CHAPTER 4 – TIME VALUE OF MONEY – UNIT 1 – SIMPLE INTEREST

Chapter 4 – Time Value of Money

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Unit 1 – Simple Interest

Suppose you deposit ₹10,000 into a bank for 2 years. The interest rate that the bank offers is 5%
p.a. After two years, you’ll receive the initial amount that you invested, i.e. ₹10,000 plus interest
for two years on this amount. The amount of interest will be 5% × ₹10,000 × 2 = ₹1,000. So, in
effect, you’ll receive ₹10,000 + ₹1,000 = ₹11,000.
Now, the initial amount that you invested, i.e. ₹10,000 is known as the Principal. The interest
rate, i.e. 5% is known as Rate of Interest. The amount of interest, i.e. ₹1,000 is simply called
Interest. The total amount received after two years is known as the Accumulated Amount or
Balance.

Simple Interest
Simple Interest means the interest which is calculated only on the Principal amount, and not on
the interest accrued on it. Some important formulas are given below:
1. I = Pit
2. A = P + I
A = P + Pit
A = P (1 + it )
A− P
3. i =
Pt
A− P
4. t =
Pi
Here,

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 CHAPTER 4 – TIME VALUE OF MONEY – UNIT 1 – SIMPLE INTEREST

I = Amount of Interest
P = Principal (initial value of investment)
i = Annual interest rate in decimal
t = Time in years
A = Accumulated amount (final value of investment)

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 CHAPTER 4 – TIME VALUE OF MONEY – UNIT 2 – COMPOUND INTEREST

Unit 2 – Compound Interest

Compound Interest
The word “compound” simply stated means “to add”. Compound Interest means that interest is
calculated not only on the Principal amount, but even on the interest amount accrued on it. The
rate of interest in case of compound interest is usually mentioned as 5% p.a. compounded
annually. This means that interest for every year will be added to the principal to calculate the
interest for the next year. For example, if I deposit ₹10,000 into a bank for two years, the compound
interest is calculated as follows:
1. For the first year: 5% on ₹10,000 for 1 year → 5% × ₹10,000 = ₹500
2. For the second year: 5% on (₹10,000 + ₹500) for 1 year → 5% × ₹10,500 = 525
Total interest received = ₹500 + ₹525 = ₹1,025. Total amount received after two years = ₹10,000
+ ₹1,025 = ₹11,025. Here, we must compare it with Simple Interest. While in Simple Interest, the
total interest was 5% × ₹10,000 × 2 = ₹1,000, in Compound Interest, the total interest is ₹1,025.
The extra ₹25 is because of the compounding of the interest of the first year to the principal
amount.
Suppose the rate of interest is 5% p.a. compounded semi-annually. This means that interest for
every six months would be added to the principal to calculate the interest for the next six months.
The interest would be calculated as follows:
1. For the first six months: 5% on ₹10,000 for 6 months → 5% × ₹10,000 × 6/12 = ₹250.
Now, this ₹250 is my interest which has accrued for 6 months.
2. For the next six months: 5% on (₹10,000 + ₹250) for 6 months → 5% × ₹10,250 × 6/12 =
₹256.25.
3. For the next six months: 5% on (₹10,000 + ₹250 + ₹256.25) for 6 months → 5% ×
₹10,506.5 × 6/12 = ₹262.66.
4. For the last six months: 5% on (₹10,000 + ₹250 + ₹256.25 + ₹262.66) for 6 months → 5%
× ₹10,768.91 × 6/12 = ₹269.22
Total interest received = ₹250 + ₹256.25 + ₹262.66 + ₹269.22 = ₹1,038.13. Total amount received
after two years = ₹10,000 + ₹1,038.13 = ₹11,038.13.
We can see that on the initial investment of ₹10,000 for two years @ 5% p.a., the interest and
amount was as under:
Particulars Interest (₹) Amount (₹)
1. Simple Interest 1,000.00 11,000.00
2. Interest Compounded Annually 1,025.00 11,025.00
3. Interest Compounded Semi-Annually 1,038.13 11,038.13

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 CHAPTER 4 – TIME VALUE OF MONEY – UNIT 2 – COMPOUND INTEREST

Thus, it can be concluded that a greater frequency of compounding results in larger amount of
interest.

