MODULE-2

TIME VALUE OF MONEY

Time Value of Money
In simple terms the concept implies that money today is always better than money
tomorrow.
Peoples prefers current consumption than to future consumption.
TVM is an important concept in financial management. It can be used to compare
investment alternatives and to solve problems involving loans, leases and savings.
The TVM is the idea that money available at the present time is worth more than
the same amount in the future due to its potential earing capacity. This core
principle of finance holds that, provided money can earn interest, any amount of
money is worth more the sooner it is received.
Rate of discount or
Length of the time (n) compound (k)

Direction of time
(PV/FV)
“Time value of money means that a sum of money is worth more now than the same sum of money in the future.”

*This is because money can grow only through investing....

 It's reasonable to assume most people

would choose the first option.

Despite the equal value at time of

disbursement, receiving the $100,000
today has more value and utility to the
beneficiary than receiving it in the future.
Reason for Time value of money
There are certain reason which determine that money has time value following are
the reason:
Risk and Uncertainty: As we know future is never certain and we can not
determine the risk involved in future because outflow of cash is in our hand as
payment where as there is no certainty for future cash inflows.
Inflation: In an inflation economy, the money received today, has more purchasing
power than the money to be received in future.
Consumption: Individuals generally prefer current consumption to future
consumption.
 Investment opportunity: An investor can profitably use the received money today
to et higher return tomorrow or after a certain period of time.
 Basic definition
◦ Present Value – earlier money on a time line
◦ Future Value – later money on a time line
◦ Interest rate – “exchange rate” between earlier money and later money

◦ Present Value (PV)

◦ The current value of future cash flows discounted at the appropriate discount rate
◦ Value at t=0 on a time line
◦ Future Value (FV)
◦ The amount an investment is worth after one or more periods.
◦ “Later” money on a time line
Interest Rates Simple Interest
Interest paid
(earned) on only
the original
amount, or
principal

Interest
Compound Rate
Effective
Interest
Interest
Interest paid
Interest earned
(earned) on any
after adjusting for
previous interest
the number of
earned as well as
compounding
on the principal
periods per year
borrowed
Formula
SI = P0(i)(n)

SI: Simple Interest

P0: Deposit today (t=0)
i: Interest Rate per
Period
n: Number of Time
Periods Formula
CI= P0
Future Value is the value at some future (1+i)n
time of a present amount of money, or a
series of payments, evaluated at a given P0: Deposit today (t=0)
interest rate. i: Interest Rate per
Period
n: Number of Time
Periods
◦ Assume that you deposit $1,000 in an account earning 7% simple interest for 2 years.
What is the accumulated interest at the end of the 2nd year?

◦ FV = P0 + SI = $1,000 + $140 = $1,140

◦ Future Value is the value at some future time of a present amount of money, or a series
of payments, evaluated at a given interest rate.

◦ What is the Present Value (PV) of the previous problem?

◦ The Present Value is simply the $1,000 you originally deposited. That is the value today!

◦ Present Value is the current value of a future amount of money, or a series of payments,
evaluated at a given interest rate.
Future Value single deposit

FV1 = P0 (1+i)1 = $1,000 (1.07)

= $1,070
Compound Interest:
You earned $70 interest on your $1,000 deposit over the first year.
This is the same amount of interest you would earn under simple interest.
Future Value single deposit formula

FV1 = P0 (1+i)1 = $1,000 (1.07)

= $1,070

FV2 = FV1 (1+i)n FV2 = P0

(1+i)(1+i)2 = $1,000(1.07)2
= $1,000(1.07)(1.07) = $1,144.90

You earned an EXTRA $4.90 in Year 2 with compound over simple interest.
◦ Suppose you invest $1000 for one year at 5% per year. What is the future
value in one year?
◦ Interest = 1000(.05) = 50
◦ Value in one year = principal + interest = 1000 + 50 = 1050
◦ Future Value (FV) = 1000(1 + .05) = 1050

◦ Suppose you leave the money in for another year. How much will you have
two years from now?
◦ FV = 1000(1.05)(1.05) = 1000(1.05)2 = 1102.50
Effects of Compounding

◦ Simple interest
◦ Compound interest
◦ Consider the previous example
◦ FV with simple interest = 1000 + 50 + 50 = 1100
◦ FV with compound interest = 1102.50
◦ The extra 2.50 comes from the interest of .05(50) = 2.50 earned on the first
interest payment.
 Future Values – Example 2
◦ Suppose you invest the $1000 from the previous example for 5 years. How much
would you have?
◦ FV = 1000(1.05)5 = 1276.28
◦ The effect of compounding is small for a small number of periods, but increases as
the number of periods increases. (Simple interest would have a future value of
$1250, for a difference of $26.28.)
Future Values – Example 3

