TIME VALUE OF MONEY

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 Learning outcomes…
Relationship between the value of money today and
in the future
To value cash flows that occur at different points in
time
How much would you need to invest today to
produce a specified future sum of money?
Difference between the quoted interest rate and
true/effective interest rate

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 What would you prefer? Why?

Rs. 100 Rs. 100

today next year

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 What would you prefer? Why?

Rs. 100 Rs. 100

today next year

You would prefer receiving Rs. 100 today as you

can invest that money on your own and earn
interest.

Money has a time value

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•Most financial decisions affect the firm’s cash flows
in different time periods. For example-
•Purchase of a fixed asset- immediate cash outlay and
cash inflows during many future periods.
•Loan from a bank- receive cash now and pay interest
and principal in future periods.
•The absolute cash flows, which differ in timing and
risk, are not directly comparable.
•Sound decision-making requires cash flows to be
logically comparable.
•Hence, cash flows should be appropriately adjusted
for the differences in timing and risk.
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 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

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Future Value of a Single Cash Flow
Suppose you invest Rs. 100 in a bank account that
pays interest of r = 10% yearly.

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 Future Value of a Single Cash Flow
The general form of equation for calculating the future
value of a cash flow after t periods may, therefore, be
written as follows:

Your wealth grows at a compound rate, and the interest

that you earn is called compound interest.

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 Future Value of a Single Cash Flow
The higher the interest rate (r) the faster your savings will
grow.
The longer you invest for (t) the more your savings will
grow.

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 Present Value of a Single Cash Flow
The general form of the equation for calculating the
present value of a cash flow to be received after t periods
may, therefore, be written as follows:

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Present Value of a Single Cash Flow

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 Time Value Adjustment

Two most common methods of adjusting cash flows

for the 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.

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Let us assume that your required interest rate is 10%. If you
are offered INR 115.50 one year from now in exchange for INR
100.00 which you should give up today, should you accept the
offer?

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 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 might be exposed to some degree of risk.
Therefore, he would require a rate of return, called risk
premium, from the investment, which compensates for
risk.
The investor’s required rate of return is:
RRR = Risk-free rate + Risk premium
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 Required Rate of Return
The risk-free rate compensates for time.
The risk premium compensates for risk.
The required rate of return is the opportunity cost of
capital in comparable risk.
The required rate of return permits to convert cash
flows occurring at different times to amounts of
equivalent value in the present, i.e., a common point of
reference.

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Suppose that Rs 1,000 are placed in the savings account
of a bank at 5% interest rate. How much shall it grow at
the end of three years?

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Suppose that an investor wants to find out the present
value of Rs. 50,000 to be received after 15 years. The
interest rate is 9%.

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 Future Value of an Annuity
Annuity is a fixed amount (payment or receipt) each
year for a specified number of years.
If you rent a flat and promise to make a series of
payments over an agreed period, you have created an
annuity.
The equal instalments of housing loans.

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Suppose a constant sum of Re 1 is deposited in a savings
account at the end of each year for four years at 6% interest.
Compute the future value of the annuity at the end of fourth
year.

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 Future Value of an Annuity

𝐹𝑛 = 𝐴(1 + 𝑟)𝑛−1 + ⋯ + 𝐴(1 + 𝑟)1 +𝐴(1 + 𝑟)0

(1 + 𝑟)𝑡 −1
𝐹𝑡 = 𝐴
𝑟

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Suppose that a firm deposits Rs. 5,000 at the end of
each year for four years at 6% rate of interest. How
much would this annuity accumulate at the end of the
fourth year?

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 Sinking Fund
A fund, which is created out of fixed payments each
period to accumulate to a future sum after a specified
period.
𝑟
𝐴 = 𝐹𝑡
(1 + 𝑟)𝑡 −1

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Suppose we want to accumulate Rs. 21,873 at the end of
four years from now. How much should we deposit each
year at an interest rate of 6% so that it grows to Rs. 21,873
at the end of fourth year?

𝐴 = 𝑅𝑠. 4,999.98 ~ 𝑅𝑠. 5,000

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 Present Value of an Annuity
Suppose a constant sum of Re 1 is deposited in a savings account
at the end of each year for four years at 10% interest. Compute
the present value of the annuity.

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 Present Value of an Annuity

The computation of the present value of an annuity can be

written in the following general form:

𝐴 1
𝑃 = 1− 𝑡
𝑟 1+𝑟

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A person receives an annuity of Rs 5,000 for four years. If
the rate of interest is 10%, the present value of annuity is?

