You are on page 1of 29

THE TIME VALUE OF MONEY The Magic of Compounding

By Prof Sameer Lakhani

OUTLINE
Why Time Value

Future Value of a Single Amount


Future Value of an Annuity Present Value of a Single Amount Present Value of an Annuity

Why Time Value


A rupee today is more valuable than a rupee a year hence. Why ?

Preference for current consumption over future consumption


Productivity of capital To generate Positive return. Inflation Rupee today has greater real PP. Many financial problems involve cash flows occurring at different points of time. For evaluating such cash flows, an explicit consideration of time value of money is required.

Time Line
Part A 0 12% 1 12% 10,000 10,000 2 12% 10,000 3 12% 10,000 4 12% 10,000 5

Part B

0
12% 10,000

1
12% 10,000

2
12% 10,000

3
12% 10,000

4
12% 10,000

Notation
PV : Present value FVn : Future value n years hence Ct A r g n : Cash flow occurring at the end of year t : A stream of constant periodic cash flow over a given time : Interest rate or discount rate : Expected growth rate in cash flows : Number of periods over which the cash flows occur.

Future Value Of A Single Amount


Rs First year: Principal at the beginning Interest for the year (Rs.1,000 x 0.10) 1,000 100

Principal at the end


Second year: Principal at the beginning Interest for the year (Rs.1,100 x 0.10) Principal at the end Third year: Principal at the beginning Interest for the year

1,100
1,100 110 1,210 1,210

(Rs.1,210 x 0.10) Principal at the end

121 1,331

Future Value Of A Single Amount

The process of Investing money as well as reinvesting the interest earned is called compounding. The future value or compound value of an investment after n years when the interest rate is r percent is: FORMULA FUTURE VALUE = PRESENT VALUE (1+r)n (Future value Interest factor / Future value factor)

Value Of FVr,n For Various Combinations Of r And n


n /r 2 6% 8% 10 % 12 % 14 % 1.254 1.300

1.124 1.166 1.210

4
6 8 10

1.262 1.361 1.464


1.419 1.587 1.594 1.851 1.791 2.518 1.772 2.144 2.594

1.574

1.689

1.974 2.195 2.476 2.853 3.106 3.707

Present Value of A Single Amount


PV = FVn [1/ (1 + r)n]
n/r 2 4 6% 0.890 0.792 8% 0.857 0.735 10% 0.826 0.683 12% 0.797 0.636 14% 0.770 0.592

6
8 10 12

0.705
0.626 0.558 0.497

0.630
0.540 0.463 0.397

0.565
0.467 0.386 0.319

0.507
0.404 0.322 0.257

0.456
0.351 0.270 0.208

Present Value of A Single Amount


Present Value is Inverse of compounding PV = FVn [1/ (1 + r)n]

Present Value Interest Factor (PVIFr,n)

Data : Calculate PV of Rs 1000 receivable 20 years hence if the discount rate is 8%? (Ans 214.54)

Present Value Of An Uneven Series


A1
PVn = (1 + r) 1 n t =1 + (1 + r)2 At (1 + r)t Cash Flow Rs. 1,000 2,000 2,000 3,000 3,000 4,000 4,000 5,000 PVIF12%,n 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 Present Value of Individual Cash Flow 893 1,594 1,424 1,908 1,701 2,028 1,808 2,020 13,376

A2
+ +

An
(1 + r)n

Year 1 2 3 4 5 6 7 8

Present Value of the Cash Flow Stream

Future Value Of An Annuity


An annuity is a series of periodic cash flows (payments and receipts ) of equal amounts 1,000 end of 5 years @ 10%
1 1,000 2 1,000 3 1,000 4 1,000 5 1,000 = 1000

+
1,100 = 1000 X (1.1)^ 1

1,210 = 1000 X (1.1)^ 2


+ 1,331 + = 1000 X (1.1)^ 3

1,464
Rs.6,105

1000 X (1.1)^ 4

Future value of an annuity = A x

(1+r)n-1 r
Future value Interest factor of an Annuity (FVIFAr,n)

What Lies In Store For You


Suppose you have decided to deposit Rs.30,000 per year in your Public Provident Fund Account for 30 years. What will be the accumulated amount in your Public Provident Fund Account at the end of 30 years if the interest rate is 11 percent ?
The accumulated sum will be : Rs.30,000 (FVIFA11%,30yrs) = Rs.30,000 (1.11)30 - 1 0.11

= Rs.30,000 [ 199.0209]
= Rs.5,970,626

How Much Should You Save Annually?


