Time Value of Money

Compiled by Dr. Divya Jindal

Which would you prefer – Rs.10,000
today or Rs.10,000 in 5 years?
Obviously, Rs. 10,000 today.

You already recognize that there is

TIME VALUE TO MONEY!!

Time Value of Money arises due to the Time

Preference for Money
 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.
 Time Value of Money

 A rupee today is worth more than a rupee

in the future.
 Time value of money refers to the concept
that a sum of money available at the present
time is worth more than the same amount
available on a future date due to its potential
earning capacity and the time preference of
money.
 Reasons for Time Value of Money

1. Preference for consumption

2. Investment opportunities/ Opportunity cost

3. Risk/Uncertainty

4. Inflation
 Reasons for Time Value of Money
1. Preference for consumption
• Present consumption is preferred to future consumption.
• More amount has to be offered in the future to induce
people to postpone present consumption.
2. Investment opportunities / Opportunity cost
• TIME allows you the opportunity to postpone consumption
and earn INTEREST (invest the amount and earn a return
on it)
3. Risk/Uncertainty
• If there is any uncertainty (risk) associated with the cash
flow in the future, the less that cash flow will be valued.
4. Inflation
• Inflation causes the real value of currency to decline over
time.
• A sum of money today will have lower value in the future
due to inflation
 Use of Time Value of Money
1. For making Personal decisions

•Saving for retirement

•Planning for major future expenditures such as tuition fees,

marriage, purchase of house/car

2. For Evaluation of Corporate finance decisions

• Helps analyze investment spread out over a time period
greater than one year

• Valuation of asset or entire business whose earnings will be

generated over extended time period
 Use of Time Value of Money

These decisions require

• valuation and comparison of uncertain future cash

flows which differ in timing and risk.

•cash flows to be appropriately adjusted for their

differences in timing and risk i.e recognition of time
value of money
 Time Line
 A time line is a graphical representation used to show the timing
and the amount of each cash flow in a cash flow stream.
 It is especially beneficial in visualizing a stream of cash flows
occurring at different points in time.
0 1 2 3 4

Period 1 Period 2 Period 3 Period 4

 Time 0 is today; Time 1 is one period from today, or the end of

period 1; Time 2 is two periods from today, or the end of Period
2, and so on.
 Often the periods are years, but other time intervals such as half-
years, quarters, months, or even days can be used.
 Cash flows may be positive (cash inflows) or negative (cash
outflows)
 Required Rate of Return

 The time preference for money is generally

expressed by an interest rate or required rate of
return.

 Interest is the compensation for the opportunity

cost of funds and the uncertainty of repayment of
the amount invested.
 Required Rate of Return

 It is also known as the Discount Rate

• The discount rate is a rate at which present and

future cash flows are traded off.

• The discount rate is also an opportunity cost, since

it captures the returns that an individual would have
made on the next best opportunity.
 Required Rate of Return
• The discount rate (required rate of return) includes
compensation for:

1. Preference for current consumption

• Greater the Preference - Higher is the Discount Rate

2. Expected inflation

• Higher inflation - Higher is the Discount Rate

3. Uncertainty of future cash flows

• Higher Risk - Higher is the Discount Rate

 Required Rate of Return
 Required Rate of Return or Interest represents both:
 The price of time (risk-free rate): This is
compensation for the opportunity cost of funds. This
compensates for postponement of consumption and
also for expected inflation
 The price of risk (risk-premium): This is
compensation for bearing risk arising from
uncertainty.

Risk-free rate + Risk premium.

 Required Rate of Return
 Alternatively,
Required rate of return
= Compensation for postponement of consumption +
expected inflation + Risk premiums to compensate for
uncertainty
= Nominal Interest rate + Risk Premium
NOTE:
 Real interest rate
is the compensation for postponement of consumption
 Nominal interest rate
= Real interest rate + compensation for expected inflation
Methods of Time Value Adjustment

1. Compounding

 The process of calculating future values of

cash flows

2. Discounting

 The process of calculating present values of

cash flows
 Future Value
 Compounding is the process of finding the future
values of cash flows by applying the concept of
compound interest.

 Compound interest is the interest that is received on

the original amount (principal) and any accumulated
interest.

