Module 2

Time Value of Money and Personal

Finance
• Time value of money: Simple Interest – Compound Interest –
Compounding Periodically and Continuously – Ordinary Annuities –
Annuities Due - Perpetuities - Effective Rate (Annual Percentage Yield) –
Concept of Time Value of Money - Future value: single cash flow - multiple
flows – annuity - Present Value: single cash flow - multiple flows – annuity –
Loans and Amortization: – Personal Finance: Reaching a Financial Goal –
Using Periodic Payments – Using Lump sum Payment - Required interest
rate to Reach Goal - Time Taken to Reach Goal – Loan Amortization –
Unpaid Balance – Effect of Paying and Extra Amount
 Question
• Suppose you were given the choice between receiving Rs 100,000 today
or Rs 100,000 in 10 years. Which option would you select?
 Reason…
• Purchasing power: Rs 100,000 can be used to buy more goods and services
today than Rs 100,000 in 10 years from now.

• Opportunity Cost: A rupee received today can be invested now to earn

interest, this can result in a higher value in the future. Sooner is better than
later.
 Time value of money
Gold Price MRF Share price
1964 63.25 2010 7579

1974 506.00

1984 1970 2014 22,200

1994 4598

2004 5850
2019 58280
2014 28006.50

2018 31438.00

2019 38755.00
 Time Preference for Money
• Time preference for money is an individual’s preference for
possession of a given amount of money now, rather than the
same amount at some future time.
• Three reasons may be attributed to the individual’s time
preference for money:
• risk
• preference for consumption
• investment opportunities

6
 Types of Interest

 Simple Interest
Interest paid (earned) on only the original
amount,
• 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 $1,000 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)

= $1,000(.07)(2)

= $140
• Simple Interest • Compound interest
• SI = P0(i)(n) • 1 year = 1000+1000(.07)
= 1070
= $1,000(.07)(2)
• 2 year = 1070 +1000(.07)
= $140 = 1144.9
= 1140
 Simple Interest and Compound Interest
• 1. If you invest Rs 15,000 in a bank account at a simple interest rate of 7 %
p.a What will be amount the end of 3 years
• A. If it is compounded annually, what will be the amount at the end of 3 rd year
 Time Value Terminology
• Compounding is the process of accumulating interest in an investment over time to earn
more interest.
• Interest on interest is earned on the reinvestment of previous interest payments.
• Discount rate is the interest rate that reduces a given future value to an equivalent present
value.
• Compound interest is calculated each period on the principal amount and on any interest
earned on the investment up to
that point.
• Simple interest is the method of calculating interest in which, during the entire term of the
loan, interest is computed on the original sum borrowed.

5-12
• Suppose you locate a two year investment that pays 14 percent per year. If
you invest Rs 325, how much will you have at the end of the two years.
• How much of this is simple interest
• How much is compound interest
 Multiple compounding
• 1 day : compounded daily
• 1 month : compounded monthly F = P( 1 + r/m)
• 3 months : compounded quarterly n*m
• 6 months : compounded half yearly
• 12 months : compounded annually
• What amount of money will be for $1000 amount to in five years time if interest is 6 per
cent per annum, compounded annually?

FV  $1000 1  0.06
5

 $1000  1.3382
 $1338.22
• From the example, now assume interest is 6 per cent per annum, compounded monthly.

FV  $1000 1  0.005
60

 $1000  1.3489
 $1348.90

5-16
• 1. If $ 8,000 is invested for 2 years at annual interest rate of 9 %,
• how much interest will be received at the end of 2 year period
• What will be the future value

• If $ 4000 is borrowed for 39 weeks at an annual interest rate of 15 % ,

• how much interest is due at the end of 39 weeks
• What will be the future value

• If $1000 is invested at 5.8% simple interest , how long it will take to grow to
$1100
 Time Value Adjustment

• Two most common methods of adjusting cash flows for time

value of money:
• Compounding—the process of calculating future
values of cash flows and
• Discounting—the process of calculating present values
of cash flows.