Conversion Period
The period at the end of which the interest is compounded is called the Conversion Period. In our
example above, first we compounded the interest after every year, therefore, the conversion period
was 1 year. After that, we compounded the interest after every six months, therefore, the
conversion period was 6 months. In such a case, the number of conversion periods per year would
be 2. Similarly, the table below shows the typical conversion periods that are used in the questions:
Conversion Period Description Number of Conversion
Periods in a Year
1 Day Compounded Daily 365
1 Month Compounded Monthly 12
3 Months Compounded Quarterly 4
6 Months Compounded Semi-Annually 2
12 Months Compounded Annually 1

Formula for Compound Interest

n
 i 
An = P 1 + 
 NOCPPY 
Where,
An = Accrued amount

P = Principal
i = Annual interest rate in decimal
NOCPPY = No. of Conversion Periods Per Year
n = total conversions, i.e. t × NOCPPY, where t = Time in years
Therefore, the formula can also be written as:
t  NOCPPY
 i 
An = P 1 + 
 NOCPPY 

Compound Interest (CI) is, therefore, given by An − P .

  i 
t  NOCPPY

Therefore, CI =  P 1 +  −P
  NOCPPY  

 i 
t  NOCPPY

Therefore, CI = P 1 +  − 1
 NOCPPY  

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 CHAPTER 4 – TIME VALUE OF MONEY – UNIT 2 – COMPOUND INTEREST

Difference Between Compound Interest and Simple Interest

The difference between Compound Interest (CI) and Simple Interest (SI) on a certain sum (P)
 
invested for (t) years at the rate (i) is given by the formula: CI − SI = P  (1 + i ) − 1 − it 
t

Effective Rate of Interest

Effective Rate of Interest is denoted by the letter E and is calculated using the formula:
t  NOCPPY
 i 
E = 1 +  −1 .
 NOCPPY 
The actual rate of interest given in the question (i) is called the Nominal Rate.

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 CHAPTER 4 – TIME VALUE OF MONEY – UNIT 4 – MISCELLANEOUS PROBLEMS

Unit 3 – Annuity and Perpetuity

Annuity
A fixed sum of money payable or receivable after every fixed period (a month, a year, etc.) for a
certain number of years is called Annuity. Thus, annuity can be defined as a sequence of periodic
payments (or receipts) regularly over a specified period of time.
Therefore, to be called annuity, both the following conditions must be satisfied:
1. Amount paid or received must be constant over the period of annuity, and
2. Time interval between two consecutive payments or receipts must be the same.

Annuity Regular and Annuity Due/Immediate

1. Annuity Regular – When the payments are made/received at the end of the year, it is said
to be Annuity Regular.
2. Annuity Due/Immediate – When the payments are made/received in the beginning of the
year, it is said to be Annuity Due/Immediate.

Future Value
When we deposit our money in a bank, or in any investment, we receive some interest. Suppose I
deposit ₹10,000 today @ 10% p.a. At the end of 1 year, I will receive ₹10,000 + (10% × ₹10,000)
= ₹11,000. Therefore, the Future Value of today’s ₹10,000 is ₹11,000 when it is invested @ 10%
p.a.
Future value is the cash value of an investment at some time in future compounded at some interest
rate. It is very similar to the compound interest. When you calculate the Amount using the formula
n
 i 
An = P 1 +  , you are actually calculating the future value of your present investment.
 NOCPPY 

The formula of Future Value can be derived simply by replacing An with Future Value and P with
t  NOCPPY
 i 
single Cash Flow. Therefore, F .V . = C.F . 1 +  .
 NOCPPY 

Future Value of Annuity Regular

Annuity Regular means that the payments/receipts are made at the end of the year.
The future value can be calculated directly by using the formula:

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 CHAPTER 4 – TIME VALUE OF MONEY – UNIT 4 – MISCELLANEOUS PROBLEMS

 i 
t  NOCPPY

 1 +  − 1
 i   NOCPPY 
A  n,  = A   , where A = Periodic Payments.

 NOCPPY  i
 NOCPPY 
 

Future Value of Annuity Due/Immediate

Annuity Due/Immediate means that the payments/receipts are made in the beginning of the year.
The future value of Annuity Due/Immediate can be calculated directly by using the formula:
 i 
Future Value of Annuity Regular ×  1 + .
 NOCPPY 

  i 
t  NOCPPY

  1 +  − 1 
 i     NOCPPY    i 
A  n,  = A   1 +
  NOCPPY 
, where A = Periodic
 NOCPPY   i 
  NOCPPY  
 
Payments.

Present Value
Present Value is simply the reverse of Future Value. When we deposit our money in a bank, or in
any investment, we receive some interest. Some I deposit ₹10,000 today @ 10% p.a. At the end of
1 year, I will receive ₹10,000 + (10% × ₹10,000) = ₹11,000. Therefore, the Present Value of the
₹11,000 that I’ll receive one year later, (i.e., in future) is ₹10,000.
We studied that future value is the cash value of an investment at some time in future compounded
at some interest rate. This means that future value is tomorrow’s value of today’s money
compounded at some interest rate. Similarly, present value is today’s value of tomorrow’s money
discounted at some interest rate.
The formula for the present value can be derived from the formula of Amount that we studied in
Compound Interest as follows:
t  NOCPPY
 i 
An = P 1 + 
 NOCPPY 
An
P= t  NOCPPY
 i 
1 + 
 NOCPPY 

