Time Value of

Money

The Time Value of Money

The Interest Rate

Simple Interest

Compound Interest

Amortizing a Loan

The Interest Rate

Which would you prefer -- Rs10,000
today or Rs10,000 in 5 years?
years
Obviously, Rs10,000 today.
today
You already recognize that there is
TIME VALUE TO MONEY!!
MONEY

Why TIME?
Why is TIME such an important
element in your decision?
TIME allows you the opportunity to postpone
consumption and earn INTEREST.
INTEREST
TIME also eats away your money through INFLATION
TIME has an OPPORTUNITY COST

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).

Simple Interest Formula

Formula

SI = P0(i)(n)

SI:

Simple Interest

P0 :

Deposit today (t=0)

i:

Interest Rate per Period

n:

Number of Time Periods

Simple Interest Example

Assume that you deposit Rs1,000 in an

account earning 7% simple interest for
2 years. What is the accumulated
interest at the end of the 2nd year?

SI

= P0(i)(n)
= Rs1,000(.07)(2)
= Rs140

Simple Interest (FV)

What is the Future Value (FV)

FV of the
deposit?
FV

= P0 + SI
= Rs1,000 + Rs140
= Rs1,140

Future Value is the value at some future

time of a present amount of money, or a
series of payments, evaluated at a given
interest rate.

Simple Interest (PV)

What is the Present Value (PV)

PV of the
previous problem?
The Present Value is simply the
Rs1,000 you originally deposited.
That is the value today!

Present Value is the current value of a

future amount of money, or a series of
payments, evaluated at a given interest
rate.

Future Value

Why Compound Interest?

Future Value

Why Compound Interest?

Future Value
Single Deposit (Graphic)
Assume that you deposit Rs1,000 at
a compound interest rate of 7% for
2 years.
years

7%

Rs1,000
FV2

Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1

= Rs1,000 (1.07)
= Rs1,070

Compound Interest
You earned Rs70 interest on your
Rs1,000 deposit over the first year.
This is the same amount of interest you
would earn under simple interest.

Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1 = Rs1,000 (1.07)
Rs1,070

FV2 = FV1 (1+i)1 = P0 (1+i)(1+i) =

Rs1,000(1.07)(1.07)=
P0 (1+i)2=
Rs1,000
2 = Rs1,144.90
Rs1,000(1.07)
Rs1,000
You earned an EXTRA Rs4.90 in Year 2 with
compound over simple interest.

General Future
Value Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.

General Future Value Formula:

FVn = P0 (1+i)n
or

FVn = P0 (FVIFi,n) -- See Table

Valuation Using Table

FVIFi,n is found on Table at the end
of the book.

Period
1
2
3
4
5

6%
1.060
1.124
1.191
1.262
1.338

7%
1.070
1.145
1.225
1.311
1.403

8%
1.080
1.166
1.260
1.360
1.469

Using Future Value Tables

FV2

= Rs1,000 (FVIF7%,2)
= Rs1,000 (1.145)
= Rs1,145 [Due to Rounding]
Period
6%
7%
8%
1
1.060
1.070
1.080
2
1.124
1.145
1.166
3
1.191
1.225
1.260
4
1.262
1.311
1.360
5
1.338
1.403
1.469

Story Problem Example

Rekha wants to know how large her deposit of
Rs10,000 today will become at a compound
annual interest rate of 10% for 5 years.
years

10%

Rs10,000

FV5

Story Problem Solution

Calculation based on general formula:
FVn = P0 (1+i)n
FV5 = Rs10,000 (1+ 0.10)5
= Rs16,105.10
Calculation based on Table
FV5 = Rs10,000 (FVIF10%, 5)
= Rs10,000 (1.611)
= Rs16,110
[Due to Rounding]

Double Your Money!!!

Quick! How long does it take to double
Rs5,000 at a compound rate of 12% per
year (approx.)?

We will use the Rule-of-72.