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 Future Value
• Compounding is the process of finding the future values of cash
flows by applying the concept of compound interest.
• Compound interest is the interest that is received on the original
amount (principal) as well as on any interest earned but not
withdrawn during earlier periods.
• Simple interest is the interest that is calculated only on the
original amount (principal), and thus, no compounding of interest
takes place.
 Example
• To see how compound interest is computed, consider the following table, which
tracks the annual growth of Rs.20,000 invested for 3 years at 10% compounded
annually.

Year Beginning Principal = P 10% Annual Interest - I Ending Principal = P+I

1 20,000.00 2,000.00 22,000.00
2 22,000.00 2,200.00 24,200.00
3 24,200.00 2,420.00 26,620.00
 Future Value
• The general form of equation for calculating the future value
of a lump sum after n periods may, therefore, be written as
follows:

Fn  P(1  i ) n
• The term (1 + i)n is the compound value factor (CVF) of a
lump sum of Re 1, and it always has a value greater than 1 for
positive i, indicating that CVF increases as i and n increase.

Fn =P  CVFn,i
 Example

• If you deposited Rs 55,650 in a bank, which was paying a 15 per cent rate of
interest on a ten-year time deposit, how much would the deposit grow at the
end of ten years?
• Option 1
Fn  P(1  i ) n
Fn  55650(1  15%)10

= Rs 225,135.287
• Option 2
• We will first find out the compound value factor at 15 per cent for 10 years
which is 4.046. Multiplying 4.046 by Rs 55,650, we get Rs 225,159.90 as the
compound value:

FV  55,650 × CVF10, 0.12  55,650  4.046  Rs 225,159.90

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• Alan and Milan want to have Rs.200,000 in Meera’s college fund
on her eighteenth birthday, and they want to know the impact on
this goal of having Rs.10,000 invested at 9.8%, compounded
quarterly, on her first birthday. To advise Alan and Milan
regarding this, find
• (a) the future value of the Rs.10,000 investment,
• (b) the amount of compound interest that the investment earns
 Solution
• a) Future value of the Rs.10,000 investment
0.098
•𝑖 = 4
= 0.0245
•𝑛 = 4 ∗ 17 = 68 𝑃 = 𝑅𝑠. 10,000
•𝑆 = 𝑃 1 + 𝑖 𝑛 = 𝑅𝑠. 10,000 1 + 0.0245 68
= 𝑅𝑠. 51,857.73
• b) Amount of interest earned is
• 𝑅𝑠. 51,857.73 − 10,000 = 𝑅𝑠. 41,857.73
• c) ??
• Suppose you need $ 400 to buy textbooks next year . You
can earn 7 percent on your money. How much you have
to put up today
 Future Value of an Annuity
• Annuity is a fixed payment (or receipt) each year for a specified number of
years. If you rent a flat and promise to make a series of payments over
an agreed period, you have created an annuity.
 (1  i) n  1 
Fn  A  
 i 
• The term within brackets is the compound value factor for an annuity
of Re 1, which we shall refer as CVFA.

Fn =A CVFA n, i
• Suppose that a firm deposits Rs 5,000 at the end of each year
for four years at 6 per cent rate of interest. How much would
this annuity accumulate at the end of the fourth year?
• Anshad deposits $ 200 at the end of each quarter in an account that pays 4%
compounded quarterly . How much money will have in his account in 3 years
 Types of Annuities
 An Annuity represents a series of equal payments (or
receipts) occurring over a specified number of
equidistant periods.
• Ordinary Annuity: Payments or receipts occur at the end of each
period.
• Annuity Due: Payments or receipts occur at the beginning of
each period.
• Ordinary Annuity • Annuity Due
1+𝑖 𝑛 −1
• 𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑃 ∗ 𝑖
 Time to reach a goal
• 1. How long does it take an investment of Rs 10,000 to double , if it is
invested at 8% compounded annually

• 2. a small business invest $ 1000 at the end of each month in an account that
earns 6 % compounded monthly. How long it will take until the business has
$ 1000,000 towards the purchase of its own office building
 Present Value

• Present value of a future cash flow (inflow or outflow) is the

amount of current cash that is of equivalent value to the
decision-maker.
• Discounting is the process of determining present value of a
series of future cash flows.
• The interest rate used for discounting cash flows is also called the
discount rate.

