Time value of Money

After reading this chapter, you will be conversant with: What Time Value of Money Means? Why Money has Time Value? Process of Compounding Process of Discounting Future Value of a Single Flow Future Value of Multiple Flows Future Value of Annuity Present Value of a Single Flow Present Value of Uneven Multiple Flows Present Value of Annuity

INTRODUCTION To keep pace with the increasing competition, companies have to go in for new ideas implemented through new projects be it for expansion, diversification or modernization. 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. How do we determine whether the project is financially viable or not? Our immediate response to this question will be to sum up the benefits accruing over the future period and compare the total value of the benefits with the initial investment. If the aggregate value of the benefits exceeds the initial investment, the project is considered to be financially viable. While this approach prima facie appears to be satisfactory, we must be aware of an important assumption that underlies. We have assumed that irrespective of the time when money is invested or received, the value of money remains the same. Put differently, we have assumed that: value of one rupee now = value of one rupee at the end of year 1 = value of one rupee at the end of year 2 and so on. We know intuitively that this assumption is incorrect because money has time value. How do we define this time value of money and build it into the cash flows of a project? The answer to this question forms the subject matter of this chapter. We intuitively know that Rs.1,000 in hand now is more valuable than Rs.1,000 receivable aft er a year. In other words, we will not part with Rs.1,000 now in return for a firm assurance that the same sum will be repaid after a year. But we might part with Rs.1,000 now if we are assured that something more than Rs.1,000 will be paid at the end of the first year. This additional compensation required for parting with Rs.1,000 now is called interest or the time value of money. Normally, interest is expressed in terms of percentage per annum for example, 12 percent p.a. or 18 percent p.a. and so on. Why should money have time value? Here are some important reasons for this phenomenon: Money can be employed productively to generate real returns. For instance, if a sum of Rs.100 invested in raw material and labor results in finished goods worth Rs.105, we can say that the investment of Rs.100 has earned a rate of return of 5 percent. In an inflationary period, a rupee today has a higher purchasing power than a rupee in the future. Since future is characterized by uncertainty, individuals prefer current consumption to future consumption.

Dr Jaideep Jadhav

Page 1

The manner in which these three determinants combine to determine the rate of interest can be symbolically represented as follows: Nominal or market interest rate = Real rate of interest or return + Expected rate of inflation + Risk premiums to compensate for uncertainty There are two methods by which the time value of money can be taken care of compounding and discounting. To understand the basic ideas underlying these two methods, let us consider a project which involves an immediate outflow of say Rs.1,000 and the following pattern of inflows: Year 1: Rs.250 Year 2: Rs.500 Year 3: Rs.750 Year 4: Rs.750 The initial outflow and the subsequent inflows can be represented on a time line as given below:

Figure 1: Time Line

PROCESS OF COMPOUNDING Under the method of compounding, we find the future values (FV) of all the cash flows at the end of the time horizon at a particular rate of interest. Therefore, in this case we will be comparing the future value of the initial outflow of Rs.1,000 as at the end of year 4 with the sum of the future values of the yearly cash inflows at the end of year 4. This process can be schematically represented as follows:

Figure 2: Process of Compounding

Dr Jaideep Jadhav

Page 2

PROCESS OF DISCOUNTING Under the method of discounting, we reckon the time value of money now i.e. at time 0 on the time line. So, we will be comparing the initial outflow with the sum of the present values (PV) of the future inflows at a given rate of interest. This process can be diagramatically represented as follows:

Figure 3: Process of Discounting

How do we compute the future values and the present values? This question is answered in the latter part of the chapter. But before that, we must draw the distinction between the concepts of compound interest and simple interest. We shall illustrate this distinction through the following illustration.

Illustration 1 If X has a sum of Rs.1,000 to be invested, and there are two schemes, one offering a rate of interest of 10 percent, compounded annually, and other offering a simple rate of interest of 10 percent, which one should he opt for assuming that he will withdraw the amount at the end of (a) one year (b) two years, and (c) five years?

