Chapter III TIME VALUE OF MONEY Aims and Objectives This chapter is intended to discuss the concept of time

value of money and its role in studying the viability of the project by comparing the initial investment future benefits. After going through this chapter we will be able to: (i) Describe concept and components of the time value of money. (ii) Classify the time value of money and describe rules of 72 and 69. (iii) Understand effective rate of interest and future value of an annuity.

Introduction
The time value of money has gained greater importance in studying the viability of the project by comparing the initial investment with the anticipated future benefits. If the anticipated future benefits are more than the initial investment then the investment is found to be viable in generating the economic benefits. The following are the reasons involved to determine the real rate of return 1 With reference to Money employment on productive assets 0 In an inflationary period, a rupee today has greater purchasing power than rupee in the future 2 The future is uncertain- Individuals prefer current consumption rather than future consumption Factors Contributing To the Time Value of Money: Money has a time value because of the following reasons: 1 Individuals generally prefer current consumption to the future consumption. 2 An investor can probably employ a rupee received today, to give him a higher value to be received tomorrow or after a certain period of time. 3 In an inflationary economy, the money received today, has more purchasing power than money to be received in future. Thus, the fundamental principle behind the concept of time value of money is that, a sum of money received today, is worth more than if the same is received after some time. For example, if an individual is given an alternative either to receive rs.10000 now or after six months; he will prefer rs.10000 now. This may be because today he may be in a position to purchase more goods with the money than what he is going to get for the same amount after six months.

Time value of money or time preference of money is one of the central ideas in finance. It becomes important and is of vital consideration in decision making. This will be clear with the following example. Example: A project needs an initial investment of Rs.1, 00,000. It is expected to give a return of Rs.20000 p.a. at the end of each year, for six years. The project thus involves a cash outflow of Rs.100000 in the zero year and cash inflows of Rs.20000 per year, for six years. In order to decide, whether to accept or reject the project, it is necessary that the present value of cash inflows received annually for six years is ascertained and compared with the initial investment of Rs.1,00,000. The firm will accept the project only when the present value of the cash inflows at the desired rate of interest is at the least equal to the initial investment of Rs.1, 00,000. Foundations of the Time Value of Money There are two; one is the time preference of money and another one is reinvestment opportunity which is identified and inter related with each other. Early receipt of money paves way for the reinvestment opportunity but the later receipt does not carry the things. Time value of money normally contains three different components viz: Real rate of return: It is the return which considers original return of the investment but it never considers the inflation rate. Expected/Anticipated rate of return: It is the positive rate of return normally expected by every one on the amount of investment from the future. Risk premiums: This allowance is normally given to the investors to compensate the uncertainty... Classifications of the Time Value of Money The concept of time value of money can be classified into two major classifications: 1 Future value of money 2 Present value of money Future value of money: It is further bifurcated into two different categories viz Future value of single sum and Future value of an Annuity

Present value of money: It is further classified into two major classes viz Present value of single sum and Present value of and Annuity Future value of single sum: 1 It could be found from the inbound relationship in between the future value of money and present value of money. FVn = PV(1+K)n FVn = Future Value of Cash Inflow PV = Initial Cash Flow K = Annual Rate of Return N = Life of Investment Example 1 If you deposit Rs.1, 000 today in a bank which pays 10% interest, find out the future value of money after 3 years. Future value of Rs.1, 000 after three years will be = Rs.1,000(1+.10) 3 = Rs.1, 000(1.331)= Rs. 1,331 Doubling period: It is the period which makes the investment as "Doubled" There are two different approaches viz 1 Rule of 72 2 Rule of 69 Rule of 72 The initial amount of investment gets Doubled within which 72/I I = Interest Rate of the investment Example: 2 The amount of the investment is Rs.1, 000. The annual rate of interest is 12%. When this amount of Rs.1, 000 will get doubled? = 72/12 = 6 years Rule of 69 The amount method is found to crude method in determining the doubling period which has its own limitations. The Rule of 69 was developed only in order to remove the bottlenecks associated with the early model of doubling period. The rule of 69 is found to be a scientific method as well as rational method in determining the doubling period of the investment =.35+ 69/I Example: 3 The amount of the investment is Rs.1, 000. The annual rate of interest is 11% when this amount of Rs 1,000 will get doubled? =.35+ 69/11= 6.6227 yrs

