Time Value of Money

Utkarsh Majmudar

September 2014
1 Formula
Present and future Value -Single period
Future Value = Present Value (1 +r)
Present Value =
Future Value
(1 +r)
Present Value Multiple periods
Present Value =
C
1
(1 +r)
+
C
2
(1 +r)
2
+
C
3
(1 +r)
3
+. . .
Future value Multiple periods
Future value = C
1
(1 +r) +C
2
(1 +r)
2
+C
3
(1 +r)
3
Present value - Perpetuity
Present value =
C
r
Present value - Growing Perpetuity
Present value =
C
r g
Present value -Annuity
Present value =
C
r

1
1
(1 +r)
n

Present value -Growing Annuity

Present value =
C
r g

(1 +g)
(1 +r)

Indian Institute of Management, Bangalore

1
2 Time Value of Money: Concepts
One of the most important principles in nance is the relationship between
Re. 1 today and Re. 1 in the future. For most of us, Re. 1 received one year
hence is less valuable than Re. 1 received immediately. And Re. 1 received
two years hence is even less valuable.
Why is this so? Suppose I lent you Re.1 today for one year. At the end
of one year I would expect you to repay me Re. 1 (the principal) along with
interest. Interest is nothing but my wages for the service that I provide you
in allowing you to use my money for one year. Suppose I charge you interest
at 15 per cent per annum. Then, at the end of year, you will repay me Rs.
1.15.Thus Rs. 1.15 received one year hence is worth Re. 1 today. Using our
example. Re.1 received one year hence is worth only 87 paise today; and Re
1 received two year hence is worth only 76 paise today. Now, the question
arises as to how do we know that Re. 1 received one year hence is worth
only 87 paise today. We rephrase the question as:
How much money should I lend so that I receive Re. 1 after a year as
principal together with interest?
Let X be the amount of money to be lent out. And we know that every
Re. 1 lent today pays back Rs. 1.15 at the end of the year. So we can
formulate our problem as:
X (1 + 0.15) = 1 or 1 (1.15) = X = 0.87
What is a time line?
A time line maps the sequence of money received and spent in a chrono-
logical sequence. Time period 0 refers to the time just prior to the decision
(to borrow or to lend; to invest in a project or not to invest in a project).
Time period 1 refers to the end of one period (one year, one month, one
week, etc.) after the decision is made. A + or a - sign may be prexed to
the money amount. The + sign indicates that the money is being received
(from now on we shall call it cash inow); and the - sign refers to the money
being spent (cash outow). If no sign is prexed it implies that the amount
is a cash inow. Also, unless otherwise stated, we will assume that the com-
pounding frequency is the same as payment frequency, for example if there
are monthly payments, the interest compounding is also monthly.
A typical time line is illustrated below:
2
-1 +1
0 1
S
Sw
Z
Z~

>

*
Cash outow Cash inow
Time period 0 Time period 1
Compounding and Discounting
Compounding refers to the ability of an asset to generate earnings that
are then reinvested and generate their own earnings. Thus Re. 1 lent out
today for two years has to be repaid by Rs. 1.32. (11.151.15 = 1.32) at
the end of two years. We call Re. 1 the present value and Rs. 1.32 future
value. The compounding process transforms a present value into a future
value.
Discounting, on the other hand, transforms future value to present value.
Thus Rs. 1.32 (future value) received two years hence is worth Re. 1 (present
value) today (1.32 (1.15)
2
= 1).
Multiple Expected Cash ows
Suppose you expect to receive the cash ows as given in the time line
below:
0 1 2 3
3000 5000 2000 7000
3000
1.15
0
= 3000.00
5000
1.15
1
= 4347.82
2000
1.15
2
= 1512.29
7000
1.15
3
= 4602.61
Total PV = 13462.72
What is the present value of the set of expected future cash ows given
above if the interest rate is 15%?
3
We can compute the present value of the set of cash ows by applying
the present value concept to each cash ow. Thus the present value of Rs.
5000 received one year hence is given by
5000
1.15
1
, similarly the present value
of Rs. 2000 received two years hence is given by
2000
1.15
2
and nally Rs. 7000
received three years hence is given by
7000
1.15
3
Annuities and Perpetuities
An annuity is a series of identical cash ows that are expected to occur
each period for a specied number of periods. Thus, when I take a loan to
buy a car, I promise to pay the nance company (say) Rs. 3125 per month
for 10 years. This is an example of an annuity.
An annuity that goes on forever is called perpetuity. Pension received
by an employee on retirement is an example of perpetuity.
Denoting the identical cash ow amount by CF, the interest rate (also
called the discount rate) by r, present value by PV and future value by FV,
the following formula aid our computation of present and future values.
The present value of an annuity is given by:
PV(annuity) = CF

