Chapter

3
TIME VALUE OF MONEY

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TIME VALUE OF
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LEARNING OBJECTIVES
Explain the time value of money.
Explain the various valuation concepts
Compute the various values based on different valuation concepts
Understand different valuation models concerned with different securities

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TIME VALUE OF
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Time Value of Money

Meaning of Time Value of Money
Money has time value. i.e, the value of money changes over a period of time The value
of a rupee received today is different from the value of a rupee to be received after a year.
A rupee today has value than a rupee after a year.
Factors contributing to the Time Value of Money
Money has a time value because of the following reasons.
individuals generally prefer current consumption to future consumption
an investor can profitably employ a rupee received today to give him a higher value to
be received tomorrow or after a certain period.
In an inflationary economy the money received today has more purchasing power
than money to be received in future.
A bird in hand is worth two in the bush : This statement implies that people consider
a rupee today worth more than a rupee in the future, say, after a year. This is because
of the uncertainty connected with the future.
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TIME VALUE OF
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Valuation concepts or Techniques

The Time value of money implies
(i) That a person will have to pay in future more for a rupee received today and
(ii) a person may accept less today for a rupee to be received in future.
The above statements relate to two different concepts they are
I

- Compound value Concept

II - Discounting or Present Value Concept

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TIME VALUE OF
MONEY

Required Rate of Return

The time preference for money is generally expressed by an interest rate. This
rate will be positive even in the absence of any risk. It may be therefore called
the risk-free rate.
An investor requires compensation for assuming risk, which is called risk
premium.

The investors required rate of return is:

Risk-free rate + Risk premium

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TIME VALUE OF
MONEY

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.

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TIME VALUE OF
MONEY

Future Value
Compounding is the process of finding the future values of cash flows by
applying the concept of compound interest.
Compound interest 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 is the interest that is calculated only on the original amount
(principal), and thus, no compounding of interest takes place.
The general form of equation for calculating the future value of a lump sum after

n periods may, therefore, be written as follows:

Fn= 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 greater than 1 for positive i, indicating that CVF increases as i
and n increase.
Fn = P*CVFn,i
37

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FINANCIAL MANAGEMENT, Dr. Sudhindra Bhat

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TIME VALUE OF
MONEY

Discounting or present value concept

The concept of present value is the exact opposite of that of a sum of money or series
of payments, while in case of present value concept, we estimate the present worth or
a future payment/installment or series of payment adjusted for the time value or
money.
The basis of present value approach is that opportunity cost exist for money lying idle.
That is to say, that interest can be earned on the money. This return is termed as
discounting rate
Given a positive rate of interest, the present value of future Rupee will always be lower.
The technique for finding the present value is termed as discounting.
Present value after n Years :
Formula :
A
PV = ----------(1 + i)n
Where :
PV = principal amount the investor is willing to forego at present
I = Interest rate
A = amount at the end of the period n.
N = Number of years
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TIME VALUE OF
MONEY

Example :
If Mr. X, depositor, expects to get Rs. 100 after one year at the rate of 10%, the amount
he will have to forego at present can be calculated as follows :
A
PV =

----------(1 + i)n
100

PV =

----------- = Rs. 90.90

(1 + .10)

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TIME VALUE OF
MONEY

Present Value of a Series of Cash flows :

In a business situation, it is very natural that returns received by a firm are spread over a number of
years. An investment made now may fetch returns for a period after some time. Every
businessman will like to know whether it is worthwhile to invests or forego a certain sum now, in
anticipating of returns he expects to earn over a number of years.

The estimate the present value of future series of returns, the present value of each expected
inflow will be calculated.

The present value of series of cash flows can be represented by the following
C1

PV =

C2

C3

Cn

----------- + ----------- + ----------- + ----------(1 + i)1

n

(1 + i)2

(1 + i)3

(1 + i)n

Ct

PV = ----------T=1 (1 + i)n

Where,

PV = sum of individual present values of each cash flow : C1, C2, C3..........
Cn = Cash flows after period 1,2,3.n ,

I = Discounting rate
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Illustration
Given the time value of money as 10% (i.e. the discounting factor) You are required
to find out the present value of future cash inflows that will be received over next
four years.

