Time Value of Money

(TVM)

BITS Pilani, WILPD

Time Value of Money (TVM)

How do we understand time value of Money (TVM)?

• Purchasing Power of Money
• Inflation
• Interest Rate
• Nominal Interest Rate and Real Interest Rates
Why Should we Study the time Value of Money (TVM)? What is the importance
of Time Value of Money (TVM) in Finance?
• Most of the financial decisions involve costs & benefits that are spread out
over time.
• Time Value of money allows comparison of cash flows from different periods

BITS Pilani, WILPD

Time Value of Money (TVM) : Motivation

Risk and Uncertainty

• Future is always uncertain and risky. Outflow of cash is in our control as

payments are made by us.

• There is no certainty for future cash inflows. Cash inflows is dependent

on our creditor, banks etc

• As an individual or firm is not certain about future cash receipts, it

prefers receiving cash now.

BITS Pilani, WILPD

Time Value of Money (TVM) : Motivation

Inflation

• In an inflationary economy, the money received today, has more

purchasing power than the money to be received in future

• In other words, a rupee today represents a greater real purchasing

power than a rupee a year later.

BITS Pilani, WILPD

Time Value of Money (TVM) : Motivation

Consumption

• Individuals generally prefer current consumption to future consumption

Investment opportunities

• An investor can profitability employ a rupee received today, to give him

a higher value to be received tomorrow or after a certain period

BITS Pilani, WILPD

Time Value of Money (Purchasing Power -
Inflation) and Interest Rate.

Nominal or Market Interest Rate is the Combination of.

BITS Pilani, WILPD
How Do You Take Care of TVM ?
BITS Pilani, WILPD
 Compounding Vs. Discounting

3/3/2024 8 BITS Pilani, WILPD

 Time Value of Money (TVM) : Types of Interest

Simple Interest (SI)

• Interest is paid (earned) on only the original amount, or principal borrowed.

Compound Interest(CI)
• Interest is paid (earned) on any previous interest earned, as well as on the principal borrowed.

• Formula: SI = P0(i)(n)
SI: Simple Interest
P0:Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods

Example: Assume that you deposit Rs.1,000 in an account earning 7% simple interest for 2
years. What is the accumulated interest at the end of the 2nd year?

SI = P0(i)(n) = Rs.1,000(.07)(2) = Rs.140

BITS Pilani, WILPD
 Time Value of Money (TVM) : Future Value and
Present Value
Simple Interest (FV)
• What is the Future Value (FV) of the deposit ?
FV = P0 + SI
= Rs.1,000 + Rs.140
= Rs.1,140
• What is Future Value ?
Is the value at some future time of a present amount of money, or a series of
payments, evaluated at a given interest rate.

Q: What is the Present Value (PV) of the previous problem ?

Present Value is simply the originally deposited. That is the value today! Rs.1,000 you

• Present Value is the current value of a future amount of money, or a series of

payments, evaluated at a given interest rate.

BITS Pilani, WILPD

General Future Value Formula

FV1 = P0(1+i)1 FV2 = P0(1+i)2

General Future Value Formula:

FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n) -- See Table I

FVn = Future Value of the initial

flow n years hence.

P0 = Initial cash flow n = Life of investment

i = Annual Interest Rate.

BITS Pilani, WILPD
Why Compound Interest ?

Future Value of a Single Rs.1,000 Deposit

20000
10% Simple
15000 Interest
Future Value (Rs. )

7% Compound
10000
Interest
5000 10% Compound
Interest
0
1st Year 10th 20th 30th
Year Year Year

3/3/2024 12 BITS Pilani, WILPD

How to see the tables

3/3/2024 14 BITS Pilani, WILPD

How to see the tables ?

3/3/2024 15 BITS Pilani, WILPD

How to see the tables ?

3/3/2024 16 BITS Pilani, WILPD

How to see the tables ?

3/3/2024 17 BITS Pilani, WILPD

 Ordinary Annuity : Payment or receipt at
How to see the tables ? the end of the period.
Annuity Due: Payment or receipt at the
beginning of the period

3/3/2024 18 BITS Pilani, WILPD

Future Value Example

X wants to know how large his Rs.10,000 deposit will

become at a compound interest rate of 10% for 5
years.

0 1 2 3 4 5

10%

Rs.10,000
FV5

3/3/2024 19 BITS Pilani, WILPD

Future Value Example Solution

Calculation based on general formula:

FVn = P0 (1+i)n
FV5 = Rs. 10,000 (1+.10)5

= Rs. 16,105.10
Calculation based on Table :
FV5 = Rs. 10,000 (FVIF10%, 5)
= Rs. 10,000 (1.611)
= Rs. 16,110 [Due to Rounding]

3/3/2024 20 BITS Pilani, WILPD

Present Value Example

X wants to know how large of a deposit to make

so that the money will grow to Rs.10,000 in 5
years at a discount rate of 10%.

