TIME VALUE OF MONEY

TERNIN0L0uY
Present Value
Future Value
Discount Rate / Compounding Rate
Time Period
Intra Year Compounding And Discounting
Biscounting Factoi Compounuing
Factoi Explaineu
Inflation
Rate
Cost Of
Capital
WACC
Cost of
Equity
Opportunity
Cost
Time Line Time Line
Time 0 Today
Time 1, 2, 3 End of Period One, Two and Three
CF
o
Todays Cash Flow
CF
1
, CF
2
, CF
3
Cash Flows at the End of Periods
One, Two and Three
i% Rate of Interest / Discounting /Compounding
Factor
CF
0
CF
1
CF
3
CF
2
0 1 2 3
i%
90% of getting a Time Value problem
correct is setting up the timeline
correctly!!!
90% of getting a Time Value problem
correct is setting up the timeline
correctly!!!
Time Line Time Line
Futuie Piesent value Single Sum
6
1 2 3 0
FV
1
= (1+i)PV
PV
FV
2
= (1+i)
2
PV
FV
3
= (1+i)
3
PV
PV = FV
1
/(1+i)
PV = FV
2
/(1+i)
2
PV = FV
3
/(1+i)
3
Futuie Piesent value Single Sum
Future Value is Compounding Future Value is Compounding
Present Value is Discounting Present Value is Discounting
Intra Year Compounding and
Discounting
Intra Year Compounding and
Discounting
FV
n
= PV (1+r/n)
m*n
Effective Interest Rate = (1+r/m)
Tiue oi False
Money has time value because you forgo
something certain today for something
uncertain tomorrow.
TRUE
Tiue oi False
The uncertainty factor increases with time the
distant the cash flows, the more uncertain they
become.
.
TRUE
Tiue oi False
The lower is the compounding period, the
higher is the effective rate of interest.
TRUE
Tiue oi False
With high inflation rate, the interest rates
tend to increase.
TRUE
Tiue oi False
One of the reasons for attributing time value to
money is that individuals prefer future
consumption to current consumption.
FALSE
Tiue oi False
The nominal rate of interest is equal to the
effective rate of interest when interest is
compounded annually.
TRUE
Tiue oi False
The rule of 72 is more precise (provides a better
estimate) than the rule of 69 to find the period
required to double your initial amount.
FALSE
Tiue oi False
Financial analysis require an explicit consideration of time
value of money because most financial problems at corporate
and individual level involves cash flows occurring at different
points in time.
TRUE
Tiue oi False
Given a principal amount of Rs. 10,000 to be invested for 9
months, it is better to invest in a scheme that offers 12%
annual compound interest than investing in a scheme that
earns 12% simple interest.
FALSE
Tiue oi False
A bank that pays 10% interest compounded annually pays a
higher effective rate of interest than a bank that pays 10%
interest compounded quarterly.
FALSE
Tiue oi False
The formula for effective rate of interest (re) is-
re= (1+r/m)
n
-1
FALSE
Tiue oi False
An investment option that comes with specified
present value and future value after given period
has hidden rate of interest.
TRUE
Tiue oi False
The present value of a mixed stream of cash flows is
the sum of the present values of the individual cash
flows.
TRUE
Tiue oi False
The price of any asset today is the present value of
all the future cash flows associated with the asset.
TRUE
Tiue oi False
In present value tables, all values are less than 1.
TRUE
Tiue oi False
The process of compounding assumes
discounting at same rate.
TRUE
Tiue oi False
Money has time value because a sum of money to be
received in future is more valuable than the same amount
today.
FALSE
Tiue oi False
The compound value of any sum invested today
varies directly with rate of interest (r) and time
period (n).
TRUE
Tiue oi False
Continuous compounding occurs when interest is
compounding daily.
FALSE
Tiue oi False
The present value of any future sum is
inversely related with rate of interest.
TRUE
Tiue oi False
Continuous compounding results in the maximum
possible future value for given rate of interest and
time period.
TRUE
Tiue oi False
The process of determining present value is often
called discounting.
TRUE
Tiue oi False
In simple interest, interest for each year in same.
TRUE
Fill In The Blanks
The process of determining present value is often called
................. and is the reverse of the ................. Process.
The process of determining present value is often called
................. and is the reverse of the ................. Process.
discounting and compounding
Fill In The Blanks
Effective annual rate of interest with half-yearly
compounding is ................. than, with quarterly
compounding.
Effective annual rate of interest with half-yearly
compounding is ................. than, with quarterly
compounding.
Less
Fill In The Blanks
Effective annual rate of interest is ................. to nominal rate
of interest, when interest is compounded annually.
Effective annual rate of interest is ................. to nominal rate
of interest, when interest is compounded annually.
equal
Fill In The Blanks
The formula for effective annual rate of interest (re) is
.................
