Financial Management FM 1: Introduction & Time Value of Money
The Role of Time Value in Finance
Most financial decisions involve costs & benefits that are spread out over time Time value of money allows comparison of cash flows from different periods Basic Concepts: Future Value: compounding or growth over time Present Value: discounting to todays value Single cash flows & series of cash flows can be considered Time lines are used to illustrate these relationships
Time Value of Money
Which would you rather have Rs 1,000 today or Rs 1,000 in 5 years? Obviously, Rs 1,000 today. Money received sooner rather than later allows one to use the funds for investment or consumption purposes. This concept is referred to as the TIME VALUE OF MONEY!!
Why Time is important?
TIME allows one the opportunity to postpone consumption and earn INTEREST.
NOT having the opportunity to earn interest on money is called OPPORTUNITY COST.
Computation Time Value of Money
How can one compare amounts in different time periods? One can adjust values from different time periods using an interest rate Remember, one CANNOT compare numbers in different time periods without first adjusting them using an interest rate
What is Compound Interest?
When interest is paid on not only the principal amount invested, but also on any previous interest earned, this is called compound interest. FV = Principal + (Principal x Interest) = 2000 + (2000 x .06) = 2000 (1 + i) = PV (1 + i)
Note: PV refers to Present Value & FV refers to Future Value
Future Value
Future Value of Single Cash Flow If you invested Rs 2,000 today in an account that pays 6% interest, with interest compounded annually, how much will be in the account at the end of two years if there are no withdrawals? FV1 = PV (1+i)n = Rs 2,000 (1.06)^2 = Rs 2,247.20 FV = future value, a value at some future point in time PV = present value, a value today which is usually designated as time 0 i = rate of interest per compounding period n = number of compounding periods
Power of Compounding
ABC wants to know how large his Rs 5,000 deposit will become at an annual compound interest rate of 8% at the end of 5 years. FVn FV5 = PV (1+i)n = Rs 5,000 (1+ 0.08)^5 = Rs 7,346.64
Future Value Interest Factor of Rs 5000 @ 8% for 5 Years Amount Rs 5000 Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 1.000 1.080 1.166 1.260 1.360 1.469 5000 5400 5830 6300 6800 7345
8
Power of Compounding: Double Your Money
How long does it take to double Rs 5,000 at a compound rate of 12% per year (approx.)? We will use the Rule-of-72.
Approx. Years to Double = 72 / i% 72 / 12% = 6 Years [Actual Time is 6.12 Years]
Rule of 69 Approx. Years to Double = 0.35 + 69/ i% 0.35 + 69 / 12% = 6.1 Years
Impact of Compounding More Frequently than Annually
Amt- Rs Annually Semi Annual Quarterly Monthly PV k n FV 100.00 12.0% 5 176.23 100.00 0.06 10 179.08 100.00 0.03 20 180.61 100.00 0.01 60 181.67
10
Annuity And Future Value of An Annuity
An Annuity is a series of periodic Cash flows: Inflows / Receipts [Example Pension/Royalty] Outflows / Payments [Example Housing Loan EMI / Contribution to Pension Fund] Future Value Interest Factor Annuity [ FVIFA ] for Rs 1000 invested at the end of the year for 5 years 12% compounded is 6.353
Future Value Interest Factor of Rs 1000 @ 12% for 5 Years Amount Rs 1000 Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Total 1.000 1.120 1.254 1.405 1.574 6.353 1000 1120 1254 1405 1574 Future Value Interest Factor for an Annuity Period Amt Rs FV Rs 1 1000 1574 2 1000 1405 3 1000 1254 4 1000 1120 5 1000 1000 Total FV 6353
11
Example of an ordinary Annuity - FVA
End of Year
0 7%
1 Rs1,000
2 Rs1,000
3 Rs1,000 Rs 1,070 Rs 1,145
FVA3 = Rs1,000(1.07)2 + Rs 1,000(1.07)1 + Rs1,000(1.07)0 = Rs 3,215 If one saves Rs1,000 a year at the end of every year for three years in an account earning 7% interest, compounded annually, how much will one have at the end of the third year?
