Chapter 3 Time Value of Money
Chapter 3 Time Value of Money
Chapter 3 Time Value of Money
69
Interest rate
Doubling period = 0.35 +
FORMULA
= Rs 17156.1
FUTURE VALUE OF AN ANNUITY
· An annuity is a series of periodic cash flows (payments and
receipts ) of equal amounts
1 2 3 4 5
1,000 1,000 1,000 1,000 1,000
+
1,100
+
1,210
+
1,331
+
1,464
Rs.6,105
How much would your investments grow at the end of the fifth
year if you were to make the following investments of Rs 2000 at
the beginning of the next 5 years in a FD which fetches an
interest rate of 10% :
PV = FV [1/ (1 + r)n]
PVA = A [ ( 1+r )n - 1 ]
r ( 1+r )n
A project guarantees Rs 1000 in each of its 8 year life; Find out the present value of the
future stream of cash flows, assuming opportunity cost of capital to be 12%:
a Interest is calculated by multiplying the beginning loan balance by the interest rate.
b. Principal repayment is equal to annual installment minus interest.
* Due to rounding off error a small balance is shown
PV of annuity due
• PV of annuity due =
PVA = A [ ( 1+r ) (n - 1) - 1 ] + A
r ( 1+r ) (n- 1)
expected that the dividend would grow annually by 2%. How much
would investors be willing to pay for the stock with a required rate of
return of 5%?
PV of a Growing Annuity = A (1 + g)
r–g
The above formula can be used when the growth rate is less than the discount rate
(g < r) as well as when the growth rate is more than the discount rate (g > r).
However, it does not work when the growth rate is equal to the discount rate
(g = r) – in this case, the present value is simply equal to n A.
PRESENT VALUE OF A GROWING ANNUITY
Suppose you have the right to harvest a teak plantation for the next 20
years over which you expect to get 100,000 cubic feet of teak per year.
The current price per cubic foot of teak is Rs 500, but it is expected to
increase at a rate of 8 percent per year. The discount rate is 15 percent.
Find out present value of the teak that you can harvest from the teak
forest
PV of teak =
500 * 1,00,000 ( 1 + 0.08 ) [ 1- ( 1 + 0.08 ) 20 ]
( 1 + 0.15 ) 20
0.15 – 0.08
= Rs 55,17,36,683
SHORTER COMPOUNDING PERIOD
m
Where r = nominal annual interest rate
m = number of times compounding is done in a year
n = number of years over which compounding is done
Example : you deposit Rs.5000, @12 percent, quarterly
compounding , maturity of 6 years
FV = 5000(1+ 0.12/4)4x6 = 5000 (1.03)24
= Rs.10,164
EFFECTIVE VERSUS NOMINAL RATE
ERI = (1+ r/m)m –1
E = effective rate of interest
r = nominal rate of interest
m = frequency of compounding per year
Example : r = 8 percent, m=4
k = (1+0.08/4)4 – 1 = 0.0824
= 8.24 percent
Nominal and Effective Rates of Interest
Effective Rate %
Nominal Annual Semi-annual Quarterly Monthly
Rate % Compounding Compounding Compounding Compounding
8 8.00 8.16 8.24 8.30
12 12.00 12.36 12.55 12.68
Continuous Compounding
• Value of compounding or discounting depends upon its
frequency.
• The value rises/falls exponentially in case of continuous
compounding.
• In practice, no one compounds interest continuously
but it is used extensively for pricing options, forwards
and other derivatives.
e = 2.7183.
• Fv = Pv * e (r*n)
21
Problem
• What will be the maturity value of a two year
deposit of Rs 1000 which is compounded
continuously at 10 % .
• FV = 1000*[2.7183](0.10*2)
= Rs 1221.4
Use of excel Spreadsheet
Parameter Symbol Built in formula in excel
http://
www.tvmcalcs.com/index.php/calculators/excel_tvm_functions/excel_tvm_functions_page1