Accounting and Finance for

Managers LESSON

13
TIME VALUE OF MONEY

CONTENTS
13.0 Aims and Objectives
13.1 Introduction
13.2 Foundations of The Time Value of Money
13.3 Classifications of The Time Value of Money
13.3.1 Rule of 72
13.3.2 Rule of 69
13.4 Frequency of Compounding
13.5 Effective Rate of Interest
13.6 Future Value of an Annuity
13.6.1 Future Value of Annuity Due
13.6.2 Sinking Fund Factor Method
13.7 Present Value of Single Cash Flow
13.8 Present Value of Annuity
13.9 Capital Recovery Factor Method
13.10 Let us Sum up
13.11 Lesson-end Activity
13.12 Keywords
13.13 Questions for Discussion
13.14 Suggested Readings

13.0 AIMS AND OBJECTIVES

This lesson is intended to discuss the concept of time value of money and its role in
studying the viability of the project by comparing the initial investment future benefits.
After studying this lesson you will be able to:
(i) describe concept and components of the time value of money
(ii) classify the time value of money and describe rules of 72 and 69
(iii) understand effective rate of interest and future value of an annuity

13.1 INTRODUCTION
The time value of money has gained greater importance in studying the viability of the
project by comparing the initial investment with the anticipated future benefits. If the
anticipated future benefits are more than the initial investment then the investment is
214 found to be viable in generating the economic benefits.
Why the time value of money principle is warranted to study under the financial Time Value of Money
management ?
The following are the many reasons involved:
To determine the real rate of return
l With reference to Money employment on productive assets
l In an inflationary period, a rupee today has greater purchasing power than rupee in
the future
l The future is uncertain- Individuals prefer current consumption rather than future
consumption

13.2 FOUNDATIONS OF THE TIME VALUE OF MONEY

There are two, one is the time preference of money and another one is reinvestment
opportunity which are identified and inter related with each other.
Early receipt of money paves way for the reinvestment opportunity but the later receipt
does not carry the things.
Time value of money normally contains three different components viz:
Real rate of return: It is the return which consider original return of the investment but
it never considers the inflation rate.
Expected/Anticipated rate of return: It is the positive rate of return normally expected
by every one on the amount of investment from the future.
Risk premiums: This an allowance is normally given to the investors to compensate the
uncertainty.

13.3 CLASSIFICATIONS OF THE TIME VALUE OF

MONEY
The concept of time value of money can be classified into two major classifications:
l Future value of money
l Present value of money
Future value of money: It is further bifurcated into two different categories viz
Future value of single sum and Future value of an Annuity
Present value of money: It is further classified into two major classes viz
Present value of single sum and Present value of and Annuity
Future value of single sum:
l It could be found from the inbound relationship in between the future value of
money and present value of money.
l FVn = PV(1+K)n
FVn = Future Value of Cash Inflow
PV = Initial Cash Flow
K = Annual Rate of Return
N = Life of Investment
Illustration 1
If you deposit Rs.1,000 today in a Indian bank which pays 10% interest, find out the
future value of money after 3 years. 215
Accounting and Finance for Future value of Rs.1,000 after three years will be = Rs.1,000(1+.10)3
Managers
= Rs.1,000(1.331)= Rs. 1,331
Doubling period: It is the period which makes the investment as "Doubled"
There are two different approaches viz
l Rule of 72
l Rule of 69

13.3.1 Rule of 72
The initial amount of investment gets Doubled within which 72/I
I = Interest Rate of the investment
Illustration 2
The amount of the investment is Rs.1,000. The annual rate of interest is 12%. When this
amount of Rs.1,000 will get doubled ?
= 72/12 = 6 years

13.3.2 Rule of 69
The amount method is found to crude method in determining the doubling period which
has its own limitations. The Rule of 69 was developed only in order to remove the
bottlenecks associated with the early model of doubling period.
The rule of 69 is found to be a scientific method as well as rational method in determining
the doubling period of the investment
=.35+ 69/I

Illustration 3
The amount of the investment is Rs.1,000. The annual rate of interest is 11% When this
amount of Rs 1,000 will get doubled?
=.35+ 69/11= 6.6227 yrs

Check Your Progress

1. State Bank of India announces that your money is getting doubled in 99 months.
What is the rate of interest payable ?
2. The next aspect in the Future value of money is interest frequency of
compounding.