33
Present Value of a Single Cash Flow
• The following general formula can be employed to calculate
the present value of a lump sum to be received after some
future periods:
Fn
P  F 
n  (1  i ) n

(1  i ) n

• The term in parentheses is the discount factor or present

value factor (PVF), and it is always less than 1.0 for positive
i, indicating that a future amount has a smaller present value.

PV  Fn  PVFn,i
34
 Example
• Calculate the present value of Rs 500000 to be received after 15 years. Her
interest rate is 9 per cent.

• What amount must be invested inorder to have Rs 12,000 after 3 years , if

money is worth 6 % compounded semiannually

• You expect to receive $ 10000 bonus after 5 years on the job. You have
calculated the present value of this bonus and the answer is $ 8000 . What
discount rate did you use in your calculation

35
 Present Value of an Annuity
• The computation of the present value of an annuity can be
written in the following general form:

1 1 
P  A   OR
 i i 1  i  
n

• The term within parentheses is the present value factor of

an annuity of Re 1, which we would call PVFA, and it is a
sum of single-payment present value factors.

P = A × PVAFn, i
 PRESENT VALUE OF ANNUITY

Q. What is the present value of a 5-year ordinary annuity

with annual payments of Rs.200, evaluated at a 15 percent
interest rate?
 PRESENT VALUE OF ANNUITY

Ans. Present value of a 5-year ordinary annuity will be:

Rs.200 x PVIFA(15%, 5 years)= Rs. 200 x 3.352= Rs. 670.40

• What is the present value of annuity of Rs 1500 payable at the end of each 6
month period of 2 years if money is worth 8 % compounded semi annually
Annuities Due
• What lump sum will be needed to generate payments of ₹5000 at the
beginning of each quarter for a period of 5 years if money is worth 7%,
compounded quarterly?
.07
• 𝑖= 4
= .0175 = 1.75%; 𝑛 = 5 ∗ 4 = 20
1− 1+.0175 −20
• 𝐴20 𝐷𝑢𝑒 = $5000 × .0175
× 1.0175 = $5000 × 41.0968 =
$205,484
 PV Annuity due
• A lottery prize worth $ 12 million is awarded in payments of $ 10,000 at the
beginning of each month for 10 years. Suppose money is worth 7.8% ,
compounded monthly. What is the real value of the prize
 Capital Recovery and Loan Amortisation
• Capital recovery is the annuity of an investment made today for a specified
period of time at a given rate of interest. Capital recovery factor helps in the
preparation of a loan amortisation (loan repayment) schedule.

 1 
A= P 
 PVAFn ,i 

The reciprocal of the present value annuity factor is called the capital recovery
factor (CRF).
A = P × CRFn,i
 Amortizing a Loan Example
Julie Miller is borrowing $10,000 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)
$10,000 = R (PVIFA 12%,5)
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774
 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 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000
[Last Payment Slightly Higher Due to Rounding]
• Suppose you have borrowed a 3 year loan of Rs 10,000 at a 9 Percent interest
rate from your employer to buy a motor cycle. Calculate your annual
installment along with loan amortization schedule
• Y bought TV costing $ 13,000 and made a down payment of $ 3000, agrees
to make payment in equal annual installment of 4 years. Interest paid is
compounded annually at 14 %

• Neeraj borrows $ 80,000 for a music system at a monthly interest of 1.25

percent . The loan to be paid is 12 equal monthly installments, payable at the
end of each month. Prepare loan amortisation schedule
 Usefulness of Amortization

1. Determine Interest Expense -- Interest

expenses may reduce taxable income of
the firm.
2. Calculate Debt Outstanding -- The quantity of outstanding debt may be
used in financing the day-to-day activities of the firm.
 Sinking fund
• When the borrower wants makes a perodic deposit that will produce a
desired amount at the end of a specified period.

