UNIT 2 TIME VALUE OF MONEY

CONTENT

• TIME VALUE OF MONEY

• CONCEPT OF COMPOUNDING
• FUTURE VALUE
• CONCEPT OF DISCOUNTING
• PRESENT VALUE
• CONCEPT OF RISK AND RETURN
 TIME VALUE OF MONEY
• The time value of money (TVM) is the idea that money available at the
present time is worth 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.
• Which would you prefer – Rs.1,000 today or Rs.1,000 ten years from today?
Common sense tells us to take the Rs.1,000 today because we recognize that
there is a time value to money. The immediate receipt of Rs.1,000 provides us
with the opportunity to put our money to work and earn interest. In a world in
which all cash flows are certain, the rate of interest can be used to express the
time value of money.
• Most financial decisions, personal as well as business, involve time value of
money considerations.
 Time Preference for Money
• Time preference for money is an individual’s preference
for possession of a given amount of money now, rather
than the same amount at some future time.
• Three reasons may be attributed to the individual’s time
preference for money:
– risk
– preference for consumption
– investment opportunities
 Required Rate of Return
• The time preference for money is generally
expressed by an interest rate. This rate will be
positive even in the absence of any risk. It may
be therefore called the risk-free rate.
• An investor requires compensation for
assuming risk, which is called risk premium.
• The investor’s required rate of return is:
Risk-free rate + Risk premium.
 Time Value Adjustment
• Two most common methods of adjusting cash
flows for time value of money:
– Compounding—the process of calculating future values of
cash flows and
– Discounting—the process of calculating present values of
cash flows.
 INTEREST
INTEREST : - Money paid (earned) for the use of money.
Interest can be calculated in two ways:
1. SIMPLE INTEREST
2. COMPOUND INTEREST
 SIMPLE INTEREST
• Simple interest is interest that is paid (earned) on only the original amount, or principal,
borrowed (lent). The amount of simple interest is a function of three variables: the
original amount borrowed (lent), or principal; the interest rate per time period; and the
number of time periods for which the principal is borrowed (lent).
The formula for calculating simple interest is
I = Po x i x n
I = 15000 x .08 x 3 = 3600
I = 240000 x .12 x 2 = 57600
Where
I = simple interest in Amount
Po = Principal, or original amount borrowed (lent) at time period 0

i = interest rate per time period

n = number of time periods
 SIMPLE INTEREST
For example,
• Assume that you deposit Rs.100 in a savings account paying 8 percent
simple interest and keep it there for 10 years.
• At the end of 10 years, the amount of interest accumulated is determined
as follows:
• Interest = Rs.100x(0.08)x(10) = Rs.80
 COMPOUND INTEREST
• COMPOUND INTEREST:- Interest paid (earned) on any previous interest earned as wellas the original amount or principal
borrowed (lent).
Vn = Vo x (1 + i)n

CI one year = 100 x (1.+0.08) =100 x 1.08

CI=108

CI After 2 years = 100 (1+0.8)2

CI after 2 Years = 100 x 1.08 x 1.08 = 116.64

CI after 3 Years = 100 x 1.08 x 1.08 x 1.08 = 125.97

Where
Vn = Compound Amount /Future Value of Money
Vo = Principal, or original amount borrowed (lent) at time period 0

i = interest rate per time period

n = number of time periods
 Future Value
• Compounding is the process of finding the future values of cash flows
by applying the concept of compound interest.
• The general form of equation for calculating the future value of a lump
sum after n periods may, therefore, be written as follows:

• The term (1 + i)n is the compound value factor (CF) of a lump sum of
Re 1, and it always has a value greater than 1 for positive i, indicating
that CVF increases as i and n increase.

Vn =Vo  CFn,i
 FUTURE VALUE (Compound Value)
• Consider a person who deposits Rs.100 into a savings account. If the
interest rate is 8 percent, compounded annually, how much will the Rs.100
be worth at the end of a year?
• Setting up the problem, we solve for the future value (which in this case is
also referred to as the compound value) of the account at the end of the
year (FV1).
FV1 = Po (1 + i)
= Rs.100 x (1 + .08) =
= Rs.108
 FUTURE VALUE (Compound Value)
• Interestingly, this first-year value is the same number that we would get if simple
interest were employed. But this is where the similarity ends. What if we leave Rs.100
on deposit for two years?
• The Rs.100 initial deposit will have grown to Rs.108 at the end of the first year at 8
percent compound annual interest. Going to the end of the second year, Rs.108
becomes Rs.116.64, as Rs.8 in interest is earned on the initial Rs.100, and Rs.0.64 is
earned on the Rs.8 in interest credited to our account at the end of the first year. In
other words, interest is earned on previously earned interest – hence the name
compound interest.
Therefore, the future value at the end of the second year is
FV2 = FV1(1 + i) = Po x (1 + i) x (1 + i)
= Po (1 + i)2 = Rs.108(1.08) = Rs.100(1.08)(1.08) = Rs.100(1.08)2 = Rs.116.64
At the end of three years, the account would be worth
FV3 = FV2(1 + i) = FV1(1 + i)(1 + i)
= Po (1 + i)3 = Rs.116.64(1.08) = Rs.108(1.08)(1.08) = Rs.100(1.08)3 = Rs.125.97
 FUTURE VALUE (Compound Value)
• In general, Vn, the future (compound) value of a deposit at the end of n periods, is

