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Published by Rishabh Gupta
This document is part of the subject financial management. Topic name time value of money
This document is part of the subject financial management. Topic name time value of money

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Published by: Rishabh Gupta on Nov 13, 2008
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U N IT1 0
T IM E V A L U E O F M O N E Y
S tru ctu re
1 0 .1 Illtro d u c tio n
O b je c tiv e s
1 0 .2 R e le v a n c e o f th e C o n c e p t
1 0 .3 F in a n c ia l M a rk e ts
10.4 InterestFactor
1 0 .4 .1 ~ e a s o h sf or H aving Illterest
1 0 .4 .2 P a r tie s P o in t o f V ie w
1 0 .4 .3 In terest R ate
1 0 .4 .4 In terest C a lc u la tio n s
1 0 .4 .5 F r e q u e n c y o f C o m p o u n d iu g
1 0 .4 .6 A v e r a g e ln te r e st E stim a tio n
10.5 Interest and D iscount Form ulae
1 0 .6 In te re s t T a b le s
1 0 .7 T im e V a lu e o f M o n e y a n d M a n a g e ria l D e c is io n s
1 0 .8 S te p -b y -s te p P ro c e d u re fo r S o lv in gt l ~ eT im e V a lu e R e la te d P r o b le n ~ s
1 0 .9 S u m m a ry
1 0 .1 0 A n sw e rs to SA Q s
M o s t b u s in e s s v e n tu re s in v o lv e u tilis a tio n o f o th e r p e o p le 's m o n e y . T l ~ ep ro p e r s o u rc in g
o f f u n d s a n d th e o p tim u m u tilis a tio n o f th e f u n d s , s o ra is e d p la y im p o rta n t ro le in th e
successful conduct of financial m anagem ent. T h e m ain problem
in fin a n c ia l m a n a g e m e n t

is th a t th e fu n d s a re ra is e d a t d iffe re n t p o in ts o ftim e a n d a re e m p lo y e d in to th e b u s in e s s a t d iffe re n t p o in tso f tim e . M a tc h in g th e tim in g s o f ris eo f fu n d s a n d th e e m p lo y m e n t o f fu n d s a n d o p tim iz in g th e tim e re la te d c o s ts a re v e ry c ru c ia l fo r th e s u c c e s s o f afilla n c e m a n a g e r. In th is c o n te x t 'tim e v a lu e o f m o n e y ' b e c o m e s im p o rta n t.

O b je c tiv e s
A fte r s tu d y in g th is u n it, y o u s h o u ld b e a b le to
in d ic a te th e re le v a n c e o f tim e v a lu e c o n c e p t,
la lo w a b o u t c a p ita l a n d m o n e y n la rk e ts ,
analyse reasons for having interest,
u s e th e in te re s t ra te fo rm u la e a n d a c q u a in t y o u rs e lf w ith th e a p p lic a b ility
a s p e c ts o f tim e v a lu e c o n c e p ts , a n d
w o rk o u t p ro b le m s in v o lv in g tiln e v a lu e o f m o n e y c o n c e p tsa r i d u se th e tim e
v a lu e ta b le s .
1 0 .2
RELEVANCE OF THE CONCEPT

T h e tim e v a lu e c o n c e p t o f m o n e y a s s u m e s in lp o rta n c e b e c a u s e o f th e f a c t th a t f u tu r e is a lw a y s a s s o c ia te d w ith u n c e rta in ty . A ru p e e in1 1 :u ld t o d a y i s v a l u e d h i g h e r t h a n t h e o n e ru p e e th a t is e x p e c tin g to b e re c o v e re d to m o rro w . T h e fo llo w in g a re p o in ts th a t c o m e in

s u p p o rt o f th e f a c t th a t'th e c o n c e p t o f tim e v a lu e o f m o n e y is q u ite re le v a n t in a n y a re a o f
d e c is io n m a k in g
:
(a )

T h e p u rc h a s in g p o w e r o f m o n e y o v e r p e rio d o f tim e g o e s d o w n in re a l tim e s . T h a t m e a n s , th o u g h n u m e ric a llyL l ~ es a m e , t h e p u r c h a s i n g p o w e r o f o n e r u p e e to d a y is c o n s id e re d to b e h ig he c o m ) t n i c a l l y t l ~ m i t s v a l u e a s o n a f u t u r e d a t e .