(1 +r)
n
1
r(1 +r)
n

While the future value of an annuity is given by:

FV(annuity) = CF

(1 +r)
n
1
r

The present value of perpetuity is given by:

PV(perpetuity) =
CF
r
Example: What is the present value of Rs. 1500 received per year forever,
if the discount rate is 8 per cent per year?
PV(perpetuity) =
CF
r
=
1500
0.08
= Rs.1850
Suppose that the Rs. 1500 received per year can be received for only 50
years. What would be the present value of this stream?
PV(annuity) = CF

(1 +r)
n
1
r(1 +r)
n

= 1500

(1.08)
50
1
0.08(1.08)
50

= 1500(12.2335)
= 18350.23
Example: Suppose I wish to buy a car costing Rs. 3 lakhs. What annual
installment must I pay to the nance company, if the interest rate is 12
4
per cent per annum and I wish to repay the entire amount (principal and
interest) in 20 years?
PV(annuity) = CF

(1 +r)
n
1
r(1 +r)
n

CF = PV(annuity)

r(1 +r)
n
(1 +r)
n
1

CF = 3

.12(1.12)
20
(1.12)
20
1

= 3(0.1339)
= 0.0402lakhs
Solving for discount rates Sometimes one knows the present value and
the future value, but not the discount rate. How does one tackle such a
situation?
Example:
Amar lends Raman a sum of Rs. 17,500 today. This sum has to be
repaid back as a lump- sum amount of Rs. 1,00,000 after ten years. At
what interest rate is Amar lending the money?
r =

FV
PV
1
n
1
r =

100000
17500
1
10
1
= 1.1904 1
= 0.19104or 19.04%
Compounding Frequency
Until now we have used a discount rate consistent with the frequency of
cash ows for example 12% per annum with annual payments. In practice,
the rates are stated in one of the two ways, an annual percentage rate (APR)
or as an annual percentage yield (APY), even though interest is calculated
and paid more often than annually. APR is also commonly called the stated
rate while APY is commonly called the eective rate.
The annual percentage rate (APR) is the periodic rate times the number
of periods in a year. This means that the APR is a nominal rate, a rate
in name only. That is, the true (eective) annual rate may be dierent
because of the compounding frequency. The compounding frequency is how
often the interest is compounded in a year. With m compounding periods
per year,
APR = (m)(r)
The annual percentage yield is the eective (true) annual return. It is
the rate you actually earn or pay in one year, taking into account the eect
5
of compounding. The APY is computed by compounding the periodic rate
for the compounding frequency.
r =

1 +
APR
m

n
1
Using Excel spreadsheet for Time Value of money computa-
tions
EXCEL FUNCTIONS
Some EXCEL functions to help you:
PV
the total amount that a series of future payments is worth
today.
FV the future value of an investment based on periodic, constant
payments and a constant interest rate.
PMT Calculates the payment for a loan based on constant pay-
ments and a constant interest rate.
NPER the number of periods for which the cash stream is likely to
be received or paid.
RATE the interest rate per period of a loan or an annuity.
TYPE =