The Rule-of-72
Quick! How long does it take to double
Rs5,000 at a compound rate of 12% per
year (approx.)?

Approx. Years to Double = 72 / i%

72 / 12% = 6 Years
[Actual Time is 6.12 Years]

Present Value
Single Deposit (Graphic)
Assume that you need Rs1,000 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%

Rs1,000
PV0

PV1

Present Value
Single Deposit (Formula)
PV0 = FV2 / (1+i)2
= FV2 / (1+i)2
0

7%

= Rs1,000 / (1.07)2
= Rs873.44
1

Rs1,000
PV0

General Present
Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
etc.

General Present Value Formula:

PV0 = FVn / (1+i)n
or

PV0 = FVn (PVIFi,n) -- See Table

Valuation Using Table

PVIFi,n is found on Table at the end
of the book.
Period
1
2
3
4
5

6%
.943
.890
.840
.792
.747

7%
.935
.873
.816
.763
.713

8%
.926
.857
.794
.735
.681

Using Present Value Tables

PV2

= Rs1,000 (PVIF7%,2)
= Rs1,000 (.873)
= Rs873 [Due to Rounding]
Period
6%
7%
8%
1
.943
.935
.926
2
.890
.873
.857
3
.840
.816
.794
4
.792
.763
.735
5
.747
.713
.681

Story Problem Example

Rekha wants to know how large of a deposit
to make so that the money will grow to
Rs10,000 in 5 years at a discount rate of 10%.

10%

5
Rs10,000

PV0

Story Problem Solution

Calculation based on general formula:

PV0 = FVn / (1+i)n
PV0 = Rs10,000 / (1+ 0.10)5
= Rs6,209.21

Calculation based on Table I:

PV0 = Rs10,000 (PVIF10%, 5)
= Rs10,000 (.621)
= Rs6,210.00 [Due to Rounding]

Types of Annuities

An Annuity represents a series of equal

payments (or receipts) occurring over a
specified number of equidistant periods.

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

Student Loan Payments

Car Loan Payments

Insurance Premiums

Mortgage Payments

Retirement Savings

Parts of an Annuity
(Ordinary Annuity)
End of
Period 1

1
Rs100

Today

End of
Period 2

End of
Period 3

2
Rs100

3
Rs100

Equal Cash Flows

Each 1 Period Apart

Parts of an Annuity
(Annuity Due)
Beginning of
Period 1

Beginning of
Period 2

Rs100

Today

Beginning of
Period 3

Rs100

Rs100

Equal Cash Flows

Each 1 Period Apart

Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period

. . .

i%
R

R = Periodic
Cash Flow

FVAn = R(1+i) + R(1+i)

... + R(1+i)1 + R(1+i)0
n-1

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
Rs1,070
Rs1,145

FVA3 = Rs1,000(1.07)2 +
Rs3,215
=
1
0
Rs1,000(1.07) + Rs1,000(1.07)
= Rs1,145 + Rs1,070 + Rs1,000
= Rs3,215

FVA3

Hint on Annuity Valuation

The future value of an ordinary
annuity can be viewed as
occurring at the end of the last
cash flow period, whereas the
future value of an annuity due
can be viewed as occurring at
the beginning of the last cash
flow period.

Valuation Using Table

FVAn
FVA3

= R (FVIFAi%,n)
= Rs1,000 (FVIFA7%,3)
= Rs1,000 (3.215) = 3,215
Period
6%
7%
8%
1
1.000
1.000
1.000
2
2.060
2.070
2.080
3
3.184
3.215
3.246
4
4.375
4.440
4.506
5
5.637
5.751
5.867

Overview View of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period

i%
R

. . .

