TIME VALUE OF MONEY

Compiled to Fulfill the Duties of Financial Management Courses

Lecturer: Prof. Dr. IstiFadah, M.Si.

Authored By:

RedygtaMeigyMaulana (190810201153)
Galuh Dewandaru Al Amanah (190810201154)
Gusti Jimmy Murhpy (190810201161)

DEPARTMENT OF MANAGEMENT
FACULTY OF ECONOMICS AND BUSINESS
UNIVERSITAS JEMBER
2020
 TABLE OF CONTENTS

TABLE OF CONTENTS 1
CHAPTER I INTRODUCTION 2
1.1 Issue Background 2
1.2 ProblemFormulation 3
1.3 Purpose 3
CHAPTER II DISCUSSION 4
2.1 The Concept of Time Value of Money 4
2.2 Utility of Time Value of Money Concept 6
2.3 Value of Money 8
2.3.1 Simple Future Value 8
2.3.2 Compounding Future Value 10
CHAPTER III CLOSING 12
REFERENCES 13

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 CHAPTER I
INTRODUCTION

1.1 Issue Background

With the passage of time, all assets decrease in value and same is the
case with money.But there is a lot difference between other assets and
money.While other assets are used by themselves to achieve the end results,
money is one aspect of any transaction.It can also be said that money
is always one aspect of all transactions as the most peculiar attribute
of money is its purchasing power. As the time passes, the purchasing
power of money decreases. That means it would not be possible to
purchase same quantity of any commodity at a future date which can be
purchased today with a currency note of same denomination. To make up
for this decrease, there can be two ways. First one is to decrease
consumption as reduced quantity would be purchased with same
amount of money and second one is to increase the amount of money
to purchase same quantity of the commodity.This reduction in the
purchasing power of money i. e. its value over the period of time is
known as the time valueofmoney.The value of money as on date is
known as present valueofmoneywhile the value of money on a future
date is known as future value of money. To arrive at present value of a
future sum, technique of discounting is used and while to reach at the future
value of present sum, technique of compounding is used and for the same
purpose a rate of required return is to be decided and used. Time value
of money is the impact of time on the value of money. Basically, it is
the change in purchasing power of money over a period of time.
The concept of time value of money is utilized in making decisions
regarding investment in different projects where multiple options for cash
outlays and cash inflows are available. The concept of time value of money
is also useful in selecting the highest paid investment option amongst all
available options ofinvestment.The concept is also useful in finding out the

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 rate of return if present value and future value of a cash stream is available.
Time value of money is a very useful conceptin financial management.

1.2 Problem Formulation

1. How the concept of time value of money?
2. How the concept of utility of time value of money?
3. How the value for money benefit?

1.3 Purpose
1. Understanding the concept of time value of money
2. Understanding the concept of utility of time value of money
3. Understanding the value for money benefit

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 CHAPTER II
DISCUSSION

2.1 The Concept of Time Value of Money

The concept of time value of money is simple to understand and interpret.
The value of money affected with the passage of time is called as time value of
money.In the period of deflation the value of money increases while it is reverse
in case of inflationary period.Money is the only commodity having purchasing
power. It is the means of transaction. It is the medium of exchange. Money serves
the purpose of exchange as it is the measure of value. The value is the purchasing
power of money which makes it powerful commodity. Moreover, if any
comparison is to be made in the values of money, few rules need to be followed.
Firstly the unit should be same, like all values should be in same currency.
Secondly, the values should be at same point of time. That means,Rs 100 today
cannotbetreated as equal to Rs 100 at a future date. The value of money at
different points of time is different like today it is having a specific value and after
one year it will have different value then after two years, it will have different
value. Usually, with passage of time, the value of money decreases.The reasons
for the same are described in the following paragraph. It would be worthy to note
here that the difference between the value of money today and the value of same
money on a future date is called time value of money.
There is impact of time on the value of money due to four reasons. First
one is the inflation rate. Inflation is a universal economic phenomenon. In
general,inflation is an economic condition where prices of commodities rise with
the passage of time. This would result in either purchasing less quantity with the
same amount of money or paying more money for the same quantity of the
commodity. Thus, it is said that duringinflationary period, the purchasing power
of money decreases.The effect of inflation is the eradication in the purchasing
power of money and the value of money is more today, in comparison to what it
would be on a future date. Second reason for the impact of time on money is the
risk involved in holding the money.Money held idly is more vulnerable to such

