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12 views

Eri

Uploaded by

anakhaanu69
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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24/27/2024 WEDNESDAY

TIME VALUE OF MONEY

The time value of money is a basic financial concept that holds that money in the present is worth
more than the same sum of money to be received in the future. This is true because money that you
have right now can be invested and earn a return, thus creating a larger amount of money in the future.

The time value of money is an important concept not just for individuals, but also for making business
decisions. Companies consider the time value of money in making decisions about investing in new
product development, acquiring new business equipment or facilities, and establishing credit terms for
the sale of their products or services.

TECHNIQUES OF TIME VALUE OF MONEY

1. COMPOUNDING
2. DISCOUNTING

1. COMPOUNDING:
Compounding is the process of finding out the future value of a present sum of money. It is
used to find out the terminal value of an investment. In this method, the interest due at the end
of the year is added to the principal which act as the principal for the second year.

The annual interest amount under simple interest method remains same whereas in
compounding the interest amount keeps on increasing.

Where,

F = Future Value

P = Principal or Present Value

r = Rate of Interest

n = Years to Maturity
ILLUSTRATION 1

Calculate the future value of an amount of ₹1,00,000 borrowed at 12% for two years under;

a) Simple Interest b) Compound Interest

Ans;) a) Simple Interest Method

Simple Interest = 1,00,000 * *2

= 24,000

Future Value = PV + SI

= 1,00,000 + 24,000

= 1,24,000

b) Compound Interest

F = P ( 𝟏 + 𝒓 )𝒏
= 1,00,000 ( 𝟏 + 𝟏𝟐/𝟏𝟎𝟎 )𝟐
= 1,00,000 ( 𝟏+. 𝟏𝟐)𝟐
= 1,00,000 * (1.12 *1.12)
= 1,00,000 * 1.2544
= 1,25,440
ILLUSTRATION 2

2. Calculate the compounded value of an investment of ₹ 10,000 invested for 3 years at 10%
interest.

i) MULTI-PERIOD OR INTRA YEAR COMPOUNDING

If the compounding is done half yearly or quarterly or monthly or daily, such compounding is
known as multi-period compounding. In such cases, the frequency of compounding will be
more than one.

𝒓 𝒎∗𝒏
F = P 𝒎
ILLUSTRATION 3

1. Calculate the compounded value of an investment of ₹ 10,000 invested for 3 years at 12%
interest.
a) Half yearly basis b) Quarterly basis
a) Half yearly basis

𝒓 𝒎∗𝒏
F = P 𝒎
.𝟏𝟐 𝟐∗𝟑
F = 10,000 𝟐
𝟔
F = 10,000
F = 10,000 * 1.4185
F = 14,185

b) Quarterly basis
𝒓 𝒎∗𝒏
F = P 𝒎
.𝟏𝟐 𝟒∗𝟑
F = 10,000 𝟒
𝟏𝟐
F = 10,000
F = 10,000 * 1.4257
F = 14,257

25/07/2024 THURSDAY

ii) EFFECTIVE RATE OF INTEREST

 In the case of multi-period of compounding, the actual rate of interest enjoyed by the
investor is higher than the nominal rate of interest.
 The rate that reflects the actual rate of interest is known as Effective Rate of Interest
(ERI) or Effective Annual Rate (EAR).
 Effective rate of Interest increases with increase in frequency of compounding.

𝒓 𝒎
ERI = 𝒎
-1

ILLUSTRATION 3

ESAF offers a nominal rate of interest of 6%. Find out effective rate of interest if;

a) When interest is compounded half yearly


b) When interest is compounded quarterly
SOLUTION:

a) When interest is compounded half yearly

𝒓 𝒎
ERI =
𝒎
–1
.𝟎𝟔 𝟐
𝟐
-1
𝟐
-1
–1
* 100
6.09%
b) When interest is compounded quarterly

Do yourself.

Works for tomorrow;


1) What will be the future value of ₹1,000 invested for 5 years at an annual interest rate of 6%
compounded annually?
2) If you invest ₹2000 at an annual interest rate of 5% compounded quarterly. What will be
the value of the investment after 3 years?
3) What is the effective annual rate if the nominal interest rate is 6% compounded quarterly?
4) You have two investment options: one offers a nominal interest rate of 5% compounded
monthly, and the other offers a nominal interest rate of 5.1% compounded annually. Which
investment has a higher effective annual rate?

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