being valued.
 This required rate of return may be defined as the minimum rate of return
necessary to induce an investor to hold the security or to buy the security. This
minimum required rate of return consisting of two parts .
 Risk Free rate(Which is equal for all securities)
 Risk Premeium (Which depends upon the risk associated with a security)
 This can be Stated as follows:
 K=If +r p
 I f=Risk Free rate
 r p= Risk Premium
 K= required rate of return
 The level of risk associated with the given cash flow can significantly
affect its value. In terms of present value ,Greater risk is incorporated
by using a higher discount rate /rate of return .The table shows that as
the risk increases the required rate of return also increases and the
increase occurs because of increase in risk premium.
 The risk free rate If remains same for all levels of risk, and the risk
premium Rp goes on increasing with the increase in risk.
Basics valuation model

 It is already stated that CV of a financial assets is the present

value of all future cash flows expected over a period of time
.For this purpose the risk return perspective is also to be
incorporated.Diffrent investors have different priorities of risk
and return. Therefore in order to develop a general model of
valuation the following are some of the assumptions to be made
 That the cash flow or the returns are estimated or forecasted as a
point estimate rather than a probability distribution. The implication
of this assumption is that future cash flows are represented by a
single figure and not a series of expected figures.
 That every investor has a subjective assessment of risk associated
with financial assets and expected cash flows, and he incorporates
this risk in the valuation procedure through discount factor.
 Therefore ,the discount factor appropriate for one investor may not be good
enough for another investor. Any investor is also subjective with reference to the
risk associated with different securities at a point of time.
 THE MODEL:
 The value of financial asset is ascertained by a direct application of the concept
of the time value of money .The value of a financial asset is determined by
discounting the expected cash flows to their present value at a discount rate
commensurate with the risk return perspective of the investor. So utilizing the
present value technique ,the value of financial assets can be expressed as follows:
V0=CF/(1+k)1+CF/(1+k)2+CF/(1+k)n
Vo=Value of the security at present
CF1=Cash flows expected at the end of year I.
K=Appropriate discount rate
N=Expected life of an asset
Valuation of Bond
 A bond or a debenture is a debt security issued by a borrower and
subscribed /purchased by a lender /investor. Bond is a usual form of
long term financing used by firms which upon issuing a bond, promise
to make certain cash flows in future in the form of interest and or
repayment under clearly defined terms and conditions in order to
understand the valuation of bonds ,the understanding of the following
basics terms is required.
PAR VALUE
 The par value also called as face value or nominal value of a bond is
the principal amount of a bond and it is stated on the face value of bond
security. The par value of bond may be Rs100, Rs1,000 or any amount.
The issue price ,however, may be less than equal to more than the par
value similarly the redemption repayment may also be less than equal
to or more than the par value.
COUPON RATE
 This is the rate at which interest on the par value of bond is
payable as per the payment schedule the interest may be paid
annually, semi annually or even monthly. The coupon rate is usually
described as % rate and is applied to the par value to find out the
periodic interest amount.
MATURITY
 The maturity of a bond refers to the period from the date of issue ,after the
expiry of which the redemption repayment will be made to the investor by the
borrower firm.
Assumption
 An assumption which may be required while valuing a
bond is that the first interest payment shall become due for
payment after one year from the date of purchase/issue of
the bond.
Valuation Model
 The value of a bond may be defined as the sum of the present values of
future interest payments plus the present value of the redemption
repayment. The appropriate discount rate to find out the present value
would be required rate of return Kd which depends upon the prevailing
risk free interest rate and risk premeium.The basic valuation model may
be modified to find out the value of a bond as follows:
 A bond of Rs.1,000 bearing a coupon rate of 12% is
redeemable at par in 10 years .Find out the value of a
bond if:
1.Required rate of return is 12% or 10% or 14%
2.Required rate of return is 14% and maturity period is 8
years or 12 years
3.Required rate of return is 12% and redeemable at
Rs.950 or Rs.1050, after 10 years.
 If the required rate of return is 12%
 =120(5.650)+1000(.322)
 =678+322
 =Rs1,000
 If required rate of return is 10%
 Bo=120(6.145)+1000(.386)
 Bo=737.4+386
 Bo= Rs1,123.40
VALUATION OF EQUITY SHARES
 Every company must have equity shares capital as it represents the real owner ship
intrest.the management in general and finance manager in particular bear the
responsibility of advancing the interest of equity share holders .The decision making
process of a finance manager is directed towards the market price of equity shares,
however the market price of equity shares is influenced by host of factors and quite often
unpredictable. So finance manager is often concerned with finding out the value of
equity shares.
 Conceptually the valuation of equity shares is the most typical because of its residual
ownership character. The equity shareholders receive the residual profits also the residual
assets in case of liquidation .
Valuation of equity shares based on
dividend discount models
 The equity shareholders are the owners of the company.
The main objective of financial management is to maximise
the wealth of the equity shareholders .Therefore ,valuation
of the equity shares has to be done with great care .The
valuation of bonds is quite easy because period and
quantum of cash flows associated with these are known
with certainty.
 Different methods of equity shares valuation are as follows:
 Valuation of equity shares based on dividends
 Valuation of equity shares based on earnings.
Valuation of equity shares based on
dividends (Dividend
 According to the discount
dividend discount Models)
model the value of shares depends
on cash inflows expected from the equity share and the required rate of
return to find out the present value of these cash inflows.
 According to the value of equity shares is the sum of the present values
of all future cash inflows associated with it. The value so calculated is
called the intrinsic value of equity share.
 Assumptions
 Dividend are paid annually by a company.
 The first payment of dividend is made after one year from the date of
purchase.
 The sale of equity shares is at the end of the year.
Single Period Valuation Model

