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Icfai FM Time Value of Money Ch. Iii

This document discusses the time value of money and various methods for calculating future and present values of cash flows. It covers compounding and discounting, future value and present value formulas for single amounts, annuities, and multiple cash flows. Formulas include future value of a single amount, present value of a single amount, future/present value of an annuity, sinking fund factor, and capital recovery factor. Worked examples are provided for concepts like compound interest, effective interest rate, and doubling period.

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504 views13 pages

Icfai FM Time Value of Money Ch. Iii

This document discusses the time value of money and various methods for calculating future and present values of cash flows. It covers compounding and discounting, future value and present value formulas for single amounts, annuities, and multiple cash flows. Formulas include future value of a single amount, present value of a single amount, future/present value of an annuity, sinking fund factor, and capital recovery factor. Worked examples are provided for concepts like compound interest, effective interest rate, and doubling period.

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Time Value of Money

A project is an activity that involves investing a sum of


money now in anticipation of benefits spread over a period
of time in the future.The sum of the benefits accruing over
the future period will be compared with the initial
investment. If the aggregate value of the benefits exceeds
the initial investment, the project is considered to be
financially viable.
Here, we have assumed that irrespective of the time when
money is invested or received, the value of money remains
the same. However, this assumption is incorrect because
money has time value. Why money have time value?
1. In an inflationary period, a rupee today has a higher
purchasing power than a rupee in the future.
2. Since future is characterized by uncertainty, individuals
prefer current consumption to future consumption.
3. The manner in which these determinants combine to
determine the rate of interest can be represented below:
Nominal or market interest interest rate
= Real rate of interest or return + Expected rate of inflation
+ Risk premium to compensate for uncertainty
There are two methods by which the time value of
money can be taken care of – compounding and
discounting.
• Under the method of compounding, we find the
Future Values (FV) of all cash flows at the end of
the time horizon at a particular rate of interest.
• Under the method of discounting, we reckon the time
value of money now i.e. at time 0 on the time value
line. So, we will be comparing the initial outflow
with the sum of the Present Value (PV) of the future
inflows at a given rate of interest.
• In simple interest, we do not earn interest on accrued
interest, if the period exceeds one year. In case of
compound interest, interest is earned on interest.
Future Value of A Single Flow(Lump Sum):
A generalized procedure for calculating the future value of
a single cash flow compounded annually is as follows:
n
FVn = PV ( 1 + k )
Where FVn = Future value of the initial flow ‘n’ years hence
PV = Initial cash flow
k = Annual rate of interest
n = Life of investment
To simplify calculations of k and n, these values are
presented in Table I (Text Book). To calculate the future
value of any investment for a given value of ‘k’ and ‘n’, the
corresponding value of ( 1 + k )n from the table has to be
multiplied with the initial investment. This is referred to as
Future Value Interest Factor(FVIF)
Doubling Period: How long will it take for the amount invested to
be doubled for a given interest?. This question can
be answered by a rule known as ‘rule 72’
For instance, at the rate of 6%, the doubling period is
72/6 = 12 years.
An accurate way of calculating doubling period is ‘rule 69’.
Formula is 0.35 + 69/ interest rate.
Growth Rate
The compound rate of growth for a given series after a
period of time can be calculated by employing the FVIF
a. The ratio of profit for year n to year 1 is to be determined.
b. The FVIF k (n-1) is to be looked at. Look at a value which
is close to ratio arrived at in (a)
c. The value close to that value is say m and the interest
rate corresponding to this is say t. Therefore,
the compound rate of growth is t percent.
Increased Frequency of Compounding:
The generalized formula for shorter compounding periods
mxn
FVn = PV 1 + k
m
Where FV n = Future value after ‘n’ years
PV = Cash flow today
k = Nominal rate of interest per annum
m = Number of times compounding is done in
a year
n = Number of years for which compounding is
done
Effective vs. Nominal Rate of Interest:
m
r = PV 1 + k -1
m

Where r = Effective rate of interest


k = Nominal rate of interest
m = Frequency of compounding per year
Future Value of Multiple Flows:
If investment amount varies every period (year),
to determine the accumulation of multiple flows as at the
end of a specified time horizon, we have to find out the
accumulation of each these flows using the appropriate FVIF
and sum up these accumulations. However, if the time period
is long say 20 years, the process is tedious. In such cases a
short cut method can be employed provided the flows are
of equal amounts.
Future Value of Annuity:
Annuity is the term used to describe a series of periodic flows
of equal amounts. These flows can be either receipts or
payments.
The future value of a regular annuity for a period of n years
at a rate of interest ‘k’ is given by the formula:
n
FVAn = A (1+k) - 1
k
Where A = Amount deposited/invested at the end of every
year for n years
k = Rate of interest (expressed in decimals)
n = Time horizon
FVAn = Accumulation at the end of n years
n
(1+k) - 1 is called the future value interest factor for
k