(b )
In d iv id u a ls p re fe r p re s e n t c o n s u m p tio n to fu tu re c o n s u tn p tio n . T h is is b e c a u s e
o f th e ris k a n d u n c e rta in ty a s s o c ia te d w ith fu tu re .
M a n a g e r ia lC or~trol
S tr a te g ie s
(c )
T h e re is a lw a y s re la te d c o s ts in a n y in v e s tm e n t. T h e s e c o s ts te n d to b rin g d o w n
fu tu re v a lu e o f m o n e y .
(d )

In fin a n c ia l m a n a g e m e n t, m o st o f t l ~ ep ro b le m s in v o lv e c o s t-flo w s o c c u rrin g a t d iffe re n t p o in ts o f tim e . F o r e v a lu a tio n a n d c o m p a ris o n o n a n u n ifo rm b a s is . th e concept of tiln e v a lu e o f m o n e y is u s e d .

(e )
T he concept is also im portant for purpose of valuation of shares and firm ..
1 0 .3
F IN A N C IA L M A R K E T S
F o r u n d e rs ta n d in g th e c o n c e p t o f tim e v a lu e o f m o n e y , a n in s ig h t in to th e fin a n c ia l

m a rk e ts is q u itein lp o rta n t.A fin a n c ia l m a rk e t is a p la c e w h e re m o n e y i s tra d e d . J u s t ta k e a n y o th e r m arket, there are buyers arid sellersi n the segm ent of m arket too.T ile huyers of m oney or funds ,arep e o p l e l e n t r e p r e n e u r s 1 i n d u s t r i a l i s L ~w h o h a v e v ia b le p ro je c ts w i t l ~ th e m a n d w h o a re lo o k in g o u t fo r s o u rc e s o f fin a n c e . T h e s e lle rs o f th e m o n e y a re p e o p le w ho have surplusm oneylfunds and w ho are ready to lend the sam e on agreed term s. T he a g re e dte rn ls n lo s tly c e n tre a ro u n d th e in te re s t a n d p rin c ip a l re p a y m e n t s c h e d u le . S in c e th e b o rro w in g sa n d re p a y m e n ts ta k e p la c e a t d iffe re n t p o in ts o f tim e th e in te re s t fa c to r p la y s a v e ry im p o rta n t ro le .

T h e fin a n c ia l m a rk e ts c a n b e b ro a d ly c la s s ifie d in to tw o c a te g o rie s ,i.e . th e c a p ita ll
in v e s tm e n t m a rk e ts ;m d in o n e y m a rk e ts . T h o u g h a c le a r d is tin c tio n b e tw e e n th e tw o is

n o t a lw a y s c le a r b e c a u s e o f o v e rla p p in g s , it is th e le n g th o f tim e w h ic h d is tin g u is h e s th e tw o .M 'arkets w hen funds are borrow edlloaned for a year or less are referred to as m oney m a rk e ts . C a p ita l m a rk e ts e n c o n lp a s s lo n g e r te rm o b lig a tio n s .

C a p ita l M a r k e ts
C a p ita l m a rk e ts d e a l in th e fo llo w in g ty p e s o f s e c u ritie s:
*
C o rp o ra te s e c u ritie s
*
G o v e rn ille llt of In d ia b o n d s
*
S ta te a n d lo c a l b o n d s
*
C o rp o ra te e q u itie s
*
M o rtg a g e s
*
M u tu a l fu ild u n its
M oney M arkets
M o n e y m a rk e ts w h ic h a re d e s c rib e d a s c e n tre s o f s h o rt te rm fu n d s in c lu d e th e fo llo w in g
m a jo r s e g m e n ts:
*.
T r e a s u r y b i 11s
*
C o n u i~ e rc ia l
b a n k lo a n s
*
C o rn n ~ e rc ia l
p a p e rs
*
C e rtific a te s o f d e p o s its

In te re s t is o n e o f th e m o s t i1 n p o rt;u lt in th e p o rtio n o f fin a n c ia l m a n a g e m e n t. In te re s t h a s becom e relev;m t because of tim e value of m oney. Interest is supposed to be the bridging c o n c e p t intirile v a lu e o f m o n e y . In te re s t is d e fin e d a s th e re n ta l c h a rg e d fo r th e u s e o f b o rro w e d m o n e y . W ith o u t a p p ly in g th e c o n c e p t o f in te re s t, d e c is io n m a k in g to r fin a n c ia l m a n a g e n le n t w ill b e irre le v a n t.

1 0 .4 .1
R easons for H aving Interest
T h e tw o p rim a ry re a s o n s fo r h a v in g in te re s t a re a s fo llo w s:
t h e o p p o r t u l ~ i t y t o i n v c s t m o n e y , a n d
the desire to spend it.
M o n e y h a s a n o p p o rtu n ity c o s t. W h c ~ i
w e a re in v e s tin g m o n e y fo r a tu tu re p e rio d w e

a lw a y ss a c rific e th e p re s e n t c o n s u m p tio n . F u rth e r, w e a lw a y s a n tic ip a te th a t th e v a lu e o t a n y in v e s tm e n t a fte r a p la n n e d llo ld in g p e rio d to b e h ig h e r th a n th e o rig in a l in v e s tm e n t. U n le s s th e c o n c e p t o f in te re s t is a p p lie d , it niay ilot be possible to realise tlie o b je c t~ v e .

