Concepts of Value and

Return (Time Value of

Money)
 Cost Benefit Analysis
• An aid to decision making
• The first step in decision-making: Identify the costs and the benefits of a decision.
• ‘Benefits’ > ‘Costs’: Take the decision
• ‘Benefits’ < ‘Costs’: Hold on!
• As financial manager, we might take several decisions:
• Marketing: To determine the incremental revenue as a result of an advertising campaign
• Operations: To determine production costs after significantly revamping the production facility
• Human Resources: To recruit full-time or on contract
• Strategy: To determine a competitor’s response to a price increase
• Mostly, in business, costs and benefits occur at different points in time!
• •Invest today to earn an income tomorrow!
 Concepts of Value and Return
• As we know, most of the time, costs and benefits occur at different points
in time, thus not comparable!
• Invest today in a project → Earn profits in future!
• If we compare the above cash flows, we find a net (positive) value of Rs.
5,000, but it ignores the timing of costs and benefits.
• In general, a rupee (received) today is worth more than a rupee (received)
in one year. Why?
• The difference in value between money today and money in the future is
called the TIME VALUE OF MONEY.
 Time Value of Money
• Most financial decisions affect a firm’s cash flows (CFs) in different time
periods.
• Example:
• If an asset is purchased, immediate cash outlay and receive CFs during many future
periods.
• If a firm borrows from bank – receives cash now and pays interest and principal in
future.
• The CFs which differ in time and risk cannot be logically comparable – if
compared, becomes a wrong decision.
• CFs need to adjusted for differences in time and risk.
• Recognition of time value of money and risk is extremely vital in financial
decision-making.
Time Value of Money (Time Preference for
money)
• Time preference for money is an individual’s preference for possession of
a given amount of money now, than the same amount on a future date.
• A rational individual prefers to possess a given amount of cash now, rather
than same amount at some future time.
Reasons:
• Risk or uncertainty
• Preference for consumption – urgency of present needs or not able to
enjoy future consumption due to illness or death, or due to inflation.
• Investment opportunities available
Time Value of Money
• Converting values across time: Future Value
• By depositing money into savings bank account, we can convert money
today into money in future (with no risk).