Solution Given the initial investment of Rs.1,000, the accumulations under the two schemes will be as follows:

End of year 1 2 3 4 5

Compounded Interest Scheme 1000 + (1000 x 0.10) = 1100 1100 + (1100 x 0.10) = 1210 1210 + (1210 x 0.10) = 1331 1331 + (1331 x 0.10) = 1464 1464 + (1464 x 0.10) = 1610

Simple Interest Scheme 1000 + (1000 x 0.10) = 1100 1100 + (1000 x 0.10) = 1200 1200 + (1000 x 0.10) = 1300 1300 + (1000 x 0.10) = 1400 1400 + (1000 x 0.10) = 1500

Dr Jaideep Jadhav

Page 3

From this table, it is clear that under the compound interest scheme interest earns interest, whereas interest does not earn any additional interest under the simple interest scheme. Obviously, an investor seeking to maximize returns will opt for the compound interest scheme if his holding period is more than a year. We have drawn the distinction between compound interest and simple interest here to emphasize that in financial analysis we always assume interest to be compounded.

FUTURE VALUE OF A SINGLE FLOW (LUMP SUM)

The above table illustrates the process of determining the future value of a lump sum amount invested at one point of time. But the way it has gone about calculating the future value will prove to be cumbersome if the future value over long maturity periods of 20 years or 30 years is to be calculated. A generalized procedure for calculating the future value of a single cash flow compounded annually is as follows: FVn where, FVn PV k n = = = = Future value of the initial flow n years hence Initial cash flow Annual rate of interest Life of investment = PV(1 + k)n

In the above formula, the expression (1 + k)n represents the future value of an initial investment of Re.1 (one rupee invested today) at the end of n years at a rate of interest k referred to as Future Value Interest Factor (FVIF, hereafter). To simplify calculations, this expression has been evaluated for various combinations of k and n and these values are presented in Table 1 at the end of this 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.

Illustration 2 The fixed deposit scheme of Andhra Bank offers the following interest rates.

Period of Deposit 46 days to 179 days 180 days to < 1 year 1 year and above

Rate Per Annum 10.0% 10.5% 11.0%

An amount of Rs.10,000 invested today will grow in 3 years to

Dr Jaideep Jadhav

Page 4

FVn

= PV(1 + k)n

= PV x FVIF (11,3) = 10,000 (1.368) = Rs.13,680

Doubling Period A frequent question posed by the investor is, How long will it take for the amount invested to be doubled for a given rate of interest. This question can be answered by a rule known as rule of 72. Though it is a crude way of calculating this rule says that the period within which the amount will be doubled is obtained by dividing 72 by the rate of interest.

For instance, if the given rate of interest is 6 percent, then doubling period is 72/6 = 12 yrs. However, an accurate way of calculating doubling period is the rule of 69, according to which, doubling period

0.35 +

Illustration 3 The following is the calculation of doubling period for two rates of interest i.e., 6 percent and 12 percent. Rate of interest Doubling Period 6% 0.35 + 69/6 = 0.35 + 11.5 = 11.85 yrs. 12% 0.35 + 69/12 = 0.35 + 5.75 = 6.1 yrs. Growth Rate The compound rate of growth for a given series for a period of time can be calculated by employing the future value interest factor table (FVIF). Illustration 4 Years Profits (in lakh) 1 2 3 4 5 6

95 105 140 160 165 170

How is the compound rate of growth for the above series determined? This can be done in two steps: a. The ratio of profits for year 6 to year 1 is to be determined i.e., 170/95 = 1.79 b. The FVIFk,n table is to be looked at. Look at a value which is close to 1.79 for the row for 5 years. The value close to 1.79 is 1.762 and the interest rate corresponding to this is 12 percent. Therefore, the compound rate of growth is 12 percent.

Dr Jaideep Jadhav

Page 5

Increased Frequency of Compounding In the above illustration, the compounding has been done annually. Suppose we are offered a scheme where compounding is done more frequently. For example, assume you have deposited Rs.10,000 in a bank which offers 10 percent interest per annum compounded semi-annually which means that interest is paid every six months. Rs. Now, amount in the beginning = 10,000 Interest @ 10 percent p.a. for first six months Amount at the end of six months Interest for second 6 months Amount at the end of the year = = = = 500 10,500 525 11,025

Instead, if the compounding is done annually, the amount at the end of the year will be 10,000 (1 + 0.1) = Rs.11,000. This difference of Rs.25 is because under semi-annual compounding, the interest for first 6 months earns interest in the second 6 months. The generalized formula for these shorter compounding periods is FVn

= PV

Where, FVn PV k m n = Future value after n years = Cash flow today = Nominal interest rate per annum = Number of times compounding is done during a year = Number of years for which compounding is done.