The formula for effective annual rate of interest (re) is
.................
re = (1 + r/m)
m
-1
Fill In The Blanks
The general formula for intra year compounding is
.................
The general formula for intra year compounding is
.................
FVn= (1 + r/m)
mn
Fill In The Blanks
Using the rule of 72 to find doubling period
we .................72 by ..................
Using the rule of 72 to find doubling period
we .................72 by ..................
divide, r
Choose The Coiiect Alteinative
Money has time value because:
a. Individuals prefer future consumption to present
consumption.
b. Money today is more certain than money tomorrow
c. Money today is wroth more than money tomorrow in
terms of purchasing power.
d. There is a possibility of earning risk free return on money
invested today.
e. (b), (c) and (d) above.
e
Choose The Coiiect Alteinative
c
Given an investment of Rs. 10,000 to be invested for
one year;
a.It is better to invest in a scheme that pays 10%
simple interest.
b.It is better to invest in a scheme that pays 10%
annual compound interest.
c.Both (a) and (b) provide the same return
Choose The Coiiect Alteinative
Given an investment of Rs. 10,000 for a period of one
year, it is better to invest in a scheme that pays:
a. 12% interest compounded annually
b. 12% interest compounded quarterly
c. 12% interest compounded monthly
d. 12% interest compounded daily
d
Choose The Coiiect Alteinative
Given an investment of Rs. 10,000 over a period of
two years, it is better to invest in a scheme that pays;
a.10% interest in the first year and 12% in second
year.
b.12% interest in the first year and 10% in second
year.
c. Both (a) and (b) above provide the same return
c
Practice Problem -1
An investor wants to have $1 million when she retires in 20 years. If she
can earn a 10 percent annual return, compounded annually, on her
investments, the lump-sum amount she would need to invest today to
reach her goal is closest to:
A.$100,000.
B. $117,459.
C. $148,644.
D. $161,506
Solution-1
This is a single payment to be turned into
a set future value FV=$1,000,000 in N=20
years time invested at r=10% interest rate.
PV =[ 1/(1+r) ]
N
FV
PV = [ 1/(1.10) ]
20
$1,000,000
PV
10
= [0.14864]($1,000,000)
PV
10
= $148,644
Practice Problem -2 Practice Problem -2
A deposit of $1300
earns $339.45 interest
in 3 years. If interest is
compounded monthly,
what is the effective
rate?
N = 3
I/Y = ?
PV = 1300
PMT = 0
FV = -1639.45
P/Y = 1
C/Y = 12
Nominal Rate = 7.76%
C/Y = 12
Effective Rate = 8.04%
N = 3
I/Y = ?
PV = 1300
PMT = 0
FV = -1639.45
P/Y = 1
C/Y = 12
Nominal Rate = 7.76%
C/Y = 12
Effective Rate = 8.04%
Practice Problem-3
A deposit of $1500
grows to $4262.04 in 7
years. If the interest is
compounded quarterly,
what is the effective
rate?
N = 7
I/Y = ?
PV = 1500
PMT = 0
FV = -4264.04
P/Y = 1
C/Y = 4
Nominal Rate = 15.2%
C/Y = 4
Effective Rate = 16.09%
N = 7
I/Y = ?
PV = 1500
PMT = 0
FV = -4264.04
P/Y = 1
C/Y = 4
Nominal Rate = 15.2%
C/Y = 4
Effective Rate = 16.09%
Practice Problem-4
9% compounded
quarterly is equivalent
to what effective rate?
Nominal = 9%
C/Y = 4
Effective Rate = ? ->
9.31%
Nominal = 9%
C/Y = 4
Effective Rate = ? ->
9.31%
Practice Problem-5
7.5% compounded
annually is equivalent to
what effective rate?
Nominal = 7.5%
C/Y = 1
Effective Rate = ? ->
7.5%
Nominal = 7.5%
C/Y = 1
Effective Rate = ? ->
7.5%
Practice Problem-6
10% compounded semi-
annually is equivalent to
what effective rate?
Nominal = 10%
C/Y = 2
Effective Rate = ? ->
10.25%
Nominal = 10%
C/Y = 2
Effective Rate = ? ->
10.25%
Practice Problem-7
At what nominal rate
compounded monthly
will money double in 6
years?
N = 6 years
I/Y = ?
PV = 1
PMT = 0
FV = 2
P/Y = 1
C/Y = 12 (compounded
monthly)
Answer: I/Y = 11.61%
N = 6 years
I/Y = ?
PV = 1
PMT = 0
FV = 2
P/Y = 1
C/Y = 12 (compounded
monthly)
Answer: I/Y = 11.61%
Practice Problem-8
At what nominal rate
compounded monthly
will money double in 6
years?
N = 6 years
I/Y = ?
PV = 1
PMT = 0
FV = 2
P/Y = 1
C/Y = 12 (compounded
monthly)
Answer: I/Y = 11.61%
N = 6 years
I/Y = ?