• Converting values across time: Present Value

• By borrowing money from bank, we can exchange future money for
money today.
Methods of Adjusting Cash Flows for Time Value of Money
• I. Compounding
• II. Discounting
I. Compounding
• It is the process of calculating future values of cash flows.
• Compounding is the process whereby interest is earned on an original
principal amount as well as to interest earned in the previous periods.
• It can be interpreted as “Interest on Interest” and results in magnification
of returns over time (Magic of Compounding).
II. Discounting
• It is the process of calculating present values of cash flows.
• Present value (PV) is the current value of a future sum of money or
stream of cash flows given a specified rate of return.
• The rate of return used for discounting is key to properly valuing future
cash flows.
• PV = FV/(1+r)t
• FV = future value
• PV = present value
• r = interest rate applicable per period
• t = number of periods
• Present value interest factor = 1/(1+r)t
Time Value of Money: Future Value
• Converting values across time: Future Value
• Future value (FV) is the value of a current asset at a future date based on
an assumed rate of growth.
• The rate of growth is the interest rate applicable to the cash flows.
• FV = PV*(1+r)t
• FV = future value
• PV = present value
• r = interest rate applicable per period
• t = number of periods
• Future value interest factor = (1+r)t
Example of Future Value
• Suppose you invest $1,000 for one year at 5% per year. What is the future
value in one year?
• Value in 1 year = Interest + Principal = 1000*0.05 + 1000 = 1050
• Using formula, FV = 1000*(1+0.05)1 = 1050
• What is the future value if you leave it invested for two more years?
What is the future value three years from now?
• FV = 1000*(1+0.05)3= 1157.63
• If you invest with simple interest for 3 years,
• FV with simple interest = 1000 + 50 + 50 + 50 = 1150
• FV with compound interest = 1157.63
• The extra 7.63 comes from interest earned on the two previous interest payments.
Example for Present Value
• You want to begin saving for your daughter’s college education and you
estimate that she will need $150,000 in 17 years. If you feel confident that
you can earn 8% per year, how much do you need to invest today?
• PV = 150,000/(1+0.08)17 = 150,000 X 0.2703 = $40,540
• Your parents set up a trust fund for you 10 years ago that is now worth
$19,671.51. If the fund earned 7% per year, how much did your parents
invest?
• PV 10 years ago = 19671.51/(1+0.07)10 = $10,000
Time Value of Money: Present Value - Some key inferences
• For a given interest rate –the further out the cash flow, the lower it’s
present value
• Example: What is the present value of $500 to be received in 5 years? 10 years?
The discount rate is 10%.
• 5 years: PV = 500/(1.1)5= 310.46
• 10 years: PV = 500/(1.1)10= 192.77
• For a given time period –the higher the interest rate, the smaller the
present value
• Example: What is the present value of $500 received in 5 years if the interest rate
is 10%? 15%?
• Rate = 10%: PV = 500/(1.1)5= 310.46
• Rate = 15%; PV = 500/(1.15)5= 248.59
Time Value of Money: Applications
• Financial decision making
• Corporate finance decisions:
• Invest in a new project requiring substantial amount of investment
• Research & development decisions
• Launching a new product or in a new market
• Personal finance decisions:
• Make an investment for future, e.g., education
• Buy an insurance policy
• Live in a rented house or buy own house?
Time Value of Money: Applications
• Annual Percentage Rate (APR)
• APR is the annual rate that is quoted by law.
• APR = Period rate times number of periods per year.
• APR becomes relevant only if the compounding interval is taken into
account. By contrast EAR is meaningful even without compounding
effect.
• Example:-Calculate APR if the semi-annual rate of interest rate is 7%.
• APR = Period rate * Period Per Year
• Here, APR = 0.07*2 = 1.4%
Time Value of Money: Applications
• Effective Annual Rate (EAR) is the actual rate of Interest paid or received during
the year after adjusting the compounding effects.
• If we want to compare two alternative investment proposals with different
compounding periods, we need EAR for comparison.
• EAR = [1+APR/m]m-1
• m: number of compounding periods
• APR: Annual Percentage Rate (quoted)
• Example:-There are two investment options available, one pays 6.25% with
daily compounding and the other pays 6.3% with semi annual compounding.
Which option should an investor choose?
• CASE 1: EAR = [1+0.0625/365]365 -1 = 6.44%
• CASE 2: EAR = [1+0.063/2]2 -1 = 6.39%
• ○Clearly, investment 1 will give better returns than 2.
 Time Preference Rate and Required rate of
return
• The time preference for money is generally expressed by an interest rate.