13.4 FREQUENCY OF COMPOUNDING

Whenever any compounding is taking place, the following methodology has to be adopted
for the determination of the future value of money.
FV = PV(1+k/m)mxn
M = Number of Times Compounding is done during the year
N = number of years
K = compounding rate
216
Illustration 4 Time Value of Money

How much does a deposit of Rs. 5,000 grow to at the end of 6 years. If the nominal rate
of interest is 12% and frequency is 4 times a year?
The future value of Rs. 5,000 will be
= Rs.5,000(1+.12/4)4×6
= Rs.5,000(2.033)= Rs.10,165

13.5 EFFECTIVE RATE OF INTEREST

It is the rate of interest at which mount of the principal grows with regards to the rate of
compounding.
r = (1+K/m)m - 1
K = Nominal Rate of Interest
r = Effective Rate of Interest
m = Frequency of Compounding
Illustration 5
A bank offers 8% nominal rate of interest with quarterly compounding.
What is the effective rate of interest ?
R = (1+.08/4)4 -1=1.082-1=.082 i.e 8.2%

13.6 FUTURE VALUE OF AN ANNUITY

l Annuity may be a series of either payments or receipts
l The annuity can be classified into two categories
v Annuity at the end of the period- Regular / Deferred Annuity
v Annuity at the beginning of the period - Annuity Due
Annuity at the end of the period

FVAn = =
[
A (1 + K) n − 1 ]
Future Value Interest Factor Annuity (FVIFA)
k

Illustration 6
Suppose you deposit Rs.1,000 annually in a bank for 5 years and your deposits earn a
compound interest rate of 10% What will be value of the deposit at the end of 5 years?
Assuming the each deposit occurs at the end of the year, the future value of this annuity?
FVAn = Rs.1,000(FVIFA) for 10% and 5 years

[(1 + .10)5 -1]

= Rs.1,000
.10
= Rs.1,000 × 6.105 = Rs.6,105

13.6.1 Future Value of Annuity Due

FVAn = =
[
A (1 + K) n − 1 ]
× (1+k) 217
k
Accounting and Finance for Illustration 7
Managers
If you invest Rs 1,000 at the beginning of every year, for four years. What will be the
value of the investment finally.

FVAn = Rs.1,000
[(1 + .10) − 1] × (1+.10)
5

.10
= Rs.1,000 × 6.7155= Rs.6,715.5

Check Your Progress

1. Four annual equal payments of Rs.2,000 are made into a deposit account
that pays 8% interest per year. What is the future value of this annuity at the
end of 4 years ?
2. You can save Rs.2,000 a year for 5 years, and Rs.3,000 a year for 3 years
thereafter. What will these savings cumulate to at the end of 8 years. If the
rate of interest is 10?

13.6.2 Sinking Fund Factor Method

It means that the amount to be deposited at the end of every year for the period of "n"
years at the rate of interest "K" in order to aggregate Re.1 at the end of the period.
A = FVA [K/(1+K)n -1]
Illustration 8
How much you should save annually to accumulate Rs.20,000 by the end of 10 years. If
the saving earns an interest of 12 %?
A = Rs.20,000[.12/(1+.12)10 -1]
= Rs.20,000(.05698)=Rs.1,139
The next most important segment is present value of money. First we will discuss the
present value of single cash flow

Check Your Progress

1. How much you should save annually to accumulate Rs.20,000 by the end of
10 years. If the saving earns an interest of 12%?
2. Mr vinay plans to send his son for higher studies abroad after 10 years. He
expects the cost of these studies to be Rs.1,00,000. How much should he
save annually to have a sum of Rs 1,00,000 at the end of 10 years. If the
interest rate is 12%?

13.7 PRESENT VALUE OF SINGLE CASH FLOW

It is the process in which the future value of single cash flow is reckoned to "0" time
horizon i.e on today.
PVn = FVn /(1+R)n
Illustration 9
Find the present value of Rs.1,000 receivable 6 years hence if the rate of discount is 6 percent
PVn = Rs.1,000/(1+.06)6
= Rs.1,000(.705)
218 = Rs.705
Shorter Discounting Periods Time Value of Money

l The discounting may be frequent in times like intra year compounding, intra month
compounding and so on.
l Subject to
v Number of periods in the analysis- increases
v Discount rate applicable per period decreases
m xn
Ê 1 ˆ
v PV= FV Á
Ë 1 + k /m ˜¯

v M = number of times discounting

v K = Discount rate
Illustration 10
Consider the following cash inflow of Rs.10,000 at the end of four years. The present
value of cash inflow when the discount rate is 12% and discounting quarterly.
PV = Rs.10,000 × (.623)=Rs.6,230

Check Your Progress

To get Rs.20,000, how much should be invested per year (at the end). The important
information of the banking investment reveals the following are the rate of interest
is 10% and the normal compounding process is once in 6 months.