Frequency of Compounding Multiple Compounding: Whenever many compounding is taking place, the following methodology has to be adopted for the determination of the future value of money. FV = PV (1+k/m) mxn M = Number of Times Compounding is done during the year N = number of years K = compounding rate Example: 4 How much does a deposit of Rs. 5,000 grow to at the end of 6 years. If the nominal rate of interest is 12% and frequency is 4 times a year? The future value of Rs. 5,000 will be = Rs.5,000(1+.12/4)46 = Rs.5,000(2.033)= Rs.10,165 Effective Rate of Interest It is the rate of interest at which mount of the principal grows with regards to the rate of compounding. r = (1+K/m) m - 1 K = Nominal Rate of Interest r = Effective Rate of Interest m = Frequency of Compounding Example: 5 A bank offers 8% nominal rate of interest with quarterly compounding. What is the effective rate of interest? R = (1+.08/4)4 -1=1.082-1=.082 i.e 8.2% Future Value of an Annuity Annuity may be a series of either payments or receipts The annuity can be classified into two categories 0 Annuity at the end of the period- Regular / Deferred Annuity 1 Annuity at the beginning of the period - Annuity Due Annuity at the end of the period [ A (1+ K) n -1 ] FVAn = ------------------------ Future Value Interest Factor Annuity (FVIFA) K

Illustration 6 Suppose you deposit Rs.1,000 annually in a bank for 5 years and your deposits earn a compound interest rate of 10% What will be value of the deposit at the end of 5 years? Assuming the each deposit occurs at the end of the year, the future value of this annuity? FVAn = Rs.1,000(FVIFA) for 10% and 5 years [(1 .10)5 -1] = Rs.1,000 --------------.10 = Rs.1,000 6.105 = Rs.6,105 Future Value of Annuity Due [ A (1+ K) n -1] FVAn = ----------------------- (1+k) K Example: 7 If you invest Rs 1,000 at the beginning of every year, for four years, what will be the value of the investment finally? [(1+ .10)5 -1] FVAn = Rs.1,000 -------------------- (1+.10) .10 = Rs.1, 000 6.7155= Rs.6, 715.5 Sinking Fund Factor Method It means that the amount to be deposited at the end of every year for the period of "n" years at the rate of interest "K" in order to aggregate Re.1 at the end of the period. A = FVA [K/(1+K)n -1] Example: 8 How much you should save annually to accumulate Rs.20,000 by the end of 10 years. If the saving earns an interest of 12 %? A = Rs.20,000[.12/(1+.12)10 -1] = Rs.20,000(.05698)=Rs.1,139

Present Value of Single Cash Flow It is the process in which the future value of single cash flow is reckoned to "0" time horizon i.e on today. PVn = FVn /(1+R)n Example: 9 Find the present value of Rs.1,000 receivable 6 years hence if the rate of discount is 6 percent PVn = Rs.1,000/(1+.06)6 = Rs.1,000(.705) = Rs.705 Shorter Discounting Periods The discounting may be frequent in times like intra year compounding, intra month compounding and so on. Subject to .1 Number of periods in the analysis- increases .2 Discount rate applicable per period decreases 1 mxn .1 .1 .2 PV= FV --------------1 + k/m M = number of times discounting K = Discount rate

Example:10 Consider the following cash inflow of Rs.10,000 at the end of four years. The present value of cash inflow when the discount rate is 12% and discounting quarterly. PV = Rs.10,000 (.623)=Rs.6,230 PRESENT VALUE OF ANNUITY .1 Present value of an annuity - Present value of future cash series - To identify the value of future cash flows on present value

(1 + K )n-1 .1 PVAn,k = --------------K(1+K)n Example: 11 If you expect to receive Rs.1,000 annually for 3 years, each receipt is expected to be at the end of the years. What would be the present value of future cash inflows @ discount rate of 10% ? PVA n,k = Rs.1,000 (2.487)= Rs.2,487 Capital Recovery Factor Method K(1 + k) A = PVA ----------------- Reciprocal to Present value of an annuity K(1+ k) n-1 Example: 12 If your father deposits Rs.1, 00,000 on retirement in a bank which pays 10% annual interest. How much can be withdrawn annually for a period of 10 years? A = PVA(1/PVIFA) A = Rs.1,00,000 (1/6.145)= Rs.16,273 Present Value of Perpetuity Perpetuity means that series with indefinite duration P? = A PVIFA k, ? Illustration 13 The present value of perpetuity of Rs.10, 000 @ 10%, how much should be invested on today? A = P?/ PVIFA k, ? = Rs.10,000/.10= Rs.1, 00,000