◦ Suppose you had a relative deposit $10 at 5.5% interest 200 years ago. How
much would the investment be worth today?
◦ FV = 10(1.055)200 = 447,189.84
◦ What is the effect of compounding?
◦ Simple interest = 10 + 200(10)(.055) = 120.00
◦ Compounding added $447,069.84 to the value of the investment
Measurement of Present Value
FV = PV(1 + r)t
PV = FV / (1+r)t
◦ Where:
◦ FV = the future value of money
PV = the present value
r = the interest rate or other return that can be earned on the money
t = the number of years to take into consideration
 Discount rate
Discount rate represents the way money now is worth more
than money later, which is also how discount rate actually
represents this phenomenon. It indicates how much a future
amount is reduced to make it correspond to an equivalent
amount today. Discounting is the key process by which costs
and benefits incurred at different time points are compared.
Present Values
◦ How much do I have to invest today to have some amount in the future?
◦ FV = PV(1 + r)t
◦ Rearrange to solve for PV = FV / (1 + r)t
◦ When we talk about discounting, we mean finding the present value of
some future amount.
◦ When we talk about the “value” of something, we are talking about the
present value unless we specifically indicate that we want the future value.

5-19
 Present Value – One Period Example
◦ Suppose you need $10,000 in one year for the down payment on a new car. If you can earn
7% annually, how much do you need to invest today?
◦ PV = 10,000 / (1.07)1 = 9345.79
◦ Calculator
◦ 1N
◦ 7 %/Y
◦ 10,000 FV
◦ PV = 9345.79

5-20
 Annuity
An annuity is a financial instrument issued and backed by an insurance company that
provides guaranteed monthly income payments for the life of the contract, regardless of
market conditions. You can customize an annuity based on a variety of options, including
how long you think you’ll live, when you want your payments to start and whether you
want to leave your income stream to a beneficiary after your death.
An annuity is a series of periodic cash flows of equal amounts. The premium payments of
a life insurance 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
due.
 Importance of TVM
Allows investors to adjust cash flows for the passage o time
It is an integral part of Capital Budgeting Processes.
Applied in present and future value calculations.

Perpetuity: A perpetuity is a security that pays for an infinite amount of time.

In finance, perpetuity is a constant stream of identical cash flows with no end.
 Practical applications of the time value of money
 Project selection: Time value of money is most importantly used in discounting cash
flow analysis. Before selecting any project, the cash flows that will be generated during
the lifetime of the project are listed. These cash flows include both cash inflows and cash
outflows. The future cash flows are discounted using the TVM formula and the present
value of these cash flows are identified. The initial investment and the discounted cash
flows are added to identify the Net Present Value (NPV) of the project. This may be done
for multiple projects and the project with the highest net present value is selected by
companies.
 Sinking fund: Finance managers of companies may decide to set aside an amount in case
of redemption of debentures in the future. The future value that is required for redemption
is set. However, the funds that must be periodically set aside for the sinking fund must be
decided based on the compounding interest rate. This amount can be calculated using the
formula of the time value of money.
 Capital recovery: The loans obtained by companies must be repaid in specific installments. Upon
identifying the number of installments, the size of installments must be identified. That is, the
amount that will be paid back in each installment must be calculated. This can once again be done
using the formula of the time value of money.

 Deferred payment: A company after obtaining a loan need not start paying interest immediately.
The interest can accumulate, and the company can start repayment even after two years. This
delayed payment of interest is called the deferred payment. The loan obtained would change in value
over two years because of the time value of money. Therefore, to calculate the annual installment
amount, the formula of TVM can be used.

