Chapter 2

TIME VALUE OF MONEY

Learning Objectives

After reading this chapter, my students will able to understand

 Meaning and Concept of Time Value of Money.
 Basic Components of Time Value of Money.
 Cash Flow Time Line.
 Future Value and Present Value
 Several Compounding other than annual compounding
 Effective Annual Interest Rate.
 Annuities and its Types.
 Loan Amortization Schedule.
 Perpetuity
120| FUNDAMENTALS OF FINANCIAL MANAGEMENT

Main Ideas from this chapter:

This chapter predicts the clear picture of value of money at different period of time and
how it is affected by the rate of interest. The core ideas of this chapter are to make one
clear about the value of money and eyes to know the difference between same amount of
money at two points of time as well as making decision in short and long-term. It also
deals with the even and uneven cash flows using cash flow time line and their
significance. Furthermore, it deals with loans, its payment modes, Annuity, Perpetuity,
Several ways of compounding, nominal and effective interest rate.

MEANING AND CONCEPT OF TIME VALUE OF

MONEY
In the world of Business, the time value of money is the best concept and plays a crucial
role. The theories developed in economics relating to saving and investment, the concept
of inflation, consumer price index are the motivators of the time value of money. When
any people save their money into a bank or any saving association then which factor
motivates them to save their money? Why do people establish a venture? What is the
meaning and concept of business and investment and why it takes place? The only
answer is the return in the form of interest or any other. Hence, the time value of money
is the difference in values of any investment or saving or borrowings etc at two different
point of time.

There are several reasons for the existence of time value of money viz the cost of living
does not remain constant; the consumer price index goes on increasing. Hence, the time
value of money remains constant forever then there is no existence of the world of
business and finance.
There are two basic components for the existence of the time value of money which are:

(a) Time Duration (n) and

(b) The rate of interest (i).

If any case, one of above two components are missing then the time value of money do
not take place because, if there is no investment opportunities (i=o%) then the value of
money at all the periods will be the same. Similarly, just holding some amount of money
immediately does not grow without time frame even the market has several investment
opportunities.
 TIME VALUE OF MONEY |121
Example 1 If No Investment Opportunities ( i.e; i=0%)
Suppose you are investing Rs. 1,000 at 0% interest for 1 year, 5 years, and 10 years or
more then the future value will also be as equal to present value Rs. 1,000. Which is
similar to put the money inside the grave? It means, if there are no investment
opportunities, then there is no time value of money.

Example 2 If time (n) = 0 period

Suppose the going rate of interest in the market is 10%, 20%, 50% or any i%, but you
don't have even a single second to invest then your money will not be charged.
Finally, it can be concluded that the time value of money means the value of Re. 1 oh
hand today and the value of money after 'n' year will not be same. When there are certain
investment opportunities. Furthermore, the investment opportunities or the interest on
investment is not the simple interest but it is compounding interest. There is very famous
quotation by Albert Einstein is that, “I don’t know what the Seven Wonders of the
World is, but I know the eighth – THE COMPOUND INTEREST”

CASH FLOW TIME LINE

Cash flow represents the flow of money, whether it is inflow or outflow. The cash flow
time line means the clear-cut picture of inflows and outflows in a line with time period.
1000 2000 3000 4000 5000

The 0 1 2 3 n above
cash flow
time line shows the cash outflow in year 1, Rs. 3,000 inflow in year 2, Rs. 4,000, inflow
in year 3 and Rs. 5,000 in year 'n'.
The cash flow time line has great value to explain the time value of money. Furthermore,
it is the simple and easiest way to explain the several values like investment, rate of
return, income in the future, total value in the future etc.
There are two types of cash flows they are:
1. Even Cash Flows
2. Uneven Cash Flows
Even Cash Flows
If the cash flows are equal in every point of time then it is called even cash flow. The
eve cash flows are also known as annuity if certain time periods are given. If the time
period is not given then it is known as perpetuity. Look at the following:

2000 2000 2000 2000

0 1 2 3 4
122| FUNDAMENTALS OF FINANCIAL MANAGEMENT
Uneven Cash Flows
If the cash flows are not equal in every year or every point of time, then it is called
uneven cash flows. Look at the following cash flow time line:

2000 2500 3000 3500

0 1 2 3 4

FUTURE VALUE (FVn)

It is the value of money at any time. In other words, it is the compounded value to a
certain amount today at certain interest rate up to a certain period of time. It is not
necessarily mean that there must be single value today to find the future value, there may
be several value today, after certain time and so on.

FV = PV (1 + i)n Formula for numerical solution.

Alternatively,
FV= PV  FVIF(i, n) Tabular approach

Example
Suppose, you invest Rs. 1,000 in a security for 5 years and which produces a rate of
return of 10% p.a., what will be the future value of your investment after 5 years?
Given:
Present value (Investment today) PV = Rs 1,000
Time of investment (n) = 5 years
Annual rate of interest (i) = 10%
Value of investment after 5 years (FV) =?
We have,

Numerical Solution:
Fv = PV (1 + i) n = 1,000(1 + 0.10)5
= 1610.51
Tabular Approach
FV= PV  FVIF i, n = PV  FVIF10%, 5 yrs
= 1,000  1.6105 = 1610.51
Hence, the future value of your Rs.1000 will be Rs. 1610.51 after 5 years at 10% rate of
return.
 TIME VALUE OF MONEY |123
PRESENT VALUE
It is the value of money on hand today or, discounted value of money to certain future
values of specified period of time at a certain discount rates. It is not necessarily mean it
is a discounted value to a single future value it can be the present values of several future
values at different points of time.

FV
PV = Numerical Solution Approach
(1  i) n
Alternatively,
PV = FV  PVIF i, n Tabular Approach
Example
Suppose, you are planning to accumulate Rs.22000 after 4 years to fulfill your
requirements in that time and planned to deposit certain amount into a bank account
which produces 11% rate of interest. So, what amount should you deposit today to
fulfill your requirements?
Given,
Future Value (FV) = Rs.22000
No. of Years (n) = 4 years
Annual Interest rate ( I ) = 11%
Present Value ( PV) = ?
Here,

I=?
We know that,
FV
Present Value (PV) =
(1  i) n
22,000
Or, PV =
(1  0.11) 4
Or, PV = RS. 14492.08

Alternatively,
124| FUNDAMENTALS OF FINANCIAL MANAGEMENT
PV = FV x PVIF( i , n)
Or, PV = 22000 x PVIF11%, 4 years
Or, PV = 22000 x 0.6587
Or, PV = RS.14491.4
Hence, the amount you should deposit to fulfill your requirement is Rs. 14492.08.
Note: The present value calculated by using formula and the table are not the same
because, the tabular value is slightly rounded to only four digits after decimal.

COMPUTATION OF NO. OF YEARS (n) AND RATE OF INTEREST (i)

The above two values, the present value and future value are dependent upon the time
period (n) and the rate of interest (i). If one of these components are missing then there
will be no difference between the present and future value. Hence, al l the four
components are equally valuable in time value of money. Which are:
FV, PV, i and n.
If one of above value is missing, then that can be calculated by suing the above
formula.
Condition 1: Finding of Rate of Interest (i)
At what % annual interest rate Rs. 5,000 will be doubled after 5 years?
Before solving this problem, one can explain that to double Rs. 5,000 in 5 years
means 100% in 5 years. So, dividing 100% by 5 = 20% per annum, which is the
concept of simple interest but we do consider the compounding interest rate in the
real world. Hence, the problem can be solved as:
PV = 5,000 i=?
F V = 10,000

0 1 2 3 4 5
Here,
Present Value (PV) = Rs. 5,000
Future Value (FV) = Rs. 10,000 (double means 5,000  2)
Time (n) = 5 years
Annual interest rate =?
We know that, (We can use any formula)
Future Value (FV) = PV(1 + i)n
or, 10,000 = 5000(1 + i)5
1
 10,000  5
or,   1= i
 5,000 
or, i = 0.1487 or 14.87%.
 TIME VALUE OF MONEY |125
Alternatively,
FV = PV  FVIFi%, n years
or, 10,000 = 5,000  FVIFi%, 5 years
10,000
or, = FVIF i%, 5 years
5,000
or, FVIF i%, 5 years =2
Now, considering the FVIF table to find the value '2' in year '5'. The value '2' does
not lie exactly at any %, it lies between 14% and 15% in year's row.
The values, FVIF14%, 5 years = 1.9254
FVIF15%, 5 years = 2.0114
Now, we can interpolate it by using the following formula:
DFLR -Factor
i = LR   (HR-LR)
DFLR -DFHR
1.9254 - 2
= 14   (15 - 14)
1.9254 - 2.0114
= 14.87%
Hence, the required rate to double the Rs. 5000 in 5 years is 14.87%.