 Simple interest is the interest that is calculated only

on the original amount (principal), and thus, no
compounding of interest takes place.
 Future Value of a Single cash flow
 FV of a lump sum (single cash flow) after n periods
n
F n = P (1 + i )
Fn = P × C V Fn,i
 Where,
 CVF (compound value factor of a lump sum of Re
1) = (1 + i)n
 CVF > 1 for positive i, i.e. CVF increases as i and n
increase.
 CVF is also known as Future Value Interest Factor
(FVIF)
 Future Value of an Uneven Periodic Sum

 A person or a firm may make regular investments

which may not be of equal (constant) amount.
 PROCEDURE: Calculate the future value of each
cash flow and aggregate all present values.
 Future Value of an Annuity
 Annuity is a fixed payment (or receipt) each year for a
specified number of years or at regular intervals for a
fixed period of time.
 (1 + i ) n − 1 
Fn = A  
 i 
Fn = A × C V F A n,i
 The term within brackets is the compound value factor
for an annuity of Re 1, also referred to as CVFA.
 CVFA is also known as FVIFA
 Multi-period Compounding

 Compounding is done more than once a year.

 The compounding period is less than one year.
 The formula for this shorter compounding period (Multi-
Period Compounding) is

i n×m
FVn = PV0 (1 + )
m
 Effective Interest Rate

 If compounding is done more than once a year, the

actual annualised rate of interest would be higher
than the nominal interest rate and it is called the
effective interest rate (EIR).

m
 i 
EIR = 1 +  − 1
 m
 Continuous Compounding
 If compounding is done daily, it is called continuous
compounding.
 In the equation for multi-period compounding, as m
i n×m
approaches infinity, (1 + ) approaches e i× n where
m
e=2.7183

 Therefore the formula for continuous compounding

i× n
is as follows: FV n = P × e
 Compounded Annual Growth Rate (CAGR)

 This is the rate at which an amount or a variable is

growing annually.

 It is assumed that there is annual compounding.

 This can be used to determine the rate at which an equity

share or any other asset is appreciating or the rate at
which profits, dividends or sales are growing annually.
 Doubling Period
 Doubling period refers to the period of time (number of
years) in which a sum of money will be doubled in
amount at a given rate of interest.

 This period may be determined by using the CVF.

EXAMPLE: How long will it take to double your
money given rate of interest of 12 percent p.a.?
 Doubling Period
 This period may also be determined by the following rules of
thumb:
1. Rule of 72
• According to this rule of thumb, the doubling period is
obtained by dividing 72 by the interest rate.

72
=
Interest rate
2. Rule of 69
This is a more accurate rule of thumb. According to this rule of
thumb, the doubling period is:
69
= 0.35 +
Interest rate
 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.
 Amount to be saved every year to accumulate into an
amount for meeting some financial goal eg purchasing
house, funding education, marriage, etc
 The factor used to calculate the annuity for a given future
sum is called the sinking fund factor (SFF).
 Sinking Fund Factor (SFF)

It represents the amount that has to be invested at the end
of every year for a period of “n” years at the rate of
interest “i”, in order to accumulate Re. 1 at the end of the
period.  
i
A = Fn  n 
 (1 + i ) − 1 
1
A = Fn ×
CVFA n ,i
Fn
=
CVFA n ,i

NB: Inverse of CVFA (FVIFA) factor is SFF

Present Value

Compiled by Dr. Divya Jindal

 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 (reverse compounding) is the

process of determining present value of a series of
future cash flows.

 The interest rate used for discounting cash flows is

also called the discount rate.
 Present Value of a Single Cash Flow
 Present value (PV) of a lump sum to be received after
some future periods is:
Fn
P = n
= F 
n  (1 + i ) −n

(1 + i )
 The term in brackets is the discount factor or present
value factor (PVF) or PVIF
−n 1
PVF = (1 + i ) =
(1 + i ) n

 Present Value Formula is

PV = Fn × PVFn ,i
 PVF is always less than 1.0 for positive i, as a future
amount has a smaller PV.
 Present Value of an Annuity
 Present value of an annuity =

1 1 
P = A − n

 i i (1 + i ) 

 The term in brackets is the present value factor of

an annuity of Re 1, also known as PVFA or PVIFA.

 PVFA is a sum of single-payment present value

factors.
P = A × P V A Fn , i
 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.
 PROCEDURE: Calculate the present value of
each cash flow and aggregate all present values.
 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.
P = A × P V A Fn , i

 1 
A = P  
 P V A Fn ,i 
A = P × C R F n ,i
 The reciprocal of the present value annuity factor is
called the capital recovery factor (CRF).
 Present Value of Perpetuity

 Perpetuity is an annuity that occurs indefinitely.

Perpetuities are not very common in financial
decision-making:
Perpetuity
Present value of a perpetuity =
Interest rate
 Present Value of Growing Annuities
 The present value of a constantly growing
annuity is given below:

A  1+ g  
n

P = 1 −   
i − g   1 + i  

 Present value of a constantly growing perpetuity

is given by a simple formula as follows:

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

Fn = A × CVFA n , i × (1 + i )

 PRESENT VALUE OF AN ANNUITY DUE

P = A × PVFA n, i × (1 + i )