Year

Cash flows (Rs.)

1,000

2,000

3,000

4,000

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TIME VALUE OF
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Solution:
1
Year

2
PVF@10%

3
Cash flow

4(2*3)
PV

0.909

1000

909

0.826

2000

1,652

0.751

3000

2.253

0.683

4000

2,732

PV series

of cash flow

7546

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TIME VALUE OF
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Valuation of Bonds or Debentures :

A bond or debenture is an instrument of long-term debt issued by a borrower.

Technique of Valuation of Bonds or Debentures : The value of bonds or debentures

is, generally, determined through the technique known as the Capitalization
technique.

The process of determination of the present value of a bond or debenture can be

considered under two heads viz.,

When a bond or debenture is redeemable (i.e. definite maturity period)

When a bond or debenture is irredeemable (i.e. as no specified definite maturity

period)

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When a bond or debengure is redeemable, its present value can be determined by

estimating its guture cash flows, and then, discounting the estimated future cash
flows at an appropriate capatializatin rate or discount rate.

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Present Value of a redeemable Bond or

Debenture
The following formula may be used to find out the present value of the bond or
debenture (assuming that the bond has a maturity period of 4 years):
I1
V =

I2

I3

14+M

----------- + ----------- + ----------- + ----------(1 + Kd)1 (1 + Kd)2

(1 + Kd)3

(1 + Kd)4

Where
V

= the present value of the bond or debenture

= annual interest payment.

Kd

= the capitalization rate or the discount rate

= The maturity value of the bond or debenture

Alternatively, the present value of the bond or debenture can be ascertained through the
table called the discount rate tables or present value tables.
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TIME VALUE OF
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Illustration
A Debenture of Rs. 1,000, issued by a company, matures in 5 years. The rate of interest
payable by the company on the debenture is 7% p.a. the appropriate capitalization rate is
5%
Calculate the present value of the debenture.
Solution :
Through the formula
I1
I2
I3
I4
15+M
V = ----------- + ----------- + ----------- + ----------- + ---------(1 + Kd)1 (1 + Kd)2
(1 + Kd)3
(1 + Kd)4 (1 + Kd)5
70
70
70
70
100
V = ----------- + ----------- + ----------- + ----------- + ---------(1 + 05)1 (1 + 05)2
(1 + 05)3
(1 + 05)4 (1 + 05)5
The present value of interest of Rs. 70 for 5 years (70 x 4.330) = 303.1
The present value of the principal at the end of the 5th year (1000x0.784) =
Present value of the debenture
= 1097.1

784.0

Note : 1 As the interest of Rs. 70 is an annual payment for 5 years, it is an annuity for 5 years. The present
value of an annuity of Re. 1 for 5 years, as per the present value tables is Rs. 4.330 (As per Table 2)
Note : 2 The Principal repayment is a lump sum repayment at the end of the 5th year, so the present value
of the principal amount (as per table 1) is 0.784 x 1000.
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TIME VALUE OF
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Present Value of a perpetual or Irredeemable

Bond or Debenture
When a bond or debenture is irredeemable, its present value can be determined by simply
discounting the stream of interest payments for the infinite period by a appropriate
capitalization rate or discount rate.
The following formula may be used to determine the rpesent value of the bone or
debenture.

V = 1/Kd
Where,
V - means the present value of the bond or debenture
I means annual interest payment

Kd means the capitalization rate or the discount rate.

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Illustration
A perpetual debenture of the face value of Rs. 1,000 is issued by a company. The rate
of interest payable by the Company is 6% p.a. The appropriate capitalization rate is 5%.
Calculate the present value of the debenture.