 Implicit rate of return: Finance companies offer certain schemes where a large amount of money
is invested at the beginning of a period and the return on investment is given back to the investor
periodically in the form of an annuity. The time value of money can be used in calculating the value
 Risk and Return
 Income received on an investment plus any change in the market price, usually
express as a percent of the beginning market price of the investment.
 Risk and return in financial management is the risk associated with a certain
investment and its returns. Usually, high-risk investments yield better financial
returns, and low-risk investments yield lower returns. That is, the risk of a particular
investment is directly related to the returns earned from it.
Concept of Risk: A person making an investment expects to get some returns from the
investment in the future. However, as future is uncertain, the future expected returns too
are uncertain. It is the uncertainty associated with the returns from an investment that
introduces a risk into a project.
 Risk and return in investing are perhaps the most crucial parameters considered by
investors while choosing an investment option. Individuals who invest on a large scale
analyze the risks involved in a particular investment and the returns it can yield.
Relationship Between Risk and
Return: The correlation
between financial risk and return is
fairly simple to comprehend. The risk
in choosing a certain investment is
directly proportional to the returns.
Therefore, selecting a high-risk
investment can give higher profits,
while a low-risk investment will
minimize the returns.
 Types of Risk
Broadly speaking, there are two main categories of
risk: systematic and unsystematic. Systematic risk
is the market uncertainty of an investment, meaning
that it represents external factors that impact all (or
many) companies in an industry or group.
Unsystematic risk represents the asset-specific
uncertainties that can affect the performance of an
investment.
◦ Unsystematic Risk
◦ Unsystematic risk is that portion of risk which can be minimize through
diversification of the investment by forming portfolio. If we form a portfolio using
the negatively correlated investment securities then it would be possible to minimize
the risk at lower level. This types of risk is known as diversiable risk Theoretically it
is possible to eliminate the portion of unsystematic risk but in real sense it is not
possible to eliminate the risk through diversification.
◦ Systematic Risk
◦ Systematic risk is that portion of risk which cannot minimize through diversification
of the investments. Systematic risk is mainly arisen from the macro economic
variables which are beyond our control. Beta is the measure of the systematic risk.
Sometimes this risk is also known as systematic market risk. Sources of systematic
risk are given below with short explanation.
Business Risk: Business risk is the risk which mainly arise when a firm or business
organization unable to generate sufficient revenue to maintain its operating expenditure
through providing service or selling products, that is risk is directly related with the operation
of the firm.
Financial Risk: When a firm is unable to pay off its fixed financial obligation then this type of
risk may arise. This type of risk is involved with the levered firm which uses debt capital for
business. In some cases this risk can lead a lead a company to bankruptcy.
Liquidity Risk: This risk is involved with the marketability of a security or investment that is
the capacity to generate asset into cash as much quicker as possible. If an investment is takes
less time to convert into cash then it is liquid asset or investment.
Country Risk: Unstable political condition of a country is responsible for this type of risk. If
this risk is more than an economy definitely fall, so does business. In our Bangladesh this type
of risk is higher.
Exchange Rate Risk: Exchange of currency is required when a country is involved with
import and export. For importing product or services foreign currency basically dollar is used.
So if there is more fluctuation of the exchange rate frequently then a business may incur loss.
This probable loss is the risk for the business.
The term ‘beta’ (β) is extensively used in
investments, particularly in capital
markets. It is used in the Capital Asset
Pricing Model (CAPM). Beta is a measure
of the systematic risk or market volatility
of a portfolio or specific security against
the benchmark or market in general.
Beta (β) is used in the CAPM, which
describes the relationship between
systematic risk and expected return for
assets (usually stocks). CAPM is widely
used as a method for pricing risky
securities and for generating estimates of
the expected returns of assets, considering
both the risk of those assets and the cost
of capital. *Stocks with betas higher than 1.0 can be interpreted
as more volatile than the S&P 500.
Beta (β), primarily used in the capital asset pricing model (CAPM), is a measure of the
volatility or systematic risk of a security or portfolio compared to the market as a whole.
Beta data about an individual stock can only provide an investor with an approximation
of how much risk the stock will add to a diversified portfolio.
For beta to be meaningful, the stock should be related to the benchmark that is used in
the calculation.
The S&P 500 has a beta of 1.0.
Stocks with betas above 1 will tend to move with more momentum than the S&P 500;
stocks with betas less than 1 with less momentum.
Types of Beta Values
Beta Value Equal to 1.0: If a stock has a beta of 1.0, it indicates that its price
activity is strongly correlated with the market. A stock with a beta of 1.0 has
systematic risk. However, the beta calculation can’t detect any unsystematic
risk. Adding a stock to a portfolio with a beta of 1.0 doesn’t add any risk to the
portfolio, but it also doesn’t increase the likelihood that the portfolio will
provide an excess return.

