Concepts of Value and Return

Chapter - 2
Concepts of Value
and Return

2Financial Management, Ninth
Chapter Objectives
 Understand what gives money its time value.
 Explain the methods of calculating present
and future values.
 Highlight the use of present value technique
(discounting) in financial decisions.
 Introduce the concept of internal rate of
return.

Time Preference for Money
 Time preference for money is an
individual’s preference for possession of a
given amount of money now, rather than the
same amount at some future time.
 Three reasons may be attributed to the
individual’s time preference for money:
 risk
 preference for consumption
 investment opportunities

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. It may
be therefore called the risk-free rate.
 An investor requires compensation for assuming
risk, which is called risk premium.
 The investor’s required rate of return is:
Risk-free rate + Risk premium.

Time Value Adjustment
 Two most common methods of adjusting
cash flows for time value of money:
 Compounding—the process of calculating future
values of cash flows and
 Discounting—the process of calculating present
values of cash flows.

Future Value
 Compounding is the process of finding the future
values of cash flows by applying the concept of
compound interest.
 Compound interest is the interest that is received on
the original amount (principal) as well as on any
interest earned but not withdrawn during earlier
periods.
 Simple interest is the interest that is calculated only
on the original amount (principal), and thus, no
compounding of interest takes place.

Future Value
 The general form of equation for calculating
the future value of a lump sum after n periods
may, therefore, be written as follows:
 The term (1 + i)n
is the compound value
factor (CVF) of a lump sum of Re 1, and it
always has a value greater than 1 for positive
i, indicating that CVF increases as i and n
increase.
n
n iPF )1( +=
= CVFn n,iF P×

Example
 If you deposited Rs 55,650 in a bank, which
was paying a 15 per cent rate of interest on a
ten-year time deposit, how much would the
deposit grow at the end of ten years?
 We will first find out the compound value
factor at 15 per cent for 10 years which is
4.046. Multiplying 4.046 by Rs 55,650, we get
Rs 225,159.90 as the compound value:
10, 0.12FV 55,650 × CVF 55,650 4.046 Rs 225,159.90= = × =

Future Value of an Annuity
 Annuity is a fixed payment (or receipt) each
year for a specified number of years. If you rent
a flat and promise to make a series of
payments over an agreed period, you have
created an annuity.
 The term within brackets is the compound
value factor for an annuity of Re 1, which we
shall refer as CVFA.
(1 ) 1n
n
i
F A
i
 + −
=  
 
= CVFAn n,iF A×

Example
 Suppose that a firm deposits Rs 5,000 at the
end of each year for four years at 6 per cent
rate of interest. How much would this annuity
accumulate at the end of the fourth year? We
first find CVFA which is 4.3746. If we multiply
4.375 by Rs 5,000, we obtain a compound
value of Rs 21,875:
4 4, 0.065,000(CVFA ) 5,000 4.3746 Rs 21,873F = = × =

Sinking Fund
 Sinking fund is a fund, which is created out of
fixed payments each period to accumulate to a
future sum after a specified period. For
example, companies generally create sinking
funds to retire bonds (debentures) on maturity.
 The factor used to calculate the annuity for a
given future sum is called the sinking fund
factor (SFF).
=
(1 ) 1
n n
i
A F
i
 
 + − 

Present Value
 Present value of a future cash flow (inflow or
outflow) 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 series of future cash flows.
 The interest rate used for discounting cash
flows is also called the discount rate.

Present Value of a Single Cash Flow
 The following general formula can be employed to
calculate the present value of a lump sum to be
received after some future periods:
 The term in parentheses is the discount factor or
present value factor (PVF), and it is always less
than 1.0 for positive i, indicating that a future amount
has a smaller present value.
(1 )
(1 )
nn
nn
F
P F i
i
−
 = = + +
,PVFn n iPV F= ×

Example
 Suppose that an investor wants to find out
the present value of Rs 50,000 to be
received after 15 years. Her interest rate is
9 per cent. First, we will find out the present
value factor, which is 0.275. Multiplying
0.275 by Rs 50,000, we obtain Rs 13,750 as
the present value:
15, 0.09PV = 50,000 PVF = 50,000 0.275 = Rs 13,750× ×

Present Value of an Annuity
 The computation of the present value of an
annuity can be written in the following general
form:
 The term within parentheses is the present
value factor of an annuity of Re 1, which we
would call PVFA, and it is a sum of single-
payment present value factors.
( )
1 1
1
n
P A
i i i
 
= − 
+  
= × PVAFn,iP A

Capital Recovery and Loan
Amortisation
 Capital recovery is the annuity of an investment
made today for a specified period of time at a
given rate of interest. Capital recovery factor
helps in the preparation of a loan amortisation
(loan repayment) schedule.
The reciprocal of the present value annuity factor
is called the capital recovery factor (CRF).
,
1
=
PVAFn i
A P
 
 
 
= × CRFn,iA P

Present Value of an Uneven
Periodic Sum
 Investments made by of a firm do not
frequently yield constant periodic cash flows
(annuity). In most instances the firm receives
a stream of uneven cash flows. Thus the
present value factors for an annuity cannot be
used. The procedure is to calculate the
present value of each cash flow and
aggregate all present values.

Present Value of Perpetuity
 Perpetuity is an annuity that occurs
indefinitely. Perpetuities are not very common
in financial decision-making:
Perpetuity
Present value of a perpetuity
Interest rate
=

Present Value of Growing Annuities
 The present value of a constantly growing
annuity is given below:
 Present value of a constantly growing
perpetuity is given by a simple formula as
follows:
1
= 1
1
n
A g
P
i g i
 + 
−  ÷
− +   
=
–
A
P
i g

Value of an Annuity Due
 Annuity due is a series of fixed receipts or
payments starting at the beginning of each
period for a specified number of periods.
 Future Value of an Annuity Due
 Present Value of an Annuity Due
,= CVFA × (1 )n n iF A i× +
= × PVFA × (1 + )n,iP A i

Multi-Period Compounding
 If compounding is done more than once a
year, the actual annualised rate of interest
would be higher than the nominal interest rate
and it is called the effective interest rate.
= –EIR 1 1
n m
i
m
×
 
+  

Continuous Compounding
 The continuous compounding function takes
the form of the following formula:
 Present value under continuous compounding:
i n x
nF P e P e×
= × = ×
× i nn
ni n
F
P F e
e
− ×
= =

Net Present Value
 Net present value (NPV) of a financial
decision is the difference between the present
value of cash inflows and the present value of
cash outflows.
0
1
NPV =
(1 + )
n
t
t
t
C
C
k=
−∑

Present Value and Rate of Return
 A bond that pays some specified amount in
future (without periodic interest) in exchange for
the current price today is called a zero-interest
bond or zero-coupon bond. In such situations,
you would be interested to know what rate of
interest the advertiser is offering. You can use
the concept of present value to find out the rate
of return or yield of these offers.
 The rate of return of an investment is called
internal rate of return since it depends
exclusively on the cash flows of the investment.

Internal Rate of Return
 The formula for Internal Rate of Return is
given below. Here, all parameters are given
except ‘r’ which can be found by trial and
error.
0
1
NPV = 0
(1 + )
n
t
t
t
C
C
r=
− =∑

Concepts of Value and Return

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