Condition 2 : Finding out the no. of years (n)

Mr. Rajat requires Rs.56000 in the future and currently he has only Rs. 24000 and
planning to deposit this amount to a bank account which pays 15% annual interest.
How long will it take him to accumulate his targeted amount?
Given,
Present Value (PV) = RS. 24000
Future Value (FV) = RS. 56000
Annual interest rate (i) = 15%
No. of years (N) =?
Here,
P V = 24
, 000 i = 15%
F V = 56,000

0 1 2 N=?

We know that,
FV= PV  (1+i) n
Or, 56000 = 24000 (1+0.15) n
56,000
Or, = 1.15n
24,000
Or, 2.3333 = 1.15n
Taking the help of Log in the both side to solve the value of ‘n’
126| FUNDAMENTALS OF FINANCIAL MANAGEMENT
Log 2.3333 = n Log 1.15
Log.2.3333
Or, n =
Log1.15
Or, n = 6.0623 years.
Alternatively,
FV = PV x FVIF (i%, n Years)
Or, 56000 = 24000 x FVIF 15%, n years
56,000
Or, FVIF 15%, n years =
24,000
Or, FVIF 15%, n years = 2.3333

Now, looking at the FVIF table to find the value ‘2.3333’ in which year it lies at 15%.
The value 2.333 lies between 6 and 7 years.
FVIF15% 6years = 2.3131
FVIF15% 7 years = 2.6600
Now, we can interpolate it as:
n =

DF Lower Year - Factor

Lower Year   (Higher Year - Lower Year)
DFLower Year - DF Higher Year
2.3131 - 3.3333
= 6  (7 - 6)
2.3131 - 2.6600
= 6.0623 Years.
Hence, the deposit of Mr. Rajat Rs. 24000 will be Rs. 56000 in 6.0623 years at 15%
annual interest.

SEVERAL COMPOUNDING OTHER THAN ANNUAL

COMPOUNDING
In the today's business world, the interest is not being compounded annually only. These
days, the financial institution started to pay the interest semi-annually, quarterly, monthly,
weekly, daily or spontaneously. There, different types of compounding brakes difference
in the values. If the interest compounds more than future value will be higher. It means, if
the bank 'A' pays 10% interest annually and bank 'B' pays the same 10% semi-annually
then one can make more money by depositing in bank 'B'. In contrast, the more
compounding decreases the present value more compounding decreases the present value
proportionately. These are illustrated below:
Compoundin i n FV PV
 TIME VALUE OF MONEY |127
g
n FV
Annually i% FV = PV(1 + i)n PV =
years (1  i) n
FV
i i 2n
Semi-annually 2n FV = PV(1 + ) PV = i
2 2 (1  ) 2n
2
FV
i i 4n
Quarterly 4n FV = PV(1 + ) PV = i
4 4 (1  ) 4n
4
FV
i i 12n
Monthly 12n FV = PV(1 + ) PV = i
12 12 (1  )12n
12
FV
i i 52n
Weekly 52n FV = PV(1 + ) PV = i 52n
52 52 (1  )
52
PV =
i i FV
Daily 365n FV = PV(1 + )365n
365 365 i 365n
(1  )
365

Continuously Compounding
FV = PV  ei  n
FV
PV =
e in
Where,
e = base of natural log (i.e. 3.71828)

Example:
a. Find the future value of RS. 60000 at 14% annual interest rate after 6 years
under each of the following compounding:
(i) Semiannually?
(ii) Quarterly?
b. Find the present value of Rs. 88000 due in 7 years discounted at 12% under each
of the following discounting:

(i) Semiannually?
(ii) Quarterly?
c. What conclusion can you draw from the results of part a. and b?
Given,
Present value (PV) = Rs. 60,000
128| FUNDAMENTALS OF FINANCIAL MANAGEMENT
Annual Interest Rate (i) = 14%
No. of Years (n) = 6
Future Valye (FV) = ??
a.
i = 14% FV = ?
6
0 1 2 3 4 5
PV=Rs. 60,000

i. Compounded Annually
FV = PV(1+i)n = 60,000(1 + 0.14)6 = Rs. 131,698.36

ii. Compound Semi-annually

i 0.14 62
FV = PV(1+ )2n= 60,000(1+ ) = RS. 135,131.50
2 2
iii. Compounded Quarterly
i 4n 0.14 64
FV = PV(1 + ) = 60,000(1+ ) = Rs. 136,999.71
4 4
iv. Compounded Monthly
i 12n 0.14 612
FV = PV(1+ ) = 60,000(1+ ) = Rs. 138,307.90
12 12

b.
Future Value (FV) = Rs. 88,000
No. of years (n) = 7 years
Annual Interest Rate (i) = 12%
Present Value (PV) =?
i = 12% FV = 88,000
6
0 1 2 3 4 5
PV=?

i. Annually
88,000
FV 7
PV = =  0.12  = Rs.39,806.73
(1  i) n 1  
 2 
ii. Semiannually
FV 88,000
2n 7 2
PV =  i =  0.12  = Rs. 38,922.48
1   1  
 2   2 
iii. Quarterly
FV 88,000
4n 7 4
PV =  i =  0.12  = Rs. 38,462.75
1   1  
 4  4 
 TIME VALUE OF MONEY |129
iv. Monthly
FV 88,000
12n 712
PV =  i  =  0.12  = Rs. 38,149.36
1   1  
 12   12 
c. The above results shows that more the no. of compounding higher will be the
future value. It means, the future value of same Rs. 60,000 is higher in
semi-annual compounding as compare to annual compounding and so on. In
contrast, more the no. of compounding lower the present values.

EFFECTIVE ANNUAL INTEREST RATE (EAR)

It is the actual rate of return under different compounding situations. If the compounding
is annual then the effective rate is also same as simple annual rate but in other situations,
the effective annual rate will be different than the simple rate.
Mathematically,
m
 i 
EAR = 1    1
 m 
Where,
i = Simple annual rate
m = No. of compounding per year

In case of annual compounding; m = 1

In case of semi-annual compounding; m = 2
In case of quarterly compounding; m = 4
In case of monthly compounding; m = 12
In case of weekly compounding; m = 52
In case of daily compounding; m = 365
In case of continuously compounding, we cannot indicate the actual no. of
compounding. So, we use the base of natural log.
 EAR = ei - 1

Example:
Suppose that an investment promises to pay a nominal 12 percent annual interest.
What is the effective annual interest rate on this investment assuming that interest is
compounded?
i. Annually?
ii. Semiannually?
iii. Quarterly?
iv. Monthly?
v. Weekly?
130| FUNDAMENTALS OF FINANCIAL MANAGEMENT
vi. Daily?
Given,
Annual interest rate (i) = 12%
Effective Annual Interest rate (EAR) =?
i. If it is compounded annually: m = 1
In case of annual compounding the nominal interest rate and the EAR will be the
same. Which can be verified as?
We have,
m
 i 
EAR = 1    1
 m
So, here m = 1
1
 0.12 
EAR = 1   1 = 0.12 or 12%
 1 
ii. If the interest is compounded semi-annually: m = 2
i = 12%

0 6m 12m
2
 0.12 
EAR = 1   1 = 12.24%
 2 
iii. If the interest is compounded quarterly: m = 4
i = 12%

0 3m 6m 9m 12m
4
 0.12 
EAR = 1   1 = 12.55%
 4 

iv. If it is compounded monthly: m = 12

0 1 2 4 5 6 7 8 9 10 11 12
3
12
 0.12 
EAR = 1   1 = 12.68%
 12 
v. If it is compounded weekly: m = 52
52
 0.12 
EAR = 1    1 = 12.73%
 52 
vi. If it is compounded daily : m = 365
365
 0.12 
EAR = 1    1 = 12.7475%
 365 
vii. If it is compounded continuously: m = 
EAR = ei - 1 = e0.12 - 1 = 12.75%

