Session 02: Time Value of Money-Part One Compounding Techniques

Session 02

Time Value of Money- Part One

Compounding Techniques

Contents

Introduction

2.1 Time preference for money

2.2 Time Preference and Required Rate of Return

2.3 Techniques of Time Value of Money

2.4 Future Value of a Lump Sum

2.5 Multi-period Compounding

2.6 Annual Interest Rate versus Effective Annual Interest Rate

2.7 Compound Value of an Annuity

Summary

Learning Outcomes

References

Introduction

Money has time value. Time value of money or time preference for money
means that the rational individuals do not value the opportunity to receive a
specific amount of money today, with the opportunity to have the same
amount at some future date. It was observed in session one that wealth
maximization as an objective of financial management, is superior to profit

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maximization. This is because the concept of wealth maximization considers

the time value of money. Therefore, the recognition of the time value of
money is extremely important in financial decision making. Time value of
money concepts is particularly important in evaluating and comparing
investment in fixed assets. If a fixed asset is purchased it require an
immediate cash outflow and will generate cash out flows during many
future periods. Since a rupee received today is worth more than a rupee
received in future, cash flows in different time period should be logically
compared. Therefore, this section mainly focuses on future value of money
which is one of the main methods for adjusting the time value of money in
financial decisions.

2.1 Time preference for Money

Money has time value because of the following reasons;

Uncertainty:

Future cash flows are always uncertain and risky. There are two type of
cash flows; cash inflows and cash out flows. Cash Outflows is in our control
because payments to external parties are made by us. There is no certainty
for future cash inflows because cash flows are dependent out on external
parties such as customers, creditors etc. Since future cash flows are
uncertain, it is rational for individual to prefer current cash receipts than
future cash receipts.

Preference for consumption:

Individuals, in general, prefer current consumption to future consumption of

goods and services. This is because, the urgency of present needs and the
risk of not being in position to enjoy future consumption due to several
reasons.

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 Session 02: Time Value of Money-Part One Compounding Techniques

Inflation:

In an inflationary environment, an individual may be able to purchase more

goods and services with some money than what he is going to get for the
same amount after one year. In other words, a rupee today represents a
greater purchasing power than a rupee a year ahead. Therefore, an
individual prefer cash receiving in today than in tomorrow.

Re – investment:

Another main reason for time preference for money is to be found in the
reinvestment opportunities for funds which are received early. For example,
an individual is given the choice of receiving Rs. 1000 either now or one
year later. His choice would obviously go for the first alternative as he can
deposit the amount in his savings account and can earn a normal rate of
interest, say 10%. At the end of the year he would have earned Rs. 1100. If
he wishes to increase his cash resources, the opportunity to earn interest
would lead him to prefer Rs. 1000 now, not Rs. 1000 after one year.

2.2 Time Preference and Required rate of Return

This time preference for money is explained by an interest rate, the interest
rate represents the price of time and the price of risk. The above example
explains that an individual is indifferent between Rs. 1000 now and Rs.
1100 after one year due to price of time. This price of time is called risk free
rate. On the other hand, investors will be exposed to some degree of risk.
Therefore, the interest rate must be included a risk premium. According to
this, an investor‘s required rate of return or interest rate is compensated both
for price of time and price of risk.

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Required rate of = Risk – Free rate + Risk premium

Return

Price of time Price of risk

2.3 Techniques of Time Value of Money

Why is consideration of time value of money important in financial decision

making? Many financial decisions taken today have implications for a
number of years. For example, if a fixed asset is purchased, it will require an
immediate cash outlay and will generate cash flows in the future. On the
other hand, if the firm borrows funds from an external source such as a bank,
issuing equity shares, it receives cash now but commits an obligation to pay
interest/dividend and return the principal in future. In order to have a
meaningful comparison of cash flows in different time periods, it is
necessary to convert these cash flows to a common point in time. The
comparison of cash flows which occur at different time periods can be done
using two techniques.

1. Future Value Techniques/ Compounding Techniques

2. Present Value Techniques/ Discounting Technique

The value of money receiving (or paying) future date with a given interest
rate is called future of money. Similarly, the worth of money today that is
receivable or payable at a future date is called present value of money. This
lesson will discuss the compounding techniques and next lesson will explain
the discounting techniques.