 Normally equity shareholders hold shares for short period .If an investor plans
to buy an equity shares to hold it for one year and then sell. In such a case the
value of the share for him will be present value of expected dividends at the
end of one year plus the present value of expected sale price at the end of the
year.

Po=D1/(1+Ke)+P1/(1+Ke)
Po=Current value of a share
D1=Expected dividend at the end of year
P1=Expected price of share at the end of year
K e=Cost of equity or Expected rate of return or Discount rate.
 Mr Mohit is planning to buy an equity share ,hold it for one year and then sell it The
expected dividend at the end of year one is 8 and the expected sale proceeds Rs,160 after
one year. Determine the value of the share to the investor assuming the discount rate of
14
RISK AND RETURN
 Risk means existence of volatility in the occurrence of
an expected incident is called risk. higher the
unpredictability greater is the risk. in reference to the
investment risk is defined as the variability of the
actual return from the expected returns from an
investment.
 The degree of risk however varies on the basis of the
feature of assets.
Causes of Risk

 Wrong decision of what to invest in.

 Wrong timings of investment.
 Nature of investments.
 Creditworthiness of issuer.
 Maturity period and length of investment.
 Amount of investment
 Method of investment ,namely secured by collateral or not.
 Terms of lending such as periodicity of servicing redemption periods etc
 Nature of industry or business in which the company is operating
 National and international factors natural calamities.
Types of Risk
 Systematic risk: systematic risk refers to that portion
of variation in return caused by factors that affect the
price of all securities.
 Systematic risk are out of external and uncontrollable
factors ,arising out of the market, nature of industry
and the state of economy and host of factors.
 Systematic risk arises due to the following factors:
 Market Risk
 Interest rate Risk
 Purchasing Power Risk
Unsystematic Risk

 Unsystematic risk refers to the portion of the risk which is caused due
to factors unique or related to a firm or industry. It is possible to reduce
unsystematic risk adding more securities to the investor portfolio.
Therefore unsystematic risk is often referred to as diversified risk.
 This type of risk can be further divided into the following parts:
 Business Risk
 Financial Risk
 Thank You