Terms Time value of money: Money value in terms of time, money value in between the present and future Future value of money: Present value of money in terms of future through compounding process Present value of money: Future value of money is reckoned to "0" time period horizon FVIF: Future value interest factor component for compounding. FVIFA: Future value interest factor component for compounding the series of cash payments or receipts. PVIF: Present value interest factor of single cash flow. PVIFA: Present value of interest factor of multiple cash flows. Regular annuity: Series which normally happen at the end of the specified horizon Annuity Due: Series which normally happen at the beginning Doubling period: During which the amount of the investment gets doubled within the given compounding factor component Effective rate of interest: It is the rate of interest which the investment grows

Exercises 1. State Bank of India announces that your money is getting doubled in 99 months. What is the rate of interest payable? 1. Four annual equal payments of Rs.2,000 are made into a deposit account that pays 8% interest per year. What is the future value of this annuity at the end of 4 years ? 1. You can save Rs.2,000 a year for 5 years, and Rs.3,000 a year for 3 years thereafter. What will these savings cumulate to at the end of 8 years, If the rate of interest is 10? 1. How much you should save annually to accumulate Rs.20, 000 by the end of 10 years, If the saving earns an interest of 12%? 1. Mr Vinay plans to send his son for higher studies abroad after 10 years. He expects the cost of these studies to be Rs.1, 00,000. How much should he save annually to have a sum of Rs. 1, 00,000 at the end of 10 years, If the interest rate is 12%? 1. To get Rs.20,000, how much should be invested per year (at the end). The important information of the banking investment reveals the following are the rate of interest is 10% and the normal compounding process is once in 6 months. 1. What is the present value of an annuity of Rs.2,000 at 10% ? 1. What is the present value of a 4 year annuity of Rs.10,000 discounted at 10 % ? 1. A 10 payments annuity of Rs.5, 000 will begin 7 years hence. (The first payment occurs at the end of 7 years) what is the value of this annuity now if the discount rate is 12 per cent? 1. How much would you invest now at 5% per annum compounded annual if you want to get Rs. 5, 00,000 after 20 years?

Choose the correct answer. 1. Time value of money is applicable in (a) Pay back period method (b) Accounting rate of return method (c) Discounted cash flows method (d) None of the above 1. Compounding factor is to determine (a) Present value (b) Future value (c) Present value and Future value (d) None of the above 1. Annuity due means that (a) Series at the end (b) Series at the beginning (c) Neither at the beginning nor at the end (d) None of the above 1. Capital recovery factor method is to find out the value of annuity through (a) Present value of an annuity (b) Reciprocal to the present value of annuity (c) Future value of annuity (d) None of the above 1. Rule of 72 is for (a) To determine the present value of the cash flows (b) To find out future value of cash flows (c) To find out the doubling period (d) None of the above 1. You want to buy an ordinary annuity that will pay you Rs.4,000 a year for the next 20 years. You expect annual interest rates will be 8 percent over that time period. The maximum price you would be willing to pay for the annuity is closest to (a) Rs. 32, 000. (b) Rs.39, 272. (c) Rs. 40,000 (d) Rs. 80,000 1. With continuous compounding at 10 percent for 30 years, the future value of an initial investment of Rs.2,000 is closest to (a) Rs. 34, 898. (b) Rs.40, 171. (c) Rs. 1,64,500 (d) Rs.3,28,282

1. In 3 years you are to receive $5,000. If the interest rate were to suddenly increase, the present value of that future amount to you would (a) fall (b) rise (c) remain unchanged (d) cannot be determined without more information. 1. To increase a given present value, the discount rate should be adjusted (a) upward (b) downward (c) true (d) false 10. When n = 1, this interest factor equals one for any positive rate of interest. (a) PVIF (b) FVIF (c) PVIFA (d) FVIFA

1. (1 + i)n
(a) PVIF (b) FVIF (c) PVIFA (d) FVIFA 1. You can use to roughly estimate how many years a given sum of money must earn at a given compound annual interest rate in order to double that initial amount. (a) Rule 415 (b) the Rule of 72(c) the Rule of 78 (d) Rule 144 1. In a typical loan amortization schedule, the dollar amount of interest paid each period . (a) increases with each payment (b) decreases with each payment (b) remains constant with each payment (d) is positive 1. In a typical loan amortization schedule, the total dollar amount of money paid each period . (a) increases with each payment (b) decreases with each payment ( c ) remains constant with each payment (d) is positive Answers; 1.C 2. C 3. A 4.B 5. C 6. B 7. B 8. A 9. B 10. D 11. B 12. B 13. B 14.C