Time Value of

Money
Compounding &
Discounting

What is Time Value of Money

Would you prefer to have Rs 1 million now or Rs

1 million - 5 years from now?
Time preference for money is an individuals
preference for possession of a given amount of
money now, rather than the same amount at some
future time.
Following reasons may be attributed to the
individuals time preference for money:
risk
preference for consumption
investment opportunities
inflation

Money has a time value because it can earn more

money over time (earning power).
Money has a time value because its purchasing power
changes over time (inflation).

Delaying Consumption

Account Value

Cost of Refrigerator

Case 1: Inflation
exceeds
earning power

N= 0
Rs 100
N=1
Rs 106
(earning rate = 6%)

N= 0
Rs 100
N=1
Rs 108
(inflation rate = 8%)

Case 2: Earning power

exceeds inflation

N= 0
Rs 100
N=1
Rs 106
(earning rate = 6%)

N= 0
Rs 100
N=1
Rs 104
(inflation rate = 4%)

Choosing from Different

Alternatives
You have three choices:

Rs 20,000 received today

Rs 31,000 received in 5 years
Rs 3,000 per year indefinitely
To make such comparisons, we must be able to
compare the value of money at different point in time.
To do this, we need to develop a method for reducing
a sequence of benefits and costs to a single point in
time.
Cannot directly compare Rs 1 today with Rs 1 to be
received at some future date
Money received today can be invested to earn a rate
of return.
Thus Rs1 today is worth more than Rs1 to be received
at some future date.

Time Value Adjustment

Two most common methods of adjusting cash

flows for time value of money:
Compoundingthe process of calculating
future values of cash flows and
Discountingthe process of calculating
present values of cash flows.
Abbreviations
PV - Present value
FV - Future value
Pmt - Per period payment amount
N - Either the total number of cash flows or
the number of a specific period
i - The interest rate per period

Timelines

A timeline is a graphical device used to

clarify the timing of the cash flows for an
investment.

Future value
Future value of lump sum

The general form of equation for

calculating the future value of a lump
n
sum after n periods
be
written
as :
F P (1 i )
n

The term (1 + i)n is the compound

value factor (CVF) of a lump sum of
Re 1, and it always
has a value
Fn =P CVF
n,i
greater than 1 for positive i, indicating
that CVF increases as i and n increase.

Future value of a Lumpsum

Suppose that you have an extra Rs 100 today that you
wish to invest for one year. If you can earn 10% per
year on your investment, how much will you have in
one year?

If you deposit Rs 55,650 in a bank, which was paying a

15 per cent rate of interest on a ten-year time deposit,
how much would the deposit grow at the end of ten
years?
We will first find out the compound value factor at 15
per cent for 10 years which is 4.046. Multiplying 4.046
FVRs
55,650
CVF
225,159.90
55,650 4.046
Rs 225,159.90
by
55,650,
we get
asthe
compound
10, 0.12Rs
value.

Compound Value factor of a

lumpsum of Re 1

Annuities

An annuity is a series of nominally equal payments

equally spaced in time
Annuities are very common:
Rent
Mortgage payments
Car payment
Pension income
The timeline shows an example of a 5-year, $100
annuity

(1 i ) n 1
Fn A

Fn =A CVFA n, i

Future value of an Annuity

What will be the future value of Rs 100 annuity for 5
years? Rate of interest is 10% per annum.

Suppose that a firm deposits Rs 5,000 at the end of

each year for four years at 6 per cent rate of interest.
How much would this annuity accumulate at the end
of the fourth year?
We first find CVFA which is 4.3746. If we multiply
4.375 by Rs 5,000, we obtain a compound value of
F
5,000(CVFA 4, 0.06 ) 5,000 4.3746 Rs 21,873
Rs
21,875:
4

PRESENT VALUE
Present value of a Single Cash Flow
Present value of a future cash flow (inflow or outflow)
is the amount of current cash that is of equivalent value.

Fn
n

F
(1

i
)
n
n
(1 i )
The term in parentheses is the discount factor or
present value factor (PVF), and it is always less than
1.0 for positive i, indicating that a future amount has a
smaller present value.
PV Fn PVFn ,i
Suppose that an investor wants to find out the present
value of Rs 50,000 to be received after 15 years. Interest
rate is 9 %.
First, we will find out the present value factor, which is
0.275.
0.275= 50,000
by Rs50,000,
we
obtain Rs
PV = Multiplying
50,000 PVF15,
0.275 = Rs
13,750
0.09
13,750.

Present value of annuity

ormulae for Present Value of Annuity is:

Present value of Rs 100 annuity for 5

years at 10% is:

Present value of an annuity

Find out the present value of a 4 year annuity of Rs
20,000 discounted at 10%.

Uneven Cash Flows: Example

Assume that an investment offers the following
cash flows. If your required return is 7%, what
is the maximum price that you would pay for
this investment?

100

200

300