Time Value of Money –Assignment Problems and Notes

Time Value

Future Value of Single Cash flow Present Value of Single Cash Flow
Future Value of Annuity Present Value of Annuity
FV of Growing Annuity Present Value of Growing Annuity
FV of Multiple Cash Flows Present Value of Growing Perpetuity

Formulas:
1. Future Value of Single Cash flow

FV = PV*(1+r) n,

Where PV = Present Value, r = Rate of interest , n = No. of years

2. Future Value of Annuity

FV= A* [(1+r) n -1]/r

Where A= Annuit , Equal annual Installments

3. Future Value of Growing Annuity

FV= A*[(1+r)n-(1+g)n]/(r-g)

4. Future Value of Multiple Cash Flows

Where CFt= Cash Flows at particular time t , n=total no of years

5. Present Value of single Cash flow

PV= FV
(1+r)n where FV=Future Value
6. Present Value of Annuity

[ ]
1
1−
(1+ r ) N
PV =FV
r
7. Present Value of Growing Annuity

[ ]
( 1+g )n
1−
( 1+r )n
PV ga= A (1+g )
r−g

Where g= Growth Rate and g>r or g<r

8. Present Value of Perpetuity A perpetuity is an annuity of with an infinite duration. Hence the
present value of perpetuity may be expressed as follows

PV∞ = CF x PVIFA
Where PV∞ = present value of a perpetuity
CF = constant annual cash flows
PVIFA = present value interest factor for perpetuity (an annuity of infinite duration)

The value of PVIFA is

∞
1 1
PVIFA=∑ =
t=1 ( 1+r )
t r
Questions:
1. Company XYZ is establishing a sinking fund to retire Rs.500000, 8% debentures, 10 yrs from
today. The company plans to put a fixed amount into the fund each year for 10 years. The First
payment will be made at the end of the current year. The company anticipates that the funds will
earn 6% a year. What equal annual contribution must be made to accumulate Rs.
500,000,10years from now?

2. Suppose a particular debenture pays interest at 8%per annum. The debenture is to be paid after
10 years at a premium of 5%. The face value of the debenture is Rs 1000.Interest is paid after
every 6 months. what is the current worth of debenture. Assuming the appropriate market
discount rate of debenture of similar risk and maturity is equal to the debentures coupon rate, that
is 8%?
3. An Investor deposits Rs 100 in a bank for 5 years at 8% interest. Find out the amount which he
will have in his account if the interest is compounded a) Annually b) Semi annually c) Quarterly
d) Continuously

4. Compute the present/Discounted value of the following future cash inflows, assuming a
required rate of 10%
a)Rs 100 a year for years 5 through 10 and
b)Rs 100 a year for years 1 through 3,nil in year 4through 5 and 100 a year for year 6 through 10.

5. An executive is about to retire at the age of 60. His employer has offered him two post
retirement options :
a) Rs 20, 00,000 lump sum b) Rs 2, 50,000 for 10 years. Assuming 10% interest rate , which is
better option ?

Solutions

1. FV =Rs.500,000, r=6%,n=10 yrs

A=?
By Table: FVA=A(FVIFA)10,6% (Future Value of Annuity Table)

500,000=A (FVIFA)10,6%

A= 500,000/13.181= Rs.37933.39

2. As the interest is compounded Semiannually over 10 years the compounding period will
become double i.e.20 years and rate of interest will become half ie half of 8%

N= 20years, r=4%

Given in the question –Face value of the debenture = Rs 1000

Premium =5%
It means after 10 years maturity value of debenture will become Rs.1050. ( 1000+5% of 1000).

In question it is asked that what is present value of debenture.