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Capital Recovery and Loan Amortisation
The annuity of an investment made today for a specified
period of time at a given rate of interest.

It helps in the preparation of a loan amortisation (loan

repayment) schedule.

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Suppose you have borrowed a 3-year loan of Rs 10,000 at 9%
from your employer to buy a motorcycle. If your employer
requires three equal end-of-year repayments, then the annual
instalment will be?

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 Interest Principal Outstanding
End of Year (a) Installment (b) payment (c) = repayment (d) = balance
r%*e b-c (e) = 𝒆𝒕−𝟏 − 𝒅

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 Present Value of Perpetuity
Perpetuity is an annuity that occurs indefinitely.

Perpetuity
Present value of a perpetuity 
Interest rate

An investor expects a perpetual sum of Rs. 500 annually

from his investment starting one year from now. What is
the present value of this perpetuity if interest rate is
10%?

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Present Value of an Uneven Cash Flows
•Investments made by a firm do not always yield constant
periodic cash flows.
•In most instances, the firm receives a stream of uneven cash
flows.
•Thus, the present value factors for an annuity cannot be used.
•The procedure is to calculate the present value of each cash
flow and aggregate all present values.
𝐶1 𝐶2 𝐶3 𝐶𝑇
𝑃𝑉 = 1
+ 2
+ 3
+ ……..+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑇
𝑇
𝐶𝑡
𝑃𝑉 = ෍
(1 + 𝑟)𝑡
𝑡 =1 31
Consider that an investor has an opportunity of receiving Rs
1000, Rs 1500, Rs 800, Rs 1100 and Rs 400 respectively at the
end of one through five years. Find out the present value of this
stream of uneven cash flows, if the investor’s required interest
rate is 8%.

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 Present Value of Growing Annuity

In financial decision making, there are a number of

situations where cash flows grow at a constant rate.
For example, in the case of certain companies, dividends
are expected to grow at a constant rate.

𝑡
𝐴 1+𝑔
𝑃= 1−
𝑟−𝑔 1+𝑟

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Present Value of Growing Perpetuity

In financial decision-making there are number of

situations where cash flows may grow at a constant
rate.
𝐴
𝑃=
𝑟−𝑔

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 Future Value of an Annuity Due
•The concepts discussed till now are based on the
assumption that series of cash flows occur at the end of
the period.
•In practice, cash flows could take place at the beginning of
the period.
•Example: Buying a fridge on an instalment basis, lease
contracts, etc.
•Annuity due is a series of fixed receipts or payments
starting at the beginning of each period for a specified
number of periods.
𝐹𝑡 = 𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑋 (1 + 𝑟)
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Suppose you deposit Re 1 in a savings account at the
beginning of each year for 4 years to earn 6% interest?
How much will be the compound value at the end of 4
years?

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 Present Value of an Annuity Due
Let us consider a 4-year annuity of Re 1 each year, the
interest rate being 10%. What is the present value of this
annuity if each payment is made at the beginning of the
year?
𝑃𝑡 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑋 (1 + 𝑟)

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 Multi-Period Compounding
•Assumption so far- cash flows occurred once a year. In
practice, cash flows could occur more than once a year.
•For example, banks may pay interest on savings account
quarterly.
•The interest rate is usually specified on an annual basis, in
a loan agreement or security and is known as the nominal
interest rate.
•If compounding is done more than once a year, the actual
annualised rate of interest would be higher than the
nominal interest rate and it is called the effective interest
rate.
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Suppose you invest Rs 100 now in a bank, interest rate
being 10% a year, and that the bank will compound
interest semi-annually (i.e., twice a year). How much
amount will you get after a year?

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 Effective Interest Rate
n m
 i
EIR = 1   –1
 m

•i - annual nominal rate of interest

•n - number of years
•m - number of compounding per year
•In annual compounding m = 1; in semi-annual
compounding m = 2; in quarterly compounding m = 4; in
monthly compounding m = 12, and in weekly
compounding m = 52.
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 Multi-Period Compounding
•For computing the compounded value of a sum in case of
the multi-period compounding:

•The compound value of an annuity in case of the multi-

period compounding is given as follows:

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Let us find out the compound value of Rs 1,000, interest
rate being 12% per annum if compounded annually, semi-
annually, quarterly and monthly for 2 years.

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 Continuous Compounding
•The continuous compounding or daily compounding
function takes the form of the following formula:
Fn  P  ei n  P  e x

•Present value under continuous compounding:

Fn  i n
P  i n  Fn × e
e

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Let us find out the compound value of Rs 1000, interest
rate being 12% per annum if compounded continuously for
2 years.

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