ANNUITY
 TIME VALUE OF MONEY |131
Annuity is an equal series of amount either payments or receipts with the same intervals
of time. These days the concept of annuity are being applied in every sector like banks
and finance companies for the settlement of loans, insurance companies, pension funds,
housing and construction companies etc. To indicate the annuity the terms like, each
year, every year, equally, each month, every 6 months, each quarter, every quarter, each
month, every months etc are being used.
The annuities are of two types:
a. Ordinary (Deferred Annuity)
b. Annuity Due
Ordinary (Deferred) Annuity
Normally, the annuity indicates the ordinary annuities. If the payments are made at
the end of each period, then it becomes ordinary (deferred) annuity.
1200 1200 1200 1200 1200

0 1 2 3 4 5
Future value of Annuity (FVAn)
FVAn = PMT  FVIFA i%, n years

Alternatively,
 (1  i) n - 1 
FVAn = PMT 
 i 
PVAn = PMT  PVIFA i, n
Alternatively,
 1 
1- 
 (1  i) n 
PVAn = PMT 
i
 
 
Annuity Due:
It is another type of annuity in which the every payment takes place at the beginning of
the defined period of time. The first payments being made today is known as annuity due.
Due the first payment being made immediately, the total future values and the total
present values of same annuities will be greater as compare to ordinary annuities value.

1200 1200 1200 1200 1200

0 1 2 3 4 5
All the formula should be multiplied by '(1 + i)'.
FVAn due = [PMT  FVIFAi,n] [1 + i]
Alternatively,
132| FUNDAMENTALS OF FINANCIAL MANAGEMENT
 (1  i) n - 1 
FVAn due = PMT (1  i )
 i 
PVAn due = [PMT  PVIFA i, n] [1 + i]
Alternatively,
 1 
1- 
(1  i) n
PVAn = PMT  (1  i )

i
 
 
Example
Find the present value of the following ordinary annuities:
a. Rs. 700 per year for 10 years at 12 percent.
b. Rs. 350 per year for 5 years at 6 percent.
c. Rs. 700 per year for 9 years at 0 percent
d. Now rework Parts a, b and c assuming that payments are made at the beginning of
each year, that is, they are ordinary annuities.
Solution:
Given,
a. Annual Payment (PMT) = Rs. 700
No. of payments (n) = 10
Annual interest rate (i) = 12%
Present value of Annuity (PVA) = ?
Here,

700 7 00 7 00 7 00 7 00 7 00 7 00 7 00 7 00 7 00

0 1 2 3 4 5 6 7 8 9 10

We know that,
Present value of Annuity (PVAn) = PMT  PVIFAi,n
= 700  PVIFA12%,10
= 700  5.6502
 TIME VALUE OF MONEY |133
= Rs. 3955.16
Alternatively,
 1   1 
1 - (1  i) n  1 - (1  0.12)10 
PVAn = PMT   = 700  
 i   0.12 

 
 
 


= 700  5.6502 = Rs. 3,955.16

Hence, the present value of Rs. 700 per year for 10 yrs at 12% is Rs. 3,955.16
b. Annual payment (PMT) = Rs. 350
No. of payments (n) = 5
Annual interest rate (i) = 6%
Present value of Annuities (PVAn) = ?
Here,
350 350 350 350 350
0 1 2 3 4 5

We have,
PVAn = PMT  PVIFAi,n
= 350  PVIFA6%,5yrs
= 350  4.2124
= Rs. 1,474.34
Alternatively,
 1   1 
1 - (1  i) n  1 - (1  0.06) 5 
PVAn = PMT   = 350   = Rs. 1,474.33
 i   0.06 

 
 
 

Hence, the present value of Rs. 350 per year for 5 yrs at 6% is Rs. 1,474.33
134| FUNDAMENTALS OF FINANCIAL MANAGEMENT
c. Given,
Annual Payment (PMT) = Rs. 700
Annual interest rate (i) = 0%
No. of payment (n) = 9
Present value of Annuity (PVAn) = ?
700 7 00 7 00 7 00 7 00 7 00 7 00 7 00 7 00

0 1 2 3 4 5 6 7 8 9

i = 0%
As we should know that, if there is no interest rate then there is no time value of
money. So, the present value of Rs. 700 per year for 9 yrs at 0% is Rs. 6,300 (700  9)

d. Now, re-working the part a, b and c as annuities due.

a.
700 700 7 00 7 00 7 00 7 00 7 00 7 00 7 00 7 00

0 1 2 3 4 5 6 7 8 9 10

We have,
PVAn due = PMT  PVIFAi,n  (1+i)
= 700  PVIFA12%,10  (1+0.12)
= 700  5.6502  1.12
= Rs. 4,429.76
Hence, the present value of annuity due is Rs. 4,429.76
 TIME VALUE OF MONEY |135
b.
350 350 350 350 350
0 1 2 3 4 5

We have,
 1 
1 - (1  i) n 
PVAn due = PMT   (1  i ) =
 i 

 


 1 
1 - (1  0.06) 5 
350   (1  0.06)
 0.06 

 

= Rs. 1,562.79
Hence, the present value of Rs. 350 per year for 5 years at 6%, (the payments are
made at the beginning) is Rs. 1,562.79
c. The present value of ordinary annuities and annuity due will be the same of there
is no investment opportunity (i = 0%)
 PVAn due = Rs. 6,300 (i.e. 9  700)

AMORTIZATION OF LOANS
A term loan is a contract under which a borrower agrees to make a service of interest and
principle payment on specific date to the lender. It is usually negotiated directly between
the borrowing firm and a financial institution collected funds from term loan are
generally used to finance the payment working capital and fixed assets.
If term loan is to be repaid in equal periodic installed, it is called as amortized loan. The
term amortized has derived from the Latin word Movs, means ‘death’ so an amortized
loan is one that is ‘killed off’ over time. It refers to the determination of equal periodic
payment, finding the interest amount for each payment period and finding the repayment
of principal in order to determine the ending balances of principal. It is a contract under
which a borrower agrees to pay an equal amount of payment for the specified time
period. The loan amortization process involves finding the future payments over the term
of the loan, whose present value equals to the amount of initial principal borrowed.
Lenders use the loan amortization schedule to determine periodic equal payments and the
allocation of each payment to interest and principal. There are mainly two steps involved
136| FUNDAMENTALS OF FINANCIAL MANAGEMENT
in loan amortization schedule. Calculation of periodic payment (installment) and set up
loan amortization schedule.
1) Determine periodic payment (installment)
Loan amount
The periodic installment (PMT) =
PVIFA , k , n years
General schedule for loan amortization:
Year PMT Interest Repayment of Principal Remaining Balance
0
1
2
3
N Nil
Note: the remaining balance in the final year must always be zero.
Where,
PMT = Periodic payments or equal installment
Interest = It is the amount calculated from the remaining balance of the loan
Repayment of Principal = PMT - Interest
Remaining balance = Previous period’s remaining balance- repayment of principal
Example
Suppose Loan Amount is Rs 10000 at 10% interest rate for the 5 years and
agreement has been made to make equal annual end of year payment over 5 years,
than the annual payment is determined as:
Required:
a. Annual Installment
b. Loan Amortization Schedule
c. What fraction of the payment represents repayment of principal in year 2?
Solution:
a.
Loan amount
Annual Payment = = = 2637.96
PVIFA10%,5 years
Hence, annual installment for the loan is Rs. 2637.96.

b. Setting Loan Amortization Schedule

Loan Amortization Schedule could be set up as follows:
Year Installment Interest Repayment of Ending
s (PMT) Principal Balance
0 - - - 10,000
1 2637.96 1,000 1,637.96 8,362.04
2 2637.96 836.20 1,801.756 6560.284
4
3 2637.96 656.02 1981.932 4578.352
8
 TIME VALUE OF MONEY |137
4 2637.96 457.83 2180.125 2398.227
5
5 2637.96 239.82 2398.227 0
2
138| FUNDAMENTALS OF FINANCIAL MANAGEMENT
c. Fraction of Payment representing repayment of principal in year 2
Repayment of Principal in Year 2 1801.756
= = = 0.6830 or,
Annual Payment 2637.96
68.30%
Hence, the fraction of payment representing the repayment of principal in Year 2 is
0.6830. It means, the payment Rs. 2637.96 includes 68.30% repayment.
Repayment of Principal= Installment- Interest
Ending Balance= Beginning Amount- Repayment of Loan

PERPETUITY
Basically, the concept of perpetuity is applicable in the Pension amount and
insurance payment as well as perpetual debt. The perpetuity is also similar with
annuity but with a '' period of time. Hence, the future value of perpetuity cannot be
calculated.
PMT
Present value of Perpetuity (PVP) =
i
By using above formula, any one of above '3' value can be computed.
Example
Find the present value of a cash flow stream of Rs. 2000 forever discounted at 8%
per annum. What would happen to the present value if the interest in general were to
doubled to 16% per annum?
Given,
PMT = Rs. 2000
i = 8%
PVP =?
We have,
PMT 2000
PVP = = = Rs. 25,000
i 0.08
Hence, the present value of Perpetuity is Rs. 25000.
If the interest rate were 16%
Again We have,
PMT 2000
PVP = = = Rs. 12,500
i 0.16
Hence, the present value of perpetuity is Rs. 12500 at 16% annual interest.