PV of debenture = PV of interest earned on the debenture + PV of Maturity Value of the

Debenture

(Interest earned on the debenture every 6 month is 4% of 1000 ie Rs 40 for 20 yrs so Rs 40 is

Annuity received )

PV= 40(PVIFA)20,4% + 1050(PVIF)20,4%

PV = 40(13.59) + 1050(0.456)
543.60 +478.8
 Rs.1022.4

3. As the investor has deposited the amount in bank at single point of time and asking about its
future value in different compounding periods so we will take the formula of future value of
lump sum.
Given P= Rs 100, r= 8%, n=5years

FV = P(1+r)n

a) Annually: FV= 1000(1+0.08)5 =146.93

b) Semiannually: FV= 100(1+r/2)2n

100(1+0.04)10
100 (1.04)10
Rs.148.02

c) Quarterly: FV=100(1+r/4)4n
100(1+0.02)20
100(1.02)20
Rs.148.59

d) Continuously: FV=100 (e)r*n ,where e is the constant which’s value is 2.71828

FV=100(2.71828).08*5
100(2.71828)0.4
Rs. 149.18

4. As per the question we have to draw the time line for better understanding.
Given in the question r=10% The time line for both the parts given in the image below.

a)Rs 100 a year for years 5 through 10

PV= Rs100 (PVIFA)10,10% - Rs.100(PVIFA)4,10%

100(6.1446)-100(3.1699)
Rs.297.47
b) Rs 100 a year for years 1 through 3,nil in year 4through 5 and 100 a year for year 6 through10
(time line for this condition given in figure ) as per this no cash flow happen in year 4 and 5. So
to simplify the calculation- we can start from time 0 and calculate cash flow of first three yrs. +
Calculate the cash flow of all 10 years and subtract the cash flow of
first 5 years from that).

PV= Rs 100(PVIFA)3,10% + [Rs 100(PVIFA)10,10% +Rs100(PVIFA)5,10%]

100(2.4869)+ [100( 6.1446)-100(3.7908)]
 248.69+ [614.46-379.08]
Rs.484.07

5. In the question it is asked that which retirement option is better , a) Rs 20, 00,000 lump sum b)
Rs 2, 50,000 for 10 years. Assuming 10% interest rate , we have to compare Rs.20,00,000
received today or Rs 2,50,000 received for 10 years every year. We will go with present value of
the annuity of Rs.2,50,000 given time as 10yrs and r=10%
PV= 2,50,000(PVIFA)10,10%
2,50,000(6.1446)
Rs. 15,36,150
It is clearly visible that lump sum of Rs.20,00,000 is more now as compared to 15,36,150.
So option (a) is better.

The Problems and concepts discussed in the class.

Present Value of Future amount

PV= FV
(1+r)n where FV=Future Value
Q.1 Mr. X has given opportunity to receive Rs.1060 one year from now. He knows that he can
earn 6% interest on his investment. What amount will he be prepared to invest for this
opportunity? n=1 year , r=6%

Given , FV= Rs. 1060, PV= 1060/(1+.06)1

1060/1.06
Rs. 1000 ( remember that present value will always
be less than future value )

Present Value of Annuity : Formula

[ ]
1
1−
(1+r )N
PV = A
r

By table: PV = FV ( PVIFA)n, r
Where, PVIFA is present value interest factor of annuity which can be seen in present value
annuity table. A is the equal future cash flows.

Q. The ABC Company expects to receive Rs.100, 000 for a period of 10 years from a new
project it has just undertaken. Assume a 10% rate of interest, what is the present value of the
cash flows received.
Sol. Given A= 100,000
PV = 100,000(PVIFA)10,10%
100,000(6.145) = Rs. 614500
Present Value of Uneven Cash Flows

C1 C2 CN
PV = + + ¿⋅¿ +
( 1 +r )1 ( 1 +r ) 2 (1 + r )N
N C
PV = ∑
t

t =1 (1 + r )t
Where C1,C2……..Cn are series of cash flows in time t1,t2……..tn respectively.
If we refer table values then it can be written as:

N Ct
∑ t
PV = C1 (PVIF)1,r +C2(PVIF)2,r +C3(PVIF)3,r+……………..t =1 ( 1+r )

Q. If ABC company expects cash inflows from its investment proposed it has undertaken in the
time period zero , Rs 200,000 and Rs.1,50,000 for the first two years respectively and then
expects annuity payment of 100,000 for the next 8 years. What is the present Value of cash
inflows assuming a 10% rate of interest .

