TIME VALUE OF MONEY

Q. Why money has time value?

Money has time value for the following reasons:-

1. Future uncertainties:
The most important reason for preference for current money is that there is always an uncertainty in
case of future money, whereas current money has a certainty.

2. Preference for present consumption:

Every person has a preference for present consumption. The present money is required to purchase
goods for present consumption. Moreover, in an inflationary situation, the money received today has a
greater purchasing power.

3. Reinvestment opportunities:
Rational individuals and firms have preference for present money because of availability of reinvestment
opportunities. Current money can be invested to earn further money. The existence of reinvestment
opportunities and the urge to earn a return by investing this current money seem to be the obvious
reason for the time preference for money.

Q. What is the difference between sinking fund factor and capital recovery factor?

Sinking Fund Factor We know the equation

which can be written as

The expression is known as the sinking fund factor. It is the amount that has to be invested
at the end of every year for a period of ‘n’ years at the rate of interest ‘k’, in order to accumulate Re. 1 at
the end of the period.

Capital Recovery Factor: Sometimes, one may be interested to know the equal annual amount paid in
order to redeem a loan of a specified amount over a specified period together with the interest at a
given rate for that period. For example, Rs 100,000 borrowed today is to be repaid in five equal
instalments payable at the end of each of next 5 years in such a way that the interest at 10% p.a. for the
intervening period is also repaid. The annuity amount in this case can be computed as follow:

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 PV = Annuity Amount × PVAF(r, n)

or, Annuity Amount = PV  PVAF(r, n)

Q. What is the difference between nominal and effective interest rate?

The Nominal Interest Rate (also known as an Annualized Percentage Rate or APR) it is the interest rate
before inflation gets added into the mix. It's also the one you're most likely to be exposed to as it's the
interest rate lenders commonly quote in loan and deposit agreements. Nominal interest is directly
affected by the rate of inflation and can make a big dent in an investor's purchasing power. .

Effective Interest Rates correct for this by "converting" nominal rates into annual compound interest.

Confusingly, in the context of inflation, 'nominal' has a different meaning. A nominal rate can mean a
rate before adjusting for inflation, and a real rate is a constant-prices rate. To avoid confusion about the
term nominal which has these different meanings, some finance textbooks use the term 'Annualized
Percentage Rate' or APR rather than 'nominal rate' when they are discussing the difference between
effective rates and APR's.

The effective interest rate is always calculated as if compounded annually. The effective rate is
calculated in the following way, where r is the effective rate, i the nominal rate and n the number of
compounding periods per year.

The general relationship between the effective and nominal rates of interest is as follows:

where, r = Effective rate of interest

k = Nominal rate of interest

m = Frequency of compounding per year.

Q. What is an annuity? What are its uses?

An annuity is a series of periodic cash flows (payments or receipts) of equal amounts. The premium
payments of a life insurance policy, for example, are an annuity. When the cash flows occur at the end
of each period the annuity is called a regular annuity or a deferred annuity. When the cash flows occur
at the beginning of each period the annuity is called an annuity. Annuity factor is used in following
financial decisions.

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i) Determining the size of annual payments to accumulate a future sum to repay an existing liability at
some future date or to provide funds for replacement of an existing machine/asset after its useful
life.
ii) In determining the amount of annual installments to repay loan taken from a financial institution
which is to be repaid in a specific number of equal installments.

Q. What is Present Value? How is it calculated?

Present value:

Present value of a future single flow is its discounted value obtained by discounting its amount by
applying a suitable discount rate and is computed by the following formula.

Where r is the discount rate per time period and n is the number of time period.

Discounting is an alternative approach for reckoning the time value of money. With the help of this
approach, the present value of a future cash flow or a stream of future cash flows can be determined.
Financial viability of a project is generally measured by the present value approach.

The present value of an annuity ‘A’ receivable at the end of every year for a period of n years at a rate of
interest k is equal to

Above equation can be reduced to

The expression is called the PVIFA (Present Value Interest Factor of Annuity) and it shows
the present value of a regular annuity of Rs. 1 for the given values of k and n.

Formulae

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According to the rule of 72, the doubling period under compurnding is obtained by
dividing 72 by the interest rate.

The process of discounting used for calculating the present value, is simply the inverse
of compounding. The present value formula is –

PV= FV X 1/(1+r)n

The present value of a cash fflow stream is equal to –

n
PVn = ∑ ❑At/( 1+r) t

t =1

An annuity is a stream of constant cash flows (payments or receipts) occuring at

regular intervals of time. When the cash flows occur at the end of each period the
annuity is called a regular annuity or a deferred annuity. When the cash flows occur
at the beginning of each period, the annuity is called an annuity due.

The future value of an annuity is given by the formula-

FVAn = A[(1+r)n-1]/ r.

The present value of an annuity is given by the formula-

PVAn = A{(1 –r)n – 1}/r(1+r)n}

A cash flow that grows at a constant rate for a specified period of time is a growing
annuity. The present value of a growing annuity is given by the following formula.

PV of a Growing Annuity = A(1+g)[1-{(1+g)/ (1+r)}n]/(r-g)

Since the cash flows of an annuity due occur one period earlier in comparison to the
cash flows of an ordinary annuity, the following relationship holds:

Annuity due value = ordinery annuity value x (1+r).

A perpetuity is an annuity of infinite duration. The present value of a perpetuity is –

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 Present value of a perpetuity = A/r

The general formula for the future value of a single cash flow after n years when
compounding is done m times a year is –

FV= PV(1+r/m) mn

The relationship between effective interest rate and the stated annual interest rate is
as follows:

Effective interest rate=

(1+stated annual interest rate)m-1.

The formula for calculating the present value in the case of shorter compounding
period is-

PV= FVn{1/(1+r/m)}mn.

Sinking fund factor

1 r
= =
FVIFA (r % , nyrs) ( 1+r )n−1

Capital recovery factor

1 r ( 1+r )n
= =
PVIFA (r % , nyrs) ( 1+ r )n−1