Module 2

The Time value of money

Topics to be covered:
I. Timelines and Notation,
II. Future Value of a Single Amount,
III. Present Value of a Single Amount,
IV. Future Value of an Annuity,
V. Present Value of an Annuity,
VI. Present Value of a Perpetuity,
VII. Intra-year Compounding and Discounting.

Timelines and Notation

• A timeline shows the timing and the amount of each cash flow in a cash flow
stream .
The below figure shows the cash flow stream of Rs.10,000 at the end of each of
next five years.

0 1 2 3 4 5
12% 12% 12% 12% 12%

10,000 10,000 10,000 10,000 10,000

The figure below shows the cash flow of the stream of Rs. 10,000 at the
beginning of the year

0 1 2 3 4
12% 12% 12% 12%

10,000 10,000 10,000 10,000 10,000

Period of time: The portion of timeline between two times on a timeline is

called period of time
For Ex: The time between time 0 and time 1is called period 1

Point of time: The time that is being referred on timeline.

 For ex : Time 1 on timeline is called point 1.

Note: A cash flow that occurs at time 0 is already in present value terms and
hence does not require any adjustment for time value of money.

• Notations:

The following notation will be used

i) PV= Present value

ii) FVn = Future value n years hence

iii) Ct= cash flow occurring at the end of year t

iv) A= A stream of constant periodic cash flows over a given time

v) r = interest rate or discount rate

vi) g = expected growth rate in cash flows

vii) n = number of periods over which cash flows occur

Techniques of computing Time value of money

Time value of money

Compunding Discounting

Future Value of Future value of Present Value of Present Value of

single cashflow Annuity single cash flow Annuity

Compounding :The process of investing money and reinvesting the interest

earned thereon in called compounding.

Discounting :
 Future Value of a Single Amount

The future value or compounded value can be calculated using

FV=PV*(1+r)n
Here FV= Future value

PV=Present Value

r or i = Rate of interest

n = no.of years

Note:

1. (1+r)n is called the future value interest factor.

2. FVIF table can be used to find out the value of interest factor.
*Attached FVIF table at the end of the notes

Problems on Future value of Single amount

1. Calculate the value 5 years hence of a deposit of Rs.1,000 made today if the
interest rate is a) 8% b)10% c)12% d)15%
2. Someone promises to give you Rs 5000 after 10 yrs in exchange for Rs 1,000
today. What interest rate is implicit in this offer?
3. If you invest Rs. 5,000 today at a compound interest of 9%, what will be its
future value after 75 years.
4. Suppose you deposit 10,000 today in a bank which pays 10% interest
compounded annually. How much will the deposit grow after 8yrs and 12
years
 Present Value of a single amount
The present value of a single amount can be calculated with the below formula

Note :

1. 1/(1+r)n is called the discounting factor or present value interest factor(PVIF

r,n)

2. (PVIF r,n) table can be used to find the interest factor. Table is attached at the
end of lesson

Problems on present value of single amount.

1) What will be the present value of Rs 10,000 receivables after 8yrs if the
discount rate is 1)10% ii)12%iii)15%
2) Designs Co. is opening a showcase office to display and sell its computer
designed poster art. Designs expect cash flows to be $100,000, 6 years hence,
if Designs uses 10 percent as its discount rate, what is the present value of the
cash flow by above three equations?
3) ABC Company expects cash flows to be $160,000 in the first year, $200,000
in the second year, $240,000 in the third year, $260,000 in fourth year and
$300,000 in fifth year. If company uses 14 percent as its discount rate, what
is the present value of the cash flows?
4) Find the present value of Rs. 10,000 to be received at the end of 10 periods at
8% per period. Solve this problem by scientific calculator and by Excel
sheet?
Annuity
• An annuity is a series of equal payments made at fixed intervals for a
specified number of periods.
• If payments occur at the end of the period then they are called ordinary /
deffered annuities
Eg : Loans(car, student), mortgages etc.
• If payments are made at the beginning of each period then it is called annuity
due.
• Eg : Rent payments, Insurance payments etc.

Future Value of an Annuity

Future Value of an ordinary annuity can be calculated using the below formula:

Note :
1. (1+r) n -1 is referred to as Future value interest factor |( FVIF r,n )
r
2. (FVIF r,n ) table can be used to find the value of interest factor. Table attached
at the end of lesson..
Future Value of an Annuity Due can be calculated using below formula