Rs 3,215 = FVA3
12
Present Value : Discounted Cash Flow
What is Present Value? Since FV = PV(1 + i)n. PV = FV / (1+i)n.
Discounting is the process of translating a future value or a set of future cash flows into a present value.
Assume that you need to have exactly Rs 4,000 saved 10 years from now how much must you deposit today in an account that pays 6% interest, compounded annually, so that you reach your goal of Rs 4,000? PV0 = FV / (1+i)2 = Rs 4,000 / (1.06)10 = Rs 2,233.58 The figure of 6% is called the Discount Factor in the above case
13
Present Value Calculations:Examples
As the number of year increases the present value becomes smaller Present value of future sum becomes smaller as we value money more or as the discount rate increases
Present Value Factor for Rs 1000 @ 8% for 5 yrs Amount Rs 1000 Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 1.000 0.926 0.857 0.794 0.735 1000 926 857 794 735
Yr 5 0.681
681
Present Value Factor for Rs 1000 @ 12% for 5 yrs Amount Rs 1000 Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 1.000 0.893 0.797 0.712 0.636 1000 893 797 712 636
Yr 5 0.567
567
Present Value Factor for Rs 1000 @ 4% for 5 yrs Amount Rs 1000 Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 1.000 0.962 0.925 0.889 0.855 1000 962 925 889 855
Yr 5 0.822
822
14
Present Value of Single Cash Flow
ABC needs to know how large of a deposit to make today so that the money will grow to Rs 2,500 in 5 years. Assume todays deposit will grow at a compound rate of 4% annually.
PV0 PV0 = FVn / (1+i)n = Rs 2,500/(1.04)^5 = Rs 2,054.81
Present Value Factor for Rs 1000 @ 4%at the end of 5 yr Amount Rs 1000 Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 1.000 0.962 0.925 0.889 0.855 1000 962 925 889 855
Yr 5 0.822 822
Amount Rs
2500
2055
15
Present Value of An Ordinary Annuity [ PVA ]
End of Year
Amt in Rs
0 7%
1 1,000
2 1,000 1,000
934.58 873.44 816.30 2,624.32 = PVA3
PVA3 = 1,000/(1.07)1 + 1,000/(1.07)2 + 1,000/(1.07)3 = 2,624.32 If one agrees to repay a loan by paying Rs1,000 a year at the end of every year for three years and the discount rate is 7%, how much could one borrow today?
16
Present Value of An Ordinary Annuity [ PVA ]
If one agrees to repay a loan by paying Rs1,000 a year at the end of every year for three years and the discount rate is 7%, how much could one borrow today?
Present Value Factor for Rs 1000 @ 7% for 3 yrs Amount Rs 1000 Yr 0 Yr 1 Yr 2 Yr 3 Total 1.000 0.935 0.873 0.816 2.624 Present Value Interest Factor for an Annuity Period Amt Rs FV Rs 1 1000 935 2 1000 873 3 1000 816 Total PV 2624
17
Factors Affecting Present Value of Money
Quantum of cash flows Timing of cash flows Interest / Discount rate Depreciation Income Tax
18
Problems to Solve
You must decide between Rs 25,000 in cash today or Rs 30,000 in cash to be received two years from now. If you can earn 8% interest on your investments, which is the better deal?
Rs 25,000in cash today Rs 30,000 in cash to be received two years from now
Which option is O.K.?
Present Value of Rs 30,000 @ 8% to be received at the end 2 yrs is Rs 30,000 * 0.857 = Rs 25,710 [ as per formula Rs 25,720.16]
Compare PV of Rs 30,000, which is Rs 25,720.16 to PV of Rs 25,000. Rs 30,000 to be received 2 years from now is better.
19
Nominal Rates of Interest and Effective Rates of Interest The coupon rate of interest is called the nominal rate of interest. The nominal rate of interest differs from the effective rate of interest due to the frequency of compounding (eg, annual,half yearly,quarterly,monthly) with the nominal rate. ABN Bank ltd offers 10% interest on a deposit of one year. Assuming 1) annual 2) half yearly and 3) quarterly frequency of interest payments , compute the effective rates of interest in the three alternatives.
20
