Financial Management

(PGDM: 2021-23)

Sessions-6&7: Time Value of Money

Sriranga Vishnu
Faculty (F&A Area)
 Time Value of Money
• Time Value for Money -
– Future uncertainties (risk)

– Preference for consumption

– Investment opportunities

– Inflationary effect (PP)

• An investment needs to be compensated for two things:

– Time

– Risk
 Time Value of Money
• 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 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 return (Rf) + Premium for Risk (Rm – Rf)

 Time Value of Money
• Three Rules of Time Value of Money -

– Comparing and Combining Values:- Only values at the

same point in time can be combined or compared

– Moving Cash Flows Forward in Time:- To move a

cash flow forward in time, we must compound it

– Moving Cash Flows Back in Time:- To move a cash

flow backward in time, we must discount it
 Time Value of Money
• 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.
 Time Value of Money
• Time Line – Graphical representation of timing of cash flows

• Future Value (FV) – Amount to which cash flows will grow

during a time period compounded at a given rate

• Present Value (PV) – Current value of future cash flows

• Annuity – Series of equal cash flows made at fixed intervals

for a specified no. of periods (Ordinary and Due)

• Perpetuity – Stream of equal payments expected to continue

forever – Consol
 Time Line

0 1 2 3
I%

CF0 CF1 CF2 CF3

• Shows the timing of cash flows

• Tick marks occur at the end of periods, so Time 0 is today;
Time 1 is the end of the first period (year, month, etc.) or the
beginning of the second period
 Even and Uneven Cash Flows

3-year $100 ordinary annuity

0 1 2 3
I%
100 100 100

Uneven cash flow stream

0 1 2 3
I%

-50 100 75 50
 Future Value
• Finding the FV of a cash flow or series of cash flows is called
compounding

• Find the future value of an initial $100 after 3 years, if annual

interest rate is10%?

• After 1 year, FV1 = PV(1 + I) = $100(1.10) = $110.00

• After 2 years, FV2 = PV(1 + I)2 = $100(1.10)2 = $121.00
• After 3 years, FV3 = PV(1 + I)3 = $100(1.10)3 = $133.10
• After N years (general case), FVN = PV(1 + I)N
 Present Value
• Finding the present value of a cash flow or series of cash flows
is called discounting (the reverse of compounding). PV shows
the value of cash flows in terms of today’s purchasing power.

• Find the PV of $100 due in 3 years if annual interest is 10%.

• Using the general FV equation for PV:

PV = FVN /(1 + I)N
PV = FV3 /(1 + I)3
= $100/(1.10)3
= $75.13
 Ordinary Annuity and Annuity Due

Ordinary Annuity

0 1 2 3
I%

PMT PMT PMT

Annuity Due

0 1 2 3
I%

PMT PMT PMT

Future Value
Future Value- Example
Future Value of Annuity- Example
Present Value- Example
Present Value of Annuity- Example
Present Value of Uneven Cash Flows- Example
Present Value of Perpuity- Example
Thank you