 ILLUSTRATIVE PROBLEMS
Illustration No. 1
 TIME VALUE OF MONEY |139
You will require Rs. 1000 in 6 years. If you earn 7 percent interest on your funds, how
much will you need to invest today in order to reach your savings goal?
Solution:
Given,
Future Value (FV) = Rs. 1,000
Annual Interest rate (i) = 7%
No. of years (n) = 6 yrs
Present Value (PV) =?

P V= ? F V = R s . 1 ,0 0 0

0 1 2 3 4 5 6

We have,
FV 1000
Present Value (PV) = n = = Rs. 666.34
(1  i) (1  0.07)6
140| FUNDAMENTALS OF FINANCIAL MANAGEMENT
Alternatively,
PV = FV  PVIF i, n
= 1000  PVIF7%, 6yrs
= 1000  0.6663
= Rs. 666.3
Hence, the amount to be inverted today is Rs. 666.34 to accumulate Rs. 1,000 after 6 yrs
at 7%.
Illustration 2
If you deposit Rs 50,000 in a saving account that pays 12 percent interest annually, how
much money will be in your account after 8 years?
Solution:
Given,
Present Value (PV) = Rs. 50,000
Annual Interest Rate (i) = 12%
No. of years (n) = 8 years
Future Value (FV) = ?
Here,

F V= ?

0 1 2 4 5 6 7 8
3
P V= R s . 50 ,00 0

We know that,
Future Value (FV) = PV(1 + i)n
= 50,000(1+0.12)8
= Rs. 123,798.16
Alternatively,
FV = PV  FVIFi,n
= 50,000  FVIF12%,8yrs
= 50,000  2.4760
= Rs. 123,800
Hence, the deposit of Rs. 50,000 today will be Rs. 123,798.16 after 8 yrs at 12%.

Illustration 3
Use the tables or a numerical solution approach to find the following values:
a. An initial Rs.8000 compounded for 5 years at 9 percent.
b. An initial Rs. 7700 compounded for 10 years at 9 percent.
c. The present value of Rs. 25000 due in 11 years at a 8.5 percent discount rate.
 TIME VALUE OF MONEY |141
Solution:
a. Present value (PV) = Rs. 8,000
Annual Interest Rate (i) = 9%
No of years (n) = 5 yrs
Future Value (FV) = ?

FV = ?
0 1 2 3 4 5
P V = R s . 8, 0 00 i = 9%

We have,
Future value (FV) = PV(1+i)n
= 8,000(1+0.09)5
= Rs. 12,309
b. PV = Rs. 7,700
i = 9%
n = 10 yrs
FV = ?

FV= ?

0 1 2 3 4 5 6 7 8 9 10
P V= R s . 7,7 00

We have,
FV = PV(1+i)n
= 7,700(1+0.09)10
= Rs. 18,228.70
c. FV = Rs. 25,000
i = 8.5%
n = 11 yrs
PV = ?
i = 8.5 %

11
0 1 2 3 4 5 6 7 8 9 10
P V= ?

We have,
Fv 25,000
PV = n = = Rs. 10190.91
(1  i) (1  0.085)11
Hence, the present value of Rs. 25,000 due in 11 yrs discounted at 8.5% is Rs. 10,190.91
Illustration 4
142| FUNDAMENTALS OF FINANCIAL MANAGEMENT
If you deposit a sum of money today into a bank account that pays 14 percent interest,
how long will it take for you to triple your money?
Solution:
Given,
Present Value (PV) = X (Let)
Future Value (FV) = 3X
Annual interest rate (i) = 14%
No. of years (n) = ?
X 3X

0 n= ?

We have,
FV = PV(1+i)n
3X = X(1 + 0.14)n
3X
= 1.14n
X
3 = 1.14n
Taking log on both sides
nlog 1.14 = log 3
Log3 4.7712
n = =
Log1.14 0.5690
n = 8.3845 yrs
Hence, to triple the any amount of money at 14% takes 8.3845 yrs

Illustration 5
The prize of last month’s Pokhara lottery was estimated to be worth Rs. 50 million. If
you were lucky enough to win, the state will pay you Rs.5 million per year over the next
10 years. Assume that the first installment is received immediately.
a. If interest rates are 7 percent, what is the present value of the prize?
b. If interest rates are 10 percent, what is the future value after 10 years?
c. How would your answers change if the payments were received at the end of each
year?
Solution:
Given,
Normal prize of Pokhara Lottery = RS. 50 M
Prize in annual installment (PMT) = Rs. 5 M
No. of Installment (n) = 10
 TIME VALUE OF MONEY |143
5m 5m 5m 5m 5m 5m 5m 5m 5m 5m
0 1 2 3 4 5 6 7 8 9 10

a. If annual interest rate (i) = 7%

Present value of prize (PVAN due ) = ?
Note: The 1st Installment is receivable immediately
We know that,
PVAn due = PMT  PVIFAi,n  (1+i)
= 5 M  PVIFA7%,10  (1+0.07)
= 5 M  7.0236  1.07
= 37.5762 M
Hence, the present value of the prize of lottery is RS. 37.5762 M.
Alternatively,
 1 
1 - (1  i) n 
PVAn (due) = PMT   (1  i)
 i 

 

 1 
1 - (1  0.07)10 
= 5M   (1  0.07 )
 0.07 

 

= Rs. 37.5762 M
b. Given,
PMT = Rs. 5 M
I = 10 %
n = 10 yrs
FVAn due = ?
144| FUNDAMENTALS OF FINANCIAL MANAGEMENT

5m 5m 5m 5m 5m 5m 5m 5m 5m 5m

0 2 6 7 8 9 10
1 3 4 5

We know that,
FVAn due = PMT  FVIFAi,n  (1+i)
= 5 M  FVIFA10%,10  (1+0.10)
= 87.6558 M

Alternatively,
 (1  i) n - 1
FVAn (due) = PMT   (1  i)
 i 
 (1  0.10)10 - 1
= 5M   (1  0.10)
 0.10 
= Rs. 87.6558 M
Hence, the future value of the prize will be Rs. 87.6558 M.
c. If the prize at the lottery was paid at the end of every year then,
a. PVAn = PMT  PVIFAi,n
= 5 M  PVIFA7%,10
= 35.1179 M
b. FVAn = PMT  FVIFAi,n
= 5 M  FVIFA10%,10
= 79.6871 M
Hence, the future value of the prize is Rs. 79.6871.
 TIME VALUE OF MONEY |145
Illustration No. 6
Your elder brother is currently 35 years old and wants to begin saving for retirement.
You advise him put Rs. 7,000 a year into the derivatives market. You estimate that the
market's return will be, on average, 18 percent a year. Assume the investment will be
made at the end of the year.
a. If your brother follows your advice, how much money will he have by age of 55?
b. How much will he have by age of 60?
Solution:
Annual investment (PMT) = Rs. 7,000
Annual interest rate (i) = 18%
a. No. of year (n) = 20 yrs (i.e. 55-35)
Future value of Annuity (FVAn) = ?
Here,
7000 7000 7000 i = 18%
7000 7000
FVAN = ?