Problems on Future value of an Annuity

1. Suppose you have decided to deposit Rs. 30,000 per year in your public
provident fund account for 30 years. What will be the accumulated amount in
your PPF account at the end of 30yrs if the interest rate is 8%
2. Reema wants to buy a house after 5 yrs. when it is expected to cost Rs.
20lakhs.How much should she save annually if her savings earn her a
compound return of 12%.
3. Futura limited has an obligation to redeem Rs 5 crores bonds 6years hence.
How much should the company deposit annually in sinking fund account
wherein it earns 14percent interest ,tp cumulate Rs. 5 crores in 6 yrs time.
4. A finance company advertises that it will pay a lump sum of Rs. 8,000 aat the
end of 6yrs to investors who deposit annually rs.1000 for 6 yrs. What is the
interest rate implicit in this offer?
5. Reshma wants to take up a trip to Europe ,it costs Rs. 10,00,000 – the cost is
expected to remain unchanged in nominal terms. She can save annually Rs.
50,000 to fulfil her desire. How long will she have to wait if her savings earn
an interest of 12%?.
6. Calculate future value of an annuity of Rs 5000deposited at the end of each
year @ 6% for a period of 5 yrs.
7. If 10 annual payments of Rs. 900 are made into saving account that pays 6
percent interest per year. What is the future value of this annuity, if
compounding take place semi-annually. Solve this problem by factor formula
and table?
8. Mohammad Ali Corporation started making sinking fund deposits of Rs.
20,000 at end of year. Its bank pays 6% compounded semi-annually.
What will the fund be worth at the end of 10yrs by factor formula and
general formula?

Present value of annuity

Present value of an ordinary annuity can be calculated using below formula
Present value an annuity due can be calculated using the below formula

PV = Present value of an annuity payment

PMT = Amount of annuity payment
r = Discount rate or interest rate
N= number of periods in which payments will be made

Problems on present value of annuity

1. You want to buy an ordinary annuity that will pay you $1,000 a year for the
next 5 year. You expect annual interest rates will be 7 percent over that time
period. What is maximum price you would be willing to pay today?
2. What is the present value of an annuity of Rs.2,000 per year, with the first
cash flow received three years from today and the last one received 8 years
from today? Use a discount rate of eight percent.
3. Find the present value of an annuity with periodic payments of Rs. 2,000, for
a period of 10 years at an interest rate of 6%, discounted semiannually by
factor formula?
4. What is the value today of a 5-year annuity due that pays Rs. 1,000 a
year assuming that rate is 7%?
5. Mr. Mohammad Ali has received a job offer from a large investment bank as
an accountant. His base salary will be Rs. 35,000 constant to date of
retirement. He will receive his first annual salary payment one year from the
day he begins to work. In addition, he will get an immediate Rs. 10,000
bonus for joining the company. Mr. Ali is expected to work for 25 years.
What is the present value of the offer if the discount rate is 12 percent?
6. You are making car payments of Rs.315/month for the next 3 years, you
know that your car loan has an interest rate of 12.4%, discounted monthly,
what was the initial price of the car?
7. Find the present value of due annuity with periodic payments of
Rs.3,000, for a period of 5 years at an interest rate of 16%, discounted
quarterly?
8. After reviewing your budget, you have determined that you can afford
to pay Rs. 12,000 per month for 3yrstowards a new car. You call a
finance company and learn that the going rate of interest on car finance
is 1.5 percent per month for 36months.How much can you borrow?
9. You want to borrow Rs. 1,080,000 to buy a flat. You approach a
housing finance company which charges 12.5 percent interest. You can
pay Rs. 180000 per year towards loan amortization. What should be the
maturity period of the loan.
10. Suppose a firm borrows Rs. 1,000,000 at in interest rate of 15 percent
and the loan is to be repaid in 5 equal instalments payable at the end of
each of the next five years. What is the annual instalment payment.
11. Your father deposits Rs300,000 on retirement in a bank which pays 10
percent annual interest. How much can be withdrawn annually for a
period of 10 years?
12. You have won the lottery! The lottery officials offer you two choices for
collecting your winnings. You may take four payments of $250,000
over the next four years or, you may take a one-time payment of
$750,000 today. Which would you take?

Perpetuity
• A perpetuity is an investment asset that pays a stated return for an infinite
amount of time. An annuity with no termination date is an example of a
perpetuity.
 • perpetuities do not have a fixed maturity date but continue paying interest
indefinitely.
• Example of perpetuity: Until 2015, the U.K. offered a government bond
called a consol, a contraction for consolidated annuities.

Present value of perpetuity

1. Calculate the present value of perpetuity of Rs 10,000 if the interest rate is 10%.
2. If the interest rate is 12 percent how much investment is required now to yield
an income of Rs. 12,000 per year from the beginning of 10th year and continuing
there after.?
Intra year compounding and discounting
Compounding : It is the process of determining future value of a cash flow or
series of cash flows. The compounded amount is equal to beginning amount
plus the interest earned.

Discounting: It is the process od determining the present value of a future cash

flow.

Discounting is reciprocal or reverse of compounding.

Problems on calculating effective interest rate
1. A bank offers an interest rate of 8 percent on deposits made with it. If the
compounding is done on a weekly basis, what is the effective interest
rate?
2. A bank offers 12 percent stated annual interest rate. What will be the
effective interest are when compounding is done annually, semiannually
and quarterly?.