Chapter - 2

Concepts of Value
and Return
Chapter Objectives
🞂Understand what gives money its time value.
🞂Explain the methods of calculating present and
future values.
🞂Highlight the use of present value technique
(discounting) in financial decisions.
🞂Introduce the concept of internal rate of return.

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Time Preference for Money
🞂Time preference for money is an individual’s
preference for possession of a given amount of
money now, rather than the same amount at some
future time.
🞂Three reasons may be attributed to the individual’s
time preference for money:
◦  risk
◦  preference for consumption
◦  investment opportunities

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Required Rate of Return
🞂The time preference for money is generally expressed
by an interest rate. This rate will be positive even in the
absence of any risk. It may be therefore called the risk-
free rate.
🞂An investor requires compensation for assuming risk,
which is called risk premium.
🞂 The investor’s required rate of return is:
Risk-free rate + Risk premium.

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Time Value Adjustment
🞂Two most common methods of adjusting cash flows
for time value of money:
◦ Compounding—the process of calculating future
values of cash flows and
◦ Discounting—the process of calculating present values
of cash flows.

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Future Value
🞂 Compounding is the process of finding the future values
of cash flows by applying the concept of compound
interest.
🞂 Compound interest is the interest that is received on the
original amount (principal) as well as on any interest
earned but not withdrawn during earlier periods.
🞂 Simple interest is the interest that is calculated only on the
original amount (principal), and thus, no compounding of
interest takes place.

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Future Value
🞂The general form of equation for calculating the
future value of a lump sum after n periods may,
therefore, be written as follows:

🞂The term (1 + i)n is the compound value factor

(CVF) of a lump sum of Re 1, and it always has a
value greater than 1 for positive i, indicating that
CVF increases as i and n increase.

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Example
🞂If you deposited Rs 55,650 in a bank, which was
paying a 15 per cent rate of interest on a ten-year
time deposit, how much would the deposit grow at
the end of ten years?

🞂We will first find out the compound value factor at

15 per cent for 10 years which is 4.046. Multiplying
4.046 by Rs 55,650, we get Rs 225,159.90 as the
compound value:

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Future Value of an Annuity
🞂Annuity is a fixed payment (or receipt) each year for
a specified number of years. If you rent a flat and
promise to make a series of payments over an agreed
period, you have created an annuity.

🞂The term within brackets is the compound value

factor for an annuity of Re 1, which we shall refer as
CVFA.

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Example
🞂Suppose that a firm deposits Rs 5,000 at the end of
each year for four years at 6 per cent rate of interest.
How much would this annuity accumulate at the
end of the fourth year? We first find CVFA which is
4.3746. If we multiply 4.375 by Rs 5,000, we obtain
a compound value of Rs 21,875:

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Sinking Fund
🞂Sinking fund is a fund, which is created out of fixed
payments each period to accumulate to a future sum
after a specified period. For example, companies
generally create sinking funds to retire bonds
(debentures) on maturity.
🞂The factor used to calculate the annuity for a given
future sum is called the sinking fund factor (SFF).

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Present Value
🞂Present value of a future cash flow (inflow or
outflow) is the amount of current cash that is of
equivalent value to the decision-maker.
🞂Discounting is the process of determining present
value of a series of future cash flows.
🞂The interest rate used for discounting cash flows is
also called the discount rate.

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Present Value of a Single Cash Flow
🞂 The following general formula can be employed to
calculate the present value of a lump sum to be received
after some future periods:

🞂 The term in parentheses is the discount factor or present

value factor (PVF), and it is always less than 1.0 for
positive i, indicating that a future amount has a smaller
present value.

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Example
🞂Suppose that an investor wants to find out the
present value of Rs 50,000 to be received after 15
years. Her interest rate is 9 per cent. First, we will
find out the present value factor, which is 0.275.
Multiplying 0.275 by Rs 50,000, we obtain Rs
13,750 as the present value:

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Present Value of an Annuity
🞂The computation of the present value of an annuity
can be written in the following general form:

🞂The term within parentheses is the present value

factor of an annuity of Re 1, which we would call
PVFA, and it is a sum of single-payment present
value factors.

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Capital Recovery and Loan
Amortisation
🞂Capital recovery is the annuity of an investment made
today for a specified period of time at a given rate of
interest. Capital recovery factor helps in the preparation
of a loan amortisation (loan repayment) schedule.

The reciprocal of the present value annuity factor is

called the capital recovery factor (CRF).

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Present Value of an Uneven
Periodic Sum
🞂Investments made by of a firm do not frequently
yield constant periodic cash flows (annuity). In
most instances the firm receives a stream of uneven
cash flows. Thus the present value factors for an
annuity cannot be used. The procedure is to
calculate the present value of each cash flow and
aggregate all present values.

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Present Value of Perpetuity
🞂Perpetuity is an annuity that occurs indefinitely.
Perpetuities are not very common in financial
decision-making:

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Present Value of Growing Annuities
🞂The present value of a constantly growing annuity
is given below:

🞂Present value of a constantly growing perpetuity is

given by a simple formula as follows:

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Value of an Annuity Due
🞂Annuity due is a series of fixed receipts or
payments starting at the beginning of each period
for a specified number of periods.
🞂Future Value of an Annuity Due

🞂Present Value of an Annuity Due

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Multi-Period Compounding
🞂If compounding is done more than once a year, the
actual annualised rate of interest would be higher
than the nominal interest rate and it is called the
effective interest rate.

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Continuous Compounding
🞂The continuous compounding function takes the form
of the following formula:

🞂Present value under continuous compounding:

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Net Present Value
🞂Net present value (NPV) of a financial decision is
the difference between the present value of cash
inflows and the present value of cash outflows.

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Present Value and Rate of Return
🞂A bond that pays some specified amount in future
(without periodic interest) in exchange for the current
price today is called a zero-interest bond or zero-
coupon bond. In such situations, you would be
interested to know what rate of interest the advertiser
is offering. You can use the concept of present value to
find out the rate of return or yield of these offers.
🞂The rate of return of an investment is called internal
rate of return since it depends exclusively on the cash
flows of the investment.

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Internal Rate of Return
🞂The formula for Internal Rate of Return is given
below. Here, all parameters are given except ‘r’
which can be found by trial and error.

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