FINANCIAL MANAGEMENT 1

Prof. R Madhumathi
Department of Management Studies
Module 2
Time Value
 Time value of Money

Present value and Future value of money

Compounding

Perpetuity
 Present value and Future value
• Future value (FV) and present value (PV) adjust all cash flows
to a common date. This is relevant when we want to
compare the cash flows occurring at different periods of
time. Either in terms of projects, performance or turnover,
the cash flows accrue to the firm at different stages. The
evaluation of all these cash flows are true when they are all
brought to the same base period.

• In financial parlance, a value of currency is not kept idle. The

amount, if invested would certainly bring additional returns
in the future. This future expectation from the present
investment is termed as the future value.
• Let us assume x amount is invested now and the investor expects
r% to accrue on the investment one year ahead. This is translated
into present and future values as follows:

PV = INR x
FV = INR x + (r * x)

This can be restated as FV = PV * (1+r)

This relationship leads to the following concept of discounting
the future value to arrive at the present value i.e.,

PV = FV / (1 + r)

This is the formula for equating the future value that is

associated at the end of 1st year. Now the concept of time over a
longer duration can be easily brought into the above equation,
where 'n' defines the time duration after which the cash flows
are expected.
• For instance, if FV is available to a person two years
hence, its present worth would be defined as

PV = FV / (1 + r)^2

Where '2' is the number of years after which the

future value is available to a person. Here interest is
earned on both the principle and the interest on first
year. This accumulation of interest as a principle and
calculation of interest on this total is called
compounding of interest.
 Interest with/without compounding
• Interest without compounding is a simple interest formula
i.e., Pnr/100
Where P is the principle, n is the number of years and r is
the interest rate.
• Interest with annual compounding adds the interest received
earlier to the principle amount and increases the final
amount that is received from the investment. Hence, the FV
of an investment for a two year duration would be
FV = PV * (1+r)* (1+r) = PV * (1+r)^2
• This equation can be generalized for 'n' years as:
PV = FV / (1 + r)^n
• The future value of (1000) with and without compounding at
4% interest rate.
 Compounding
• In compounding, it is assumed that a certain sum accrues at the
end of a time duration, which is again reinvested. In short, when
a sum invested in a year will yield interest and the interest is
reinvested for the next year and so on till the time when
withdrawal is made. The 3 year or 4 year bank deposit is a typical
example of this annual interest compounding.

FV = Principal + interest
FV = P(1+r)^n

• The term (1+r)^n is the compound value factor (CVF) of a lump

sum of INR 1, and it always has a value greater than 1 for positive
r, indicating that CVF increases as r and n increase.
 Compounding in less than a year duration
• Usually, it is common practice to compound the
interest on a yearly basis. But, there are instances
when compounding is done on a half-yearly,
quarterly, monthly or a daily basis. The half-yearly
interest rates indicate that interest is payable
semiannually, i.e., interest is received r%/2 twice
every year. When the principle of compounding is
applied, this implies that the r%/2 received twice an
year will yield an actual rate which is higher than the
declared (r%) rate. This actual rate is called the
effective annual rate.
• For instance, let us take an illustration of a banker declaring a
10% p.a. interest payable semiannually. This implies that at the
end of the year the amount received for every one rupee will
be
1 * (1+[10%/2]) * (1+[10%/2]) i.e., (1.05) * (1.05) = (1.05)^2 =
1.1025

• The interest amount will be 1.1025 - 1 = .1025 and in percentage

terms it will be 10.25%. The effective rate of interest is hence
10.25% and not 10%. This translates itself into the following
formula:

FV = PV (1+ r/m)^(m*n)
where m is the number of times within a year interest is paid.
When half-yearly interest payments are made 'm' will be 12/6 i.e.,
2. When quarterly interest payments are made 'm' will be 12/3
i.e., 4. When monthly compounding is done then 'm' will be 12/1
i.e., 12. Compounding on a daily basis, 'm' will be 365/1 i.e., 365.
This is referred to as multi-period compounding.
 Multi-Period Compounding
• Multi-period compounding is used in practice, when
cash flows occur more than once a year.