• This rate will be positive even in the absence of any risk – called as risk-free
rate.
• In reality, an investor will be exposed to some degree of risk.
• So, he would require a rate of return, called risk premium, from the
investment, to compensate him for both time and risk.
• Required rate of return = Risk-free rate + Risk premium
• Required rate of return may also be called as the Opportunity cost of
capital.
 Opportunity Cost of Capital
• Opportunity Cost of Capital is called so because the investor (both
individuals and firms) can invest their money in assets and securities of
equivalent risk.
• Useful for evaluating the desirability of alternative financial decisions.
 I. Compound Value or Future Value
• Compounding – is the process of finding future value of a payment or a
series of payment by applying the concept of compound interest.
• Compound interest – Interest earned on principal plus interest not
withdrawn.
• Formula:
• FV = PV (1+r)n
• where (1+r)n is the compound value factor (CVF) of a lumpsum of Re. 1 and
it always has a value greater than 1 for a positive r, indicating that CVF
increases as r and n increase.
• Example: If a person requires 10% interest rate for Re. 1 invested today for
1 year, Future Value will be Re. 1.10.
i. Future Value of a Lumpsum Amount
• Example 7: What will Rs.247,000 grow to be in 9 years if it is invested
today in an account with an annual interest rate of 11%?
• Solution:
PV = Rs. 247,000
n =9
r = 11% = 0.11
FV = PV (1+r)n
FV = Rs. 247,000 (1.11)9 = 247,000 X CVIF9,11%
= 247,000 X 2.558 = Rs. 631,826
 ii. Future Value of an Annuity
• Annuity is a fixed payment (or receipt) each year for a specified number of
years.
• The series of cash flows can be represented on a time line as below, PV of
Re.1 at 5% interest:
 ii. Future Value of an Annuity
• Example 8: A firm deposits Rs. 5,000 at the beginning of each year for
four years at 6% rate of interest. How much would this annuity
accumulate at the end of the fourth year?
• Solution
• FV = 5,000 (CVIFA4,6%)
= 5,000 X 4.3746
= Rs. 21,873
 Future Value of Uneven Periodic Sum –
Deposited at the beginning of the year
• Example 9: A firm deposits Rs. 5,000, Rs. 6,000, Rs. 7,000 and Rs. 8,000 at
the beginning of each year for four years at 6% rate of interest. How
much would this series of cash flows accumulate at the end of the fourth
year?
• Solution
• Future Value after 4 years = 5,000 (FVIF4,6%) + 6,000 (FVIF3,6%) + 7,000
(FVIF2,6%) + 8,000 (FVIF1,6%)
• = 5,000 X (1.06)4 + 6,000 X (1.06)3 + 7,000 X (1.06)2 + 8,000 X (1.06)1
• = (5,000 X 1.2625) + (6,000 X 1.191) + (7,000 X 1.1236) + (8,000 X 1.06) =
5,300 + 6,741.6 + 8,337 + 10,100
• = 6,328 + 7,146 + 7,865.2 + 8,480 = 29,819.2
 Future Value of Uneven Periodic Sum
Deposited at the end of the year
• Example 10: Suppose Jennifer deposits $500 in an account at the end of
first year, $400 at the end of the second year, and $300 at the end of the
third year. If her opportunity cost is 7.5%, how much will be in the
account immediately after the third deposit is made?
• Solution
• Future Value at the end of third year = 500 (FVIF2,7.5%) + 400 (FVIF1,7.5%) +
300 (FVIF0,7.5%)
• = 500 X (1.075)2 + 400 X (1.075)1 + 300 X (1.075)0
• = 500 X 1.1556 + 400 X 1.075 + 300 X 1
• = 577.8 + 430 + 300 = 1,307.8
II. Present Value:
• Present value is the amount of current cash that is of equivalent value to
the decision maker.
• Discounting – is the process of determining present value of a future
payment or series of payments.
• Discount rate – is the compound interest rate used for discounting CFs.
• Annuity – is a fixed payment each year for a specified number of years.
i. PV of an uneven periodic sum: (refer to PV of Re. 1 table)
PV = F1 + F2 + F3 + ------ + Fn
(1+r)1 (1+r)2 (1+r)3 (1+r)n
ii. PV of an Annuity: (refer to PV of an Annuity table)
PV = A + A + A + ------ + A
(1+r)1 (1+r)2 (1+r)3 (1+r)n
Or
PV = A x PVIFA (Present Value Interest Factor Annuity)
 i. Present Value of a Lumpsum Amount
Example 1: If you wish to accumulate Rs.140,000 in 13 years, how
much must you deposit today in an account that pays an annual
interest rate of 14%?
How much will it be if the interest rate is 10 %?
Solution
i. If r = 14 %
PV = Future Amount / (1+r)n
Future Amount = Rs. 140,000, r = 14 % = 0.14, n = 13
PV = 140,000 / (1+0.14)13 = 140,000 X 0.182
= Rs. 25,480 must be deposited today
ii. If r = 10 %
PV = 140,000 / (1+0.10)13 = 140,000 X 0.290
= Rs. 40,600 must be deposited today
 ii. Present Value of Uneven Periodic Sum
Example 2: X Ltd invests in a project costing Rs. 100,000 today. The project is expected
to give returns of Rs. 30,000, Rs. 40,000, Rs. 40,000, Rs. 30,000 and Rs. 20,000 at the
end of 1st, 2nd , 3rd , 4th and 5th year respectively. Assume a discount rate of 10%.
Calculate the present value of all the inflows.
Sol:
PV = F1 / (1+r)1 + F2 / (1+r)2 + ….. F5 / (1+r)5

