TIME VALUE OF MONEY

Understand what is meant by "the time value of money.

Describe how the interest rate can be used to adjust the value of cash flows to a single point
in time.
Calculate the future value of an amount invested today.
Calculate the present value of a single future cash flow.
Understand the relationship between present and future values.
Understand in what period of time money doubles
Understand shorter compounding periods
Calculate & understand the relationship between effective & nominal interest rate.
Use the interest factor tables and understand how they provide a short cut to calculating
present and future values.

You all instinctively know that money loses its value with time. Why does this happen?
What does a Financial Manager have to do to accommodate this loss in the value of money with
time? In this section, we will take a look at this very interesting issue.
Why should financial managers be familiar with the time value of money?
The time value of money shows mathematically how the timing of cash flows, combined with the
opportunity costs of capital, affect financial asset values. A thorough understanding of these
concepts gives a financial manager powerful tool to maximize wealth.
What is the time value of money?
The time value of money serves as the foundation for all other notions in finance. It impacts business
finance, consumer finance and government finance. Time value of money results from the concept of
interest.
This overview covers an introduction to simple interest and compound interest, illustrates the use of
time value of money tables, shows a approach to solving time value of money problems and
introduces the concepts of intra year compounding, annuities due, and perpetuities. A simple
introduction to working time value of money problems on a financial calculator is included as well
as additional resources to help understand time value of money.
Time value of money
The universal preference for a rupee today over a rupee at some future time is because of the
following reasons:

Alternative uses/ Opportunity cost

Inflation
Uncertainty

The manner in which these three determinants combine to determine the rate of interest
can be represented symbolically as:
Nominal or market rate of interest rate = Real rate of interest + Expected rate of
Inflation + Risk of premiums to compensate uncertainty
Basics
Evaluating financial transactions requires valuing uncertain future cash flows. Translating a value to
the present is referred to as discounting. Translating a value to the future is referred to as
compounding.
The principal is the amount borrowed. Interest is the compensation for the opportunity cost of funds
and the uncertainty of repayment of the amount borrowed; that is, it represents both the price of
time and the price of risk. The price of time is compensation for the opportunity cost of funds and
the price of risk is compensation for bearing risk.
Interest is compound interest if interest is paid on both the principal and any accumulated interest.
Most financial transactions involve compound interest, though there are a few consumer transactions
that use simple interest (that is, interest paid only on the principal or amount borrowed).
Under the method of compounding, we find the future values (FV) of all the cash flows at the
end of the time horizon at a particular rate of interest. Therefore, in this case we will be
comparing the future value of the initial outflow of Rs. 1,000 as at the end of year 4 with the sum of
the future values of the yearly cash inflows at the end of year 4. This process can be schematically
represented as follows:
PROCESS OF DISCOUNTING
Under the method of discounting, we reckon the time value of money now, i.e. at time 0 on the
time line. So, we will be comparing the initial outflow with the sum of the present values (PV) of
the future inflows at a given rate of interest.
Translating a value back in time -- referred to as discounting -- requires determining what a future
amount or cash flow is worth today. Discounting is used in valuation because we often want to
determine the value today of future value or cash flows.
The equation for the present value is:
Present value = PV = FV / (1 + i) n
Where:
PV = present value (today's value),
FV = future value (a value or cash flow sometime in the future),
i = interest rate per period, and
n = number of compounding periods
And [(1 + i) n ] is the compound factor.
We can also represent the equation a number of different, yet equivalent ways:
Present Value = PV = FV/ (1+i)n = FV * 1/ (1+i)n = FV * (1/1+i)n

=FV (Discount factor for i & n)

= FV (PVIFi, n)

Where PVIFi,n is the present value interest factor, or discount factor.

In other words future value is the sum of the present value and interest:

Future value = Present value + interest

From the formula for the present value you can see that as the number of discount periods, n,
becomes larger, the discount factor becomes smaller and the present value becomes less, and as the
interest rate per period, i, becomes larger, the discount factor becomes smaller and the present value
becomes less.
Therefore, the present value is influenced by both the interest rate (i.e., the discount rate) and the
numbers of discount periods.
Example 1
Suppose you invest 1,000 in an account that pays 6% interest, compounded annually. How much
will you have in the account at the end of 5 years if you make no withdrawals? After 10 years?
Answer:
FV5 = Rs 1,000 (1 + 0.06)5 = Rs 1,000 (1.3382) = Rs 1,338.23
FV10 = Rs 1,000 (1 + 0.06)10 = Rs 1,000 (1.7908) = Rs 1,790.85
What if interest was not compounded interest? Then we would have a lower balance in the account:
FV5 = Rs 1,000 + [Rs 1,000(0.06) (5)] = Rs 1,300
FV10 = Rs 1,000 + [Rs 1,000 (0.06) (10)] = Rs 1,600
Example 2
Suppose you are faced with a choice between two accounts, Account A and Account B. Account A
provides 5% interest, compounded annually and Account B provides 5.25% simple interest.
Consider a deposit of Rs 10,000 today. Which account provides the highest balance at the end of 4
years?
Answer:
Account A: FV4 = Rs 10,000 (1 + 0.05) 4 = Rs 12,155.06
Account B: FV4 = Rs 10,000 + (Rs 10,000 (0.0525) (4)] = Rs 12,100.00
Account A provides the greater future value.
Example 3
Suppose that you wish to have Rs 20,000 saved by the end of five years. And suppose you deposit
funds today in account that pays 4% interest, compounded annually. How much must you deposit
today to meet your goal?
Answer:
Given: FV = Rs 20,000; n = 5; i = 4%
PV = Rs 20,000/ (1 + 0.04)5 = Rs 20,000/1.21665
PV = Rs 16,438.54
1. You invest Rs 5,000 today. You will earn 8% interest. How much will you have in 4 Years? (Pick
the closest answer)
Rs 6,802.50
Rs 6,843.00
Rs 3,675