0 1 2 3 4 5

10%

Rs.10,000
PV0

3/3/2024 21 BITS Pilani, WILPD

Present Value Example Solution

Calculation based on general formula:

PV0 = FVn / (1+i)n
PV0 = Rs.10,000 / (1+ 0.10)5
= Rs.6,209.21

Calculation based on Table :

PV0 = Rs.10,000 (PVIF10%, 5)
= Rs.10,000 (.621)
= Rs. 6,210.00
3/3/2024 22 BITS Pilani, WILPD
Increased Frequency of Compounding

Suppose you bought a scheme where compounding is done more

frequently.
For example, assume you deposit Rs. 10,000 in bank which offers 10% interest
per annum compounded semi-annually which means that interest is paid
every six months.

Beginning amount = Rs.10,000

BITS Pilani, WILPD

 Increased Frequency of Compounding

Beginning amount = Rs.10,000

Interest @10% p.a for first 6 months: 10,000 * (0.1/2)
Rs. 500

Interest @10% p.a for second 6 months:10,500 * (0.1/2)

Rs.525

Amount at the end of the Rs. 11,025

year:
BITS Pilani, WILPD
 Frequency of Compounding
General Formula:
FVn = PV0(1 + [i/m])m n
n:Number of Years
m:Compounding Periods per Year
i:Annual Interest Rate
FVn,m: FV at the end of Year n
PV0: PV of the Cash Flow today

Accounting and Finance for Bankers Slide 26

24October2022

BITS Pilani, WILPD

 Impact of Frequency
You have Rs.1,000 to invest for 2 Years at an annual interest
rate of 12%.

Annual FV2 = 1,000 (1+ [.12/1])(1) (2)

= 1,254.40

Semi FV2 = 1,000(1+ [.12/2])(2) (2)

= 1,262.48

BITS Pilani, WILPD

 Impact of Frequency
Qtrly FV2 = 1,000 (1+ [.12 / 4])(4) (2)

= 1,266.77

Monthly FV2 = 1,000(1+ [.12 /12]) (12) (2)

= 1,269.73

Daily FV2 = 1,000 (1+[.12 / 365 ]) (365) (2)

= 1,271.20

BITS Pilani, WILPD

Semi Annual Compounding

BITS Pilani, WILPD

Quarterly Compounding

BITS Pilani, WILPD

Comparison

BITS Pilani, WILPD

 Which loan is cheaper?

• Is a loan with a 14% annual interest with monthly

compounding cheaper than a loan with a 14.75% interest
rate with annual compounding?

• How does it compare to a loan with a 14.5% with semi-

annual compounding?

3/3/2024 32 BITS Pilani, WILPD

Which loan is cheaper?

To compare the rates we need to express them in a single, consistent

format.

In this case, effective annual rate is the most appropriate.

• 14.75% with annual compounding 14.75%

• 14% with monthly compounding = ( 1 + .14/12 )^12 -1 = 14.93%
• 14.5% with Semi Annual compounding = ( 1 + .145/2 )^2 -1 = 15.03%
Therefore the 14% stated rate loan is not cheaper than the 14.75% stated
rate loan, although it is cheaper than the 14.5% loan

3/3/2024 33 BITS Pilani, WILPD

Which loan is cheaper?
SI No Compounding Period Effective Rate
1 Annual 12.00%
2 Semi-annual 12.36%
3 Quarterly 12.551%
4 Monthly 12.683%
5 Daily 12.747%
6 Hourly 12.75%
7 Per Second 12.749685%
8 Continuous 12.749685%

Suppose Interest rate is 12% and compounded annually.

When compounding becomes continuous, the effective interest rate is expressed as

follows:
Effective interest rate = e^r -1 = [(2.71828)^.12] – 1 = 1.127-1 = 12.7

where e (2.71828) is the base of natural logarithm, and r is the stated interest rate
3/3/2024 34 BITS Pilani, WILPD
Double Your Money!!!

Quick! How long does it take to double

Rs. 5,000 at a compound rate of 12% per
year (approx.)?

We will use the “Rule-of-72”.

3/3/2024 35 BITS Pilani, WILPD

The “Rule-of-72”

Quick! How long does it take to

double Rs. 5,000 at a compound
rate of 12% per year (approx.)?

Approx. Years to Double = 72 / i%

72 / 12% = 6 Years
[Actual Time is 6.12 Years]

3/3/2024 36
BITS Pilani, WILPD
Rule of 69

However, an accurate way of

calculating doubling period is the
“rule of 69”
= 0.35 + (69/Interest Rate)

BITS Pilani, WILPD

 Present Value of an Ordinary Annuity

• Annuity = Equal Annual Series of Cash Flows

• Example: How much could you borrow if you

could afford annual payments of Rs. 2,000
(which includes both principal and interest) at
the end of each year for three years at 10%
interest?