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risk. Third reason is the consumption preference of the consumer. An individual
consumer has the preference to consume today over future consumption as future
is unknown. The consumer consumption preference also has its impact on future
flow of money and hence on the value of money. All consumers try find out a
tradeoff between present and future consumption. Everyone has desire of
fulfilling his needs today itself and not in future. Present consumption is
postponed only in the expectation of having increased amount on a future date. If
money is not consumed today, it can even be employed to earn some return. That
means money can be invested today, in an appropriate investment avenue. And
thus, the fourth reason is the availability and attractiveness of investment
opportunities in the economy. If there will be no lucrative investment
opportunities available in the economy, the consumer would prefer to consume
the money and if yielding investment opportunities are there in the economy, the
money will be investedin the want of increased amount on a future date. In this
case, the consumer will postpone present consumption and depart from his
moneyfor some time, to invest it in a suitable investment avenue yearning for
appropriate return.Investment means deferring of present consumption. All these
reasons have their effect on the time value of money. Once the concept of time
value of money is understood, next step would be to understand the meaning of
present value and future value.
From Exhibit 1, it can be understood that if one has to find out the future
value of any present sum of money, the technique of compounding is to be used
and if the present value of any future sum is to be calculated, then technique of
discounting is used. In the following example, Rs 1100 is the future value of Rs
1000 today and Rs 1000 is the present value of Rs 1100 to be received after one
year @ 10%. Similarly Rs1210 is the future value of Rs 1000 invested for two
years @ 10% and Rs 1000 is the present value of Rs 1210 to be received after two
years, invested @ 10%.

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 As shown in Exhibit 1 and 2, when Rs 1000 is invested for two years @
10%, the future amount is Rs 1210. This process can go on for n number of years.
Instead of going year by year, following formula can be used to arrive at the
future value of an investedsum or the present value of a future sum.

FV = PV (1 +i)n
FV = 1000 (1 + 10/100)2
FV = 1210
The concepts of present value and future value are simple to understand
and applyas only simple calculations are involved.The understanding of these
concepts is helpful inmany ways, as discussed in coming paragraphs.

2.2 Utility of Time Value of Money Concept

As it is observed that traditionally the value of money was considered
same at all points of time. A hundred rupee note was considered a hundred rupee
note forever. No impact of timeon money was considered. With the development
of knowledge, it was understood that time has its effect on the value of money.

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This led to the development of the concept of time value of money. Consideration
of present value of money and future value of money gave fruitful insight into the
impact of time on the value of money. Whenever one has to receive money in
future, it is beneficial to calculate its present value and analyze it in the context of
present cash outflow and required rate of return.This makes the comparison at of
cash outflows and cash inflows at same point of time, which is otherwise not
comparable, at least on time basis. The concept of time value of money is really
useful when the cash inflows of different point of time are to be analyzed. It
makes the cash flows comparable. If the cash flows are spread over a couple of
years, it becomes difficult to compare them. Thus, the biggest advantage of the
concept of time value of money is that it brings the cash flows of different point of
time at par, which makes them comparable. Now, bringing all cash flows at par, in
itself has a great many uses, especially in analyzing those projects where the cash
flows are uneven and the project lifeisinyears.The organizations utilize the
concept of time value of money in analyzing, ranking, comparing, short
listingandselectingorrejectingvarious projects and capital investment
opportunities. In such cases, it is very necessary to bring the cash flows at same
point of time. Here, the concept of present value and future value comes into the
light. Thus, another utility of the concept of time value of money is the calculation
of present value of any future sum of money and vice-versa.This makes the
decision making regarding investments easier. For example, if Rs 1080 are
receivedafter one year from today, if Rs 1000 is invested, it becomes easy to
compare these amounts if the value of Rs 1080 is found as on date. In order to
find out the present value of Rs 1080, a discount rate would be needed. If the
discount rate is 8%, there is no earning and if the discount rate is below 8% there
is earning and if the discount rate is above 8% there is loss. Now, this calculation
is based on the concept of time value of money. Individualinvestorsutilize the
concept of time value of money to analyze various investment opportunities
available to them.Once understood, the time value of money concept is simple to
apply and do further analysis of investment opportunities.Analysis of investment
opportunities is needed to be done as we know that returns on the investments are