• The interest rate is usually specified on an annual

basis in a loan agreement or security (such as bonds).
The annual interest rate is referred as the nominal
interest rate. If compounding is done more than once
a year the actual rate of interest paid (or received) is
the effective interest rate is different from the
nominal interest rate as illustrated earlier. Effective
interest rate would be higher than the nominal
interest rate when the compounding is done more
frequently.
 • The formula for calculating Effective Interest Rate
(EIR) is:
EIR = {[1+r/m]^(n X m)} -1
Where r is the annual nominal rate of interest, n number of years
and m the number of compounding per year.

We can use the following formula for computing the Future

compound value of a sum in case of the multi-period compounding:

FV= PV{[(1+r/m)^(n X m)]}

Where FV is the future value, PV is the present value, r is the annual

rate, n is the number of years and m is the number of compounding
per year.
 Continuous Compounding
• Sometimes compounding may be done continuously.
For example, banks may pay interest continuously;
they call it daily compounding. It can be
mathematically proved that the continuous
compounding function will reduce to the following:
FV = P {e^i}
When i = (r * n) and e is mathematically defined as
2.7183.
 Compound Value of an Annuity
• There can be a uniform cash flow accrual every year
over a period of 'n' years. The uniform flow is called
"Annuity".
• An annuity is a fixed payment (or receipt) each year for
a specified number of years. The future compound
value of an annuity is as follows:
FV = A {[(1+r)^n - 1]/ r}
• The term within the curly brackets {} is the compound
value factor for an annuity of amount A (INR 1).

• The present value of an annuity hence will be

PV = A {[1 - 1/(1+r)^n]/r}
 Compound value of an annuity Due
• When an annuity's cash payments are made at the end of
each period, it is referred as regular annuity. On the
other hand, the annual payments/receipt can also be
made at the beginning of each period. This is referred to
as annuity due.

• Lease is a contract in which lease rentals (payment) are

to be paid for the use of an asset. Hire purchase contract
involves regular payments (installments) for acquiring
(owning) an asset. A series of fixed payment starting at
the beginning of each period for a specified number of
periods is called an annuity due.
 Compound value of an annuity Due
• The formula for the compound value of an annuity
due is:
FV = A[(1 + r) + (1+r)^2+ (1+r)^3 +....+ (1+r)^n-1]
FV = A {[(1+r)^(n-1) -1] / r}
Hence,
PV = A {[1 - 1/(1+r)^n]/r * (1+r)

PV = A(PVRA,r)(1+r)

Where PVAR is present value of regular annuity and r

is the interest rate.
 Multi-period Annuity Compounding
• The compound value of an annuity in case of
the multiperiod compounding is given as
follows:

FV = A ‹{[(1+r/m)^(n * m)] -1 } /(r/m)›

PV = A ‹{1 -[1/(1+r/m)^(n * m)]} / (r/m)›

• In all instances, the discount rate will be (r/m)

and the time horizon will be equal to (n X m).
 Growing Annuity
 An annuity may not be a constant sum through the
time duration, it may also grow at a rate of g% every
year. This is referred as a growing annuity. When there
is a growth for specific number of years, the present
value of an annuity is stated using the following
formula:

 Hence, Future value of a growing annuity can be defined by

the following formula:
 Present value of Perpetual Annuity
• Perpetuity is an annuity that occurs indefinitely. In
perpetuity, time period, n, is so large (mathematically n
approaches infinity) that the expression (1+r)^n in the
present value equation tends to become zero, and the
formula for a perpetuity simply condenses into:

PV = A/r

where A is the annuity amount occurring indefinitely

and r is the interest rate.
 Present Value of a Growing Annuity
• In financial decision-making there are number of situations
where cash flows may grow at a compound rate. Here, the
annuity is not a constant amount A but is subject to a
growth factor 'g'. When the growth rate 'g' is constant, the
formula can be simplified very easily. The calculation of the
present value of a constantly growing perpetuity is given by
the following equation:
PV = A/(1+r) + A(1+g)/(1+r)^2 + A(1+g)^2/(1+r)^3 + .....