1 0 .4 .2 P a r tie s P o in to f V ie w
In a n y fin a n c ia l m a rk e t th e re a re tw o p a rtie s , v iz
b o rro w e rs a n d le n d e rs. F ro m b o rro w e rs

p o in ts of v ie w , in te re s t is ju s tifie d a s th e re is o p p o rtu n ity to'invest borrow ed m oney at h ig h e r ra te th a n th e ra te p a id f o r its u s e . F r o m le n d e r's p o in t o f v ie w , in te re s t re p re s e n ts h isc o m p e n s a tio n fo r n o t b e in g a b le to s p e n d h is n io n e y e ls e w h e re .

10.4.3 InterestRate
R e g a rd le s s o f th e ty p e o f lo a n s in v o lv e d , in te re s t ra te is a fu n c tio n o f th e s u p p ly a n d its
dem and for m o n e y . S h o rt te rm in te re s t ra te s a re d e te rm in e d b y c u rre lit s u p p ly a n d

dem and factors. Long term interest rates are determ inedb y th e a n tic ip a te d s u p p ly a n d d e m a n d re la tio n s h ip s o v e r th e life o f th ein te re s t b e a rin g se c u rity . W h e n fu n d s a re in s h o rt s u p p ly re la tiv e to d e m a n d , s h o rt te rmin te re s t ra te t a n b e e x p e c te d to ris e . W h e n sh o rt te rm ra te s g o u p , lo n g te rm ra te c a n n o t h e lp th e a ffe c te d .

L e v e l o f in te re s t ra te s h a s a s ig n ific a n t im p a c t o n th e n a tio n s e c o n o m y . T hechanges on
interest rates cause m oney shift from one financial m arket to another. T he m ost im portant
fa c to r fro m b u s in e s s v ie w p o in t is th e e a s e w ith w h ic hlo n g te rm c a p ita l p ro je c ts c a n b e
fin a n c e d .
1 0 .4 .4
Interest C alculations
T h e a m o u n t o f in te re s t a s s o c ia te d w ith a n y ty p e o f fin a n c ia l tra n s a c tio n c a n b e c a lc u la te d
by using six stand'ud form ulae. T hey are discussed in the ensuing paragraphs.
( i ) S in g le P a y m e n t (C o m p o u n d ) a m o n g F a c to r
T h is is th e b a s ic fo rm u la in th e c o n c e p t o f tim e v a lu e o f m o n e y . T h is is tlie fu tu re
a in o u n t o f'S ' th a t. s o m e p r e s e n t a m o u n t 'P ' w ill a c c u m u la te in
'n'years ati
percent interest rate. T h e form ula is as follow s:
T h e s a m e is illu s tra te d b y n ie a ris o f s o m e e x a m p le s .
E x a m p le1
Apresent value of R s. 1000 atan m iu a l interest rate of 10% over a period of
1 0 y e a rs w ill a c c u m u la te a s
S=lQ O O( 1+1 0 j1 0= R s . 2 5 9 3 .7 0
T hus, a present value of R s. 1000 ata n annual interest rate of 10% over a period
o f1 0 y e a rs w ill h a v e a c o m p o u n d e d v a lu e o f R s . 2 5 9 3 .7 0 .
E x a m p le2
Asum of R s. 5000 at an antiual interest rate of 20% over a period of8 years
w ill h a v e a c o m p o u n d e d v a lu e o f R s . 2 1 4 9 9 .
( i i ) S in g le P a y m e n t P r e s e n t V a lu e F a c to r
T h is fa c to r is th e a m o u n t 'P ' th a ta fu tu re a m o u n tS re c o v e ra b le in
'n' y e a rs is n o w
w orth w ith interest at' i ' p e rc e n t. T h is is th e re c ip ro c a l o f c a s e (i). T h e fo rm u la is
E x a m p le1
T h e p re s e n t v a lu e o f 5 0 0 0 re c o v e ra b le a t tlle e lid o f th e5 th y e a r, a t a n a lu iu a l
in te re s t ra te o f 1 0 % w ill b e R s . 3 1 0 4 .6 1 .
E x a m p le2
T h e p re s e n t v a lu e o f R s .1 0 0 0 re c o v e ra b le a t tlie e n d o f th e 8 th y e a r a ta n a n n u a l
in te re s t ra te o f 2 0 % w ill b e R s . 2 3 2 .6 0 .

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