Soln. first we will make a timeline for the above question which is given below:

Now Calculations done as:

1. Present Value of Rs.200,000due in year 1 = 200,000(PVIF)1,10%
Rs.200,000(0.909)=Rs.181800

2. Present Value of Rs.150,000due in year 2= 150,000(PVIF)2,10%

Rs 150,000(0.826)= Rs.123900

3. Present Value of 8 years annuity with cash inflow of Rs. 100,000

a) at the beginning of the year 3= Rs 100,000(PVIFA)5,10%= Rs 100,000(5.335)= Rs.533500
b) at the beginning of the year 1= 533500(PVIF)2,10%= 533500(.826)= Rs.4,40,671

4.Present value of total series of cash flows = Rs.(181800+123900+440671)= Rs 7,46,371

Present Value of an infinite life Annuity (Perpetuities) An Annuity that goes forever is called
as perpetuity. The present value of the perpetuity of C amount can be given by formula:

PV∞ = C x PVIFA
• Where PV∞ = present value of a perpetuity
 • C = constant annual cash flows
• PVIFA = present value interest factor for perpetuity (an annuity of
infinite duration)
∞
1 1
The value of PVIFA is PVIFA=∑ =
t=1 ( 1+r )
t r
C
PV∞ = r

Q. Mr. X wishes to find out the PV of investment which yield Rs 500 in perpetuity, discounted
at 5% rate .

PV∞ = C/r= 500/0.05=Rs 10,000

That means if Mr. X invest Rs 10,000 today at the rate of 5%, he will keep earning Rs 500
annually as interest for lifetime, keeping the invested money intact.

Other Solved examples:

Loan Amortization:

Q. A ltd company borrows from a commercial bank Rs 10,00,000 at 12% rate of interest to be
paid in equal annual installments. What would be the size of the installments be ? Assume
repayment period would be 5years.
Given PV= Rs.10,00,000, r= 12%,n=5years

PV=A(PVIFA)5,12%
A= PV/(PVIF)5,12%
10,00,000/3.605)= Rs.2,77,393

Problems to Practice:
1. After receiving your budget you have determined that you can afford to pay Rs.12000 per
month for 3 years towards your car loan.
You call finance company and learn that the ongoing rate of interest on car loan is 1.5%/month
for 36 months. How much you can borrow ?\

2. You want to buy a house after 5 years when it is expected to cost Rs 2 million .How much
you should save annually if your saving earn a compound return of 12%/annum.
3.Future ltd has an obligation to redeem Rs.500 million bonds 6 years hence. How much should
the company deposit annually in a sinking fund a/c wherein it earns 14% interest to cumulate
Rs.500 million in 6 years time?
4. A finance company advertises that it will pay a lump sum of Rs.8000 at the end of 6 years to
investors who deposit annually Rs.1,000 for 6 years. What interest rate is implicit in this offer?
5. You want to take a holiday cruise which cost Rs. 10,00,000- the cost is expected to remain
unchanged in nominal terms. You can save annually Rs. 50,000 to fulfill your wish . how long
will you have to wait if your savings earn an interest of 12%.

6. Your Father deposits Rs.300,000 on retirement in a bank which pays 10% annual interest.
How much can be withdrawn annually for a period of 10 yrs.

7. You want to borrow Rs. 10,80,000 to buy a flat. You approach a housing finance company
which charges 12.5% interest. You can pay Rs.1,80,000 per annum toward loan amortization.
What should be the maturity period of the loan?

8. Suppose someone offers you the following financial contract: if you deposit rs.10,000 with
him he promises to pay Rs.2500 annually for 6 years. What interest rate do you earn on this
deposit ?