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 Session 02: Time Value of Money-Part One Compounding Techniques

2.4 Future Value of a Lump Sum

In this concept, the interest earned on the initial deposit (principal) amount,
becomes part of the principle at the end of the first compounding period. Let
us illustrate this by a simple example. If you invest Rs. 1000 in a savings
banks account at 5% rate of interest for one year, you will have 1050 in your
account at the end of first year.

1000 + (1000 x 0.05) = 1050

FV = pv + (pv x i)

FV = pv (1 + i)

What would be the future sum if you deposited Rs. 1000 for two years? The
value of the deposit will consist of four components.

1. Principal

2. First period interest on principal

3. Second period interest on principal

4. Second period interest on first period interest

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Therefore,

FV = PV + (PV x i) + (PV x i) + (PV x i x i)

= PV (1 + i + i + i2)

FV = PV (1 + 2i + i2)

Since (1 + 2i + i2) = (1 + i) (1 + i)

FV = PV (1 + i) (1 + i)

FV = PV (1 + i)2

This compounding procedure is applicable for any number of years. Thus

the compounding of interest can be calculated as follows.

Therefore,

FV after 1 period = PV (1 + i)

FV after 2 periods = PV (1 + i) 2

FV after 3 periods = PV (1 +i) 3

,,

,,

FV after 10 periods = pv (1 + i)10

FV after n periods = pv(1 + i)n

FVn = PV (1 + i)n

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 Session 02: Time Value of Money-Part One Compounding Techniques

In which,

FV = Amount at the end of the period (Future Value).

PV = Initial cash flow at the beginning of the period (Present Value).

I = Annual interest rate

n = Number of years

Suppose that an investor deposits Rs. 10,000 in a bank account which pays
10% interest compounded annually. What will be the balance of the account
after 10 years?

Solution 1

PV = 10,000 F10 = 10000 (1 +.10)10

n = 10 F10 = 10000 (2.5937)

i = 0.10 F10 = 25937

===

Activity 2.1: Compound Interest

If you deposit Rs. 10,000 today at 12% rate of annual interest for 8 years, what will be
the balance at the end of your investment horizon?

Table of Compound Factors

The compound value can be computed for any lump sum at i rate of interest
for a given number of years, using the above equation. However, the
calculations will become very difficult if the number of years involved is
large, say 25 or35 years. The compound value of Rs. 1 for various periods
of time at different rates of interest can be recalculated. Such pre calculated
compound value factors (CVF) are available in table A given at the end of
this module. Accordingly, to solve the future value problems we consult a

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future interest factor table. The table shows the future value factor for
certain combinations of periods and interest rates. For example, the
compound value factor when i = 10 and n = 20 is 6.728. When i = 15and n =
18 the compound factor is 12.375. Using compound value factors, we can
calculate the future value of a lump sum as follows.

FV = PV (CVFi,n)

Let us solve the previous example using compound value factors in table A.
From the table, the CVF when i = 10 and n = 10 is 2.5737. Therefore,

FV = PV (CVFi,n)

FV = 10, 000 (2.5937)

FV = 25937

2.5 Multi-period Compounding

In the above example we assumed annual compounding of interest at the

end of the year. In practice, interest income can occur more than once a year.
For example, banks may pay interest on saving accounts semi – annually,
quarterly and monthly. Suppose you invest Rs. 1000 now in a bank, interest
rate being 10% a year, and that bank will compound interest semiannually.
How much will you get after a year? Semi – annual compounding means
that there are two compounding periods within the year and interest is
actually paid after every six months at a rate of one – half of the annual rate
of interest. Thus, the amount of interest for first six months will be,

Interest income = Rs. 1000 x 10% x = 50

And the outstanding amount at the beginning of the second six-month

period will be. Rs. 1000 + Rs. 50 = Rs. 1050. Now you will earn interest on
Rs. 1050. The interest on Rs. 1050 for next six months will be:

(1050 x 10% x ) = 52.50

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 Session 02: Time Value of Money-Part One Compounding Techniques

Thus, you will accumulate Rs. 1000 + 50 + 52.50 = 1102.50 at the end of a
year. The general formula for solving for the compounding value at the end
of year ―n‖ where interest in paid ―m‖ times a year is given below.