13.8 PRESENT VALUE OF ANNUITY

l Present value of an annuity - Present value of future cash series - To identify the
value of future cash flows on present value

Ê (1 + K) n -1 ˆ
l PVAn,k = Á æÆ Present value factor annuity
Ë K(1 + k)n ˜¯

Illustration 11
If you expect to receive Rs.1,000 annually for 3 years, each receipt is expected to be at
the end of the years. What would be the present value of future cash inflows @ discount
rate of 10% ?
PVA n,k = Rs.1,000 × (2.487)= Rs.2,487

Check Your Progress

1. What is the present value of an annuity of Rs.2,000 at 10% ?

2. What is the present value of a 4 year annuity of Rs.10,000 discounted at
10 % ?
3. A 10 payments annuity of Rs.5,000 will begin 7 years hence. (The first payment
occurs at the end of 7 years) what is the value of this annuity now if the
discount rate is 12 per cent ?

13.9 CAPITAL RECOVERY FACTOR METHOD

Ê K(1 + k) ˆ
A = PVA Á æÆ Reciprocal to Present value of an annuity
Ë (1 + K) n -1 ˜¯ 219
Accounting and Finance for Illustration 12
Managers
If your father deposits Rs.1,00,000 on retirement in a bank which pays 10% annual
interest. How much can be withdrawn annually for a period of 10 years?
A = PVA(1/PVIFA)
A = Rs.1,00,000 (1/6.145)= Rs.16,273

Present Value of Perpetuity

Perpetuity means that series with indefinite duration
P? = A × PVIFA k, ?
Illustration 13
The present value of perpetuity of Rs.10,000@ 10%, how much should be invested on
today ?
A = P?/ PVIFA k, ?
= Rs.10,000/.10= Rs.1,00,000

Check Your Progress

1. Time value of money is applicable in

(a) Pay back period method (b) Accounting rate of return method
(c) Discounted cash flows method (d) None of the above
2. Compounding factor is to determine
(a) Present value (b) Future value
(c) Present value and Future value (d) None of the above
3. Annuity due means that
(a) Series at the end (b) Series at the beginning
(c) Neither at the beginning nor at the end (d) None of the above
4. Capital recovery factor method is to find out the value of annuity through
(a) Present value of an annuity
(b) Reciprocal to the present value of annuity
(c) Future value of annuity
(d) None of the above
5. Rule of 72 is for
(a) To determine the present value of the cash flows
(b) To find out future value of cash flows
(c) To find out the doubling period
(d) None of the above

13.10 LET US SUM UP

The time value of money has gained greater importance in studying the viability of the
project by comparing the initial investment with the anticipated future benefits. Real rate
of return is the return which consider original return of the investment but it never considers
220 the inflation rate. Expected/Anticipated rate of return is the positive rate of return
normally expected by every one on the amount of investment from the future. Time Value of Money

Risk premiums is an allowance is normally given to the investors to compensate the

uncertainty.

13.11 LESSON-END ACTIVITY

How much would you invest now at 5% per annum compounded annual if you want to
get Rs. 5,00,000 after 20 years.

13.12 KEYWORDS
Time value of money: Money value in terms of time, money value in between the
present and future
Future value of money: Present value of money in terms of future through compounding
process
Present value of money: Future value of money is reckoned to "0" time period horizon
FVIF: Future value interest factor component for compounding
FVIFA: Future value interest factor component for compounding the series of cash
payments or receipts
PVIF: Present value interest factor of single cash flow
PVIFA: Present value of interest factor of multiple cash flows
Regular annuity: Series which normally happen at the end of the specified horizon
Annuity Due: Series which normally happen at the beginning
Doubling period: During which the amount of the investment gets doubled within the
given compounding factor component
Effective rate of interest: It is the rate of interest which the investment grows

13.13 QUESTIONS FOR DISCUSSION

1. Define time value of money
2. Explain the foundations of the time value of money
3. Explain the classifications of the time value of money
4. Illustrate the rule of 69 with live example from the banking industry
5. Explain the applications of the time value of money in the banking companies
6. Which method is applied for EMI calculation by the financing companies?

13.14 SUGGESTED READINGS

R.L. Gupta and Radhaswamy, “Advanced Accountancy”.
V.K. Goyal, “Financial Accounting”, Excel Books, New Delhi.
Khan and Jain, “Management Accounting”.
S.N. Maheswari, “Management Accounting”.
S. Bhat, “Financial Management”, Excel Books, New Delhi.
Prasanna Chandra, “Financial Management – Theory and Practice”, Tata McGraw
Hill, New Delhi (1994).
I.M. Pandey, “Financial Management”, Vikas Publishing, New Delhi.
Nitin Balwani, “Accounting & Finance for Managers”, Excel Books, New Delhi.
M.P. Pandikumar “Accounting & Finance for Managers” Excel Books, New Delhi. 221