Page 23 - DMGT515_PERSONAL_FINANCIAL_PLANNING

Personal Financial Planning

Notes
Example: A project needs an initial investment of ` 1,00,000. It is expected to give a
return of ` 20,000 p.a. At the end of each year, for six years. The project thus involves a cash
outflow of ` 1,00,000 in the ‘zero year’ and cash inflows of ` 20,000 per year, for six years. In
order to decide, whether to accept or reject the project, it is necessary, that the present value of
cash inflows received annually for six years is ascertained and compared with the initial
investment of ` 1,00,000. The firm will accept the project only when the present value of the cash
inflows at the desired rate of interest is at least equal to the initial investment of ` 1,00,000.

2.2 Valuation Concepts or Techniques

The Time value of money implies:

(i) that a person will have to pay in future more, for a rupee received today and
(ii) a person may accept less today, for a rupee to be received in the future.
The above statements relate to two different concepts:

(i) Compound Value Concept
(ii) Discounting or Present Value Concept

2.3 Compound Value Concept

In this concept, the interest earned on the initial principal amount becomes a part of the principal
at the end of a compounding period.
Illustration 1
` 1,000 invested at 10% is compounded annually for three years, Calculate the Compounded
value after three years.
Solution:
Amount at the end of 1st year will be: 1,100
[1000 × 110/100 = 1,100]
Amount at the end of 2nd year will be: 1,210

[1100 × 110/100 = 1,210]
Amount at the end of 3rd year will be: 1,331
[1210 × 110/100 = 1,331]

This compounding process will continue for an indefinite time period.
Compounding of Interest over ‘N’ years: The compounding of Interest can be calculated by the
following equation.

A = P (1 + i) n
In which,
A = amount at the end of period ‘n’.
P = Principal at the beginning of the period.
i = Interest rate.

n = Number of years.

18 LOVELY PROFESSIONAL UNIVERSITY