Annuity (FVIFA hereafter) and it represents the


accumulation of Re. 1 invested or paid at the end of every
year for a period of n years at the rate of interest ‘k’.
As in the case of the future value of a single flow, this
expression has also been evaluated for different
combinations of ‘k’ and ‘n’ and tabulated in Table 2.
So, given the annuity payment, we have to just multiply it
with the appropriate FVIFA value and determine the
accumulation.
Sinking Fund Factor:
We have the equation
n
FVAn = A (1+k) - 1
k
This can be rewritten as

A = FVA k
n
( 1 +k ) – 1

The expression k
n
( 1 +k ) – 1
is called the sinking fund factor. It represents the amount
that has to be invested at the end of every year for a period
of ‘n’ years at the rate of interest ‘k’, in order to accumulate
Re. 1 at the end of the period.
Present Value of A Single Flow:
Discounting is an alternative approach for reckoning the
time value of money. We can determine the present value of
a future cash flow or a stream of future cash flows. The PV
approach is commonly followed for evaluating the financial
viability of projects.
In general the present value (PV) of a sum (FVn) receivable
after n years at a rate of interest (k) is given by the
following expression.
n
PV = FVn = FVn / ( 1 +k )
FVIF( k,n)
The inverse of FVIF(k,n) is defined as PVIF (k,n) ( Present
Value Interest Factor for k, n). Therefore, the above
equation can be written as
PV = FVn x PVIF( k, n )
So, to determine the PV of a future sum, we have to just
locate the PVIF factor for the given values of k and n and
multiply this factor value with the given sum. Since,
PVIF (k,n) represents the present value of Re. 1 receivable
after n years at a rate of interest k, it is obvious that PVIF
values cannot be greater than one. The PVIF values for
different combinations of k and n are given in Table 3.
Present Value of Uneven Multiple Flows:
Like the procedure followed to obtain the future value of
multiple cash flows, the procedure adopted to determine
the present value of a series of future cash flows can prove
to be cumbersome, if the time horizon to be considered is
quite long. These calculations can ,however, be simplified
if the cash flows occurring at the end of the time periods
are equal. In other words, if the stream of cash flows can be
regarded as a regular annuity or annuity due, then the
present value of this annuity can be determined using an
expression similar to FVIFA expression which is PVIFA
given in Table 4.
Present Value of An Annuity:
The present value of an annuity ‘A’ receivable at the end of
the every year for a period of n years at a rate of interest k
is equal to
n
PVAn = A/ (1+k) + A/ (1 +k)² + A/ (1+k)³ +-------- + A/ (1+k)

which reduces to
n
PVAn = A x ( 1 + k) - 1
k ( 1 +k ) n

n
( 1 + k) - 1 is called PVIFA ( Present Value Interest factor Annuity)
k ( 1 +k ) n
and it represents the present value of a regular annuity of Re.1 for
the given values of k and n.
Conditions to be fulfilled:
(a) the cash flows are equal; and (b) the cash flows occur at
the end of every year. It must also be noted that
PVIFA(k,n) is not the inverse of FVIFA(k,n) although
PVIF (k,n) is inverse of FVIF (k,n).
Capital Recovery Factor:
Manipulating the relationship between PVAn ,A, k and n,
we get an equation
n
A = PVAn k ( 1 +k )
(1 + k) n – 1
n
k ( 1 +k ) is known as the capital recovery factor.
(1 + k) n – 1
The application of the capital recovery factor helps in
answering questions like:
 What should be the amount paid annually to liquidate
a loan over a specified period at a given interest rate?
 How much can be withdrawn periodically for a certain
length of time, if a given amount is invested to-day?
Present Value of Perpetuity:
An annuity of an infinite duration is known as perpetuity.
The present value of such perpetuity can be expressed as
follows:
P∞ = A x PVIFA k, ∞
Where P∞ = Present value of perpetuity
A = Constant annual payment
PVIFA k, ∞ = Present value interest factor for a perpetuity
The value of PVIFA k, ∞ is
∞ t
∑ 1 / ( 1 +k ) = 1
k
We can say that PV interest factor of a perpetuity is simply
one divided by interest in decimal form. Hence PV of
perpetuity is simply equal to the constant annual payment
divided by the interest rate.

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