35 37 38 n = 20 yrs 54 55
36
We know that,
Future value of Annuity (FVAn) = PMT  FVIFAi,n
= 7,000  FVIFA18%,20yrs
= 7,000  146.6280
= Rs. 1,026,396

Alternatively,
 (1  i) n  1
FVAn = PMT  
 i 
 (1  0.18) 20  1
= 7,000 
 0.18 
= 1,026,395.79
Hence, if my brother follows my advice then he will have accumulated Rs. 1,026,396 by
the age of 55.
b. Future value of annuity by the age of 60 (FVAn) = ?
No. of payments (n) = 25 (60 - 35)
Here,
7000 7000 7000 i = 18%
7000 7000
FVAN = ?

35 37 38 n = 25 yrs 59 60
36
We have,
146| FUNDAMENTALS OF FINANCIAL MANAGEMENT
 (1  i) n  1
FVAn = PMT  
 i 
 (1  0.18) 25  1
= 7,000 
 0.18 
= 7,000  342.6035
= 2,398,224.40
Hence, the brother would have accumulated Rs. 2,398,224.40 by the age of 60.
Illustration No. 7
You need to accumulate Rs. 50,000 at the end of 13 years. To accumulate this sum, you
planned to deposit a certain amount of money at the end of each of the next 13 years and
deposit it in the bank. The bank pays 8.5 percent interest compounded annually. If so,
what amount should you have to save each year (to the nearest rupee) to accumulate your
required money? What if you deposit a certain amount of money at the beginning of each
of the next 13 years?
Solution:
Given,
Amount to be accumulated at the end of 13 yrs (FVAn) = 50,000
No. of deposit (n) = 13
Annual interest rate (i) = 8.5%
Annual deposit at the end of every year (PMT) = ?
Here,
I = 8.5%

pmt = ? ? ? ? ? ? ? ? ? ? ? ? ? FVAN = 50,000

0 1 2 3 4 5 6 7 8 9 10 11 12 13

We know that,
 (1  i) n  1
Future value of Annuity (FVAn) = PMT  
 i 
 (1  0.085)13  1
50,000 = PMT  
 0.085 

50,000 = PMT  22.2109

50,000
PMT =
22.2109
PMT = Rs. 2,251.15
Hence, to accumulate Rs. 50,000 at the end of 13 yrs, you need to deposit Rs. 2,251.15 at
the end of each year at 8.5% annual interest rate.
* If the deposits are made at the beginning of the year
Amount to be accumulated at the end of 13 yrs (FVAn) = 50,000
 TIME VALUE OF MONEY |147
No. of deposit (n) = 13
Annual interest rate (i) = 8.5%
Annual deposit at the end of every year (PMT) = ?
We know that,
 (1  i) n  1
FVAn Due = PMT    (1  i )
 i 
 (1  0.085)13  1
50,000 = PMT    (1  0.085)
 0.085 
50,000 = PMT  22.2109  1.085
50,000
PMT =
24.0988
= Rs. 2,074.79
Hence, to accumulate Rs. 50,000 at the end of 13 yrs, you need to deposit Rs. 2,074.79 at
the start of the each year.
Illustration No. 8
Find the present value of the following cash flow stream, discounted at 11 percent: Rs.
200 in year 1; Rs. 800 in year 2; Rs. 1200 in year 3 through 20. Also find the future value
of same cash flow stream in 20th year.
Solution:
Given,
Year Cash flows
1 200
2 800
3 to 20 1,200
Annual interest rate (i) = 11%
Total present value (TPV) = ?
Total future value (TFV) = ?
Here,
I = 11%
TFV = ?
200 800 1200 1200 1200 1200 1200 1200 1200 1200 1200 1200

0 1 2 3 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
4
TPV = ?
This question can be solved in many ways. Some of them are presented below:
We have,
CF1 CF2 CF3 CF4 CF20
PV =     .... 
(1  i) (1  i)
1 2
(1  i) 3
(1  i) 4
(1  i) 20
Since, the same formula cans he shown into the table as:
Year CF(a) PVIF at 11% (b) Present value (ab)
1 200 0.9009 180.18
148| FUNDAMENTALS OF FINANCIAL MANAGEMENT
2 800 0.8116
3 1,200 0.7320
4 1,200 0.6587
.....
20 1,200 0.1240 148.8
TPV Rs. 8,330.42
The above calculation takes more time to solve the problem. But, we have no option if
each year's cash flows are un-even. Since, the cash flows in this question are equal from
year 3 to 20. So, it can be shortened as:
Year CF (a) Dfat 11% (b) PV
1 200 0.9009 180.18
2 800 0.8116 649.28
3 to 20 1,200 6.2508* 7,500.96
TPV = Rs. 8,330.42
Where,
Dfat 11%, 3 to 20
PVIFA11%,20 yrs = 7.9633
PVIFA11%,2 yrs = (1.7125)
Dfat11%,3 to 20 yrs = 6.2508
Hence, the total present value of above cash flow stream is Rs. 8,330.42
Again, we can calculate the future value as:
TFV = CF1(1+i)20 + CF2(1+i)19 + CF3(1+i)18+.....+ CF20(1+i)0
= 200(1+0.11)20+800(1+0.11)19+1200(1+0.11)18+.....+1200(1+0.11)0
= Rs.
Using the table if each year's cash flows are uneven:
Year CF(a) FVIF at 11% (b) Future value (ab)
1 200 8.0623  20yrs
2 800 7.2633  19 yrs
3 1,200 6.5436  18 yrs
4 1,200
...
20 1,200 1  0yrs
 TIME VALUE OF MONEY |149
In this question, the cash flows from year 3 to 20 are same. Som we can easily solve as:
Year CF (a) FVIF at 11% (b) FV (a  b)
1 200 8.0623 1,612.46
2 800 7.2633 5,810.64
3 to 20 1,200 62.0928* 74,511.36
TFV = Rs. 81,934.46
Where,
FVIFA11%, 3 to 20
FVIFA11%,20yrs = 64.2028
FVIFA11%,2yrs = (2.11)
FVIFA11%,3 to20yrs = 62.0928
Hence, the total future value of the above cash flows after 20 yrs will be Rs. 81,934.46.
Illustration No. 9
You have borrowed Rs. 15000 at a compound annual interest rate of 16 percent. You feel
that you will be able to make annual payments of Rs. 3,000 per year on your loan? How
long will it take to paid off the entire loan?
Solution:
Given,
Loan amount (PVAn) = Rs. 15,000
Annual interest rate (i) = 16%
Annual Payments (PMT) = Rs. 3,000
No. of payments (n) = ?
Here,
3000 3000 3000

0 1 2 3
PVAN = 15,000 i = 16% n=?

We know that,
Present value of Annuity (PVAn) = PMT  PVIFAi,n
15,000 = 3,000  PVIFA16%,n yrs
15,000
= PVIFA16%,n yrs
3,000
PVIFA16%,n yrs =5
Now, considering the PVIFA table to find the value of '5' at 16% in which year it lies.
At 16%, we do not get the exact '5'. The value '5' lies in between 10 and 11 yrs. So, it
takes 10 to 11 yrs to payback the entire loan.
If we just go approximately, it takes 11 yrs. But to find the actual year we can interpolate
the values as:
150| FUNDAMENTALS OF FINANCIAL MANAGEMENT
Here,
PVIFA16%,10yrs = 4.8332
N = ??
PVIFA16%,11yrs = 5.0286
Interpolation formula:
Actual 'n' =
Factor lower year  true factor
Lower year   [higher year  lower year]
factor lower year  factor higher year
4.8332 - 5
= 10   [11  10]
4.8332 - 5.0286
= 10.85 yrs
Hence, to return the loan it takes exactly 10.85 yrs.
Since, the no. of year is in fraction, we cannot explain as one should pay Rs. 3,000
10.895 times. Rather, we can explain it as
To discharge the entire loan it takes 11 yrs but the loan can be slightly higher than Rs.
15,000
Verification to find the final payment
PVAn = PMT  PVIFAi,n
= 3,000  PVIFA16%,11yrs
= 3,000  5.0286 = Rs. 15,085.80
Alternatively, the PMT can be slightly lower than Rs. 3,000.
Verification
PVAn = PMT  PVIFAi,n
15,000 = PMT  PVIFA16%,11yrs
15,000 = PMT  5.0286
15,000
PMT =
5.0286
 PMT = Rs. 2,982.94