• This equation can be simplified as:

PV = A / (r - g)
 Example
• Johnson products Co. a personal care products company
was proposed to be acquired by a public held company.
Icare corp. The proposed acquiring was for about INR 67
million in shares. Johnson Company's shares soared by
INR 5.625 (per share) or 30% on the Stock Exchange,
closing at INR 24.625. Shares of Icare, closed unchanged
at INR 25.25.
• Most of the two dozen or so major players in the
personal-care industry, many of whom need additional
capital and marketing capabilities, have viewed
consolidation as inevitable still the potential for fierce
competition from the bigger mainstream companies has
remained a major concern.
 Johnson's Results on the Rise
• The company's results have improved steadily
since fiscal year X when it lost INR 2.5 million on
reduced sales. In the year ended Aug.31 Johnson
Products earned INR 3.4 million or INR 2.86 a
share on sales of INR 42.9 million.
• The agreement with Icare calls for retaining the
same team as chief executive team. Each share of
Johnson Products will be converted to receive one
Icare share.
• Icare chairman and chief executive officer, called
the merger "Complementary to several of the
business Icare is pursuing."
Questions
1. Suppose the INR 3.4 million annual income is a
perpetuity. What is the present value of Johnson
Products' future income calculated at a riskless 7%
discount rate?
2. What is the present value of the acquired firm if we
add to the riskless interest rate a 5% risk premium?
3. Now assume the income stream is a growing
perpetuity beginning at INR 3.4 million and growing at
8% annually. The discount rate is k=12%. What is the
present value of the perpetuity?
4. The graph in the article shows an income growth rate
much greater than 8%. How would your answer to (3)
change if the growth rate was 10% for 10 years and 0%
thereafter?
Qn 1: Suppose the INR 3.4 million annual income is a
perpetuity. What is the present value of Johnson
Products' future incomes calculated at a riskless 7%
discount rate?

Applying the perpetuity formula PV= C/r, we obtain

the PV of all future earnings:

Thus according to this formula it would seem that

Icare is offering too much.
Qn2: What is the present value of the acquired firm if we
add to the riskless interest rate a 5% risk premium?

Because the cash flows are uncertain, a risk premium

should be added to the discount rate (7%). Therefore,
with a modest risk premium of 5% the earnings should
be discounted at k= 12%(7% + 5%).
Incorporating uncertainty into the calculation gives us an
even lower present value:

The risk factor strengthens our previous conclusion - that Icare's

offer is too high.
Qn 3: Now assume the income stream is a growing perpetuity
beginning at INR 3.4 million and growing at 8% annually.
The discount rate is k=12%. What is the present value of
the perpetuity?

Using the growing perpetuity formula, We obtain

Qn 4: The graph in the article shows an income growth rate
much greater than 8%. How would your answer to (3) change
if the growth rate was 10% for 10 years and 0% thereafter?

The net income in year n was INR 3.4 million. Therefore it will
be INR 3.4 million X (1.1) = INR 3.74 million in n+1, We find
that the present value of these 10 years of income is
• INR 3.4 million X (1.1) ^ 10 = INR 8.82 million in the last year
of the 10% growth trend.
• All other cash flows obtained form year 11 on can be totaled
by using the perpetuity formula
• Accordingly the PV in terms of year- 10 is:

and the PV is

The some of these two components gives the PV of Johnson

Products cash flow
Pv= INR 30.84 million + INR 23.67 million = INR 54.51 million
which is less than what Icare offered.