PV = 1
PMT = 0
FV = 2
P/Y = 1
C/Y = 12 (compounded
monthly)
Answer: I/Y = 11.61%
Practice Problem-9 Practice Problem-9
A present value of
$1301.69 has a future
value of $2569.26 in 7
years and 7 months.
What is the nominal
rate compounded
monthly?
N = (7 Years * 12) + 7
months = 91 months
I/Y = ?
PV = 1301.60
PMT = 0
FV = - 2569.26
P/Y = 12
C/Y = 12
Answer: I/Y = 9%
N = (7 Years * 12) + 7
months = 91 months
I/Y = ?
PV = 1301.60
PMT = 0
FV = - 2569.26
P/Y = 12
C/Y = 12
Answer: I/Y = 9%
A principal of $7100 has
a maturity value of
$13,966.77 in 10 years.
If the interest rate is
compounded annually ,
what is the nominal
rate?
N = 10
I/Y = ?
PV = 7100
PMT = 0
FV = -13966.77
P/Y = 1
C/Y = 1
Answer: I/Y = 7%
N = 10
I/Y = ?
PV = 7100
PMT = 0
FV = -13966.77
P/Y = 1
C/Y = 1
Answer: I/Y = 7%
Practice Problem-10 Practice Problem-10
A deposit of $1500
earned $672.45 interest
over 7.5 years. What
nominal interest rate
compounded semi-
annually was paid on
the deposit?
N = 7.5
I/Y = ?
PV = 1500
PMT = 0
FV = - 2172.45
P/Y = 1
C/Y = 2
Answer: I/Y = 5%
Nominal Rate
N = 7.5
I/Y = ?
PV = 1500
PMT = 0
FV = - 2172.45
P/Y = 1
C/Y = 2
Answer: I/Y = 5%
Nominal Rate
Practice Problem-11 Practice Problem-11
A person opens a bank
account with a deposit
of $150. At the end of 3
years there is $179.34
in the account. What
nominal interest rate
compounded quarterly
was earned on the
account?
N = 3 years
I/Y = ?
PV = 150
PMT = 0
FV = -179.34
2nd I/Y
P/Y = 1
C/Y = 4
Answer: I/Y = 6%
N = 3 years
I/Y = ?
PV = 150
PMT = 0
FV = -179.34
2nd I/Y
P/Y = 1
C/Y = 4
Answer: I/Y = 6%
Practice Problem-12 Practice Problem-12
A present value of
$1301.69 has a future
value of $2569.26 in 7
years and 7 months.
What is the nominal
rate compounded
monthly?
N = (7 Years * 12) + 7
months = 91 months
I/Y = ?
PV = 1301.60
PMT = 0
FV = - 2569.26
P/Y = 12
C/Y = 12
Answer: I/Y = 9%
N = (7 Years * 12) + 7
months = 91 months
I/Y = ?
PV = 1301.60
PMT = 0
FV = - 2569.26
P/Y = 12
C/Y = 12
Answer: I/Y = 9%
Practice Problem- 13
Practice Problem-14
A companys 2005 sales
were $100 million. If
sales grow at 8% per
year, how large will they
be 10 years later, in
2015, in millions?
FV of a lump sum
Answer:
N 10
I/YR 8%
PV -$100.00
PMT $0.00
FV $215.89
FV of a lump sum
Answer:
N 10
I/YR 8%
PV -$100.00
PMT $0.00
FV $215.89
Practice Problem-15
Suppose a U.S.
government bond will
pay $1,000 three years
from now. If the going
interest rate on 3-year
government bonds is
4%, how much is the
bond worth today?
PV of a lump sum
Answer:
N 3
I/YR 4%
PV $889.00
PMT $0
FV -$1,000.00
PV of a lump sum
Answer:
N 3
I/YR 4%
PV $889.00
PMT $0
FV -$1,000.00
Practice Problem-16
The U.S. Treasury offers to
sell you a bond for
$613.81. No payments
will be made until the
bond matures 10 years
from now, at which time
it will be redeemed for
$1,000. What interest
rate would you earn if
you bought this bond at
the offer price?
Interest rate on a simple
lump sum investment
N 10
I/YR 5.00%
PV -$613.81
PMT $0
FV $1,000.00
Interest rate on a simple
lump sum investment
N 10
I/YR 5.00%
PV -$613.81
PMT $0
FV $1,000.00
Practice Problem-13
Addico Corp's 2005
earnings per share were
$2, and its growth rate
during the prior 5 years
was 11.0% per year. If
that growth rate were
maintained, how long
would it take for
Addicos EPS to double?
Number of periods
N 6.64
I/YR 11.00%
PV -$2.00
PMT $0
FV $4.00
Number of periods
N 6.64
I/YR 11.00%
PV -$2.00
PMT $0
FV $4.00