2. You have Rs 450,000 to invest. If you think you can earn 7%, how much could you accumulate in
10 years?(Pick the closest answer)
Rs 25,415
Rs 722,610
Rs 722,610
3. If a commodity costs Rs500 now and inflation is expected to go up at the rate of 10% per year,
how much will the commodity cost in 5 years?
Rs 805.25
Rs 3,052.55
Cannot tell from this information

In what period of time money will be doubled?

Investor most of the times want to know that in what period of time his money will be doubled. For
this the rule of 72 is used.
Suppose the rate of interest is 12%, the doubling period will be 72/12=6 yrs.
Apart from this rule we do use another rule, which gives better results, is the rule of 69
= .35 + 69/int rate
= .35 + 69/12
= .35 + 5.75 = 6.1 yrs
Practice Problems
What is the balance in an account at the end of 10 years if Rs 2,500 is deposited today and the
account earns 4% interest, compounded annually? Quarterly?
If you deposit Rs10 in an account that pays 5% interest, compounded annually, how much will you
have at the end of 10 years? 50 years? 100 years?
How much will be in an account at the end of five years the amount deposited today is Rs10, 000
and interest is 8% per year, compounded semi-annually?
Answers
1. Annual compounding: FV = Rs 2,500 (1 + 0.04) 10 = Rs 2,500 (1.4802) = Rs 3,700.61
Quarterly compounding: FV = Rs 2,500 (1 + 0.01) 40 = Rs 2,500 (1.4889) = Rs3, 722.16
2.
10 years:
FV = Rs10 (1+0.05) 10 = Rs10 (1.6289) = Rs16.29
50 years:
FV = Rs10 (1 + 0.05) 50 = Rs10 (11.4674) = Rs114.67

100 years:
FV = Rs10 (1 + 0.05) 100 = Rs10 (131.50) = Rs 1,315.01
3. FV = Rs 10,000 (1+0.04) 10 = Rs10, 000 (1.4802) = Rs14, 802.44
For example, assume you deposit Rs. 10,000 in a bank, which offers 10% interest per annum
compounded semi-annually which means that interest is paid every six months.
Now, amount in the beginning = Rs. 10,000
Interest @ 10% P.A for first six months 10,000*0.1/2 = 500
Amount at the end of six months = 10,500
Interest @ 10% P.A for next six months 10,500 * 0.1/2 = 525
Amount at the end of the year = 11,025
Instead, if the compounding is done annually, the amount at the end of the year will be 10,000 (1 +
0.1) = Rs, 11000. This difference of Rs. 25 is because under semi-annual compounding, the interest
for first 6 moths earns interest in the second 6 months.

The generalized formula for these shorter compounding periods is

FVn = PV (1+ K/M)MN

Where
FVn= future value after n years
PV = cash flow today
K = Nominal Interest rate per annum
M = Number of times compounding is done during a year
N = Number of years for which compounding is done.
Effective vs. Nominal Rate of interest
We have seen above that the accumulation under the semi-annual compounding scheme exceeds the
accumulation under the annual compounding scheme compounding scheme, the nominal rate of
interest is 10% per annum, under the scheme where compounding is done semi annually, the
principal amount grows at the rate of 10.25 percent per annum.
This 10.25 percent is called the effective rate of interest which is the rate of interest per annum under
annual compounding that produces the same effect as that produced by an interest rate of 10 percent
under semi annual compounding.
The general relationship between the effective a nominal rates of interest is as follows:

= (1+k/m)m 1
r = Effective rate of interest
k = Nominal Rate of interest
m = Frequency of Compounding per year

Example
Find out the effective rate of interest, if the nominal rate of interest is 12% and is quarterly
compounded?
Answer:
Effective rate of interest = (1 + K/m)m 1
= (1 + 0.12/4)4 1
= (1+ 0.03)4 1 = 0.126 = 12.6% p.a compounded quarterly

By now you should have clear understanding of

Compounding Discounting
Doubling period (Rule of 72)
Doubling period (Rule of 69)
Shorter compounding periods
Effective vs. Nominal Rate of interest

By now you should be an expert in using the following two tables:

A-1 The Compound Sum of one rupee FVIF
A-3 The Present Value of one rupee PVIF
IMPORTANT
The inverse of FVIF is PVIF i.e. inverse of FVIF is PVIF.

Instructor: Sarbesh Mishra, PhD

Assistant Professor, Finance
NICMARs CISC, NAC Campus
Hyderabad 500 084.