Illustration 5 Under the Vijaya Cash Certificate scheme of Vijaya Bank, deposits can be made for periods ranging from 6 months to 10 years. Every quarter, interest will be added on to the principal. The rate of interest applied is 9 percent p.a. for periods from 12 to 23 months and 10 percent p.a. for periods from 24 to 120 months. An amount of Rs.1,000 invested for 2 years will grow to FVn = where m = = = = PV frequency of compounding during a year 1,000 1,000(1.025)8 1,000 x 1.2184 = Rs.1,218

Dr Jaideep Jadhav

Page 6

Effective vs. Nominal Rate of Interest We have seen above that the accumulation under the semi-annual compounding scheme exceeds the accumulation under the annual compounding scheme by Rs.25. This means that while under annual compounding scheme, the nominal rate of interest is 10 percent per annum, under the scheme where compounding is done semi-annually, the principal amount grows at the rate of 10.25 percent per annum. This 10.25 percent is called the effective rate of interest which is the rate of interest per annum under annual compounding that produces the same effect as that produced by an interest rate of 10 percent under semi-annual compounding. The general relationship between the effective and nominal rates of interest is as follows:

k (1 k) n 1
r =

where, r k m

= = =

Effective rate of interest Nominal rate of interest Frequency of compounding per year

Illustration 6 Find out the effective rate of interest, if the nominal rate of interest is 12 percent and is quarterly compounded. Effective rate of interest

k (1 k) n 1

= = =

(1 + 0.03)4 1 = 1.126 1 0.126 = 12.6% p.a.

FUTURE VALUE OF MULTIPLE FLOWS Suppose we invest Rs.1,000 now (beginning of year 1), Rs.2,000 at the beginning of year 2 and Rs.3,000 at the beginning of year 3, how much will these flows accumulate to at the end of year 3 at a rate of interest of 12 percent per annum? This problem can be represented on the time line as follows: Figure 4: Compounding Process for Multiple Flows

Dr Jaideep Jadhav

Page 7

To determine the accumulated sum at the end of year 3, we have to just add the future compounded values of Rs.1,000, Rs.2,000 and Rs.3,000 respectively1[1] At k = = = 0.12, the above sum is equal to Rs.1,000 x FVIF x

] = Rs.7,273

Therefore, to determine the accumulation of multiple flows as at the end of a specified time horizon, we have to find out the accumulations of each of these flows using the appropriate FVIF and sum up these accumulations. This process can get tedious if we have to determine the accumulation of multiple flows over a long period of time, for example, the accumulation of a recurring deposit of Rs.100 per month for 60 months at a rate of 1 percent per month. In such cases a short cut method can be employed provided the flows are of equal amounts. This method is discussed in the following section

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. For example, if you are required to pay Rs.200 per annum as life insurance premium for the next 20 years, you can classify this stream of payments as an annuity. If the equal amounts of cash flow occur at the end of each period over the specified time horizon, then this stream of cash flows is defined as a regular annuity or deferred annuity. When cash flows occur at the beginning of each period the annuity is known as an annuity due. The future value of a regular annuity for a period of n years at a rate of interest k is given by the formula: FVAn = A(1 + k)n-1 + A(1 + k)n-2 + A(1 + k)n-3+..+A

which reduces to FVAn where, A k n = = = = Amount deposited/invested at the end of every year for n years Rate of interest (expressed in decimals) Time horizon

Dr Jaideep Jadhav

Page 8

FVAn The expression

Accumulation at the end of n years.