Fn V = PV (1 + i m )mn

Where, PV = Principal amount

i = Interest rate

m = no of times interest compounding is done during a year

n = no. of years

Suppose that you invest Rs. 5,000 in a bank account with an annual interest
of 12%. If the interest is paid quarterly, what will be the balance of the
account after 6 years?

Solution 2

In this question we have the following

PV = 5,000 FV =pv(1 + i/m)mn

i = 12% FV = 5,000 (1 +0.12/4)4x6

n =6 FV = 10163.97

m=4

Activity 2.2: Multi Period Compound Interest

What would be the balance of the bank account in example 2 if the interest is paid
monthly?

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2.6 Annual Interest Rate versus Effective Annual

Interest Rate

We have seen above that Rs. 1000 grows to Rs. 1102.50 at the end of a year
if the annual interest rate is 10% and compounding is done semi-annually.
This means that Rs. 1000 grows at the rate of 10.25% per annum. You
received more under semi-annual compounding because you earned interest
on interest for the second 6 months. The rate of 10.25% is called the
effective rate of interest. (EIR). When interest is compounded half- yearly
basis, interest amount works out more than the interest calculated on yearly
basis. Similarly, when interest is calculated on quietly, interest amount
works out more than the interest calculated on semiannual basis. So,
compounding is more frequent, then the amount of interest per year works
out more.

The general formula for the EIR is as follows.

 i m
EIR = 1 +  −1
m
 

Where, EIR = effective rate of interest

i = annual interest rate

m = Frequency of compounding per year

A bank offers 12% annual rate of interest with semi-annual compounding.

What will be the effective rate of interest (EIR)?

Solution 3

 0.12 2
1+ −1
 2 
EIR =

= 12.36%

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 Session 02: Time Value of Money-Part One Compounding Techniques

Activity 2.3: Effective Interest Rate

What would be the effective rate of interest in above example if the interest is paid
quarterly?

2.7 Compound Value of an Annuity

In the previous section we discussed how to find the future value of a single
amount invested today. But many investments provide a series of cash flows
over time. When cash flows are constant and equally spaced payment, it is
called an annuity. When cash flows occur at the end of each period, the
annuity is called a regular annuity. Annuities are very common in today‘s
financial world. You may be making regular payment on a car loan or your
insurance premium. You may also be receiving interest payment on your
bonds. The equal amount of deposit (Rs. 100) for period of four years can be
visualized as follows.

Cash flow series of an Annuity

To calculate the future value of the above annuity, we have to find the future
value of each cash flow at the end of year 4. This implies that Rs. 100/=
deposited at the end of the first year will grow for 3 years, Rs. 100/= at the
end of second year for 2 years, Rs. 100/= at the end of third year for 1 year
and Rs. 100 at the end of the fourth year will not yield any interest. If the
interest rate is 6% of the compound value of Rs. 100 annuities is:

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1 2 3 4
100 100 100 100
100(1.06)0 100

100(1.06)1 106

100 (1.06)2 112.4

100 (1.06)3 119.1

437.5

The computations shown in the above can be expressed as follows.

F4 = A(1 + i)3 + A(1 + i)2 + A(1 + i) + A

F4 = A[(1 + i)3 + (1 + i)2 + (1 +i) +1]

When this is extended for ‗n‘ periods, the future value formula takes the
following form.

FnV = A (1 + i)n - 1

Where A is the constant periodic flow of cash, i is the rate of interest and n
is the number of periods. Using this formula we can solve the above
example.

FnV = 100 (1 + 0.06)4 - 1

0.06

= 437.50

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 Session 02: Time Value of Money-Part One Compounding Techniques

Compound Value of Annuity Factor (CVAF) Tables

Table B at the end of module gives compound value factors for an annuity
of Re. 1 for various combinations of time periods and rates of interest. For
example the compound value of an annuity when i = 9% and ‗n‘ = 10 is
15.193. Using this (CVAF) table, the future value of the annuity can be
calculated as follows.

