Financial Management I

Session 8
Time Value of Money
Understanding role of the dimension of
time in changing/ affecting value of money.
Preference of money
Liquidity preference theory
Risk aversion (uncertainty and risk)
Preference for consumption (now then later)
Investment opportunities (to earn more)


Compensation for parting with liquidity (preference)
Required rate of return = Risk free rate + Risk premium = opportunity cost of
comparable risk


Common methods of adjusting cash flows for time value of money
Compounding process of calculating future values of cash flows
Discounting process of calculating present values of cash flows

PV & NPV
Investment project Vs. Financing project

Present value (PV) = C
1
/(1+r)
Net Present Value (NPV) = C
0
+ {C
1
/(1+r)} where, C
0
is normally negative in an investment project

We have seen that;
PV= {C
1
/(1+k)
1
} + {C
2
/(1+k)
2
}++{(C
n
/(1+k)
n
}

NPV=Wealth = {C
1
/(1+k)
1
} + {C
2
/(1+k)
2
}++{(C
n
/(1+k)
n
} C
0


Return is defined as

r
t
=(p
t
-p
0
)/p
0
for a period t

to make it annual

r
a
=365/t
Present & Future value
Rs. Next Year



114

107













100 106.54 Rs. Now
Ram wants to consume now but Shikha wants to wait.
But both want to invest. Shikha, who is aggressive, prefers
to invest in a high risk high return instrument giving her
14% return and would wait till the maturity. Whereas
Ram, who is also in the same risk class, would invest and
simultaneously borrow Rs. 106.54 at risk free rate of @7%.
He will use the borrowed money Rs 106.54 for immediate
Consumption and would payoff the loan and the interest the
next year with his Investment of Rs.100 @ 14%.

NPV of Shikhas investment (114/1.07) -100 = 6.54
NPV of Rams investment 106.54 -100 = 6.54
Future Value
Concept of simple interest & compounded interest

Future value of a single cash flow

Future sum=principal + interest on principal
F
1
=P + P x i =P(1+i)

Future sum=principal + interest on principal + interest on interest
F
2
=F
1
+ F
1
x i = F
1
(1+i) = P (1+i) (1+i) = P (1+i)
2
General form
F
n
= P (1+i)
n


Here, (1+i)
n
is known as Compounded value factor (CVF) of Rs.1 (or any
currency). Its value will be >1 for any positive I (why?).


Future value of F at i rate of interest for n period
F
n
= P x CVF
n.i
Annuity
Fixed payment/receipt every year/period
Over a specified period
E.g. Annual lease rent, repayment of house loan
in equal installments
End of year
Deposit at the end of the year
1 2 3 4
Rs.1 Rs.1 Rs.1 Rs.1.000
Rs.1.060
Rs.1.124
Rs.1.191
Future sum Rs.4.375
Future Value of an annuity
F
4
= A(1+i)
3
+A(1+i)
2
+ A(1+i) + A
= A {(1+i)
3
+(1+i)
2
+ (1+i) + 1}

General form F
n
= A [{(1+i)
n
1} / i]

Where, [{(1+i) 1}/ i] is known as Compounded Value
Factor for an Annuity (CVFA) for Rs. 1 (or any currency)

Future value = Annuity cash flow x compounded value
factor for annuity of Rs. 1

F
n
= A x CVFA
n,i
Sinking Fund
How much should we deposit per annum/period
to accumulate x amount at the end of n period
when the interest rate is i?

Created to retire debt, special provision/reserve

Problem is just opposed to Future Value of
Annuities

here for a given Future value, we are required to
create annuities.
Annuity in a sinking fund
Sinking Fund Factor (SFF)
Its range is between 0 and 1
Its basically the reciprocal of CVFA, i.e., SFF=(1/CVFA)

CVFA and SFF are related in the following way;
Fn = A x CVFA
n,i
Fn / CVFA
n,i
=A
Since we have defined SFF as 1/CVFA, thus,
A = Fn x SFF
n,i


Sinking fund annuity = Future Value / Compounded
value factor of an annuity of Rs. 1

The general form is A = F
n
[ i / {(1+i)
n
-1}] (how?)

Present Value
Present value of cash flow (inflow or outflow?)
What is the present value of future flows
For comparison and decision making

Net Present value (negative vs. positive)

Signs (- / +) of cash flows (Investment project
and Financing/borrowing project)
Present value of a single cash flow
Future value of Principal + interest (for one year)
F
1
= P (1+i)
1

Present value of Principal + Interest (for one year)
P = F
1
/ (1+ i)
1

Future value of Principal + interest (for two years)
F
2
= P (1+i)
2

Present value of Principal + Interest (for two years)
P = F
2
/ (1+ i)
2

The general form P = F
n
/ (1+i)
n
= F
n
{(1+i)
-n
} = F
n
{ 1/ (1+i)
n
}

Where, { 1/ (1+i)
n
} is discount factor or present value factor

Present value = Future value x present value factor of Rs.1

PV = F
n
x PVF
n,i

Things to dofor you!
Use excel examples in text book to create excel sheets
for calculating Time value under discussed
schemes/topics

Look at the end of the text book to find and see different
tables (detailed) discussed.

Solve problems under the discussed topics

Study from your text to prepare for the next class which
will be continuation of the current topic under discussion
(Present value onwards).