0 if all payments/receipts are at the end of the period

(this the default),
1 if all payments/receipts are at the beginning of the period.
Let us now look at some examples to understand how these functions
can be used:
Example1: Ram is to pay me Rs. 125 after one year. If I have lent him
money at 15interest, how much money have I lent him?
We use the function
pv(rate,nper,pmt,fv,type)
Enter in one cell:
=pv(15%,1,0,125,0)
This will give the result:
-Rs108.70
Example 2: If I have lent Ram Rs. 110 today, how much will he pay me
back after one year if the interest rate is 15%?
We use the function
fv(rate,nper,pmt,pv,type)
Enter in one cell:
=fv(15
6
This will give the result:
Rs126.50
Example 3: Ram will pay me a xed sum of money at the end of every
year for the next 10 years against a loan that I have given him. Suppose
he will repay me Rs. 100 each year and the interest rate is 15%, how much
have I lent him?
We use the function
pv(rate,nper,pmt,pv,type)
Enter in one cell:
=pv(15%,10,100,0)
This will give the result: -Rs501.88
Example 4: Ram will pay me a xed sum of money at the end of every
year for the next 10 years against a loan that I have given him. Suppose
I have lent him Rs. 5,000 and the interest rate is 15%, how much will he
repay me every month?
We use the function
pmt(rate,nper,pv,fv,type)
Enter in one cell:
=pmt(15%,10,-5000,0,0)
This will give the result: Rs996.26
Example 5: Ram will pay me a xed sum of money at the end of every
year for the next 10 years against a loan that I have given him. Suppose I
have lent him Rs. 5,000 and if he repay me Rs. 1000 every year for 10 years,
at what rate of interest have I lent him money?
We use the function
Rate(nper,pmt,pv,fv,type)
Enter in one cell:
=rate(10,1000,-5000,0,0)
This will give the result:
15%
Example 6: I have lent a certain sum of money to Ram at 15% interest.
He promises to pay me at the end of each of the following year the said
amounts:
Year 1 2 3 4 5
Amount 120 135 80 25 1200
How much have I lent him?
For such problems we use a special function:
7
NPV returns the net present value of a stream of cash inows and out-
ows.
We use the function
npv(rate, value1,value2)
Enter in one cell:
=npv(15%, 120,135,80,25,1200)
This will give the result: Rs869.93
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3 Derivations
Here
PV is present value
FV is future value
r = cost of funds/opportunity cost/cost of capital
g is the growth rate of cash ow
3.1 Present value of a perpetuity
PV =
C
(1 +r)
+
C
(1 +r)
2
+
C
(1 +r)
3
+. . . (1)
Multiplying both sides by (1+r) we get
PV(1 +r) = C +
C
(1 +r)
+
C
(1 +r)
2
+
C
(1 +r)
3
+. . . (2)
Subtracting 2 from 1 we get
PV(1 +r) PV = C
= PVr = C
= PV =
C
r
3.2 Present value of a growing perpetuity
PV =
C
(1 +r)
+
C(1 +g)
(1 +r)
2
+
C(1 +g)
2
(1 +r)
3
+. . . (3)
Multiplying both sides by
(1+r)
(1+g)
we get
PV
(1 +r)
(1 +g)
=
C
(1 +g)
+
C
(1 +r)
+
C(1 +g)
(1 +r)
2
+. . . (4)
Subtracting 3 from 4 we get
PV
(1 +r)
(1 +g)
PV =
C
(1 +g)
Therefore,
PV(1 +r) PV(1 +g) = C
PV(r g) = C
PV =
C
r g
Alternative approach
PV =
C
(1 +r)
+
C(1 +g)
(1 +r)
2
+
C(1 +g)
2
(1 +r)
3
+. . .
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This series will continue for an innite amount of periods. This formula
could be rewritten as
PV =
C
(1 +r)
+
C
(1 +r)

1 +g
1 +r

+
C
(1 +r)

1 +g
1 +r

2
+. . .
This is considered to be an innite geometric series with a common
ratio of (1+g)/(1+r). Putting this formula into the innite geometric series
formula would result in
PV =
C
(1+r
1
1+g
1+r
Simplifying
PV =
C
r g
3.3 Present value of an annuity
Present value of perpetuity is PV =
C
r
.
Now, consider another perpetuity that starts in year n. The present
value of the perpetuity in year n will be PV =
C
r
. The present value of this
perpetuity in year 0 will be PV =
C
r(1+r)
n
.
Subtracting the two will give us present value of annuity
Figure 1: Present value of an annuity
PV =
C
r

1
1
(1 +r)
n

Alternative approach
PV =
C
(1 +r)
+
C
(1 +r)
2
+
C
(1 +r)
3
+. . .
C
(1 +r)
n
By using the geometric series formula
1
, the formula can be rewritten as
PV =
C
1+r

C
!+r
1
(1+r)
n
1
1
(1+r)
1
The sum of rst n terms of a geometric series is given by a
1x
n
1x
where a is the rst
term of the series, and x is the common ratio
10
Simplifying
PV =
C
r

1
1
(1 +r)
n

3.4 Present value of a growing annuity

The approach is similar to that of constant payment annuity.
Figure 2: Present value of a growing annuity
PV =
C
r g

C(1 +g)
n
r g

1
(1 +r)
n
PV =
C
r g

(1 +g)
(1 +r)

Alternative approach
PV =
C
(1 +r)
+
C(1 +g)
(1 +r)
2
+
C(1 +g)
2
(1 +r)
3
+. . .
By using the geometric series formula,
1
the formula can be rewritten as
PV =
C
r g

1
(1+g)
n
(1+r)
n
1
1+g
1+r
Simplifying
PV =
C
r g

1 +g
1 +r

11