CORPORATE FINANCE

(Time Value of Money)

RP_CF1_Time Value of Money 1

 Time Value of Money : Introduction
Money has time value. A rupee today is more valuable than a rupee a year hence.
Why? There are several reasons:
• Individuals, in general, prefer current consumption to future consumption.
• Capital can be employed productively to generate positive returns. An
investments of one rupee today would grow to (l+r) a year hence (r is the rate
of return earned on the investments).
• In an inflationary period a rupee today represents a greater real Purchasing
Power than a rupee a year hence.
Money of the financial problems involves cash flows occurring at different points of
the time. For evaluating such cash flows an explicit consideration of the Time Value
of money is required.

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 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.

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 Methods of Time Value of Money
Time Value of
Money

Compounding Discounting
(Future Value) (Present Value)

• Single Flow • Single Flow

• Multiple Flows • Uneven Multiple Flows
• Annuity • Annuity
• Perpetuity

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Growth of $100 at Various Interest Rates and Time Periods

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Present Value of $1 at Various Interest Rates and Time Periods

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 Calculation of Future Values
Suppose you have ₹ 1,000 today and you deposit it with a financial institution, This
pays 10 percent interest compounded annually, for a period of 3 years. The deposit
would grow as follows:
First year: Principal at the beginning ₹ 1,000
Interest for the year (1,000×0.10) 100
Principal at the End: 1100
Second year: Principal at the beginning ₹ 1100
Interest for the year (1100×0.10) 110
Principal at the End: 1210
Third year: Principal at the beginning ₹ 1210
Interest for the year (1210×0.10) 121
Principal at the End: 1331

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 Calculation of Future Values (Cont’d)
Let us look at the problem analytically. If we deposit a sum of money with the present value
PV in a bank that pays interest at the rate r, then after one year it will become PV(1 + r). Let
us call this amount its future value FV.
We may write it as
FV= 𝑃𝑉 1 + 𝑟
We may also think of (1 + r) as a growth factor. Continuing this process for another year,
compounding the interest annually, the future value will become
FV= 𝑃𝑉 1 + 𝑟 1 + 𝑟
FV= 𝑃𝑉(1 + 𝑟)2
If we can continue this compounding for ‘n’ years, the future value then
FV= 𝑷𝑽(𝟏 + 𝒓)𝒏
Where FV = Future value n years hence,
PV = Amount invested today or Present value of money,
r = Interest rate per period, and
n = Number of periods of investments.
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 Calculation of Future Values (Cont’d)
If we do the compounding quarterly, the amount of interest credited will be only at
the rate r/4, but there will also be 4n compounding periods in n years.
𝒓 𝟒𝒏
FV= 𝑷𝑽(𝟏 + )
𝟒
Similarly, for monthly compounding, the interest rate is r/12 per month and the
compounding occurs 12n times in n years. Thus, the above equation becomes
𝒓 𝟏𝟐𝒏
FV= 𝑷𝑽(𝟏 + )
𝟏𝟐

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 Calculation of Present value of a Single Flow
Suppose some one promise to give you ₹ 1,000 three years hence. What is the present
value of this amount if the interest rate is 10 percent?
The present value can be calculated by discounting ₹ 1,000, to the present point of
time, as follows:
𝐹𝑉
PV =
(1+𝑟)𝑛
(1 + 𝑟)𝑛 in above equation called the discounting factor or the present value interest
(PVIFi,n). The value of PVIFi, n for several combinations of i and n.
Problem-1:
Find the present value of ₹ 2,000 receivable 8 years hence if the rate of discount is 10
Percent.

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 Annuity and Perpetuity
An annuity is a series of periodic cash flows (payments of receipts) of equal
amounts. An annuity represents such a series of cash payments, even for monthly or
weekly payments.
Example: Premium of a life insurance policy, Loan that you take out and then pay
back in monthly instalments(EMIs).
• When the cash flows occur at the end of each period the annuity is called a regular
annuity or a deferred annuity.
• When the cash flows occurs at the beginning of each period the annuity is called an
annuity due.
A perpetuity is a stream of payments that continues forever.

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 Present value of an Annuity and Perpetuity
If there is a cash flow C at the end of first, second, third... period, then the sum of
discounted cash flows is given by
𝐶 𝐶 𝐶 𝐶
𝑆= + + +…………..+
1+𝑟 (1+𝑟)2 (1+𝑟)3 (1+𝑟)𝑛
𝐶 1
If we take a = and x =
1+𝑟 1+𝑟
𝑆 = 𝑎 + 𝑎𝑥 + 𝑎𝑥 2 +………….+𝑎𝑥 𝑛−1
𝑎(1−𝑥 𝑛 )
Sum of all the terms 𝑆𝑛 =
(1−𝑥)
𝐶 1
1+𝑟
[1− (1+𝑟)𝑛
]
𝑆𝑛 = 1
(1−1+𝑟)
Multiplying the numerator and the denominator in the above expression by (1 + r)
𝑪[𝟏−(𝟏+𝒓)−𝒏 ]
PV of an Annuity (C,r,n) or Sn =
𝒓
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 Present value of an Annuity and Perpetuity(Cont’d)
For a perpetuity (1 + 𝑟)−∞ = 0
𝐶[1−(1+𝑟)−𝑛 ]
𝑆𝑛 =
𝑟
𝐶[1−(1+𝑟)−∞ ]
𝑆𝑛 =
𝑟
𝐶[1−0]
𝑆𝑛 =
𝑟