PV = 30,000 / (1 + 0.1)1 + 40,000 / (1 + 0.1)2 + 40,000 / (1 + 0.1)3 + 30,000 / (1 + 0.1)4 +

20,000 / (1 + 0.1)5

= (30,000 X 0.909) + (40,000 X 0.826) + (40,000 X 0.751) + (30,000 X 0.683) + (20,000

X 0.621) = Rs. 123,260
 iii. Present Value of an Annuity
• Example 3: X Ltd invests in a project costing Rs. 100,000 today. The
project is expected to give returns of Rs. 40,000 per year for five years.
Calculate the present value of all the inflows. Assume a discount rate of
10%.
• Solution:
• PV = A (PVIFA)

• PV = 40,000 (3.790) = Rs. 151,600

 iv. Present Value of Perpetuity
• Perpetuity is an annuity that occurs indefinitely.
• The cash flows should be identical.
• Perpetuities are not very common in financial decision making.
• But one can find a few examples. For instance, in the case of irredeemable
preference shares (i.e., preference shares without a maturity), the company is
expected to pay preference dividend perpetually.
• In a perpetuity, time period, n, is so large that the expression (1 + i)n tends to
become zero.
• PV of Perpetuity = Perpetuity / Interest rate
•P=A/i
• The formula attempts to determine the terminal value of the identical cash
flows.
• Example 4: An investor expects a perpetual sum of Rs. 500 annually from
his investment. What is the present value of this perpetuity if his interest
rate is 10%?
• Solution:
• PV of Perpetuity = Rs. 500 / 0.10 = Rs. 5,000

• Example 5: Consider a pertuity paying Rs 1,000 a year. If the relevant

discount rate is 7%, what is the value of the perpetuity today?
• PV of Perpetuity = 1,000 / 0.07 = Rs. 14,285.71
Present Value of Constant Perpetuity

• Perpetuity is a series of cash flows that have an infinite life.

• Perpetuity may grow at a constant rate.
• The formula is derived from the dividend growth model.
• In case of perpetuity, n is not definite; n extends to infinity (∞)
• Formula: PV of Perpetuity = A
(r – g)
• Here, A is the constantly growing annuity.
• The interest rate or the discounting rate is expressed as r.
• The growth rate is expressed as g.
• Example 5: A trading business intends to receive an income of Rs.
120,000 for infinite tenure. The cost of capital for the business is at 13%.
The cash flows grow at the proportionate basis of 3%. Help the
management to determine it.
• Solution:
• PV of Perpetuity = A / (r – g)
• Rs. 120,000 / (13% – 3%) = Rs. 12,00,000
• PV of the perpetuity is Rs. 12,00,000
 Example 6
• An individual investor owns preference shares in company ABC. The
business intends to distribute preference dividends of Rs. 20 per share for
infinite tenure. The required rate of return for the investor is at 8%. The
cash flows grow at the proportionate basis of 2%. The investor currently
holds 200 shares of the company ABC. Help the investor to determine it.
• Solution:
• Total value of dividends = Rs. 20 X 200 shares = Rs. 4,000
• PV of Perpetuity = A / (r – g) = Rs. 4,000 / (8% - 2%)
• = Rs. 66,666.67
 Multiperiod Compounding
• Find out the compound value of Rs. 1,000 interest rate being 12% per annum if
compounding is done annually, semi-annually, quarterly, and monthly for 2
years.
• i. Annual compounding
• F2 = 1,000 X (1.12)2 = 1,000 X 1.254 = Rs. 1,254
• ii. Half-yearly compounding
• F2 = 1,000 X (1 + 0.12/2)2X2 = 1,000 X (1.06)4 = 1,000 X 1.262 = Rs. 1,262
• iii. Quarterly compounding
• F2 = 1,000 X (1 + 0.12/4)2X4 = 1,000 X (1.03)8 = 1,000 X 1.267 = Rs. 1,267
• iv. Monthly compounding
• F2 = 1,000 X (1 + 0.12/12)2X12 = 1,000 X (1.01)24 = 1,000 X 1.270 = Rs. 1,270
• V. Daily Compounding = F2 = 1,000 X (1 + 0.12/365)2X365 = Rs. 1,271
 Few links
• https://analystprep.com/cfa-level-1-exam/quantitative-methods/present-
and-future-values-annuities-and-cash-flows-cfa/
• https://www.investopedia.com/terms/f/futurevalue.asp
• https://app.myeducator.com/reader/web/1123a/topic02/fw51q/