Time Value of Money

REASONS FOR TIME VALUE OF MONEY

The time value of money (TVM) is the concept that money you have now is worth more than
the identical sum in the future due to its potential earning capacity. Risk and Uncertainty - future is uncertain and there are risk involved

The time value of money draws from the idea that rational investors prefer to receive money Inflation - money received today may have more purchasing power than money to be received
today rather than the same amount of money in the future because of money's potential to in the future.
grow in value over a given period of time. For example, money deposited into a savings account
Consumption - individual generally prefers current consumption than future consumption
earns a certain interest rate and is therefore said to be compounding in value.
Investment Opportunities - receiving money today gives the investor the opportunity to invest
The time value of money (TVM) is the idea that money available at the present time is worth
the money that he received today to a higher rate of return
more than the same amount in the future due to its potential earning capacity. This core
principle of finance holds that, provided money can earn interest, any amount of money is
worth more the sooner it is received.
COMPOUNDING OF INTEREST AND FUTURE VALUES (SINGLE PAYMENT)

Compounding is the process of moving Cash flows forward in time while discounting is the
ILLUSTRATION process of moving cash flows back in time.
Assume that someone offers to pay you for some work you are doing for them: They will either
pay you $1,000 now or $1,100 one year from now. Compound interest is basically paid on interest; interest was reinvested and became part of the
principal which will earn another interest
Which pay option should you take?
Simple Interest – do not earn interest (not part of the principal)
It depends on what kind of investment return you can earn on the money at the present time.
Since $1,100 is 110% of $1,000, then if you believe you can make more than a 10% return on Compound Interest – earns interest (forms part/ become part of the principal)
the money by investing it over the next year, you should opt to take the $1,000 now. On the
other hand, if you don't think you could earn more than 10% in the next year by investing the
money, then you should take the future payment of $1,100
QUESTIONS: TRUE OR FALSE

IMPORTANCE
QI. Interest earned on a given deposit that has become part of principal at end of period is
Time Value of Money (TVM) is an important concept in financial management. It can be used to called simple interest.
compare investment alternatives and to solve problems involving loans, leases, and savings. Q2. The nominal and effective rates are equivalent for annual compounding.

Time value of money is very important because it can help guide investment decisions. For Q3. Time value of money is based on the belief that a peso that will be received at some future
instance, suppose an investor can choose between two projects: Project A and Project B. Both date is worth more than a peso today.
projects have identical descriptions except that Project A promises a $1 million cash payout in
year 1, whereas Project B offers a $1 million cash payout in year 5. If the investor did not Q4. Present value is the amount of money that would have to be invested today at given
understand the time value of money, they might believe that these two projects are equally interest rate over a specified period in order to equal a future amount.
attractive. In fact, however, time of money dictates that Project A is more attractive than
Project B because its $1 million payout has a higher present value.

Time Value of Money is important in Capital Budgeting Decisions - these where the company
chooses to invest in a project such as expansion or strategic acquisition or just purchase of a
new machine
 PRESENT VALUE (SINGLE PAYMENT)
Compound Interest Simple Interest
-The interest was reinvested and became Interest do not earn another interest • Present value is the value today of a future cash flow or series of cash flow.
part of the principal -later earns another Present value is a future amount discounted to present by some required rate.
interest
Formula: FV = PV x (1+i)^n Formula: FV = PV x (I+rate) • FORMULA: PV= FV x (1+i)^-n

i = Annual rate / m
FV=Future Value; PV = Present Value or Rate= simple interest rate (annual rate)
Principal m = number of compounding periods per year (semi-annually, monthly, quarterly)

i= Annual Rate / m n = mxt (number of periods of growth)

m= period (semi-annually=2, monthly=12, t = Period or Term (in years)

quarterly=4)
QI. If single amount of 200,000 is to be received in 3 years and discounted at 10%. What is the
present value?
n= mxt
Answer: PV = FV x (1+i)^-n; THUS, = 200,000 x (1.1)^-3
t=Period or Term (in years)
Example: Principal amount or Present value is 10,000 at Year 0. Invested in bank and earns a = 150,263
rate of 6% per annum. Interest is compounded annually. Term is 2 yrs. What is the Future
value of 10,000? Q2. If we expect to receive a check for 250,000 in 3 years and opportunity cost is 9%, the
Formula: FV = PV (1+i)^n Formula: FV = PV x (I+rate) present value of the future payment is?
= 10,000+ (10,000x6%) + (10,000x6%)
i= rate /m; then= 6% / 1, so, j = 6% = 11,200 Answer= 193,045.87

m= I (since int is compounded annually)

FV= 10,000 (1+6% ) ^ (2 yrs x 1)
ANNUITY VS PERPETUITY
FV= 10,000 x 1.1236:
FV= 11,236 • Annuity= series of fixed payments required to be paid at specific frequency over a period of
time.
Interest Earned = FV – PV
PV = FV x (1+i)^-n

• An annuity represents such a series of cash payments, even for monthly or weekly payments.
QUESTIONS:
• A perpetuity is a stream of payments that continues forever
QI.X invested 5,000 in an account paying interest rate of 4% compounded annually. What
amount will be the account at end of 4 years? Ordinary Annuity Annuity Due
Payment at the END of payment interval Payment at BEGINNING of intervals
Q2. X is considering investing today. He wants to receive 500,000 after 6 years. What amount
must X invest in order to receive 500,000 when rate is 11%. Interest is compounded annually.

Q3. Principal is 10,000; rate is 6%; interest is compounded quarterly. Term = 2 years. What is
the Future value?
For even Cash Flow:

PRESENT VALUE OF PRESENT VALUE OF ANNUITY FUTURE VALUE OF ORDINARY

ORDINARY ANNUITY DUE ANNUITY

Series of payment = made at Series of payment = made at Series of payment = made at END
END of each interval BEGINNING of each interval of each interval

Example: Annual payment is 10,000; Rate is 10%; interest compounded semi-annually and Term is 5 years.

QUESTIONS: EFFECTIVE ANNUAL INTEREST RATE

QI.X bought a new car. The annual payments required by the Car Company is 50,000 per year,
payable at the beginning of each year starting Jan 1, 2020. The term is 5 years. Interest rate is • EAR= (1+i)^n minus 1
12%; compounded annually. What is the cash price of the new car?
Q2. X want to accumulate 2M after 10 years. How much must be saved by X every end of six
months or semi-annually to obtain / accumulate a total of 2M? Rate is 12% per annum. Example:
• A simple annual interest rate of 12% compounded semi-annually is an effective yield of?
A real estate investor feels that the cash flow from a property will enable his to pay a lender Rs.
EAR = (1+0)2-1
15,000 per year, at the end of every year, for 10 years. How much should the lender be willing
to loan her if he requires a 9% annual interest rate Answer: 12.36%
You are borrowing Rs. 80,000 for 25 years at 10% nominal annual interest. How much must
your annually payments be if you will completely retire the loan over the 25-year period. PERPETUITY
Perpetuity is an infinite series of payments of equal face value

FORMULA= Fixed payment divided by i

UNEVEN CASH FLOWS
• i= rate / m
• Need to get the PV or FV per cash flow per year (using the PV/FV on single payment)
Example:
• Previous formulas are NOT APPLICABLE (Annuity formula)
Calculate the PV of 10,000 perpetuity at a 7% discount rate
Example: ANS" 142,857
Cash flows at end of Yr I is 10,000 and end of Year 2 is 20,000. Rate is 10%. What is the Present
value?

ANS:= 1.1^-1 x 10,000 PLUS 1.1^-2x 20,000 25,619.83