You want to buy a house after 5 years when it is expected to cost Rs.2 million. How much should you save annually if your savings earn a compound return of 12 percent ? The future value interest factor for a 5 year annuity, given an interest rate of 12 percent, is :

(1+0.12)5 - 1
FVIFA n=5, r=12% = 0.12 The annual savings should be : Rs.20,00,000 = Rs.314,812.81 6.353 = 6.3528

Annual Deposit In A Sinking Fund


Futura Limited has an obligation to redeem Rs.500 million bonds 6 years hence. How much should the company deposit annually in a sinking fund account wherein it earns 14 percent interest to cumulate Rs.500 million in 6 years time ?
The future value interest factor for a 6 year annuity, given an interest rate of 14 percent is : FVIFAn=6, r=14% = (1+0.14)6 1 0.14 The annual sinking fund deposit should be : Rs.500 million 8.5355 = Rs.58.5789 million = 8.5355

Finding The Interest Rate


A finance company advertises that it will pay a lump sum of Rs.8,000 at the end of 6 years to investors who deposit annually Rs.1,000 for 6 years. What interest rate is implicit in this offer?
The interest rate may be calculated in two steps : 1. Find the FVIFAr,6 for this contract as follows : Rs.8,000 = Rs.1,000 x FVIFAr,6 FVIFAr,6 2. = Rs.8,000 Rs.1,000 Look at the FVIFAr,n table and read the row corresponding to 6 = 8.000

years until you find a value close to 8.000. Doing so, we find that
FVIFA12%,6 is 8.115So, we conclude that the interest rate is slightly below 12 percent.

How Long Should You Wait


Question: You want to take up a trip to the moon which costs Rs.1,000,000 the cost is expected to remain unchanged in nominal terms. You can save annually Rs.50,000 to fulfill your desire. How long will you have to wait if your savings earn an interest of 12 percent ? The future value of an annuity of Rs.50,000 that earns 12 percent is equated to Rs.1,000,000.
50,000 x FVIFAn=?,12% = 1,000,000 50,000 x 1.12n 1 = 1,000,000 0.12

1.12n - 1 =
1.12n n log 1.12 n = = =

1,000,000 x 0.12 = 2.4


50,000 2.4 + 1 = 3.4 log 3.4 0.5315

n x 0.0492 = 0.0492

0.5315 = 10.8 years

You will have to wait for about 11 years.

Present Value Of an Annuity


You expect to receive Rs 1,000 annually for 3 years at the end of period .What is the present value of this stream if the discount rate is 10%.
1000 x 1 1.1 + 1000 x 1 1.1 2 + 1000 x 1 1.1 3

= 1000x0.9091 + 1000 x 0.8264 + 1000 x 0.7513


= Rs 2486.8 Time Line 0 1 1000 2 1000 3 1000

909.1

826.4
751.3 2486.6 Present Value

Present Value Of an Annuity


1Present value of an annuity = A
1 (1+r)n
r

Value of PVIFAr,n for Various Combinations of r and n


n /r 6 % 2 4 6 1.833 3.465 4.917 8% 1.783 2.312 4.623 10 % 1.737 3.170 4.355 12 % 1.690 3.037 4.111 14 % 1.647 2.914 3.889

6.210

5.747

5.335
6.145 6.814

4.968
5.650 6.194

4.639
5.216 5.660

10 7.360 6.710 12 8.384 7.536

Present Value Of an Annuity


1Present value of an annuity = A
1 (1+r)n
r

How much you can borrow for a Car: You can afford to pay Rs 12000 per month for 36 months at 1.5 % per month. (Ans PVIFA = 27.6607, 331928.2 )

Loan Amortisation Schedule


Loan : 1,000,000 r = 15%, n = 5 years
1,000,000 = A x PVIFAn =5, r =15% = A x 3.3522 A = 298,312
Year Beginning Annual Amount (1) 1 2 3 4 Instalment (2) (3) 150,000 127,753 102,169 727,482 Interest Principal Remaining Repayment Balance (2)-(3) = (4) (1)-(4) = (5) 148,312 170,559 196,143 225,564 851,688 681,129 484,986 259,422

