The Time Value of Money

Dr. Medha Joshi

What is Time Value?
● We say that money has a time value because
that money can be invested with the
expectation of earning a positive rate of
return
● “a rupee received today is worth more than a
rupee to be received tomorrow”
● That is because today’s rupee can be invested
so that we have more than one rupee
tomorrow
 Why Time Value of Money is
Important Concept in Finance?
Useful in Decision making :
• Personal decisions and
• Complex Corporate financial Decisions

Valuation of Securities :
• Stocks/ Shares
• Bonds/ Debentures

3
 Intuitive Basis for Present Value
● 3 reasons why cash flow in the future is worth
less than a similar cash flow today.
1. Individuals prefer present consumption to
future consumption. If preference for current
consumption is strong then ? And if
weaker then ?
2. When there is monetary inflation, the value of
currency decreases over time. Greater the
inflation greater the difference in value
between a cash flow today and the same cash
flow in future
4
Intuitive Basis for Present Value

● A promised cash flow may not be delivered.

1. Promisor default on payment, promisee not
around to receive payment
2. Some other contingency might intervene to
prevent the promised payment or to reduce
it
3. Any uncertainty (risk) associated with the
cash flow in the future reduces the value of
the cash flow.

5
● Process by which future cash flows are
adjusted to reflect these factors is called
discounting and the magnitude of these
factors is reflected in the discount rate.
● Discount rate can be viewed as composite of
• the expected real return (reflecting
consumption preferences in the aggregate
over investing population),
• the expected inflation rate (to capture the
deterioration of purchasing power)
• the uncertainty associated with the cash
flow.
The Terminology of Time Value
● Present Value - An amount of money today,
or the current value of a future cash flow
● Future Value - An amount of money at some
future time period
● Period - A length of time (often a year, but can
be a month, week, day, hour, etc.)
● Interest Rate - The compensation paid to a
lender (or saver) for the use of funds
expressed as a percentage for a period
(normally expressed as an annual rate)
Abbreviations

● PV - Present value
● FV - Future value
● Pmt - Per period payment amount
● N - Either the total number of cash flows or
the number of a specific period
● i - The interest rate per period
Timelines
● A timeline is a graphical device used to
clarify the timing of the cash flows for an
investment
● Each tick represents one time period

PV FV

0 1 2 3 4 5
Today
Calculating the Future Value
● Suppose that you have an extra Rs. 100 today that
you wish to invest for one year. If you can earn 10%
per year on your investment, how much will you
have in one year?

-100 ?

0 1 2 3 4 5

● Suppose that at the end of year 1 you decide to

extend the investment for a second year. How much
will you have accumulated at the end of year 2?
Calculating the Future Value (cont.)

● Suppose that at the end of year 1 you decide to

extend the investment for a second year. How much
will you have accumulated at the end of year 2?

-110 ?

0 1 2 3 4 5
Generalizing the Future Value

● Recognizing the pattern that is developing,

we can generalize the future value
calculations as follows:

● If you extended the investment for a third

year, you would have:
Compound Interest
● Note from the example that the future value is
increasing at an increasing rate
● In other words, the amount of interest earned
each year is increasing
• Year 1: Rs. 10
• Year 2: Rs. 11
• Year 3: Rs. 12.10
● The reason for the increase is that each year
you are earning interest on the interest that
was earned in previous years in addition to
the interest on the original principle amount
Present Value: An Example
● Suppose you have a plan to start your own business
10 years down the line and after some research, you
determine that you will need about Rs. 10,00,000. If
you can earn 8% per year on your investments, how
much do you need to invest today to achieve your
goal?
Present Value: An Example
● Suppose you have a plan to start your own business
10 years down the line and after some research, you
determine that you will need about Rs. 10,00,000. If
you can earn 8% per year on your investments, how
much do you need to invest today to achieve your
goal?

15
Annuities
● An annuity is a series of nominally equal
payments equally spaced in time
● Annuities are very common:
• Rent
• Mortgage payments
• Car payment
• Pension income
● The timeline shows an example of a 5-year,
Rs. 100 annuity
100 100 100 100 100

0 1 2 3 4 5
The Principle of Value Additivity
● How do we find the value (PV or FV) of an
annuity?
● First, you must understand the principle of
value additivity:
• The value of any stream of cash flows is
equal to the sum of the values of the
components
● In other words, if we can move the cash flows
to the same time period we can simply add
them all together to get the total value
 Present Value of an Annuity
● We can use the principle of value
additivity to find the present value of an
annuity, by simply summing the present
values of each of the components:
 Calculate the Present Value of an Annuity

100 100 100 100 100

0 1 2 3 4 5

● Using the example, and assuming a

discount rate of 10% per year, find that
the present value of annuity?
 Calculate the Present Value of an Annuity
100 100 100 100 100

0 1 2 3 4 5

● Using the example, and assuming a discount rate of

10% per year, we find that the present value is:

62.09
68.30
75.13
82.64
90.91
379.08 100 100 100 100 100

0 1 2 3 4 5

20
Present Value of an Annuity (cont.)

● Actually, there is no need to take the present

value of each cash flow separately
● We can use a closed-form of the PVA equation
instead:
Present Value of an Annuity (cont.)

● We can use this equation to find the present

value of our example annuity as follows:

● This equation works for all regular annuities,

regardless of the number of payments
The Future Value of an Annuity

● We can also use the principle of value

additivity to find the future value of an
annuity, by simply summing the future
values of each of the components:
The Future Value of an Annuity (cont.)

● Using the example, and assuming a discount rate of

10% per year, we find that the future value is:

146.41

100 100 100 100

133.10
121.00
110.00
100
} = 610.51
at year 5

0 1 2 3 4 5
The Future Value of an Annuity (cont.)

