ENGINEERING ECONOMICS

& MANAGEMENT
Time value of money
Lecture 12
“Time value of money”
 Introduction
 The time value of money (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 earning 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.

 Time Value of Money (TVM) is an important concept in

financial management. It can be used to compare
investment alternatives and to solve problems involving
loans, leases, savings.
Cont..

 TVM help us in knowing the value of money invested.

As time changes value of money invested on any
project/ firm also changes. And its present value is
calculated by using “mathematical formula”, which tell
us the value of money with respect of time. i.e.
 Reason for Time value of Money

 There are certain reason which determine that money has

time value following are the reason;
1. Risk and Uncertainty – As we know future is never
certain and we can’t determines 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.
2. Inflation - In an inflationary economy, the money received
today, has more purchasing power than the money to be
received in future. In other words, a rupee today
represents a greater real purchasing power than a rupee
in future.
Cont..

3. Consumption - Individuals generally prefer

current consumption to future consumption.
4. Investment opportunities - An investor can profitably
use the received money today to get higher return
tomorrow or after a certain period of time.
e.g.- if an individual is given an alternative either to
receive Rs.10,000 now or after one year, he will prefer
Rs.10,000 now. This is because, today, he may be in a
position to purchase more goods with this money than
what he is going to get for the same amount after one
year.
 Importance of TVM

1. In Investment Decisions - Small businesses often

have limited resources to invest in business
operations, activities and expansion. One of the
factors we have to look at is how to invest, is the time
value of money.
2. In Capital Budgeting Decisions - When a business
chooses to invest money in a project - such as an
expansion, a strategic acquisition or just the
purchase of a new piece of equipment -- it may be
years before that project begins producing a positive
cash flow. The business needs to know whether
those future cash flows are worth the upfront
Cont..

Example showing methods how TVM is used by firm in

making different decision;
Companies apply the TVM in various ways to make yes-or-no
decisions on capital projects as well as to decide between
competing projects. Two of the most popular methods are net
present value and internal rate of return, or IRR. In the first
method, you add up the present values of all cash flows
involved in a project. If the total is greater than zero, the project
is worth doing.
In the IRR method, you start with the cost of the project and
determine the rate of return that would make the present
value of the future cash flows equal to your upfront cost. If
that rate -- called the internal rate of return -- is greater than
your discount rate, the project is worth doing. The higher
the IRR, the better.
 Valuation concepts.

The time value of money establishes that there is a preference

of having money at present than a future point of time. It
means;
 If an individual is given an option A to receive Rs.10,000 now or
option B after three year, he will prefer Rs.10,000 now
because although the amount is the same, you can do much
more with the money if you have it now because over time
you can earn more interest on your money. By receiving
Rs.10,000 today you can increase the future value of your
money by investing and gaining interest over a period of time.
For Option B, you don't have time on your side, and the
payment received in three years would be your future value.
Cont..

If you are choosing Option A, your future value will be

Rs.10,000 plus any interest acquired over the three years.
The future value for Option B, on the other hand, would
only be Rs.10,000. So how can you calculate exactly how
much more Option A is worth, compared to Option B. To
illustrate, we have provided a timeline:
Cont..

 As we prefer to choose to option A for receiving the

amount and invest the total amount at a simple annual
rate of 4.5%, the future value of your investment at the
end of the first year is Rs.10,450, as on end of second
year it will be Rs.10,920.25 and same continued as third
year and as on end of third year the amount will be
Rs.11411.66

 Figure shows how value of

money is increasing by the
time.
Cont..

Ques. At the end of 3rd year what amount we will get or what will
be the future value of Rs.10,000 at rate of 4.5%
uniformly.
Solution; 𝐹
As we know 𝑉 𝐹𝑉 = 𝑃𝑉 (1 + 𝑖
) 𝑛
(1+𝑖)𝑛
PV=

•where, PV= Rs.10,000 , i= 4.5% and n= 3 years Therefore,

•FV= 10,000 ( 1 + 0.045)3

• = 10,000 (1.045) 3 = 10,000 (1.14116612)

• = Rs.11411.66 ( at the end of the 3rd year)
 Techniques of time value of
money.
There are two techniques for adjusting time value of
money. They are:
1.Compounding Techniques/Future Value Techniques
The process of calculating future values of cash flows.
In this concept, the interest earned on the initial
principal amount
becomes a part of the principal at the end of the
compounding period.
2. Discounting/Present Value Techniques
The process of calculating present values of cash
flows.
 Methods of calculating future value.

 Compounding. - It is the process of finding the future

values of cash flows by applying the concept of
compound interest.
 Compound interest. - It 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. - It is the interest that is calculated
only on the original amount (principal), and thus, no
compounding of interest takes place.
 Conclusion
 By all the above discussion we get to know about the
value of money with respect to time.
 We learn the importance of TVM how it will help in
making different decision which will provide profit to
firm.
 We get to know how future value and present value of
money is calculated.
 What are different techniques and methods for
calculating TVM.
 How comparison between different project is done by
the firm on the basis of return.
Thanks!