Time Value of Money

Topics to be Covered..
What is the Time Value of Money? Simple & Compound Interest Future Value Present Value Annuities NPV IRR PAYBACK

Time Value of Money

Which would you rather have Rs.1,000 today or Rs.1,000 in 5 years?
Obviously, Rs. 1,000 today. Everyone knows that money deposited in a savings account will earn interest. Because of this universal fact, we would prefer to receive money today rather than the same amount in the future

Simple Interest
With Simple Interest, you dont earn interest on interest Year 1: 5% of Rs.100 = Rs.5 + Rs.100 = Rs.105

Year 2: 5% of Rs.100 =
Year 3: 5% of Rs.100 =

Rs.5 + Rs.105 = Rs.110

Rs.5 + Rs.110 = Rs.115

Year 4: 5% of Rs.100 =
Year 5: 5% of Rs.100 =

Rs.5 + Rs.115 = Rs.120

Rs.5 + Rs.120 = Rs.125

Compound Interest
With compound interest, a depositor earns interest on interest! Year 1: 5% of Rs.100.00 = Rs.5.00 + Rs.100.00 = Rs.105.00 Year 2: 5% of Rs.105.00 = Rs.5.25 + Rs.105.00 = Rs.110.25

Year 3: 5% of Rs.110.25 = Rs.5 .51+ Rs.110.25 = Rs.115.76

Year 4: 5% of Rs.115.76 = Rs.5.79 + Rs.115.76 = Rs.121.55 Year 5: 5% of Rs.121.55 = Rs.6.08 + Rs.121.55 = Rs.127.63

Future Value
If you invested Rs. 4,000 today in an account that
pays 8% interest, with interest compounded annually, how much will be in the account at the end of two years if there are no withdrawals?

8%

Rs.4,000
FV

Future Value (Formula)

FV = PV (1 + i)^n
F.V Future Value

= 4000(1+0.08)^2 = Rs.4665.6

P.V Present Value i Interest Rate n Number of Compounding Period

Present Value
Assume that you need to have exactly Rs.10,000 saved 10 years from now. How much money must you deposit today in an account that pays 8% interest, compounded annually, so that you reach your goal of Rs.10,000?

8%

10

Rs.10,000
PV0

Present Value (Formula)

PV0 = FV / (1+i)n = Rs.10,000 / (1.08)10 = Rs.4631.93

0
8%

10

Rs.10,000
PV0

Annuities
An Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods FVA = A (1+i)n 1 i PVA = A 1 - [1/(1+i)n] i

Example of an Ordinary Annuity -FVA

End of Year

0 7%

1 Rs.1,000

2 Rs.1,000

3 Rs.1,000 Rs.1,070 Rs.1,145

FVA3 = Rs.1,000(1.07)2 + Rs.1,000(1.07)1 + Rs.1,000 (1.07)0 = Rs.3,215

If one saves Rs.1,000 a year at the end of every year for three years in an account earning 7% interest, compounded annually, how much will one have at the end of the third year?

Rs.3,215 = FVA3

Example of an Ordinary Annuity -PVA

End of Year

0 7%

1 Rs.1,000

2 Rs.1,000

3 Rs.1,000

Rs.934.58 Rs.873.44 Rs.816.30

Rs.2,624.32 = PVA3 PVA3 = Rs.1,000/(1.07)1 + Rs.1,000/(1.07)2 + Rs.1,000/(1.07)3 = Rs.2,624.32
If one agrees to repay a loan by paying Rs.1,000 a year at the end of every year for three years and the discount rate is 7%, how much could one borrow today?

Net Present Value

NPV = the total PV of the annual net cash flows - the initial outlay
FORMULA:

Ct=cash inflow in the period t C0=cash outflow of today K=required rate of return T=time period

Example:
This project will have an immediate cash outflow of 100,000. Other cash outflows for years 16 are expected to be 5,000 per year. Cash inflows are expected to be 30,000 each for years 16. And there are no cash flows expected after year 6. The required rate of return is 10%.

Year
T=0 T=1 T=2 T=3 T=4 T=5

Cash flow
-1,00,000/(1.10)0 30,000-5000/(1.10)1 30,000-5000/(1.10)2 30,000-5000/(1.10)3 30,000-5000/(1.10)4

Present value
-1,00,000 22,727 20,661 18,783 17,075 15,523

30,000-5000/(1.10)5
30,000-5000/(1.10)6

T=6

14,112

TOTAL

1,08,881

Internal Rate of Return (IRR)

IRR: the return on the firms invested capital. The Internal Rate of Return (IRR) of a Capital Budgeting project is the discount rate at which the Net Present Value (NPV) of a project equals zero.

IRR:

CFt t (1 + IRR)

= IO

 YEAR 0 1 2 3 4 5
Cost of capital is 10%

PROJECT A PROJECT B - 1000 - 1000 500 100 400 200 200 200 200 400 100 700

Project A

Project B

Accept if greater than or equal to the required rate of return Reject if less than required rate of return

Payback Period
Year 0 1 2 3 4 5 Cash flow -1000 500 400 200 200 200 Net Cash Flow -1000 - 500 -100 100 300 400
Payback Period Payback Period = 2 + (100)/(200) = 2.5 years