1,000,000 298,312 851,688 298,312 681,129 298,312 484,986 298,312

5
a

259,422 298,312

38,913

259,399

23*

Interest is calculated by multiplying the beginning loan balance by the interest rate.

b. Principal repayment is equal to annual instalment minus interest. * Due to rounding off error a small balance is shown

Annuity Due
A 0 A
Annuity due

Ordinary annuity

A 2 A 2

A n1

A n

1 A 1

A n1 n

Thus,

Annuity due value = Ordinary annuity value (1 + r) This applies to both present and future values. So two steps are involved in calculating the value of an annuity due. First calculate the present or future value as though it were an ordinary annuity Second multiply your answer by (1 + r)

Present Value Of A Perpetuity

A perpetuity is an annuity of Infinite duration. Present value of a perpetuity is simply equal to the constant annual payment divided by the interest rate.

A Present value of perpetuity =

r
The present value of a perpetuity of Rs 10,000 if the interest rate is 10% = 10,000/0.1 = Rs 100,000.

Shorter Compounding Period


Future value = Present value 1+
Future value of a single cash flow after n years when compounding is done m times a year

mxn

Where r = nominal annual interest rate

m = number of times compounding is done in a


year n = number of years over which compounding is done
Example FV: Rs.5000, 12 percent, quarterly, 6 years

5000(1+ 0.12/4)4x6 = 5000 (1.03)24

= Rs.10,164

Example PV: RS 5,000 ,12 percent ,quarterly, 6years PV = Rs 5,000 X PVIF(12/4) , (6x4) = Rs 5000 x 0.4919 = Rs 2459.66

Effective Versus Stated Rate


Rs 1000 will grow to Rs 1123.6 at the end of a year if the stated rate of interest is 12 percent and compounding is done semi annually. This means that Rs 1000 grows at the rate of 12.36

percent per annum.The figure of 12.36 percent is called the effective interest rate the rate
of interest under annual compounding which produces the same result as that produced by an interest rate of 12 percent semi annual compounding.

Effective interest rate = 1 + Stated annual interest rate m

m -1

Effective Versus Stated Rate


Example : k = 8 percent, m=4 r = (1+.08/4)4 1 = 0.0824 = 8.24 percent
Nominal and Effective Rates of Interest
Effective Rate % Nominal Rate % 8 12 Annual Compounding 8.00 12.00 Semi-annual Compounding 8.16 12.36 Quarterly Compounding 8.24 12.55 Monthly Compounding 8.30 12.68

QUESTION
Q) A 12 payment annuity of Rs 10,000 will begin 8 years hence.( The first payment occurs at
the end of 8 years).What is the Present value of this annuity if the discount rate is 14 percent? Ans Step No 1 - Rs 10,000 (PVIFA 14% , 12 years) = Rs 10,000 (5.660) = Rs 56,600

Step No 2 - Rs 56,600 (PVIF 14%, 7 years) = Rs 56,600 (0.400) = Rs 22,640.


Q) What is the present value of an Income stream which provides Rs 2,000 a year for the first five years and Rs 3,000 a year forever thereafter if the discount rate is 10 percent?

Hint: The present value for a perpetual annuity is derived by dividing the constant annual
flow by the discount factor? Ans The present value of the income stream is: 2,000 x PVIFA (10%, 5 years) + 3000/0.10 x PVIF (10%, 5 years)

= 2,000 x 3.791 + 3000/0.10 x 0.621


= Rs.26,212

QUESTION
Q) As a winner of a competition you can choose one of the following prizes:
a) Rs 5,00,000 now b) Rs 1,000,000 at the end of 6 years c) Rs 60,000 a year forever

d) Rs 1,00,000 per year for 10 years


e) Rs 35,000 next year and rising thereafter by 5 % per year forever. If the interest rate is 10% which prize has the highest present value .

Ans

a)
(b) (d)

PV = Rs.500,000
PV = 1,000,000 PVIF10%,6yrs = 1,000,000 x 0.564 = Rs.564,000 PV = 100,000 PVIFA10%,10yrs = 100,000 x 6.145 = Rs.614,500

(c ) PV = 60,000/r = 60,000/0.10 = Rs.600,000

(e)

PV = C/(r-g) = 35,000/(0.10-0.05) = Rs.700,000

Option e has the highest present value viz. Rs.700,000

THANK YOU

You might also like