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negatively correlated with the amount of risk associated with the investment. If
investor chooses to invest his funds in bank fixed deposits or government
securities called as gilt edged securities, he would get minimum returns, as these
are the most safe investment avenues in terms of repayment of principal amount
and payment of interest. As the investor moves on the continuum of risk, in the
want of increased return, he needs to analyze the investment opportunity from
different angles, as with increase in risk only the probability of receiving more
returns increase and not the returns in themselves.Thus, an individual investor
needs to analyze the investment opportunity available to him, prior to making any
investment with the help of time value of money concept. Another utility of the
concept of time value of money is the valuation of financial assets securities.
Proceedings of abond which are supposed to be received after say five years or
seven years or even after fifteen years and bond is to be purchased today. Now,
the decision has to be made regarding the purchase of the bond. This is done by
utilizing the concept of time value of money.The cash inflows from the bond are
discounted and compared with the present purchase price of the bond and decision
is made. Similarly, the concept of time value of money is used in valuationof
other financial securities, having longer maturity period.An individual if has to
know about his retirement corpus, the concept of time value of money is to be
utilized for the purpose. The concept of time value of money will help in
calculating the monthly amount need to be saved in order to gather aspecific
amount at the time of retirement, keeping in consideration the effect of time on the
value of money. Time value of money isutilized in calculating EMIs of long
duration loans as well. A single amount is disbursed today and the recovery is
made in equated monthly installments. Thus, in case of creation of sinking fund
and in case of capital recovery, the concept of time value of money is utilized.
This concept is also useful in calculating the implicit rate of return of a project.
This is the ratewhich a project is going to earn for itself. This rate of return is than
compared with the required rate of return, in order to analyze the project further.In
business and economics, the concept of time value of money has much more
utility as there are n number of projects available for investment and the firm has

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difficulty in deciding upon the ones on which it can put its stakes. Here, various
capital budgeting techniquesareusedby the organizations in order to finalize
promising projects. Yet another utility of the concept of time value of money is in
the valuation of firm or business. This is useful at the time of sale and purchase of
the firm or business. In such cases, the present value of future stream of
profitstobe generated from the businessneeds to be calculated and to be compared
with the price being asked for the firm or business.Similar analysis needs to be
done in the case of mergers and acquisitions. When two organizations merge or
when one organization acquires another, the number of shares, the proportion in
profits etc. are decided on the basis of generating profit in future. These expected
flow of profits in future and the present terms and conditions are then analyzed to
arrive at various decisions regarding share in new business etc.the concept of time
value of money is useful in cases of mortgages. It helps in the calculation of
monthly mortgage payment. Time value of money concept is useful in all
situations where cash flows at different point of time need to be brought at one
point of time for decision making.

2.3 The Value for Money Benefit

In life in society, money has a functioning value. First, money has a value
for time. Money now has more value than it will come. This time difference is
widely used by the banking world in providing banking services in order to
benefit through the difference in interest on funds from the public and the
difference in investment interest. Second, money has an opportunity cost that is
the opportunity to spend money for business purposes, having enough money to
transact will get a chance to get relative profit. Third, money has an intrinsic value
and a nominal value stated in the currency that is useful as a means of payment of
transactions.
2.3.1 Simple Future Value
A person considers the current value of money of Rp100,000,000 to
be deposited in a bank savings account, at an interest rate of 12% per year.
What is the amount of savings at the end of the first year?