• Eg : You decided , you want to go for a World tour after a 3 years . You
estimated that your total expense could be 1 million. How much do you have
to deposit/ save in your account in order to achieve your target.
 Sinking Funds
• A company establishes a sinking fund to discharge a debt of $300,000 due in
5 years by making equal semiannual deposits, the first due in 6 months. If the
deposits are placed in an account that pays 6% p.a , compounded
semiannually, what is the size of the deposits?
 Present Value of Perpetuity
• Perpetuity is an annuity that occurs indefinitely. Perpetuities are not very
common in financial decision-making:
Perpetuity
Present value of a perpetuity 
Interest rate

Eg : an investment offers a perpetual cash flow of $ 500

every year. The return you require in such investment is 8
percent. What is the value of the investment
 Continuous Compounding
• Because more frequent compounding means that interest is paid more
often (and hence more interest on interest is earned), it would seem
that the more frequently the interest is compounded, the larger the
future value will become.
 Continuous compounding
• We say that as the number of periods increases, the future value approaches a limit,
which is the number 𝑒 = 2.7182818 . . . .
• In general, if $P is invested for t years at a nominal rate r compounded continuously,
then the future value is given by the exponential function
• 𝑆 = 𝑃𝑒 𝑟𝑡
• (a) Find the future value if $1000 is invested for 20 years at 8%, compounded
continuously.
• (b) What amount must be invested at 6.5%, compounded continuously, so that it
will be worth $25,000 after 8 years?
 Continuous compounding
Solutions to questions in previous slide

• (a) Find the future value if $1000 is invested for 20 years at 8%, compounded continuously.
• 𝑆 = 𝑃𝑒 𝑟𝑡
• $1000 ∗ 𝑒 20∗.08 = $4,953.03
• (b) What amount must be invested at 6.5%, compounded continuously, so that it will be worth
$25,000 after 8 years?
• 𝑆 = $25,000; 𝑟 = 0.065; 𝑡 = 8
• $25,000 = 𝑃𝑒 0.065∗8 ; $25,000 = 𝑃 ∗ 1.6820
$25,000
• 𝑃= 1.6820
= $14,863.01
 Annual Percentage Yield
• When we invest money at a given compound interest rate, the method of
compounding affects the amount of interest we earn. As a result, a rate of 8% can
earn more than 8% interest if compounding is more frequent than annually. The
rate of interest earned in reality per year is called annual percentage yield (APY), or
effective annual rate. This can be calculated as below
• Let 𝑟represent the annual (nominal) interest rate for an investment. Then the annual
percentage yield (APY) found as follows.
• Periodic Compounding. If 𝑚 is the number of compounding 𝑚
periods per year, then
𝑟 𝑟
𝑖 = is the interest rate per period, and 𝐴𝑃𝑌 = 1 + −1= 1+𝑖 𝑚−1
𝑚 𝑟 𝑚
and in continuous compounding 𝐴𝑃𝑌 = 𝑒 − 1
 Effective annual rate (EAR)
• The actual rate that you will earn from investment if there is a multiple
compounding . This will help in comparing interest rate.

• EAR = (1+ i/m)^m-1

 Eg:
• A bank is offering 12 percent compounded quaterely. If you put $ 100 in an
account, how much will you have at the end of one year? What is EAR?
How much will you have at the end of two years.
 Doubling period
• The Rule 72 says that the time to double your money approximately equals to
72/i,
 DOUBLING PERIOD
Thumb Rule : Rule of 72
Doubling period =
72
Interest rate
Interest rate : 15 percent
Doubling = 72 =
period 15 4.8 years

A more accurate thumb rule : Rule of 69

Doubling period = 0.35 + 69

Interest rate

Interest rate : 15 percent

Doubling period = 0. 35 + 69 = 4.95 years
15
• An investor deposits $10,000. Ten years later it is worth $17,910. What rate of
return did the investor earn on the investment?
• Suppose you make an investment of $10,000. This first year the investment returns
15%, the second year it returns 2%, and the third year in returns 10%. How much
would this investment be worth at the end of three years, assuming no withdrawals are
made?
• A finance company advertise that it will pay a lump sum of Rs 44650 at the end of 5
years to the investment, when you deposit annually Rs 6000 for 5 years . What is the
investment rate implicit to this offer
• Suppose that a courst settlement results in a $ 750,000 award. If this is invested at 9%,
compounded semi annually, how much will it provide at the beginning of each half year,
for a period of 7 years.