(1 k) n 1 is called the Future Value Interest Factor for Annuity (FVIFA, k

2 [1] Candidates who would like to know whether there is any short cut for evaluating (1 + k) n for values of k not found in the table, are informed that there is no short cut method except using logarithms or the X Y function found in scientific calculators. Illustration 7 Under the recurring deposit scheme of the Vijaya Bank, a fixed sum is deposited every month on or before the due date opted for 12 to 120 months according to the convenience and needs of the investor. The period of deposit, however, should be in multiples of 3 months only. The rate of interest applied is 9 percent p.a. for periods from 12 to 24 months and 10 percent p.a. for periods from 24 to 120 months and is compounded at quarterly intervals. Based on the above information the maturity value of a monthly installment of Rs.5 for 12 months can be calculated as below: Amount of deposit Rate of interest = = Rs.5 per month 9 percent p.a. compounded quarterl

Effective rate of interest per annum Rate of interest per month

0.0931

= (r + 1)1/m 1 = (1 + 0.0931)1/12 1 = 1.0074 1 = 0.0074 = 0.74% Maturity value can be calculated using the formula FVAn = = = 5 x 12.50 = Rs.62.50 If the payments are made at the beginning of every year, then the value of such an annuity called annuity due is found by modifying the formula for annuity regular as follows: FVAn(due) = A (1 + k) FVIFAk,n Illustration 8 Under the Jeevan Mitra Plan offered by Life Insurance Corporation of India, if a person is insured for Rs.10,000 and if he survives the full term, then the maturity benefits will be the basic sum of Rs.10,000 assured plus bonus

Dr Jaideep Jadhav

Page 9

which accrues on the basic sum assured. The minimum and maximum age to propose for a policy is 18 and 50 years respectively. Let us take two examples, one of a person aged 20 and another of 40 years old to illustrate this scheme. The person aged 20, enters the plan for a policy of Rs.10,000. The term of policy is 25 years and the annual premium is Rs.41.65. The person aged 40, also proposes for the policy of Rs.10,000 and for 25 years and the annual premium he has to pay comes to Rs.57. What are the rates of return enjoyed by these two persons?

Rate of return enjoyed by the person of 20 years of age Premium = Rs.41.65 per annum = Term of Policy 25 years Rs.10,000 + bonus which can be overlooked as it is a fixed amount and does not vary with the term of policy. We know that the premium amount when multiplied by FVIFA factor will give us the value at maturity. i.e. P x (1 + k) FVIFA (k,n) = MV where, Maturity Value = P= n = k = MV = Therefore, Annual premium Term of policy in years Rate of return Maturity value

41.65 x (1 + k) FVIFA (k,25) = 10,000 (1 + k) FVIFA (k,25) = 240.01 From table 2 at the end of the book, we can find that (1 + 0.14) FVIFA (14,25) i.e. (1.14) FVIFA (14,25) and (1 + 0.15) FVIFA (15,25) i.e. (1.15) FVIFA (15,25) By interpolation = 207.33 = 1.14 x 181.871 = 207.33

= 244.71 = 1.15 x 212.793 = 244.71

= =

14% + (15% - 14%) x 14% + 1% x

= 14% + 0.87% = 14.87% Rate of return enjoyed by the person aged 40 Premium Term of Policy = = Rs.57 per annum 25 years

Dr Jaideep Jadhav

Page 10

Maturity Value

Rs.10,000 = = 10,000 175.44

Therefore, 57 x (1 + k) FVIFA (k,25) (1 + k) FVIFA (k,25)

From table 2 at the end of the book, we can find that (1 + k) FVIFA (13%, 25) = 175.87 i.e. (1.13) (155.62) = 175.87 i.e. k = 13% (appr.) Here we find that the rate of return enjoyed by the 20-year old person is greater than that of the 40-year old person by about 2 percent in spite of the latter paying a higher amount of annual premium for the same period of 25 years and for the same maturity value of Rs.10,000. This is due to the coverage for the greater risk in the case of the 40year old person. Now that we are familiar with the computation of future value, we will get into the mechanics of computation of present value. Sinking Fund Factor We have the equation FVA =

We can rewrite it as A = FVA

The expression (1 k) n 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 as explained earlier is an alternative approach for reckoning the time value of money. Using this approach, we can determine the present value of a future cash flow or a stream of future cash flows. The present value approach is the commonly followed approach for evaluating the financial viability of projects. If we invest Rs.1,000 today at 10 percent rate of interest for a period of 5 years, we know that we will get Rs.1,000 x FVIF (10,5) = Rs.1,000 x 1.611 = Rs.1,611 at the end of 5 years. The sum of Rs.1,611 is called the accumulation of Rs.1,000 for the given values of k and n. Conversely, the sum of Rs.1,000 invested today to get Rs.1,611 at the end of 5 years is called the present value of Rs.1,611 for the given values of k and n. It, therefore, follows that to determine the present value of a future sum we have to divide the future sum by the FVIF value corresponding to the given values of k and n i.e. present value of Rs.1,611 receivable at the end of 5 years at 10 percent rate of interest.