FVADn = R(1+i)n + R(1+i)n-1 +

... + R(1+i)2 + R(1+i)1
= FVAn (1+i)

n-1

FVADn

Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period

7%
Rs1,000

Rs1,000

Rs1,000

Rs1,070
Rs1,145
Rs1,225

FVAD3 = Rs1,000(1.07)3 +
Rs3,440 =
Rs1,000(1.07)2 + Rs1,000(1.07)1
= Rs1,225 + Rs1,145 + Rs1,070
= Rs3,440

FVAD3

Valuation Using Table

FVADn
FVAD3

= R (FVIFAi%,n)(1+i)
= Rs1,000 (FVIFA7%,3)(1.07)
= Rs1,000 (3.215)(1.07) = 3,440
Period
6%
7%
8%
1
1.000
1.000
1.000
2
2.060
2.070
2.080
3
3.184
3.215
3.246
4
4.375
4.440
4.506
5
5.637
5.751
5.867

Overview of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period

n+1

. . .

i%
R

R
R = Periodic
Cash Flow

PVAn

PVAn = R/(1+i)1 + R/(1+i)2

+ ... + R/(1+i)n

Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period

7%
934.58
873.44
816.30

Rs1,000

2,624.32 = PVA3

Rs1,000

Rs1,000

PVA3 = Rs1,000/(1.07)1 +
Rs1,000/(1.07)2 +
Rs1,000/
(1.07)3
= 934.58 + 873.44 +816.30
= Rs2,624.32

Hint on Annuity Valuation

The present value of an ordinary
annuity can be viewed as
occurring at the beginning of the
first cash flow period, whereas
the present value of an annuity
due can be viewed as occurring
at the end of the first cash flow
period.

Valuation Using Table

PVAn
PVA3

= R (PVIFAi%,n)
= Rs1,000 (PVIFA7%,3)
= Rs1,000 (2.624) = 2,624
Period
6%
7%
8%
1
0.943
0.935
0.926
2
1.833
1.808
1.783
3
2.673
2.624
2.577
4
3.465
3.387
3.312
5
4.212
4.100
3.993

Overview of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period

PVADn

. . .

i%
R

n-1

R: Periodic
Cash Flow

PVADn = R/(1+i)0 + R/(1+i)1 + ... + R/(1+i)n-1

= PVAn (1+i)

Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period

7%
Rs1,000.00
Rs 934.58
Rs 873.44

Rs1,000

Rs1,000

Rs2,808.02 = PVADn

PVADn = Rs1,000/(1.07)0 + Rs1,000/(1.07)1 +

Rs1,000/(1.07)2 = Rs2,808.02

Valuation Using Table

PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = Rs1,000 (PVIFA7%,3)(1.07)
= Rs1,000 (2.624)(1.07) =2,808
Period
6%
7%
8%
1
0.943
0.935
0.926
2
1.833
1.808
1.783
3
2.673
2.624
2.577
4
3.465
3.387
3.312
5
4.212
4.100
3.993

Steps to Solve Time Value

of Money Problems
1. Read problem thoroughly
2. Determine if it is a PV or FV problem
3. Create a time line
4. Put cash flows and arrows on time line
5. Determine if solution involves a single
CF, annuity stream(s), or mixed flow
6. Solve the problem

Mixed Flows Example

Rekha will receive the set of cash flows
below. What is the Present Value at a
discount rate of 10%?
10%

PV0

10%
Rs600Rs600Rs400Rs400Rs100

How to Solve?
1. Solve a piece-at-a-time
piece-at-a-time by
discounting each piece back to t=0.
2. Solve a group-at-a-time
group-at-a-time by first
breaking problem into groups
of annuity streams and any single
cash flow group. Then discount
each group back to t=0.

Piece-At-A-Time
0

10%
600

600

400

400 100

545.45
495.87
300.53
273.21
62.09

Rs1677.15 = PV0 of the Mixed Flow

Group-At-A-Time (#1)
0

600

600

10%

400

400

100

Rs1,041.60
Rs 573.57
Rs 62.10
Rs1,677.27 = PV0 of Mixed Flow [Using Tables]
Rs600(PVIFA10%,2) =
Rs600(1.736) = Rs1,041.60
Rs400(PVIFA10%,2)(PVIF10%,2) = Rs400(1.736)(0.826) =
Rs573.57
Rs100 (PVIF
)=
Rs100 (0.621) =
Rs62.10

Group-At-A-Time (#2)
0

1
400

Rs1,268.00

Plus

Rs347.20

Plus
Rs62.10

1
200

1
Rs100

400

400

4
400

PV0 equals
Rs1677.30.

