Time value of Money

The time value of money (TVM) is the concept that a sum of money is
worth more now than the same sum will be at a future date due to
its earnings potential in the interim.

This is a core principle of finance. A sum of money in the hand has

greater value than the same sum to be paid in the future.

The time value of money is also referred to as the present discounted

value

Suppose I offer you the choice of taking Rs. 1,00,000 from me today, or
taking this same sum from me after a year.

What decision will you make?

If you chose to take the sum today, you’ve made the right choice.

There are 2 reasons why taking up the first option is better –

High purchasing power – Because of inflation, it’s safe to consider

that an amount of money can get us more services and goods than it
can in the future.
You have chosen the first option in the previous example because you
understand that Rs. 1,00,000 can get you more things today than it will
get you a year later.

Risks involved– What if, in the previous example, you chose to receive
the money a year later, but when you approach me then, I don’t have
any money to give to you?
This could also happen to you if you lend money to someone, but they
go bankrupt before they can repay you. This shows that there is
a certain level of risk involved if you choose to get your money at a
later date.
With these two reasons, we can justify the existence of the concept of
the time value of money. Now, let us discuss some components that
we’ll need to be able to calculate the time value of money.
Components of TVM
The key components are as mentioned below –

1. Interest/Discount Rate (i)– It’s the rate of discounting or compounding that we apply
to an amount of money to calculate its present or future value.

2. Time Periods (n) – It refers to the whole number of time periods for which we want
to calculate the present or future value of a sum. These time periods can be annually,
semi-annually, quarterly, monthly, weekly, etc.

3. Present value (PV)– The amount of money that we obtain by applying a discounting
rate on the future value of any cash flow.

4. Future value (FV)– The amount of money that we obtain by applying a

compounding rate on the present value of any cash flow.

5. Instalments (PMT)– Instalments represent payments to be paid periodically or

received during each period. The value is positive when payments have been received and
become negative when payments are made.

Let’s find out by learning about the two main calculations that we
encounter in situations of time value.

1. Present Value (PV)

The present value is known as the current value of a sum of money
that we will receive in the future.

The PV of a sum of money can be used to determine the current value

of projected cash flow from a bond, an annuity, a loan, or any such
instance where you are supposed to receive money from a third party
in the future and you want to know exactly how much that money will
be worth today.
It is given by the following formula –
PV = FV / (1 + i)^n
Here, we require three things to calculate the present value –

1. What is the value of the sum we will receive in the future? (FV);
2. What is the rate of discounting at which the purchasing power of
the money will fall? (i); and
3. After how many years will we receive the concerned sum of
money? (n).

Example explanation from PPT

 Future Value
Future value (FV) is the value of a current asset at a future date based
on an assumed rate of growth.
The future value is important to investors and financial planners, as
they use it to estimate how much an investment made today will be
worth in the future

FV = PV (1+i)n
This formula requires only three things to give us a future value –

1. What amount of money do we have right now? (PV);

2. What is the assumed interest rate at which it will grow? (i); and
3. After how many years will we need the money? (n)

Now we see a short video on Simple and Compound Interest to know

it’s impact on Future value
Video will run
Now we will understand the effects of compounding periods on future
Value
Easily explain through ppt
Annuity
The difference between an annuity derivation and a perpetuity
derivation is related to their distinct time periods. An annuity uses
a compounding interest rate to calculate its present value or future
value, while a perpetuity uses only the stated interest rate or discount
rate. However, several different kinds of annuities exist, and some
seek to replicate the features of perpetuity.

An annuity is an equal and annual series of payments made over a

predetermined time period
A series of equally spaced and level cash flows extending over a finite
number of periods
Annuities can be used for a variety of purposes, but the most common one
is providing a steady income for retirees. 

Perpetuity
A perpetuity is an infinite series of periodic payments of equal face
value. Therefore, a perpetuity's owner will receive constant payments
forever.
A series of level cashflows that continue forever.
A perpetuity calculation in finance is used in valuation methodologies
to find the present value of a company's cash flows. This is done by
discounting back at a certain rate.
While the actual face value of a perpetuity is indeterminable because
of its indefinite time period, its present value can be derived. The
present value is equal to the sum of the discounted value of each
periodic payment. The value of a perpetuity is derived as follows:

PV of Perpetuity = ICF / r

Here,

 The identical cash flows are regarded as the CF.

 The interest rate r the discounting rate is expressed as r.
 Applications of TVM
 Loans EMI
 Bonds Valuation
 Capital Budgeting

1. LOANS EMI- EMIs, short for Equated Monthly Installments,

constitute the prime method of repaying back a loan. The
need for the concept of time value arises when it comes to
calculating the value of the EMIs. Let us return to the
example we had talked about before.

EXAMPLE: -
You went to purchase a bike worth Rs. 3,00,000 and the dealer gives you a choice.

1. You either pay Rs 3,00,000 now, or

2. opt for instalments of Rs 1,00,000 at the end of each year for the next three years.

SOLUTION: -
Let’s evaluate each choice one by one
 The first one is pretty simple, right? You can just pay off Rs.
3,00,000 this instant, but this amount can cause a huge dent in your
savings, depending on your income and financial status.
 Now, for the second one, if you pay Rs. 1,00,000 at the end of
each year for three years, it might cause you a bigger dent in your
savings because as we’ve learned, the value of money keeps increasing
over time.
 Therefore, it is clear that even if we are paying three
instalments’ of Rs. 1,00,000 each, the effective value of these
instalments’ can be much higher in the future.
 It’s because the instalments are not the present values, whereas
the Rs. 3,00,000 is the present value of your purchase.
One should always make sure that they are either comparing two
future values or two current values to come to a correct investment
decision.
 Therefore, to make the correct decision, you should
evaluate the present value of all the instalments’, add up
their value, and then compare that value to the current price
of the product to see how much interest you’re paying on the
product.
 This technique is relevant for any loan – from a home
loan to a simple EMI-system purchase of home appliances. You
can read about calculating EMIs in an easy way.

2. BONDS- A bond is a fixed-income instrument that represents

a loan made by an investor to a borrower (typically corporate
or governmental). A bond could be thought of as
an I.O.U. between the lender and borrower that includes the
details of the loan and its payments. Bonds are used by
companies, municipalities, states, and sovereign governments
to finance projects and operations. Owners of bonds are
debtholders, or creditors, of the issuer.
Bond details include the end date when the principal of the
loan is due to be paid to the bond owner and usually include
the terms for variable or fixed interest payments made by the
borrower.

EXAMPLE-
• Suppose an investor wants to invest in a security
that will yield them an interest rate of at least
10%.

• How will the investor be able to decide if the

bonds they want to purchase will give them as
many returns?

Solution-

• Calculating the YTM requires the calculation of

the PV of every cash flow from the bond to the
investor.

• Therefore, the investor can compare the YTM

rate with their desired rate of interest to decide
if the bonds are a suitable purchase for them.

• In this way, the concept of time value is essential

for an investor looking to buy bonds in the future.
 CAPITAL BUDGETING

Capital budgeting is the process a business undertakes to

evaluate potential major projects or investments.
Construction of a new plant or a big investment in an outside
venture are examples of projects that would require capital
budgeting before they are approved or rejected.

As part of capital budgeting, a company might assess a

prospective project's lifetime cash inflows and outflows to
determine whether the potential returns that would be
generated meet a sufficient target benchmark. The capital
budgeting process is also known as investment appraisal.