Illustration No. 11
Your late Uncle entitles you to receive Rs. 2,500 at the end of every two years for the
next two decades. The first cash flow is two years from now. At 10 percent compound
annual interest rate, what is the present value of this cash flow pattern?
Solution:
Given,
Total time = 20 yrs (2 decades)
Every other years payments = Rs. 2,500
Annual interest rate (i) = 10%
Present Value (PV) = ?
 TIME VALUE OF MONEY |151
Here,
I = 10%

2500 2500 2500 2500 2500

1 6 7 8 9 10 11 12 13 14 15 16 18 19 20
0 2 3 4 5 17
PV = ?
Since, the given cash flow pattern is unusual because the payments take place in a
interval of every 2 years. Some people can estimate it also as annuity because it also have
equal payments and same time intervals but that is not true because we do not consider
the interval of more than 1 year in an annuity. So, it is not annuity.
Now, we first need to find the annual payments (PMT) assuming that the Rs. 2,500 of
every other year as future value.
 FVAn = Rs. 2,500
n = 2 yrs, i = 10%
PMT = ?
PMT = ? PMT = ?
FVAN = 2500
0 1 2
i = 10%
We have,
 (1  i) n  1
FVAn = PMT   
 i 
 (1  0.10) 2  1
2,500 = PMT   
 0.10 
2,500
PMT =
2.1
 PMT = Rs. 1,190.4762
Now, out cash flow line will be,
I = 10%

1190.4762 1190.4762 1190.4762 1190.4762

1 20
0 2 3
PVAN = ?
Now, we have,
 1 
1  (1  i ) n 
PVAn = PMT  
 i 

 

152| FUNDAMENTALS OF FINANCIAL MANAGEMENT
 1 
1  (1  0.10) 20 
= 1,190.4762  
 0.10 

 


= 1,190.4762  8.5136
= Rs. 10,135.20
Hence, the present value of this unusual cash flow pattern is Rs. 10,135.20
Illustration 12
To complete your last year in higher secondary school and then go through BBA you will
need Rs. 1,00,000 per year for four years, starting next year. Your father offers to you to
put through in the BBA and he will deposit in a bank time deposit paying 9% interest a
sum of money that is sufficient to provide the four payments Rs. 1,00,000 each. His
deposit will be made today. How large must your father deposit today? What will be the
remaining balance in your account immediately you make the first withdrawal (i.e. after
1 year)? After the last withdrawal?
Solution:
Given,
Annual withdrawal needed (PMT) = Rs. 100,000
Time (n) = 4
Annual interest rate (i) = 9%
Amount to be deposited today
For the four annual withdrawals (PVAn) = ?
We know that,
 1   1 
1  (1  i ) n  1  (1  0.09) 4 
PVAn = PMT   = 100,000 
 i   0.09 

 
 
 


= 100,000  3.2397

= Rs. 323,972

Hence, the amount to be deposited today is Rs. 323,972.

 TIME VALUE OF MONEY |153

After 1 year, the deposit made today Rs. 323,972 will grow at 9% to Rs. 353,130
[323,972  1.09 = Rs. 353,130]
If you withdraw Rs. 100,000 out of Rs. 353,130 after 1 year, the remaining balance in
your account will be Rs. 253,130 (i.e. 353,130 - 100,000). And the remaining balance
after cash withdrawal will be zero because, the deposit made today is just sufficient to
make the form payments only.
Illustration 13
If you take out a Rs. 1,200,000 vehicles loan from EBL that calls for 60 monthly
payments at an APR of 14 percent, what will your monthly payment be? What will be
your effective annual interest rate on the loan?
Solution:
Given,
Vehicle loan from EBL today (PVAn) = Rs. 1,200,000
No. of payments (n) = 60 (monthly)
Annual interest rate (i or APR) = 14%
Monthly payments (PMT) = ?
Effective Annual interest rate (EAR) = ?
Here,

I = 14%

0 12 3 4 5 6 7 8 9 10 1112 1 2 3 4 60 5
PVAN = 1,200,000
We have,
 1 
1  i n 
 (1  ) 
12
PVAn = PMT  
 i 
 12 
 
 
 1 
1  0.14 n 
 (1  ) 
12
1,200,000 = PMT  
 0.14 
 12 
 
 
154| FUNDAMENTALS OF FINANCIAL MANAGEMENT
1,200,000 = PMT  37.7438
1,200,000
PMT =
37.7438
= Rs. 31,793.30
Hence, the monthly payment is Rs. 31,793.30
Here,
m
 i 
EAR = 1    1
 m
12
 0.14 
= 1   1
 12 
= 0.1493 or 14.93%
Hence, the effective annual interest rate on the loan is 14.93%.
Illustration 14
You are planning to borrow Rs. 5, 00,000 on a 5-year, 12 percent, annual payment, fully
amortized term loan.
Required:
a. Find the annual installment.
b. Set up loan amortization schedule.
c. What fraction of the payment made at the end of the third year will represent
repayment of principal?
Solution:
Given,
Loan (PVAn) = Rs. 500,000
No. of years (n) = 5
Annual interest rate (i) = 12%
What fraction of the payment made at the end of 3rd year will represent the repayment of
principal?
We know that:
Present value of Annuity (PVAn) = PMT  PVIFAi,n
Loan amount
 Annual installment (PMT) =
PVIFAi, n
500,000
=
PVIFA12%,5yrs
500,000
= = Rs. 138,703.95
3.6048
Hence, Annual installment of the loan is Rs. 138,703.95
Now, preparing the loan amortization schedule
Year PMT (a) Interest at 12% (b) Repayment of Remaining balance
principal (a - b) of loan
0 - - - 500,000
 TIME VALUE OF MONEY |155
1 138,703.95 60,000 78,703.95 421,296.05
2 138,703.95 50,555.53 88,148.42 333,147.63
3 138,703.95 39,977.72 98,726.23 234,421.40
4 138,703.95 28,130.57 110,573.38 123,848
5 138,703.95 14,861.76 123,842.19 5.81
Note: The remaining balance at the end of last year must always be zero. Here, the
remaining balance is Rs. 5.81 which is due to rounding error.
Now,
Fraction of payment representing repayment of principal in year 3
Repayment of Principal in year 3 98,726.23
= = = 71.18%
Payment (PMT) 138,703.95
Illustration No. 15
You have won the Biratnagar Lottery. Lottery officials offer the choice of the following
alternative payments:
Alternative 1: Rs. 20,000 one year from now.
Alternative 2: Rs. 40,000 five years from now.
a. Which should you choose if the discount rate is:
i) 0 percent ii) 10 percent? iii) 20 percent
b. What rate of interest makes both the options equally attractive?
Solution:
Prize of the Biratnagar Lottery has two options:

Option 1
Rs. 20,000 one year from now

0 20,000
Option 2
Rs. 40,000 five years from now
40,000

0 1 2 3 4 5
a. Which option should be chosen if the discount rate is
i. 0%
We know that, at 0% interest rate, there will be no time value of money. So, the PV and
FV will be equal. So, the 2nd option is preferable due to higher value.
ii. 10%
For the comparison and decision making both the values should be brought to same point
of time. So, bringing both the values at t = '0' at 10%.
20,000
PV of alternative 1 = = Rs. 18,181.82
(1  0.10)1
156| FUNDAMENTALS OF FINANCIAL MANAGEMENT
40,000
PV of alternative 2 = = Rs. 24,836.85
(1  0.10) 5

20,000 40,000

0 1 2 3 4 5
Since, the PV of alternative-2 is higher than the PV of alternative-1 at 10%. So, 2 nd option
is preferable.
iii. 20%
20,000
PV of option 1 = = Rs. 16,666.67
(1  0.20)1
40,000
PV of option 2 = = Rs. 16,075.10
(1  0.20) 5
Option 1
i = 20% 20,000

Option 2
i = 20% 40,000

0 1 2 3 4 5

At 20% annual interest rate, the PV of alternative 1 is Rs. 16,666.67, which is greater
than the PV of alternative 2 Rs. 16,075.10. So, option 1 is preferable.
b. Finding the interest rate to make both the options equally attractive.
We know that,
To make both the options equally attractive, PV of both alternatives must be same.
 PV1 = PV2
20,000 40,000
=
(1  i ) 1
(1  i ) 5
(1  i) 5 40,000
=
(1  i )1 20,000
(1+i)5-1 =2
4
(1 + i) =2
1+i = (2)1/4
i = (2)1/4-1
 i = 0.1892 or 18.92%
Hence, at 18.92% annual interest rate, both the options will be equally attractive.
 TIME VALUE OF MONEY |157