200

Frequency of
Compounding
General Formula:
FVn = PV0(1 + [i/m])mn
n:
m:
i:
FVn,m:

Number of Years
Compounding Periods per Year
Annual Interest Rate
FV at the end of Year n

PV0:

PV of the Cash Flow today

Impact of Frequency
Rekha has Rs1,000 to invest for 2
years at an annual interest rate of
12%.
Annual

FV2
= 1,000(1+
[.12/1])(1)(2)
1,000
= 1,254.40

Semi

FV2
= 1,000(1+
[.12/2])(2)(2)
1,000
= 1,262.48

Impact of Frequency
Qrtly

FV2
= 1,000(1+
[.12/4])(4)(2)
1,000
= 1,266.77

Monthly

FV2

= 1,000(1+
[.12/12])(12)(2)
1,000
= 1,269.73

Daily

FV2

= 1,000(1+
1,000 [.12/365])(365)(2)
= 1,271.20

Effective Annual
Interest Rate
Effective Annual Interest Rate
The actual rate of interest earned
(paid) after adjusting the nominal
rate for factors such as the number
of compounding periods per year.

(1 + [ i / m ] )m - 1

Effective
Annual Interest Rate
Bala, the Dosawala has a Rs1,000 FD
at the XLRI, SBI branch. 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%!

Steps to Amortizing a Loan

1.

Calculate the payment per period.

2.

Determine the interest in Period t.

(Loan balance at t-1) x (i% / m)

3.

Compute principal payment in Period t.

(Payment - interest from Step 2)

4.

Determine ending balance in Period t.

(Balance - principal payment from Step 3)

5.

Start again at Step 2 and repeat.

Amortizing a Loan Example

Rekha is borrowing Rs10,000 at a
compound annual interest rate of 12%.
Amortize the loan if annual payments are
made for 5 years.
Step 1:Payment
PV0 = R (PVIFA i%,n)
Rs10,000
= R (PVIFA 12%,5)
Rs10,000
= R (3.605)
R = Rs10,000 / 3.605 = Rs2,774

Amortizing a Loan Example

End of Payment Interest Principal Ending
Year
Balance
0
------10,000
1

2,774

1,200

1,574

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

13,871

3,871

10,000

[Last Payment Slightly Higher Due to Rounding]

Usefulness of Amortization
1.

2.

Determine Interest Expense -Interest expenses may reduce

taxable income of the firm.

Calculate Debt Outstanding -- The

quantity of outstanding debt
may be used in financing the
day-to-day activities of the firm.

Present Value of a
Growing Annuity
A cash flow that grows at a
constant rate for a specified
period of time is a Growing
Annuity.

Present Value of a
Growing Annuity
You have the right to harvest a teak plantation
for the next 20 yrs. over which you expect to
get 100,000 cubic feet of teak per year. The
current price per cubic feet of teak is Rs.500,
but it is expected to increase @ 8% per yr. the
discount rate is 15%. What is the PV of teak?
PV of teak= Rs.500x100,000(1.08)
= Rs.551,736,683

Present Value of a
Growing Perpetuity
A perpetuity is an annuity of
infinite duration. Whereas a
growing perpetuity is an annuity
that grows at a constant rate till
infinity.
PV=

Present Value of a
growing Perpetuity
An office complex is expected to generate a
net rental of Rs.3 million next year, which is
expected to increase by 5% every year if we
assume that the increase will continue
indefinitely, the rental stream is a growing
perpetuity. If the discount rate is 10%, the PV
of the rental stream is:
PV=
=Rs.60 million