FV = A (CVAFi.n)

Suppose Rs.2000/= is deposited at the end of each of the next five years at
5% annual interest rate. The investor wants to determine how much of
money he will have at the end of the 5th year. To find the answer to this
question we need to find CVAF when i = 5% and n = 5. From the table we
find that the compound value of annuity factor (CVAF) is. 5.526. Thus,
when multiplied by Rs.2000/= annuity we find the total sum as Rs.11052.

Symbolically, Fv = A (CVAFi,n)

Fv = Rs.2000 (CVAF5,5)

= Rs.2000 (5.526)

= Rs.11052

Activity 2.4: Annuity

If the interest is assumed to rise from 5% to 7% what would be the value of the above
annuity ?

Annuity Due

In the above example you make your first deposit (Rs.100) one year from
today. However, first deposit (Rs. 100) could be made at the beginning of
the year rather than one year from today. Both deposited have the same total
amount over the four years period. But the value of these two types of
deposited is different. If payments are stating at the beginning of each

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period for a specific number of periods is called an annuity due. In above

example, when deposits are made at the end of the year (as ordinary
annuity), the future value of your deposits at the end of four years is Rs.
437.50. If you deposit Rs. 100 in beginning of the ach year (as annuity due),
the cash flow time line for this annuity is as follows.

1 2 3 4
100 100 100 100
100(1.06)1 106

100(1.06)2 112.4

100(1.06)3 119.1

100(1.06)4 126.2
463.7

As you can see, the future value of the annuity due Rs. 463.70 is greater
than the future value of ordinary annuities (Rs. 437.50). Because, cash
deposit in annuity due receives interest for one additional year. The above
timeline solution shows that the computation of the future value of the
annuity due is the same as the computation of the future value of an ordinary
annuity except that each deposit is multiplied by an additional (1+i).
Therefore, the formula for the future value of an annuity due can be found
out as follows.

Using above Formula, we find that FnV due is

To compute the future value of annuity due using compound value of

annuity factor (CVAF) table, relent annuity factor should be multiplied by
(1+i).

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 Session 02: Time Value of Money-Part One Compounding Techniques

For above example,

FnV (Due) = 1000 (4.375)(1.06)

= Rs. 463.70

Activity 2.7: Review Question

1. Why do not the rational individuals value the opportunity to receive a specific
amount of money today with the opportunity to have the same amount at some
future date?

2. A bank offers the following alternative interest payment schemes.

▪ An annual interest rate of 12%

▪ An annual interest rate of 10%; interest being paid semiannually.

▪ An annual interest rate of 9%; interest being paid monthly.

Which scheme should be selected by a rational investor? Why?

3. Mr. Salgadu plans to send his son for higher studies abroad after 10 years. He
expects the cost of these studies to be Rs. 5,00,000. How much should be save
annually to have a sum of Rs. 5,00,000 at the end of 10 years, if the annual interest
rate is 12% ?

4. Suppose that you have inherited Rs. 150,000 from your grandmother. Your desire
is to have Rs. 1,000,000 saved in 10 years’ time. Therefore, you decide to place
the money you inherited in a fixed deposit account immediately and to deposit a
equal annual amount from your employment income in a savings account over the
next ten years beginning from the end of the first year. The bank pays an annually
compounded interest of 18% percent on fixed deposit and 12 percent on savings
balances. What is the annual deposit that you should place on your savings
account?

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Summary

You are supposed to devote about 3-4 hours to complete this session. You
should learn the concepts with the examples given in the session. Before
reading this session, make sure that you know the meaning of wealth
maximization of the firm. The session covers time preference for money,
time Preference and Required rate of return, techniques of time value of
money, future value of a lump sum, multiperiod compounding, annual
interest rate versus effective annual interest rate, and compound value of an
annuity. Further, after completion of this session, learners will be able
achieve following learning outcomes.

Learning Outcomes

▪ Define and explain the concept of time preference for money.

▪ Calculate the compounding value of the present cash flows.
▪ Use the tables of compound factors to calculate the compounding
value present cash flows.

References

Financial Management: Theory & Practice (with Thomson ONE – Business

School Edition 1-Year Printed Access Card) 14th Edition —by— Eugene
F. Brigham and Michael C. Ehrhardt.

Financial Management: Theory & Practice 15th Edition —by— Eugene F.

Brigham and Michael C. Ehrhardt.

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