 SUMMARY
Due to the Inflation in the world the prices of the commodities do jot remain constant
with the passage of time and it is almost impossible to expect the same price of the
commodities at two different point of time. Similarly, the cost of living of the people also
goes on increasingly. Furthermore, the theory of economics says that saves and invests
your money. So, all above has automatically proven that the same amounts of money at
two different points of time do not remain constant and it is called the Time Value of
Money. There are basic two components for the existence of the time value of money:
The time period and the investment opportunities or interest rate. Hence, a rupee on hand
today is worth more than the same rupee one after any time in the future if there is
investment opportunity and time for investment. The interest rate indicates the
compounding interest not the simple interest. The compounding interest means any
income must always be re-invested at the same rate of interest continuously.
There may be several types of compounding including annually, semi-annually,
quarterly, monthly, weekly, daily and continuously. The more the number of
compounding higher will be the future values and vice-versa. Hence, the effective annual
interest rate of semi-annually compounding will be greater than the annual compounding
and so on. The effective annual interest rate for semi-annual compounding considers
interest on interest for second 6 months in the same year as compare to annual
compounding so the EAR for semiannual compounding will be greater than the EAR of
annual compounding and the same applies for quarterly, monthly, daily etc.
Annuities are equal series of money in same intervals of time whether payments or
receipts. The annuities are of two types: Ordinary and the due. If the payments are made
at the end of the period then it becomes ordinary annuities. In contrast, if the payments
are made at the start of the period then it becomes annuity due. The present and the future
value of annuity due will be greater than the values of ordinary annuities due to one
payment being made on hand or immediately.
These days the payments of loans in installment is being much famous in the world of
business and the schedule to show the equal installment, interest on installment,
repayment of the principal and the remaining balance of loan over the time.
In Some cases, we can see the annuities with indefinite period of time and is called
Perpetuities. The perpetuity has no time period so the future value cannot be calculated.
Finally, the time value of money is the most important discipline in the world of finance
and business.

 TRUE OR FALSE

158| FUNDAMENTALS OF FINANCIAL MANAGEMENT
1. Inflation has no meaning with Time Value of Money.
a. True b. False
2. Present value and interest rate have positive relationship.
a. True b. False
3. Future and present values of Annuity due are always greater than Future and Present
values of deferred annuity.
a. True b. False
4. Future value of perpetuity cannot be calculated.
a. True b. False
5. Rupee 1 on hand today is worth less as compare to Rupee one after one year even
though there is investment opportunities.
a. True b. False
6. The Time value of money takes place even there is no investment period.
a. True b. False
7. Double in value of money in 5 years meaning 20% annual growth rate if it is
compounded annually.
a. True b. False
8. Future value of money compounded quarterly is lower than same value compounded
semi-annually.
a. True b. False
9. The remaining balance of final year of loan amortization schedule must always be
zero.
a. True b. False


 THEORETICAL QUESTIONS
1. Why people do not put their money six-fit under the grave rather than making
investment or depositing into the bank? Explain.
2. Explain the different types of annuities with suitable examples.
3. What do you mean by time value of money? Will it be same at different
compounding? Explain.
4. Explain the simple interest rate, periodic interest rate and the effective annual interest
rate.
5. What is loan amortization schedule and why it is prepared?
 TIME VALUE OF MONEY |159
6. Why Albert Einstein may have said the compounding interest as eighth wonder in the
world? How it is different from simple interest rate that normal people can easily
understand. Explain.
7. Explain the cash flow time line and its importance.