= Rs.

= Rs.

= Rs.1,000

Dr Jaideep Jadhav

Page 11

In general the present value (PV) of a sum (FVn) receivable after n years at a rate of interest (k) is given by the expression. PV =

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) Therefore to determine the present value 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 at the end of this book. Illustration 9 The cash certificates of Andhra Bank is a term deposit scheme under reinvestment plan. Interest on deposit money earns interest as it is reinvested at quarterly rests. These deposits suit depositors from lower and middle income groups, since the small odd sums invested grow into large amounts over a period of time. Given an interest rate of 12 percent p.a. on a certificate having a value of Rs.100 after 1 year, the issue price of the cash certificate can be calculated as below. The effective rate of interest has to be calculated first. r r = = = 12.55%

The issue price of the cash certificate is PV = = = Rs.88.85

Illustration 10 Pragati cash certificate scheme of Syndicate Bank is an ideal scheme for all classes of people under different income groups. A small odd sum can be invested for a period ranging from 1 to 10 years. The certificates are issued in convenient denominations of Rs.25, Rs.100, Rs.1,000, and Rs.1,00,000. The rate of interest is 12 percent p.a. compounded quarterly. To calculate the issue price of a certificate of Rs.1,00,000 to be received after 10 years, the following formula can be used PV =

Firstly, the effective rate of interest has to be calculated. r = = 12.55%

The issue price of the cash certificate can now be calculated as: PV = = = Rs.30,658

Dr Jaideep Jadhav

Page 12

PRESENT VALUE OF UNEVEN MULTIPLE FLOWS Suppose a project involves an initial investment of Rs.10 lakh and generates net inflows as follows: End of Year 1 Rs.2 lakh 2 Rs.4 lakh -> 3 Rs.6 lakh What is the present value of the future cash inflows? To determine it, we have to first define the relevant rate of interest. The relevant rate of interest as we shall see later, will be the cost of the funds invested. Suppose, we assume that this cost is 12 percent p.a. then we can determine the present value of the cash flows using the following two-step procedure: Step 1 Evaluate the present value of cash inflow independently. In this case, the present values will be as follows: Year 1 2 3 Cash Flow (Rs. in lakh) 2 4 6 Present Value (Rs. in lakh) 2 x PVIF (12,1) = 2 x 0.893 = 1.79 4 x PVIF (12,2) = 4 x 0.797 = 3.19 6 x PVIF (12,3) = 6 x 0.712 = 4.27

Step 2 Aggregate the present values obtained in Step 1 to determine the present value of the cash flow stream. In this case the present value of the cash inflows associated with the project will be Rs.(1.79 + 3.19 + 4.27) lakh = Rs.9.25 lakh. A project is said to be financially viable if the present value of the cash inflows exceeds the present value of the cash outflow. In this case, the project is not financially viable because the present value of the net cash inflows (Rs.9.25 lakh) is less than the initial investment of Rs.10 lakh. The difference of Rs.0.75 lakh is called the net present value. 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 the FVIFA expression.

PRESENT VALUE OF AN ANNUITY The present value of an annuity A receivable at the end of every year for a period of n years at a rate of interest k is equal to PVAn = which reduces to PVAn = Ax ;

Dr Jaideep Jadhav

Page 13

The expression is called the PVIFA (Present Value Interest Factor Annuity) and it represents the present value of a regular annuity of Re.1 for the given values of k and n. The values of PVIFA (k,n) for different combinations of k and n are given in Table 4 given at the end of the book. It must be noted that these values can be used in any present value problem only if the following conditions are satisfied: (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 the inverse of FVIF (k,n). The following illustration illustrates the use of PVIFA tables for determining the present value

Illustration 11

The Swarna Kalash Yojana at rural and semi-urban branches of SBI is a scheme open to all individuals/firms. A lump sum deposit is remitted and the principal is received with interest at the rate of 12 percent p.a. in 12 or 24 monthly installments. The interest is compounded at quarterly intervals. The amount of initial deposit to receive a monthly installment of Rs.100 for 12 months can be calculated as below: Firstly, the effective rate of interest per annum has to be calculated.