FVn = Po x (1 + i)n
Where:
FVn = Future value after n years / periods
Po = Principal or original amount borrowed (lent).
i = Interest rate
n = Number of years

Vn =Vo  CFn,i
FUTURE VALUE TABLE
 Present Value
• Present value of a future cash flow (inflow or outflow) is
the amount of current cash that is of equivalent value to
the decision-maker.

• Discounting is the process of determining present value

of a series of future cash flows.
Discount Rate (capitalization rate)
• Interest rate used to convert future values to present
values.
 Present Value of a Single Cash
Flow
• The following general formula can be employed to calculate the present value of a
lump sum to be received after some future periods:

• The term in parentheses is the discount factor or present value factor (PVF), and it
is always less than 1.0 for positive i, indicating that a future amount has a smaller
present value.
Vo Vn  DFn,i
18
 Example
• Suppose that an investor wants to find out the present value
of Rs 50,000 to be received after 15 years. Her interest rate is
9 percent. First, we will find out the present value factor,
which is 0.275. Multiplying 0.275 by Rs 50,000, we obtain Rs
13,750 as the present value:

PV = 50,000  DF15, 0.09 = 50,000  0.275 = Rs 13,750

 PRESENT VALUE (PV)
• PRESENT VALUE (PV):- The current value of a future amount of money, or a series of
payments, evaluated at a given interest rate.

Where :
PVo = Present Value
FVn = Future Amount of money
i = Interest rate
n = Number of years
OR
V0 = Vn (DFi,n)
 Compounding More Than Once a Year(Multiple):
• If interest is compounded more than once a year, the effective interest rate will be
higher than the nominal rate.
• The general formula for solving for the future value at the end of n years where interest
is paid m times a year is
FVn = PV0(1 + [i/m])mn
• To illustrate, suppose that now interest is paid quarterly and that you wish to know the
future value of Rs. 100 at the end of one year where the stated annual rate is 8 percent.
The future value would be
• FV1 = Rs. 100(1 + [0.08/4])(4)(1)
• = Rs. 100(1 + 0.02)4 = Rs. 108.24
 Sinking Fund
• Sinking fund is a fund, which is created out of fixed payments
each period to accumulate to a future sum after a specified
period. For example, companies generally create sinking funds
to retire bonds (debentures) on maturity.
• The factor used to calculate the annuity for a given future sum
is called the sinking fund factor (SFF).
 Present Value of an Annuity
• The computation of the present value of an
annuity can be written -

• The term within parentheses is the present value

factor of an annuity of Re 1, which we would call
ADF, and it is a sum of single-payment present
value factors.
Vo = Vn× ADFn, i
 Capital Recovery and Loan
Amortisation
• Capital recovery is the annuity of an investment made
today for a specified period of time at a given rate of
interest. Capital recovery factor helps in the preparation
of a loan amortisation (loan repayment) schedule.




 Present Value of an Uneven
Periodic Sum
• Investments made by of a firm do not
frequently yield constant periodic cash
flows (annuity). In most instances the firm
receives a stream of uneven cash flows.
Thus the present value factors for an
annuity cannot be used. The procedure is
to calculate the present value of each cash
flow and aggregate all present values.
 Present Value of Perpetuity
• Perpetuity is an annuity that occurs indefinitely.
Perpetuities are not very common in financial
decision-making:

Present value of a Perpetuity

perpetuity  Interest
rate

• Present value of a constantly growing perpetuity is

given by a simple formula asfollows:
A
P=
i–g
 Value of an Annuity Due
Annuity due is a series of fixed receipts or payments starting at the beginning
of each period for a specified number of periods.
• Future Value of an Annuity Due
Vn = Vo ACFn,i × (1 i)

• Present Value of an Annuity Due Vo=Vn*DCF i,n*(1+i)

Note-

1. THE NOTES PROVIDED WILL HELP YOU TO

UNDERSTAND THE CONCEPT OF Time Value of
Money and also find enclosed the Table (Compound
and Discounted Interest Factor Value) and the
Practice Sheet with the notes.
2. All the Students are required to solve the Practice
Sheet of Time Value of Money and submit on or
before 15 March 2023 .

Dr M Tiwari