𝑪
𝑺𝒏 =
𝒓

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 Practice Problems
1. You would like to buy a house that is currently on the market at Rs.85,000, but
you cannot afford it right now. However, you think that you would be able to buy
it after 4 years. If the expected inflation rate as applied to the price of this house is
6% per year, what is its expected price after four years?
2. Johnson has deposited $6,000 in a money market account with a variable interest
rate. The account compounds the interest monthly. Johnson expects the interest
rate to remain at 8% annually for the first 3 months, at 9% annually for the next 3
months, and then back to 8% annually for the next 3 months. Find the total
amount in this account after 9 months.
3. You expect to receive $10,000 as a 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?

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 Loan Amortization, Payment
Problem: Mr.A borrows Rs.10,000 at the annual interest rate of 9%, and he is
required to pay it back in 60 equal monthly instalments, the first one is due at the end
of the first month. How much is the monthly instalment?
Present Value of a Loan = Present value of all future payments.
𝑪[𝟏−(𝟏+𝒓)−𝒏 ]
𝑺𝒏 =
𝒓

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 Loan Amortization, Payment
Problem: Mr.A borrows Rs.10,000 at the annual interest rate of 9%, and he is
required to pay it back in 60 equal monthly instalments, the first one is due at the end
of the first month. How much is the monthly instalment?
Present Value of a Loan = Present value of all future payments.
𝑪[𝟏−(𝟏+𝒓)−𝒏 ]
𝑺𝒏 =
𝒓
Monthly payment (𝑺𝒏 ) = 10,000; No.of instalments (n) = 60
Interest rate (r) = 0.09/12 = 0.0075
𝑪[𝟏−(𝟏+𝟎.𝟎𝟎𝟕𝟓)−𝟔𝟎 ]
𝟏𝟎, 𝟎𝟎𝟎=
𝟎.𝟎𝟎𝟕𝟓
C = 207.58

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 Loan Amortization: Down Payment
Problem: Suppose the price of a house that you are interested in buying is $100,000
and you have your $15,000 down payment handy. The bank will loan you the
remaining $85,000 at 8% annual interest for a 25-year term. Find your monthly
payment.
Present Value of a Loan = Present value of all future payments.
𝑪[𝟏−(𝟏+𝒓)−𝒏 ]
𝑺𝒏 =
𝒓
No.of instalments (n) = 25*12=300
Interest rate (r) = 0.08/12 = 0.0067

C = 656.04

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 Loan Amortization, Payment: Annuity Due
Problem: Williams has won a in the state lottery that will pay him $50,000 annually
in 20 annual instalments. He will get the first instalment right now. Using a discount
rate of 10% per year, find the present value of all these payments.

Present Value of a Loan = Present value of all future payments.

𝑪[𝟏−(𝟏+𝒓)−𝒏 ]
Present Value of Annuity (𝑺𝒏 )=
𝒓
Present value of annuity, where the cash flows are at the beginning of each period for
the next ‘n’ periods is as follows.
𝑪[𝟏− 𝟏+𝒓 𝟏−𝒏 ]
Present Value of Annuity (𝑺𝒏 )= C +
𝒓
𝑺𝒏 = 468,246

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 Time Required for Doubling the Amount
Period required for doubling the amount:
A common question which arises among the investors is that how much period will it
take for the amount invested to be doubled at a given rate of interest.
• For the explanation of this, Rule of “72”, is to be applied. Under this rule, the
period within which the amount will be doubled is obtained by dividing 72 by the
rate of interest.
For instance, if the rate of interest is 6%, double period is 72/6 = 12 years.
• However, an accurate way of calculating the doubling period is the Rule of “69”.
Under this Rule, doubling period = 0.35+ (69/Interest Rate).

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 Effective Annual Interest Rate(EAR): Multi-Period Compounding
If a compounding is done more than once a year, the actual annualised rate of interest
would be higher than the nominal interest rate. It is called as the effective interest
rate.
𝑟 𝑛∗𝑚
EAR or EIR= 1 + −1
𝑚

Problem:
Rajan invested Rs. 20,000 in a bank, with a annual interest rate of 10 percent. The
bank will compound interest semi-annually. What will be the effective annual interest
rate.