Present Value of Annuity Regular

Annuity Regular means that the payments/receipts are made at the end of the year.
Present Value of Annuity Regular = Annuity × Sum of Discounting Factors

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 CHAPTER 4 – TIME VALUE OF MONEY – UNIT 4 – MISCELLANEOUS PROBLEMS

( Factor ) − 1
n

Present Value of Annuity Regular = Annuity 

( Discount Rate )  ( Factor )
n

t  NOCPPY
 i 
1 +  −1
Present Value of Annuity Regular (P.V.) = Annuity   NOCPPY 
.
t  NOCPPY
 i   i 
   1 + 
 NOCPPY   NOCPPY 
Note – The Present Value of Annuity is sometimes also denoted by V.

Present Value of Annuity Due/Immediate

P.V. of Annuity Due/Immediate = Initial Cash Payment/Receipt + P.V. of Annuity Regular (for n
– 1 periods)
n = t × NOCPPY

Applications of Future Value and Present Value

Following are some of the applications of future value and present value:
1. Sinking Fund
2. Leasing
3. Capital Expenditure (Investment Decision)
4. Net Present Value (NPV)
5. Valuation of Bond
Let’s look at these applications one by one.

Sinking Fund
Sinking Fund is a fund created for a specified purpose. Some amount is deposited in this fund
regularly over a period of time at a specified interest rate. Interest is compounded at the end of
every period. We can clearly calculate the future value to find out how much balance the fund
would have at the end of the period.

Leasing
Leasing in layman’s terms means taking some asset on rent. The party who lends the asset is called
the “lessor”, and the party who borrows the asset is called the “lessee”. You’ll study about leases
in detail later in CA Intermediate and CA Final. Obviously, the lessor would charge some rent on
the asset lent by him. This rent is known as “Lease Rental”. By using the concepts of Present Value
and Future Value, we’ll see whether leasing is preferable for the company or not. Following
examples will make things clear.

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Capital Expenditure (Investment Decision)

We have studied in Accounts that an expenditure which results in benefit for more than one year
is known as a Capital Expenditure. Usually, a Capital Expenditure results in a huge amount of
Outflow. However, there’s anticipation of periodic inflows as well. These inflows would obviously
last till the life of the capital expenditure. In order to find out whether a capital expenditure is
beneficial or not, we compare the outflow that occurs today with the present value of all the future
inflows. If the present value of the inflows exceeds the outflow, the capital expenditure is said to
be beneficial. Following examples will make things clear:

Net Present Value (NPV)

This is similar to what we studied above in Capital Expenditure (Investment Decisions). The only
difference is, that while in Capital Expenditure (Investment Decisions), we used to just see whether
the present value of future cash flows is exceeding our initial investment or not, here, in Net Present
Value, we’re actually going to find out how much does the present value of future cash inflows
exceed our initial investment. The difference between the present value of future cash flows and
the initial cash outflow is known as the Net Present Value (NPV). Needless to say, if NPV is +ve,
it is beneficial to take the project, whereas, if NPV is -ve, it is worthless to take the project.
Net Present Value = P.V. of Cash Inflows – Initial Cash Outflow
Sometimes, it may so happen, that a project requires not just the initial investment, but also some
additional investment in the future. In such a case, we not only take the P.V. of the Cash Inflows,
but we also calculate the P.V. of the Cash Outflows, and then compare the same.
Net Present Value = P.V. of Cash Inflows – P.V. of Cash Outflows

Valuation of Bond
A Bond is a financial instrument similar to a debenture. When you purchase a debenture, you pay
a certain amount of money, and you receive interest periodically from it. Similarly, Bond is also a
financial instrument, containing a fixed percentage of interest. Bonds are generally issued for a
fixed term longer than one year. After the specified duration, the bond is redeemed.

Perpetuity
Perpetuity is simply an annuity that lasts forever. For e.g., if I receive ₹10,000 at the end of every
year for the rest of my life, we’ll call this perpetuity. The present value of perpetuity is calculated
A
by using the formula: . Here, A is the payment or receipt each period.
i
NOCPPY

Perpetual Growth or Growing Perpetuity

We studied perpetuity where we said that if I want ₹10,000 every year for the rest of my life, this
is called perpetuity. On the other hand, if I want ₹10,000 at the end of the first year, ₹15,000 at the
end of the second year, ₹20,000 at the end of the third year, ₹25,000 at the end of the fourth year,
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 CHAPTER 4 – TIME VALUE OF MONEY – UNIT 4 – MISCELLANEOUS PROBLEMS

and so on for the rest of my life, it is called Perpetual Growth. The present value of Growing
A
Perpetuity is calculated by the formula: . Here, A is the periodic payment or receipt; i is the
i−g
annual rate of interest in decimal; and g is the annual growth rate in decimal.

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