The Concepts and examples discussed in the class dated May 14, 2020

Present Value of Growing Annuity

A cash flow that grows at a constant rate for a specified period of time is a growing annuity
A time line of a growing annuity is as follows

A ( 1+g ) A ( 1+g )2 .. . .. A ( 1+g )n

0 1 2 .. . .. . n

The present value of a growing annuity can be calculated using the following formula

[ ]
( 1+ g )n
1−
( 1+r )n
PV ga= A (1+ g )
r −g
The above formula can be used when
 The growing rate is less than the discount rate (g<r) or
 The growing rate is more than the discount rate (g>r)
 However, it doesn’t work when the growing rate is equal to the discount rate (g=r)

Q. Suppose you are harvesting a teak plantation for the next 20 years over which you expect to
get100,000 cubic square feet of teak /year. The current price per cubic feet of teak is Rs. 500, but
it is expected to grow at the rate of 8%/year. The discount rate is 15%. what is the present value
of teak that you can harvest from the teak forest ?

Formula:

[ ]
= Rs. 55,17,36,683
( 1+ g )n
1−
Present Value of Growing Perpetuity ( 1+r )n
PV teak =A ( 1+ g )
r−g

( 1+0.08 )20 0.15−0.08 ¿

 teak
[ ( 1+.15 )20 ¿ ]
We know that the present value of the perpetuity of C amount can be given by formula:
C
PV∞ = r
When the perpetuity is growing at the certain rate then it PV will be:
C
PVg∞ = r−g

Q. An office complex is expected to generate a net rental of Rs.3 Million next year ,which is
expected to increase by 5% every year .If we assume that increase will continue indefinitely then
rental stream is a growing perpetuity . if the discount rate is 10%,the PV of rental stream will
be ?
C
PVg∞ = r−g
3000000
(0.1−0.05) =Rs. 60million

Effective Rate of Interest –Intra year compounding /Discounting

Suppose you deposit Rs 1000 in bank which provide 12% interest rate .
Let’s say if Compounding done
Annually : FV =PV(1+r)n = 1000(1+0.12)1=Rs 1120
Semiannually: FV=PV(1+r/2)2n = 1000(1+0.06)2*1 = Rs.1123.6
Quaterly: FV=PV(1+r/4)4n = 1000(1+0.03)4*1 = Rs. 1125.50
The general formula for future value of single cash flow after n years when compounding done
m times in a year is: FV= PV(1+r/m)m*n

Here we see that as the frequency of compounding in a year is increased interest is also increased
so as the rate increased from 12% to more then 12% depend on frequency of compounding. For
example if compounding is done semiannually Rs 1000 grows at the rate of 12.36% per annum
as compared to 12% which was in the case of annual compounding. The figure 12.36% is known
as effective rate of interest. Which can be calculated by formula

[ ]
m
Stated annualinterest rate
Effective Interest rate= 1+ −1
m
So in above example:
Effective Interest Rate:

[ ]
1
0.12
Annually, if r=12%, 1+ = 12%
1

[ ]
2
0.12
Semi annually, 1+ = .1236= 12.36%
2
 [ ]
4
0.12
Quarterly , 1+ = .1255=12.55%
4
Continuous Compounding , er-1 = (2.71828).12-1= .1275= 12.75%

Equated Annual installments

For an amortized loan we would like to know a) the periodic installment payment and
b) the loan amortization schedule which is
showing the breakup of the periodic installment payments between interest component and
principal component.
Eg. Suppose a firm borrows Rs 1000,000 at the interest rate of 15% and loan is to be repaid in 5
equal installments payable at the end of each year for next 5 years . The annual installment A is
obtained by PVA formula:
Loan Amount = A*PVIF5,15%, = 1000000=A*3.3522
1000000
A= = Rs. 298312
3.3522

Loan Amortization Schedule(all values in Rs.)

Year Beginning Equated Annual Interest 15% Principal Balance

(1) Amount (2) installment (3) (4) =(2)-(3) Repayment (6)=(1)-(5)
(5)
1 1000,000 Rs. 298312 Rs.150,000 Rs.148312 Rs.851688
2 Rs.851688 Rs. 298312 Rs.127,753 170559 681129
3 681129 Rs. 298312 102169 196143 484986
4 484986 Rs. 298312 72748 225564 259422
5 259422 Rs. 298312 38913 259399 23*