Beta Value Less Than One: A beta value that is less than 1.0 means that the
security is theoretically less unstable than the market. Including this stock in a
portfolio makes it less risky than the same portfolio without the stock. For
example, utility stocks often have low betas because they tend to move more
slowly than market averages.
Beta Value Greater Than One: A beta that is greater than 1.0 indicates that the security's
price is theoretically more volatile than the market. For example, if a stock's beta is 1.2, it
is assumed to be 20% more volatile than the market. Technology stocks and small cap
stocks tend to have higher betas than the market benchmark. This indicates that adding the
stock to a portfolio will increase the portfolio’s risk, but may also increase its expected
return.

Negative Beta Value: Some stocks have negative betas. A beta of -1.0 means that the
stock is inversely correlated to the market benchmark on a 1:1 basis. This stock could be
thought of as an opposite, mirror image of the benchmark’s trends. Put options and inverse
Exchange Traded Fund (ETFs) are designed to have negative betas. There are also a few
industry groups, like gold miners, where a negative beta is also common.
 Market risk premium
The market risk premium is the additional return
an investor will receive (or expects to receive)
from holding a risky market portfolio instead of
risk-free assets.
A risk premium is a return on investment above
the risk-free rate that an investor needs to be
compensated for investing in higher-risk
investments. Put simply, the more risk an
investment has, the higher the return an investor
needs to make it worthwhile.

Market Risk Premium Formula & Calculation

Market Risk Premium = Expected Rate of Return – Risk-Free Rate

 Concepts Used to Determine Market Risk Premium
There are three primary concepts related to determining the premium:
Required market risk premium: the minimum amount investors should accept. If an
investment’s rate of return is lower than that of the required rate of return, then the
investor will not invest. It is also called the hurdle rate of return.
Historical market risk premium: a measurement of the return’s past investment
performance taken from an investment instrument that is used to determine the
premium. The historical premium will produce the same result for all investors, as the
value’s calculation is based on past performance.
Expected market risk premium: based on the investor’s return expectation.
Risk-return trade-off definition

The risk-return trade-off states that the level of return to be earned from an
investment should increase as the level of risk goes up. Conversely, this means
that investors will be less likely to pay a high price for investments that have a
low risk level, such as high-grade corporate or government bonds.
Q1. If you deposit Rs. 1,000 in the bank at a nominal interest rate of 6 percent,
you will have Rs. 1,060 at the end of the year. Suppose that the inflation rate
during the year is also 6 percent. Find real amount in Rupees?
Q2. You save Rs. 1000 and invest it at a nominal interest rate of 8%. Given the
expected inflation is 5% per year, what is the real rate of return?
Q4. Suppose the current market value of Rs. 100 and no dividend income after
one year. Find expected rate of return?
Outcome (After One Year) Probability (%)
“Bull Market” (Stock price P1*=140) 30% or 0.3

“Normal Market” (Stock price P1*=110) 40% or 0.4

“Bear Market” (Stock price P1*=80) 30% or 0.3

100% or 1.0
 Standard Deviation
 Standard deviation is a basic mathematical concept that measures volatility in the
market or the average amount by which individual data points differ from the mean.
Simply put, standard deviation helps determine the spread of asset prices from their
average price.
 When prices swing up or down significantly, the standard deviation is high, meaning
there is high volatility. On the other hand, when there is a narrow spread between
trading ranges, the standard deviation is low, meaning volatility is low. What can we
determine by this? Volatile prices mean standard deviation is high, and it is low when
prices are relatively calm and not subject to wild swings.
 It is a measure of how much an investment's returns can vary from its average return.
It is a measure of volatility and, in turn, risk. Finding out the standard deviation as a
measure of risk can show investors the historical volatility of investments. The higher
the standard deviation, the more volatile or risky an investment may be.
Where:
ri = actual rate of return
r average = rate of return
n = number of time periods
Note: For math-oriented readers, standard deviation is the square root of the
variance.
Let’s say you invest in Company XYZ which has returned an average of 10% per year for
the last 10 years. We’ll compare how risky this stock is compared to Company ABC.
We’ll take a closer look at the year-by-year returns that compose that average:
Let’s start by calculating the standard deviation for Company XYZ
stock.

Next, we add up column D (3,850), then divide

that number by the number of time periods minus
one (10-1=9). This is called the unbiased approach
and it’s important to remember that some investors
calculate standard deviation using all time periods
(10 in this case, rather than nine).
Then we take the square root of the result::
Standard deviation = √(3,850/9) = √427.78 =
0.2068 or 20.68%.
Using the same process, we can calculate that the
standard deviation for the less volatile Company
ABC stock is a much lower 0.0129 or 1.29%.