3/3/2024 38 BITS Pilani, WILPD

 Present Value of an Ordinary Annuity

Using PVIFA Tables

PVA = 2,000(PVIFA,10%,3)
= 2000 * 2.487

= Rs. 4,973.70

3/3/2024 39 BITS Pilani, WILPD

 Example of an Ordinary Annuity -- PVA

End of Year
0 1 2 3 4
7%
Rs.1,000 Rs.1,000 Rs.1,000
Rs.934.58
Rs.873.44
Rs.816.30
PVA3 = Rs.1,000/(1.07)1 +
Rs.1,000/(1.07)2 +
Rs.2,624.32 = PVA3
Rs.1,000/(1.07)3
= Rs.934.58 + Rs.873.44 +Rs.816.30
= Rs.2,624.32
3/3/2024 40 BITS Pilani, WILPD
 Future Value of an Annuity Due

• Annuity = Equal Annual Series of Cash Flows

• Example: How much will your deposits grow

to if you deposit Rs. 100 at the beginning of
each year at 5% interest for three years.

3/3/2024 41 BITS Pilani, WILPD

 Future Value of an Annuity Due

Using the FVIFA Tables

FVA = 100(FVIFA,5%,3)(1+k) = Rs. 330.96

FVA = 100*(3.152)*(1.05) = Rs. 330.96

3/3/2024 42 BITS Pilani, WILPD

 Valuation Using Table
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
FVAn = Rs. (FVIFAi%,n)
FVA3 = Rs.1,000 (FVIFA7%,3)
= Rs.1,000 * (3.215)
= Rs.3,215
3/3/2024 43 BITS Pilani, WILPD
Future Value of an Ordinary Annuity

Using the FVIFA Tables

Annuity = Equal Annual Series of Cash Flows

Example: How much will your deposits grow to if
you deposit Rs. 100 at the end of each year at
5% interest for three years.

3/3/2024 44 BITS Pilani, WILPD

 Future Value of an Ordinary Annuity

Using the FVIFA Tables

FVA = 100(FVIFA,5%,3) = Rs. 315.25

3/3/2024 45 BITS Pilani, WILPD

 Example of an FV of an Ordinary Annuity – (FVA)

End of Year
0 1 2 3 4
7%
Rs. 1,000 Rs.1,000 Rs.1,000
Rs.1,070
Rs.1,145

Rs. 3,215 = FVA3

FVA3 = Rs. 1,000(1.07)2 + Rs.1,000
(1.07)1 + Rs.1,000(1.07)0 = Rs.1,145 +
Rs.1,070 +Rs.1,000 = Rs.3,215
3/3/2024 46 BITS Pilani, WILPD
Steps to Amortizing a Loan

Step 1 : Calculate the payment per period.

Step 2: Determine the interest in Period t.
( Loan Balance at t-1) x (i% / m)
Step 3: Compute principal payment in Period t.
( Payment - Interest from Step 2)

Step 4: Determine ending balance in Period t.

(Balance - principal payment from Step 3)

Start again at Step 2 and repeat.

BITS Pilani, WILPD

Amortizing a Loan Example 01

You borrowed Rs.10,000 at an annual

interest rate of 12%. Amortize the loan if
annual payments are made for 5 years.
EYI = Equal Yearly Instalment
Step 1: Payment
PV0 = R (PVIFA i%, n )
Rs. 10,000 = R (PVIFA 12%, 5 )
Rs.10,000 = R (3.605)
R = Rs.10,000 / 3.605 = Rs. 2,774
3/3/2024 48 BITS Pilani, WILPD
Amortizing a Loan Example 01 2774 – 1200= 1574

(12% * 10,000)
End of Payment Interest Principal Ending
Year Balance
0 --- --- --- $10,000 10000-1574
1 $2,774 $1,200 $1,574 8,426
8426-1763
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
12% * 8426 4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000
2774 – 1011=1763
[Last Payment Slightly Higher Due to Rounding]
3/3/2024 49
BITS Pilani, WILPD
Amortizing a Loan Example 02

You borrow Rs. 30,00,000 at 9 % compound annual interest rate for 10

years.

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 and what is the
amount of loan principal?

3/3/2024 50 BITS Pilani, WILPD

Amortizing a Loan Example 02

Present Value of an Ordinary Annuity.

30,00,000 = EYI * (1- ((1/1.09)^10) / (0.09)

General Formula
(1/1.09)^10 = 0.422
1-0.422 = 0.577
0.577/.09 = 6.417
EYI = 30,00,000 / 6.417 = Rs.467508
PV = Present Value, In this example, RS.30,00,000
P = Equal Instalment (You need to calculate)
r = Interest Rate (in this example it is 9%)
n = Time period (in this example it is 10 years

3/3/2024 51 BITS Pilani, WILPD