 NUMERICAL PROBLEMS
Problem No. 1
a. If you deposit Rs. 10,000 in a bank account that pays 13 percent interest annually,
how much money will be in your account after 7 years?
b. What is the present value of a security that promises to pay you Rs. 55,000 in 20
years? Assume that you can earn 14 percent if you were to invest in other securities
of equal risk.
Problem No. 2
Find the following values, using the numerical solution approach.
a. An initial Rs. 4000 compounded for 1 year at 8 percent.
b. An initial Rs. 5000 compounded for 7 years at 9 percent.
c. The present value of Rs. 5500 due in 1 year at discount rate of 9 percent.
d. The present value of Rs. 5500 due in 3 years at discount rate of 9 percent.
Problem No. 3
Which amount is worth more at 14 percent: Rs. 7,000 in hand today or Rs. 14,000 due in
six years?
Problem No. 4
a. To the closes year, how long will it take Rs. 7000 to double if it is deposited and
earns the following rates?
i. 9 percent; ii. 13 percent;
Problem No. 5
Shangrila Corporation's 2010 sales were Rs. 20 million. Sales were Rs. 10 million 5 years
earlier (in 2005).
a. To the nearest percentage point, at what rate the sales of Shangrila have been
growing?
b. Suppose someone calculated the sales growth for Shangrila Corporation in part a as
follows: "Sales doubled in 5 years. This represents a growth of 100 percent in 5
years. So, dividing 100 percent by 5, we find the growth rate to be 20 percent per
year." Explain what is wrong with this calculation.
Problem No. 6
Find the present value of the following of ordinary annuity.
a. Rs. 900 per year for 10 years at 18 percent.
b. Rs. 950 per year for 5 years at 16 percent.
c. Rs. 900 per year for 8 years at 0 percent
160| FUNDAMENTALS OF FINANCIAL MANAGEMENT
d. Now rework Parts a, b and c assuming that payments are made at the beginning of
each year, that is, they are annuity due.
Problem No. 7
Find the future value of the following annuities. The first payment in these annuities is
made at the end of Year 1; that is, they are ordinary annuities.
a. Rs. 800 per year for 10 years at 12 percent.
b. Rs. 400 per year for 5 years at 6 percent.
c. Rs. 800 per year for 5 years at 0 percent.
d. Now rework Parts a, b and c assuming that payments are made at the beginning of
each year, that is, they are annuities due.
Problem No. 8
a. A Mortgage company offers to lend you Rs. 85,000, the loan calls for payments of
Rs. 8,273.59 per year for 30 years. What interest rate is the Mortgage Company
charging you?
b. While Prabha Tamang was a student at the Pokhara University, she borrowed Rs.
12,000 in student loans at an annual interest rate of 9 percent. If Tamang repays Rs.
1,400 per year, how long to the nearest year, will it take him to repay the loan?
c. If you borrow Rs. 8,000 and agree to repay the loan in five equal annual payments at
the end of each year at an annual interest rate of 13%, what will your payment be?
What if you make the first payment on the loan immediately instead at the end of the
first year?
Problem No. 9
An investment pays you Rs. 100 at the end of each of the next 3 years. The investment
will then pay you Rs. 200 at the end of Year 4, Rs. 300 at the end of year 5 and Rs. 500 at
the end of year 6. If the rate of interest earned on the investment is 8 percent, what is its
present value? What is its future value?
Problem No. 10
Find the present values and future values of the following cash flow streams under the
following conditions:
Year Cash Stream A Cash Stream B
1 Rs. 100 Rs. 300
2 400 400
3 400 400
4 400 400
5 300 100
a. The appropriate interest rate is 7 percent.
b. What is the value of each cash flow stream at a 0 percent interest rate?
Problem No. 11
Your broker offers to sell you a note for Rs. 13,250 that will pay Rs. 2,345.05 per year
for 10 years. If you buy the note, what rate of interest (to the closest percent) will you be
earning?
Problem No. 12
 TIME VALUE OF MONEY |161
You have been offered a note with four years to maturity, which will pay Rs. 3,000 at the
end of each of the four years. The price of the note to you Rs. 10,200. What is the
implicit compound annual interest rate implied by this contract (to the nearest whole
percent)?
Problem No. 13
Sheela wants to buy car that costs Rs. 15,000. She has arranged to borrow the total
purchase price of the car from her credit union at a simple interest rate equal to 9 percent.
The loan requires quarterly payments for a period of 3 years. If the first payment is due
three months (one quarter) after purchasing the car, what will be the amount of Sheela's
quarterly payments on the loan?
Problem No. 14
You need to accumulate Rs. 40,000. To do so, you plan to make deposits of Rs. 7000 per
year, with the first payment being made a year from today, in a bank account which pays
6 percent annual interest. Your last deposit will be more than Rs. 7000 if more is needed
to round out to Rs. 40,000. How many years will it take you to reach your Rs. 40,000
goal, and how large will the last deposit be?
Problem No. 15
It is now January 1, 2011. You plan to make 5 deposits of Rs. 1000 each six months, with
the first payment being made today. If the bank pays a nominal interest rate of 12
percent, but uses semiannual compounding, how much will be your account after 10
years?
Problem No. 16
An investment pays you Rs. 400 at the end of each of the next 3 years. The investment
will then pay you Rs. 800 at the end of Year 4, Rs. 1200 at the end of year 5 and Rs. 1500
at the end of year 6. If the rate of interest earned on the investment is 9 percent, what is
its present value? What is its future value?
Problem No. 17
You just started your first job and you want to buy a house within 5 years. You are
currently saving for the down payment. You plan to save Rs. 20,000 the first year. You
also anticipate that the amount you save each year will rise by 10 percent a year as your
salary increases over time. Interest rates are assumed to be 14 percent and all savings
occur at year end. How much money will you have for a down payment in 5 years?
Problem No. 18
What is the present value of perpetuity of Rs. 700 per year if the appropriate discount rate
is 9 percent? If interest rates in general were to double and the appropriate discount rose
to 18 percent, what would happen to the present value of the perpetuity?
Problem No. 19
Find the interest rates on each of the following:
a. You borrow Rs. 1400 and promise to pay back Rs. 1498 at the end of year 1.
b. You lend Rs. 700 and receive a promise to be paid Rs. 749 at the end of year 1.
c. You borrow Rs. 85,000 and promise to pay back Rs. 201,229 at the end of 10 years,
162| FUNDAMENTALS OF FINANCIAL MANAGEMENT
d. You borrow Rs. 9,000 and promise to make payments of Rs. 2,684.80 per year for 5
years.
Problem No. 20
Find the amount to which Rs. 500 will grow under each of the following conditions:
a. 12 percent compounded annually for 5 years
b. 12 percent compounded semi annually for 5 years
c. 12 percent compounded quarterly for 5 years
d. 12 percent compounded monthly for 5 years
Problem No. 21
Find the present value of Rs. 500 due in the future under each of the following
conditions:
a. 12 percent simple rate compound annually.
b. 12 percent simple rate, semi-annual compounding, discounted back 5 years.
c. 12 percent simple rate, quarterly compounding, discounted back 5 years.
d. 12 percent simple rate, monthly compounding, discounted back 1 year.
Problem No. 22
Suppose you were to receive Rs. 5,000 at the end of 10 years. If your opportunity rate is
12 percent, what is the present value of this amount if interest rate is compounded (i)
semi-annually?
Problem No. 23
Find the future values of the following ordinary annuities:
a. FV of Rs. 400 each 6 months for 5 years at a simple rate of 12 percent compounded
semiannually.
b. FV of Rs. 200 each 3 months for 5 years at a simple rate of 12 percent compounded
quarterly.
c. The annuities described in Parts a and b have the same amount of money paid into
them during the 5-year period and both earn interest at the same simple rate, yet the
annuity in Part b earns Rs. 101.60 more than the one in Part a over the 5 years. Why
does this occur?
Problem No. 24
Laxmi bank pays 8 percent interest, compounded quarterly, on its money market account.
The managers of NCC Bank want its money market account to equal Laxmi Bank's
effective annual rate. But interest rate to be compounded on monthly basis. What simple
or quoted rate must NCC Bank set?
Problem No. 25
The Prime Bank pays 7 percent interest, compounded annually, on deposits. The Kist
Bank pays 6.5 percent interest, compounded quarterly.
a. Based on effective interest rates, in which bank would you prefer to deposit your money?
b. Could your choice of banks be influenced by the fact that you might want to
withdraw your finds during the year as opposed to at the end of the year? In
 TIME VALUE OF MONEY |163
answering this question, assume that funds must be left on deposit during the entire
compounding period in order for you to receive any interest?
Problem No. 26
Merina Shrestha invested Rs. 150,000 18 months ago. Currently, the investment is worth
Rs. 168,925. Merina knows the investment has paid interest every three months (i.e.
quarterly), but she doesn't know what the yield on her investment is. Help Merina,
compute both the annual percentage rate (APR) and the effective annual rate of interest?
Problem No. 29
Ojha Company just borrowed Rs. 50,000. The loan is to be repaid in equal installments at
the end of the each of the next 5 years and the interest rate is 10 percent.
a. Set up an amortization schedule for the loan
b. How large must each annual payment be if the loan is for Rs. 1,00,000? Assume that
the interest rate remains at 10 percent and that the loan is paid off over 5 years.
c. How large must each payment be if the loan is for Rs. 1,00,000, the interest rate is
10 percent, and the loan is paid off in equal installments at the end of the each of the
next 10 years? This loan is for the same amount as the loan in part b, but the
payments are spread out over twice as many periods. Why are these payments not
half as large as the payments on the loan in part b?
Problem No. 30
Assume that you sold your house on December 31 and that you took a mortgage in the
amount of Rs. 50,000 as part of the payment. The mortgage has a quoted (or simple)
interest rate of 12 percent, but it calls for payments every 6 months, beginning in June 30
and the mortgage is to be amortized over 3 years.
a. What is the periodic equal payment?
b. What is the total amount of interest that was paid during the first year?
c. Prepare the amortization schedule.
d. What is the fraction of interest in the second last payment?
Problem No. 31
You borrow Rs. 40,000 at 14 percent compound annual interest for four years. The loan
is repayable in four equal annual installments payable at the end of each year.
a. What is the annual payment that will completely amortize the loan over four years?
b. Of each equal payment, what is the amount of interest? The amount of loan
principal?
c. What fraction of payment made in year two represents the principal?
d. What fraction of payment made in year four represents the interest?
Problem No. 32
Sangeeta recently obtained a 10 year loan of Rs. 5, 00,000. The loan carries a 9 percent
interest compounded annually and calls for annual installment payments at the end of
each of the next 10 years.
164| FUNDAMENTALS OF FINANCIAL MANAGEMENT
a. How much (in rupees) of the first year's installment represents repayment is
principal?
b. How much total interest will be paid over the life of the loan?
Problem No. 33
a. You opened an account in Nabil Bank Ltd. The bank pays interest at 9 percent per
annum and compounds quarterly. If you deposit Rs. 4,000 now, how much shall it
grow at the end of 6 years?
b. What rate will you earn if the money deposited in the bank account doubles in 6
years?
c. How long will it take to grow Rs. 4,000 to Rs. 11000 if the bank pays interest at 10
percent per annum compounded annually?
d. Assume that you deposit Rs. 4,000 at the end of each quarter for 6 years. What will
be the balance in your account at the end of 6 th year if the bank pays interest at 11
percent per annum compounded quarterly.
Problem No. 34
Assume that it is now January 1, 2011 and you will need Rs. 2,000 on January 1, 2015.
Your bank compounds interest at a 9 percent annual rate.
a. How much must deposit on January 1, 2012 to have a balance of Rs. 2,000 on
January 1, 2015?
b. If you want to make equal payments on each January 1 from 2012 through 2015 to
accumulate the Rs. 2,000, how large must each of the 4 payments be?
c. If your mother offered either to make the payments calculated in part b (Rs. 437.34)
or to give you a lump sum of Rs. 1500 on January 1, 2012, which would you choose?
d. If you have only Rs. 1500 on January 1, 2012, what interest rate, compounded
annually, would you have to earn to have the necessary Rs. 2,000 on January 1,
2015?
b. ?
Problem No. 36
To complete your sister’s last year in BBA and then go through MBA, she will need Rs.
20,000 per year for 4 years, starting next year (that is she will need to withdraw the first
Rs. 20,000 one year from today). Your rich father offers to put her through MBA and he
will deposit in a bank paying 7 percent interest a sum of money that is sufficient to
provide the four payments of Rs. 20,000 each. His deposit will be made today.
a. How large must the deposit be?
b. How much will be in the account immediately after your sister make the first
withdrawal? After the last withdrawal?


TIME VALUE OF MONEY |165