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Time Value of Money

The time value of money concept states that present money is worth more than future money due to investment potential and associated risks. It includes calculations for present value, future value, and annuities, demonstrating how interest compounding affects the total amount over time. Practical examples illustrate decision-making between immediate and future cash bonuses, factoring in inflation and interest rates.

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Wali Ullah Simanto
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11 views5 pages

Time Value of Money

The time value of money concept states that present money is worth more than future money due to investment potential and associated risks. It includes calculations for present value, future value, and annuities, demonstrating how interest compounding affects the total amount over time. Practical examples illustrate decision-making between immediate and future cash bonuses, factoring in inflation and interest rates.

Uploaded by

Wali Ullah Simanto
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Time Value of money

The time value of money is a basic financial concept that holds that money in the present is worth more
than the same sum of money to be received in the future. This is true because money that you have
right now can be invested and earn a return, thus creating a larger amount of money in the future. (Also,
with future money, there is the additional risk that the money may never actually be received, for one
reason or another.) The time value of money is sometimes referred to as the net present value (NPV) of
money.

A) Present value and future value

P = Principle/ Investment / Amount of loan at beginning of period


S = accumulated sum
i = annual interest rate
n = length of period (years)
Compounded interest

Then at the end of first year = P + P× i = P (1+i)

Then at the end of Second year = P(1+i) + P(1+i) × i = P(1+i)(1+i)= P(1+i)2

Then at the end of third year = P(1+i)2 + P(1+i)2 ×i = P(1+i)3

then at the end of fourth year = P(1+i)4

then at the end of fifth year = P(1+i)5

From this it becomes evident that, at the end of the nth year,

S =P (1+i)n ………… (Y)

Or, P =

Example: what will be repaid at the end of the 15 years to the person who lends $120 at 4% interest
compounded annually?

Solution: S =P (1+i)n

= 120× (1+ 0.04)15

= $216.12
Example: what is the present worth of receiving $1000 twenty years from now if money can earn 5
percent interest compounded annually?

Solution :

P=

= $376.93

If m is the number of times a year that interest is paid then,

S =P (1 + )nm

Example: find the accumulation of $100 invested for 20 years at 6% interest if:

a. Interest is compounded annually (m=1)


b. Interest is compounded semiannually (m =2)
c. Interest is compounded monthly (m =12)
d. Interest is compounded Quarterly (m =4)

Answer:

A. S = 100* (1 + ) 20*1 = $320.71


B. S = 100* (1 + ) 20*2 = $326.2
C. S =100* (1 + ) 20*12 = $331.02
Future and Annuity:

A = invested made at each year for n years // 10 yrs

Then, accumulation of first years investment is S1 = A (1+i)n-1

accumulation of second years investment is S2= A (1+i)n-2

accumulation of third years investment is S3= A (1+i)n-3

accumulation of fourth years investment is S4 = A (1+i)n-4

and so forth , till n-2 year’s investment is Sn-2 = A (1+i)2

n-1 year’s investment is Sn-1 = A (1+i)

accumulation of nth years’ investment is Sn = A

Total accumulation is

S = A [1+(1+i)+ (1+i)2+(1+i)3 +(1+i)4 +……………….+(1+i)n-2 + (1+i)n-1 ] ………………..(A)

Multiplying both sides by (1+i)

S (1+i) = A [(1+i)+(1+i)2+ (1+i)3+(1+i)3 +(1+i)5 +……………….+(1+i)n-1 + (1+i)n ]………………..(B)

(B)– (A):

Subtracting the two equations from each other

iS = A [(1+i)n -1 ]

or, S= A{ }……………………………….(C)

Example:

How much can be deposited at the end of each year/month in a sinking fund for 15 years to accumulate
$1000 if interest at 5%?

Solution:

S=A{ }

Or, A = 1000 * = $46.34


S=A{ }

Present and Annuity

Equating ( y) and (c) ,

P(1+i)n = A { }

Or P = A ………….(D)

Example: what is the present worth of $200 received at the end of each year for 10 years if money
earns 3%?

Solution:

P=A

P = 200 *8.30 =$1706


Example

Suppose that you have earned a cash bonus for an outstanding performance at your job during the last
year. Your pleased boss gives you 2 options to choose from:

● Option A: Receive $10,000 bonus now

● Option B: Receive $10,800 bonus after one year

Further information which you may consider in your decision:

- Inflation rate is 5% per annum.

- Interest rate on bank deposits is 12% per annum.

Which option would you choose?

Solution:

Although in absolute terms Option B offer the higher amount of bonus, Option A gives you the choice of
receiving bonus one year earlier than Option B. This can be beneficial for the following reasons:

To start with, you can buy more with $10,000 now than with $10,800 in one year's time due to the 5%
inflation.

Secondly, if you receive the bonus now, you could invest the cash in a bank deposit and earn a safe
annual return of 12%. in contrast, you stand to lose this interest income if you choose Option B.

Thirdly, future is uncertain. In worst case scenario, the company you work for could become bankrupt
during the next year which would significantly reduce your chances of receiving any bonus. The
probability of this happening might be remote, but there would be a slim chance none the less.

The above considerations must be incorporated into the decision analysis by factoring them into a
discount rate which will then be used to calculate the future values and present values as illustrated
below.

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