Time Value of Money

 Animportant principle in finance is that the value of

money is time dependent.
 The value of a unit of money is different in different
time periods.
 The value of a sum of money received today is more
than its value received after some time.
 Conversely, a sum of money received in future is
less valuable than it is today.
 The time value of money is also referred as time
preference for money.
Reasons for Time Value of
Money
Investment Opportunities:
Money has the potential to grow over a period of time because it can
be invested somewhere. For example, if Rs. 1000 can be invested in a
fixed deposit for one year at 7% p.a., the money will grow to Rs, Rs.
1070 at the end of one year. Therefore, given the choice of Rs. 1000
now or the same amount in one year’s time, it is always preferable to
take Rs. 1000 now.
Inflation:
Inflation is the fall in the purchasing power of money. It makes
money cheaper and the goods and services costlier. Suppose you
can buy 1 kg of rice with Rs. 50 today. If the inflation rate is
10%, You need Rs. 55 to buy 1 kg of rice a year from now.
Reasons for Time Value of Money
 Risk:
Money received now is certain, whereas money tomorrow is
less certain. This ’bird in the hand’ principle is extremely
important in investment appraisals.
 Personal consumption preference :
Many people have a strong preference for immediate rather
than delayed consumption. For a hungry man, promise of a
meals next month means nothing.
 Techniques
 There are two types of techniques:
1. Compounding Technique
2. Discounting Technique
 Compounding Techniques

 Incompounding technique, interest is added

(compounded) to the initial deposit (principal)
and becomes part of the principal at the end of
each compounding period.
 Annual compounding, semi-annual compounding,
quarterly compounding, monthly compounding
etc.
Compounding Technique
Formula
A = P (1+i)n
In which,
A = Amount at the end of the period
 P= Principal at the beginning of the period
i = Rate of interest
 N= number of years
Compounding Technique
Formula
 For semi-annual compounding, the formula is:
A = P (1+i/2)n x2
 For quarterly compounding, the formula is:
A = P (1+i/4)n x4
 Alternatively,for compounding more than once a year,
the formula can be expressed as:
A = P (1+i/m)n xm
Where m = number of times per year compounding is
made.
Discounting Technique

 Theact of estimating the present value of a

future payment or a series of cash flows that are
to be received in the future.
A discount rate (also referred to as the discount
yield) is the rate used to discount future cash
flows back to their present value.
Discounting Technique
Formula

Where:
FV is used to denote the future value of cash flow
r is used to denote the discount rate
t is used to denote the time period that an
investment will be held for
NPV [Net Present Value]
 Thepresent value can also be the sum of all
future cash flows discounted back. It is known as
the Net Present Value (NPV).
NPV = F / [ (1 + i)^n ]
Where,
PV = Present Value
F = Future payment (cash flow)
i = Discount rate (or interest rate)
n = the number of periods in the future the cash
flow is
Discount Rates
 The discount rate is the interest rate used to
determine the present value of future cash flows in
a discounted cash flow (DCF) analysis.
 Discount rates can be used to account for risk
associated with a potential investment and the time
value of money. The rate also represents a
company’s opportunity cost and can act as a hurdle
rate used for decision making.
Types of Discount Rates
Weighted Average Cost of Capital (WACC):
Normally used to compute a company’s enterprise
value.
Cost of equity: Can be used to calculate a
company’s equity value.
Cost of debt: Used for bond and fixed-income
security valuation.
A pre-defined hurdle rate: Generally used in
evaluating corporate projects that are internal and
to account for the time value of money
 Risk-free rate: Used in calculating the cost of
equity (as calculated using the CAPM)
Bibliography
 Financialmanagement : Dr Sangeeta Sahni , Dr
Rahul Mehrotra
 https://corporatefinanceinstitute.com/resources/
valuation/discounting/
Name : Pratiksha Pandey
Course : BBA ( Bachelor’s of
Business administration)
Year /Semester : 2nd year/ 3rd
semester