Concept of Time Value of Money

Time Value of Money

The time value of money is the principle
that a certain currency amount of money
today has a different buying power (value)
than the same currency amount of money in
the future.

The value of money at a future point of time

would take account of interest earned or
inflation accrued over a given period of time.
 Time Value of Money

Value of money varies with

time.

Not only is the amount of money

important, equally important is
the time when is it received or
paid.
 Time preference for money

Time preference for money is an individual’s

preference for possession of a given amount of
money now, rather than the same amount at some
future time.

Three reasons may be attributed to the

individual’s time preference for money:
 Risk
 preference for consumption
 investment opportunities
 Time Value of Money
Time value of money can be said as the
value of money as it is today and what can
be earned after a few years.
It helps taking the decisions such as
Bank deposits
Purchasing a car or house
Retirement plans
Interest plans
Interest earned
Interest paid on loans
 Time Value of Money

What is interest?
The compensation for waiting is the time value of money is
called interest. Interest is a fee
that is paid for having the use of money.
 Required Rate of Return

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 therefore 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 rate + Risk premium.
 Time Value Adjustment

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 - Future Value

 Compounding is the process of finding the future values of cash

flows by applying the concept of compound interest.

 Compound interest is the interest that is received on the original

amount (principal) as well as on any interest earned but not
withdrawn during earlier periods.

 Simple interest is the interest that is calculated only on the original

amount (principal), and thus, no compounding of interest takes place.
 Time Value of Money - Compound Value

Annual Compounding
Multi-period compounding
Compound value of annuity
Compound/Future value of annuity due
Compound value annuity for annuity due.
 Time Value of Money - Compound Value

Annual Compounding
Multi-period compounding
Compound value of annuity
Compound/Future value of annuity due
Compound value annuity for annuity due.
 Time Value of Money - Compound Value

Annual Compounding
Multi-period compounding
Compound value of annuity
Compound/Future value of annuity due
Compound value annuity for annuity due.
Time Value of Money - Annual Compounding

The compound value is the future value of money.

This is calculated for a single cash flow or for a series
of cash flows.
Ex: If an investor deposited Rs 10,00,000 @ 8 % rate
of interest for 5 years. Calculate the amount he would
receive at the end of the period.
Time Value of Money –
Multi Period Compound Value
 Compound value can be calculated for more than one period in a
year.
 It can be calculated semi-annually, quarterly or monthly.
 It the nominal rate is 12% per annum, then the effective rate of
interest would become higher as the interest will be calculated after
every 6 months.
 Ex: Deposit = Rs 10,0000
Interest = 10% compounded semi-annually.
What is the amount received after 1 year and 5 years?
What is the effective rate of return?
 Time Value of Money - Compound Value

The future value varies with the interest rate,

compounding frequency and the number of periods.

If the future value of 1 principal investment is known, we can use it

to calculate the future value
of any amount invested. For example, at 8% interest per period, 1
accumulates as follows:
Future value of 1 at 8% for 1 period = 1.00000 × 1.08 = 1.08000
Future value of 1 at 8% for 2 periods = 1.08000 × 1.08 = 1.16640
Future value of 1 at 8% for 3 periods = 1.16640 × 1.08 = 1.25971
 Time Value of Money - Compound Value
Future Value of a Single Cash Flow
 Let
Amount invested today: A
Rate of interest: r
Period of investment: n
 Then future value F is given by
F = A(1 + r)n

 The process of finding the FV is known as Compounding

Application of interest over interest is known as
compounding.
 Example:
You are investing Rs. 10,000 today in a fixed deposit (FD) with SBI
for 5 years;
SBI pays an interest rate of 5% per annum on a 5-year FD
What is the amount that you will get after 5 years (i.e., FV of your
investment)
 Time Value of Money - Compound Value
XYZ Company invests 40,00,000 in certificates of deposit
that earn 16% interest per year, compounded semi-
annually. What will be the future value of this investment
at the end of 5 years when the company plans to use it to
build a new plant?
 Future Value of a series of payments

Calculated the FV at the end of five years of the

following series of payments at 10% rate of interest.

• R1 = Rs 1000 at end of 1st year

• R2 = Rs 2000 at end of 2nd year
• R3 = Rs 3000 at end of 3rd year
• R4 = Rs 2000 at end of 4th year
• R5 = Rs 1500 at end of 5th year
 Future Value of a series of payments

• FV = Rs 1000 for 4 at 10% = Rs 1464

• FV = Rs 2000 for 3 at 10% = Rs 2662
• FV = Rs 3000 for 2 at 10% = Rs 3630
• FV = Rs 2000 for 1 at 10% = Rs 2200
• FV = Rs 1500 for 0 at 10% = Rs 1500
• SUM = Rs 11456
Time Value of Money - Future Value of an
Annuity
 Time Value of Money - Future Value of an
Annuity
Future Value of an Annuity: Example
 Time Value of Money - Present Value
Present value of a future cash flow (inflow or outflow) is
the amount of current cash that is of equivalent value to the
decision-maker.

Discounting is the process of determining present value of

a series of future cash flows.

The interest rate used for discounting cash flows is also

called the discount rate
Time Value of Money - Present Value of a Single Cash
Flow
Time Value of Money - Present Value of a Single Cash
Flow

Example
Time Value of Money - Present Value of an Annuity
Time Value of Money - Present Value of an Annuity

Example
 Time Value of Money – Sinking Fund

Sinking Fund is fund, which is created out of fixed payments

each period to accumulate to a future sum after the specific
period.

For example companies generally create sinking funds to retire

bonds (debenture) on maturity.