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 Present Value of Perpetuity
Perpetuity is an annuity that occurs indefinitely.
𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 𝐴𝑚𝑜𝑢𝑛𝑡
Present value of a perpetuity =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
𝐶
=
𝑟

Problem:
If an investor expects a perpetual sum of Rs.500 annually from his investment. What
is the present value of this perpetuity if interest rate is 10 percent.?

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 Present Value of Growing Annuity and Perpetuity
The present value of a constantly growing annuity is given below
𝐶 1+𝑔 𝑛
PV= 1−
𝑟−𝑔 1+𝑟

Present value of a constantly growing perpetuity

𝑪
PV=
𝒓−𝒈
C = Cash flow to be received one period hence.
r = Discount Rate
G= Growth rate
Assumptions:
• Cash flows to be received one period hence.
• Discount rate (r) > Growth rate (g).
• Timing Assumptions.

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 Present Value of Growing Perpetuity (Cont’d)
Problem-1:
The annual rent of the building is Rs. 2,00,000. The cash flows are expected to rise at
5% per year and the appropriate discount rate is 17% per year. If it assumes that the
rise in cash flows will continue indefinitely, Calculate present value of future cash
flows.
Problem-2:
Southern textiles company decides to declare dividend of Rs. 4.50 per share. In the
subsequent years the dividend will grow at 3.5 percent in perpetuity. What is the
present value of the all the dividends if the discount rate is 10 percent?.

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 Future Value of an Annuity
Future value of an annuity ( C ) received or paid at the end of each year for ‘n’ years
with a discount rate ‘r’ can be calculated as follows.
(𝟏+𝒓)𝒏 −𝟏]
FV of an Annuity (C,r,n) = c
𝒓
Problem:
An Individual sets aside 20,000 at the end of year, starting when he is 30 years old
and expected retirement at the age of 65 years. The expected return on investment is
8% per year. Calculate the expected value of the account on his retirement date.

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 Future value of an Annuity (Cont’d)
Problem: Suppose you deposit ₹1,000 in a bank for 5 years and your deposit earn a compounded
interest rate of 10 percent. What will be the value of this series of deposits (an annuity) at the end of 5
years? Assuming that each deposit occurs at the end of the year, the future value of this annuity will
be:

Total Future Value =

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 Future Value of a Growing Annuity
The present value of a constantly growing annuity
𝐶 1+𝑔 𝑛
PV= 1−
𝑟−𝑔 1+𝑟
𝐹𝑉𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 𝑃𝑉𝐴𝑛𝑛𝑢𝑖𝑡𝑦 × (1 + 𝑟)𝑛
𝐶 1+𝑔 𝑛
𝐹𝑉𝐺𝑟𝑜𝑤𝑖𝑛𝑔 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 1− × (1 + 𝑟)𝑛
𝑟−𝑔 1+𝑟
𝐶
𝐹𝑉𝑮𝒓𝒐𝒘𝒊𝒏𝒈 𝑨𝒏𝒏𝒖𝒊𝒕𝒚 𝑫𝒆𝒇𝒆𝒓𝒓𝒆𝒅 = (1 + 𝑟)𝑛 − 1 + 𝑔 𝑛
𝑟−𝑔
𝐶
𝑭𝑽𝑮𝒓𝒐𝒘𝒊𝒏𝒈 𝑨𝒏𝒏𝒖𝒊𝒕𝒚 𝑫𝒖𝒆 = (1 + 𝑟)𝑛 − 1 + 𝑔 𝑛 1+𝑟
𝑟−𝑔

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 Present and Future Value of Growing Annuities
(Practice Problems)
Problem-1:
Aditya is 30 years of age and his salary next will be ₹ 9,00,000. Aditya thinks that
his salary will increase at a steady rate of 5% per annum and his retirement at age 60.
a) If the discount rate is 8%, what is the PV of these future salary payments?
b) If Aditya saves 5% of his salary each year and invests these savings at an interest
rate of 8%, how much will he have saved by age of 60?
c) If Aditya plans to spend these savings in even amounts over the subsequent 20
years, how much can he spend each year?.

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 Present Vale of Annuities and Perpetuities
(Practice Problems)
Problem-2:
What is the present value of perpetuity of ₹1,00,000 per year if the appropriate
discount rate is 7%. If interest rates in general were to double and the appropriate
discount rate rose to 14%, what would happen to the present value of the perpetuity.?
Problem-3:
Suppose you are going to receive $15,800 per year for five years. The appropriate
interest rate is 7.9 percent.
a) What is the present value of the payments if they are in the form of an ordinary
annuity? What is the present value if the payments are an annuity due?
b) Suppose you plan to invest the payments for five years. What is the future value if
the payments are an ordinary annuity? What if the payments are an annuity due?
c) Which has the highest present value, the ordinary annuity or annuity due? Which
has the highest future value? Will this always be true?

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