● Just as we did for the PVA equation, we could

instead use a closed-form of the FVA
equation:

● This equation works for all regular annuities,

regardless of the number of payments
The Future Value of an Annuity (cont.)

● We can use this equation to find the future

value of the example annuity:
 Annuities Due
● Thus far, the annuities that we have looked at begin
their payments at the end of period 1; these are referred
to as regular annuities
● A annuity due is the same as a regular annuity, except
that its cash flows occur at the beginning of the period
rather than at the end

5-period Annuity Due 100 100 100 100 100

5-period Regular Annuity 100 100 100 100 100

0 1 2 3 4 5
Present Value of an Annuity Due

● We can find the present value of an annuity due in

the same way as we did for a regular annuity, with
one exception
● Note from the timeline that, if we ignore the first cash
flow, the annuity due looks just like a four-period
regular annuity
● Therefore, we can value an annuity due with:
Present Value of an Annuity Due (cont.)

● Therefore, the present value of our example

annuity due is:

● Note that this is higher than the PV of the,

otherwise equivalent, regular annuity
Future Value of an Annuity Due

● To calculate the FV of an annuity due, we can

treat it as regular annuity, and then take it one
more period forward:

Pmt Pmt Pmt Pmt Pmt

0 1 2 3 4 5
Future Value of an Annuity Due (cont.)

● The future value of our example annuity is:

● Note that this is higher than the future value

of the, otherwise equivalent, regular annuity
Deferred Annuities

● A deferred annuity is the same as any other

annuity, except that its payments do not begin
until some later period
● The timeline shows a five-period deferred
annuity

100 100 100 100 100

0 1 2 3 4 5 6 7
PV of a Deferred Annuity
● We can find the present value of a
deferred annuity in the same way as any
other annuity, with an extra step
required
● Before we can do this however, there is
an important rule to understand:
When using the PVA equation, the
resulting PV is always one period before
the first payment occurs
PV of a Deferred Annuity (cont.)

● To find the PV of a deferred annuity, we first

find use the PVA equation, and then discount
that result back to period 0
● Here we are using a 10% discount rate

PV2 = 379.08
PV0 = 313.29
0 0 100 100 100 100 100

0 1 2 3 4 5 6 7
PV of a Deferred Annuity (cont.)
Step 1:

Step 2:
FV of a Deferred Annuity

● The future value of a deferred annuity is

calculated in exactly the same way as any
other annuity
● There are no extra steps at all
Uneven Cash Flows

● Very often an investment offers a stream of

cash flows which are not either a lump sum
or an annuity
● We can find the present or future value of
such a stream by using the principle of value
additivity
Uneven Cash Flows: An Example (1)

● Assume that an investment offers the following cash

flows. If your required return is 7%, what is the
maximum price that you would pay for this
investment?
100 200 300

0 1 2 3 4 5
Uneven Cash Flows: An Example (2)

● Suppose that you were to deposit the following

amounts in an account paying 5% per year. What
would the balance of the account be at the end of the
third year?
300 500 700

0 1 2 3 4 5
 PRESENT VALUE OF PERPETUITY

Perpetuity refers to an infinite amount of time.

In finance, it is a constant stream of identical cash
flows with no end

Present value of perpetuity = Pmt / i

40
 Non-annual Compounding
● So far we have assumed that the time period
is equal to a year
● However, there is no reason that a time period
can’t be any other length of time
● We could assume that interest is earned
semi-annually, quarterly, monthly, daily, or
any other length of time
● The only change that must be made is to make
sure that the rate of interest is adjusted to the
period length
Non-annual Compounding (cont.)
● Suppose that you have Rs. 1,000 available for
investment. After investigating the local banks, you
have compiled the following table for comparison. In
which bank should you deposit your funds?
 Non-annual Compounding (cont.)
● To solve this problem, you need to determine
which bank will pay you the most interest
● In other words, at which bank will you have
the highest future value?
● To find out, let’s change our basic FV equation
slightly:

In this version of the equation ‘m’ is the

number of compounding periods per year
Non-annual Compounding (cont.)

● We can find the FV for each bank as follows:

ICICI Bank:

Bank of Baroda:

State Bank of India:

Obviously, you should choose the State Bank of India

Continuous Compounding

● There is no reason why we need to stop increasing

the compounding frequency at daily
● We could compound every hour, minute, or second
● We can also compound every instant (i.e.,
continuously):

● Here, F is the future value, P is the present value, r is

the annual rate of interest, t is the total number of
years, and e is a constant equal to about 2.718
Continuous Compounding (cont.)
● Suppose that the Bank of Maharashtra is
offering to pay 10% per year compounded
continuously. What is the future value of your
Rs. 1,000 investment?

● This is even better than daily compounding

● The basic rule of compounding is: The more
frequently interest is compounded, the higher the
future value
Continuous Compounding (cont.)

● Suppose that the Bank of Maharashtra is

offering to pay 10% per year compounded
continuously. If you plan to leave the money
in the account for 5 years, what is the future
value of your Rs. 1,000 investment?
 DOUBLING PERIOD
Thumb Rule : Rule of 72
72
Doubling period
= Interest rate
Interest rate : 15 percent
72
Doubling period
15 = 4.8 years
=
A more accurate thumb rule : Rule of 69
69
Doubling period = 0.35Interest rate
Interest
+ rate : 15 percent
69
Doubling period15= 0.35 = 4.95 years
+
 Equated Monthly Instalment
● Suppose you want to take a housing loan of
Rs. 1 lakh which you have to repay in 10
years. The rate of interest is 12% p.a.
Calculate Equated Monthly Instalments