BCH 503 SM02

TIME VALUE OF MONEY
“A rupee today is more valuable than a year later.” This is the “time value of
money” concept based on. The consideration of the time value of money and risk is
extremely important in making important financial decisions.
Time value of money is central to the concept of finance. It recognizes that the
value of money is different at different points of time. Since money can be put to
productive use, its value is different depending upon when it is received or paid. In
simpler terms, the value of a certain amount of money today is more valuable than
its value tomorrow.
Factors Affecting Value of Money:

1. Risk and Uncertainty
2. Inflation
3. Consumption
4. Investment Opportunities
5.
The time value of money draws from the idea that rational investors prefer to
receive money today rather than the same amount of money in the future because
of money’s potential to grow in value over a given period. For example, money
deposited into a savings account earns a certain interest rate and is therefore said to
be compounding in value.
Valuation:
It establishes that there is a preference for having money at present than a future
point of time.
 A person should pay more in future for a rupee received today.
 A Person may accept less today for a rupee received in future.
Methods in adjusting the time value of money:
1. Compounding Techniques/Future Value Techniques.

2. Discounting/Present Value Techniques.
1. Compounding Techniques/Future Value Techniques:
 It is similar to a compound interest calculation. The interest earned on the
initial principal amount becomes a part of the principal at the end of the
compounding period.
 The process of investing money as well as reinvesting interest earned
thereon is called Compounding.
FVn= PV (1+r)n
In this equation (1 + r)n is called the future value interest factor (FVIF).
Where,
FVn = Future value of the initial cash flow n year hence
PV = Initial cash flow
r = Annual rate of Interest
n = number of years
2. Discounting or Present Value Concept

 The process of determining the present value of a future payment or receipts
or a series of future payments or receipts is called discounting.
 The compound interest rate used for discounting cash flows is also called the
discount r.
Future Value of an annuity:

 An annuity is a stream of constant cash flows (payments or receipts)
occurring at regular intervals of time. The premium payments of a life
insurance policy, for example, are an annuity. When the cash flows occur at
the end of each period, the annuity is called an ordinary annuity or a deferred
annuity.
 When the cash flows occur at the beginning of each period, the annuity is
called an annuity due.
Present Value of an Annuity:

 PVA is the present value of an annuity which has a duration of n periods,
 A is the constant periodic flow, and
 r is the discount rate.
PVAn = A [| 1 – (1/1 + r)”}/ r]
Uses:
 How much amount one can borrow,
 Period of Loan Amortization,
 Determine the Periodic withdrawal and finding the interest rates.
Present Value of Perpetuity:

A Perpetuity is an annuity of infinite duration.
P∞ = Ax PVIFA r∞
Where is the present value of perpetuity and A is the constant annual payment?
PVIFAr∞ = 1/r
Effective versus Stated Rate

The general relationship between the effective interest rate and the stated annual
interest rate is as follows:
Effective interest rate = (1 +Stated annual interest rate/m) m – 1
Where m is the frequency of compounding per year.
When compounding becomes continuous, the effective interest rate is expressed as

follows:
Effective interest rate =e r – I

Where e is the base of natural logarithm and r is the stated interest rate.
Rule of 72:
According to the rule of 72, the doubling period under compounding is obtained by
dividing 72 by the interest rate.
Time Value and Purchasing Power:
 The time value of money is also related to the concepts of inflation and
purchasing power. Both factors need to be taken into consideration along
with whatever rate of return may be realized by investing the money.
 Inflation and purchasing power must be factored in when you invest money
because to calculate your real return on investment, you must subtract the
rate of inflation from whatever percentage return you earn on your money.
 If the rate of inflation is higher than the rate of your investment return, then
even though your investment shows a nominal positive return, you are losing
money in terms of purchasing power.

BCH 503 SM02

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BCH 503 SM02

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TIME VALUE OF MONEY

Factors Affecting Value of Money:

Methods in adjusting the time value of money:

1. Compounding Techniques/Future Value Techniques.

2. Discounting or Present Value Concept

Future Value of an annuity:

Present Value of an Annuity:

Present Value of Perpetuity:

Effective versus Stated Rate

Where m is the frequency of compounding per year.

When compounding becomes continuous, the effective interest rate is expressed as

Effective interest rate =e r – I

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