= = = 12.55%

After calculating the effective rate of interest per annum, the effective rate of interest per month has to be calculated which is nothing but (1.1255)1/12 1 = 0.00990 The initial deposit can now be calculated as below: PVAn = A

= 100

= = 100 x 11.26 = Rs.1,126.

Illustration 12

Dr Jaideep Jadhav

Page 14

The annuity deposit scheme of SBI provides for fixed monthly income for suitable periods of the depositors choice. An initial deposit has to be made for a minimum period of 36 months. After the first month of the deposit, the depositor receives monthly installments depending on the number of months he has chosen as annuity period. The rate of interest is 11 percent p.a. which is compounded at quarterly intervals. If an initial deposit of Rs.4,610 is made for an annuity period of 60 months, the value of the monthly annuity can be calculated as below. Firstly, the effective rate of interest per annum has to be calculated r =

= 11.46%

After calculating the effective rate of interest per annum, the effective rate of interest per month has to be calculated which is nothing but (1.1146)1/12 1 = 0.00908 The monthly annuity can now be calculated as PVAn = A

4,610

= A

4,610

= Ax = 99.8833

= Rs.100

Capital Recovery Factor Manipulating the relationship between PVAn, A, k & n we get an equation: A = PVAn

is known as the capital recovery factor.

Illustration 13 A loan of Rs.1,00,000 is to be repaid in five equal annual installments. If the loan carries a rate of interest of 14 percent p.a. the amount of each installment can be calculated as below.

Dr Jaideep Jadhav

Page 15

If R is defined as the equated annual installment, we are given that R x PVIFA (14%, 5) = Rs.1,00,000 Therefore, R =

=Rs.29,129 =

Notes:
1.

We have introduced in this example the application of the inverse of the PVIFA factor which is called the capital recovery factor. 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 rate of interest? How much can be withdrawn periodically for a certain length of time, if a given amount is invested today? In this example, the amount of Rs.29,129 represents the sum of the principal and interest components. To get an idea of the break-up of each installment between the principal and interest components, the loan repayment schedule is given below:

2.

Year (A) 0 1 2 3 4 5

Equated installment (B) (Rs.) 29,129 29,129 29,129 29,129 29,129

annual Interest content of Capital content of (B) (B) [(D) = (B C)] (C) (Rs.) (Rs.) 14,000 11,882 9,467 6,715 3,577 15,129 17,247 19,662 22,414 25,552

Loan outstanding payment (E) (Rs.) 1,00,000 84,871 67,624 47,962 25,548

after

The interest content of each installment is obtained by multiplying interest rate with the loan outstanding at the end of the immediately preceding year. As can be observed from this schedule, the interest component declines over a period of time whereas the capital component increases. The loan outstanding at the end of the penultimate year must be equal to the capital content of the last installment but in practice there will be a marginal difference on account of rounding-off errors. 3. The equated annual installment method is usually adopted for fixing the loan ment schedule in a hire purchase transaction. But the financial institutions in India repaylike IDBI, IFCI and ICICI do not follow this scheme of equal periodic amortization. Instead, they stipulate that the loan must be repaid in equal installments. According to this scheme, the principal component of each payment remains constant

Dr Jaideep Jadhav

Page 16

and the total debt-servicing burden (consisting of principal repayment and interest payment) declines over time.

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: = A PVIFAk, Where, = Present value of a perpetuity = Constant annual payment PVIFAk, = Present value interest factor for a perpetuity Therefore, The value of PVIFAk, is P P A

We can say that PV interest factor of a perpetuity is simply one divided by interest rate expressed in decimal form. Hence, PV of a perpetuity is simply equal to the constant annual payment divided by the interest rate. Students who are interested in knowing the derivation of the formulae for PVIFA and FVIFA may refer the Appendix to this chapter.

SUMMARY

Inflation, uncertainty and opportunity cost whatever the reason, money has time value. A rupee today is certainly more valuable than a rupee a year hence, the difference usually represented by interest. Therefore, two cash flows occurring at different points of time are not comparable. Compounding and discounting are two methods used to take care of time value of money. Discounting involves determining the present values of all the future cash flows so that they are comparable to the initial outflow. The rate of interest usually employed is the cost of capital of the firm.

Dr Jaideep Jadhav

Page 17