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FV1 = PV + (PV × i)
FV1 = PV(1 + (1 × i))
FV1 = PV (1 + i) (4.1)(Rao, 1995)

In this case,
FV = Future value
PV = Present value
i = Interest Rate
Answer
FV1 = RP100,000,000 (1 + 0.12)
FV1 = Rp100,000,000 + 12,000,000
= Rp112.000.000

Next, what is the amount of rupiah savings at the end of the second year?
FV1 = PV + (PV + i) = PV (1 × i)
FV2 = PV(1 + i) + (PV(1 × i) × i)
FV2 = PV(1 + i) (1 × i)
FV2 = PV(1 + (1 × i)2 (4.2)
Answer
FV2 = RP112,000,000 (1 + 0.12)
= Rp112,000,000 + 13,440,000
= Rp125.440.000
Based on the case for Equations (4.1) and (4.2) future values can be
formulated as follows.
FVn = PV (1 + i)n (4.3)(Rao, 1995)

2.3.2 Compounding Future Value Concept

In the equation (4.1) the future value at the end of the year within 2
years is determined based on the principal value plus the interest rate in the
first year, and plus the interest income in the second year. The calculation
process differs between the calculation of ordinary flowers and compound

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flowers (the concept of flower-flowering). The understanding of the concept
of compound interest can be derived through equations (4.2), i.e.
FV2 = PV (1 + i)2 = PV (1 + 2i + i2) (4.4) (Rao, 1995)
The equation (4.4), 1 represents the principal value, 2i is the ordinary
interest income for two years and i2 is interest-flowering.
Example:
FV2 = Rp100,000,000 [(1 + 2(0.12) + (0.12)2]
= Rp100,000,000 (1 + (0.24) + 0.0114)
= Rp100,000,000 + Rp24,000,000 + Rp1,440,000
= Rp125.440.000

Future value is determined by summing the principal value of

Rp100,000,000, ordinary interest Rp24,000,000 (or Rp12,000,000 per year
for two years), and compound interest rp1,440,000 (or Rp12,000,000 first
year interest income multiplied by 12% interest rate in the second year).
Based on the calculation of annuity interest and ordinary interest
chart can be described in Figure 4.1.

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 CHAPTER III
CLOSING

Time value of money is an important concept in financial

management. This concept says that the money has different value at
different points of time. Traditionally, the money was assumed to have the
same value at all points of time meaning that a Rs 100 note was assumed
to be always having purchasing power of Rs 100. With knowledge
development, it is understood that the purchasing power of currency is
affected and in most of the economies, it is reduced basically due to the effect of
inflation along with other reasons as well. The change in purchasing power of the
currency with the passage of time is known as the time value of money. Time
value of money concept is useful for individuals as well as for corporate.
An individual utilizes the concept of time value of money for analyzing
investment opportunities, to calculate sinking funds and to study capital
recovery options. Corporate entities utilize the concept of time value of
money to analyze various projects available for capital investment.Capital
budgeting techniques are utilized by the firms to short list and select various
capital investment projects. Time value of money concept is alsoutilized for the
purpose of valuation of firms at the time of buying and selling of businesses. The
calculation of present and future value of goodwill of any business can be
improvisedusing time value of money concept. This concept is also useful in
case of valuation of firms at the time of mergers and acquisitions in order to
decide upon the share of old firms in new firm, share in profits, decision
making power etc. The organizationsalso use this concept for the purpose of
calculation of sinking fund, monthly payouts in the cases of mortgage, lease
or rental agreements etc.

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 REFERENCES

ShrotriyaVikas. 2019. Time Value Of Money-The Concept and Its Utility.

International Journal of Vivekananda Global University.
Harmono. 2014. Financial Management: Balanced Scorecard Based. Jakarta:
Publisher BumiAksara.

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