Solution

V = 1/Kd Here, I = Annual Interest i.e. 1000 x 6/100 = 60

Kd = 5% or 0.05

Therefore 60/0.05 = Rs. 1,200

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TIME VALUE OF
MONEY

Valuation of reference shares

Meaning: preference shares are a type of shares issued by a joint stock company for
raising share capital from the public. It may be redeemable preference shares or
irredeemable preference shares.

The value of preference shares also is, generally, determined through the
capitalization technique.

The process of determination of the present value of preference share is the same
as that of bonds or debentures. The process or determination of the present value of
a preference share can be considered under two heads viz.

When preference share is redeemable

When preference share is irredeemable.

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When preference share is redeemable

preference share:

Present value of a redeemable preference share can be determined by estimating its future cash
flows, and then discounting the estimated future cash flows at an appropriate capitalization rate or
discount rate.

The estimated future cash flows from the preference share consists of the stream of future dividend
payment plus the par value of the preference share.

The following formula may be used to determine the present value of the preference share
(assuming that the bond has a maturity period of 3 years)
D1
V=

D2

-----------

+ -----------

(D + Kp)1

(D + Kp)2

D+M
+ -----------

(D + Kp)3

Where V = present value of the preference shares

D = Annual dividend payment
Kp = Capitalization rate or discount rate

M = Maturity value i,e., the value of the preference share.

Alternatively, the present value of the preference share can be determined though the table called the
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TIME VALUE OF
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Illustration 14
X Ltd. Has issued 7% preference shares of Rs. 100 each. The preference shares are
redeemable after 5 years. The appropriate capitalization rate is 5%.
Calculate the present value of a preference share
D1
D2
D3
D4
D5+M
V = ------------ + ------------ + ----------- + ----------- + ---------(D + Kp)1 (D + Kp)2 (D + Kp) (D + Kp)4 (D + Kp)5
7
7
7
V = ----------- + ----------- + ----------- +
(1 + 05)1 (1 + 05)2
(1 + 05)3

7
100
----------- + ---------(1 + 05)4 (1 + 05)5

That is,
7 x 4.330 = 30.31
100 x 0.684 = 78.40
Present value
108.71
Note
(i) Present value of an annuity of Re 1 at the capitalization rate of 5% at the end of the 5th year is 4.330
(ii) Present value of rupee at the capitalization rate of 5% at the end of the 5th year is 0.784 Copyright 2006, Dr Sudhindra Bhat
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TIME VALUE OF
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Present value of perpetual or an irredeemable

preference share:
The present value of irredeemable preference share can be determined by simply
discounting the streams of dividend payment for the infinite period by an appropriate
capitalizations rate of discount rate.
Formula :
D
V = ----

Kp
Where
V = Present value of the preference share.

D = annual dividend payment on the preference share

Kp = Capitalization rate.
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Valuation of Equity shares

The valuation of equity shares is difficult as compared to the valuation of debenture
or preference shares. This is because of two reasons.
Equity Shears do not carry a fixed dividend or interest rate as is the case with
preference shares or debentures Equity shareholders may or may not get
dividends.
Earnings or dividends on equity shares are expected to grow unlike interest on
debentures and preference dividend.
Methods of Valuation : Valuation basically based on two approaches :
(1) Dividend Capitalization Approach
(2) Earning Capitalization Approach

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Assignment for Student

Exercise one: Practice all the problems in the text Book.

Exercise Two : Comparing Auto Loan Alternatives
You are considering the purchase of new car. You have negotiated with the
salesperson at the dealership and you can purchase the vehicle for Rs. 30,000. You
have Rs. 8,000 that you can use as a down payment.
Prior to going into the dealership, you have set an absolute limit of Rs. 375 for the
amount of monthly payments that you can make on the car. You are willing to finance
over five years but you cannot exceed the payment of Rs. 375 per month. The dealer
is willing to offer you financing at an annual rate of 6.5% for a 5-year loan. The dealer
is willing to offer 5.5% financing on a 4-year loan.
Can you meet your payment restriction and finance the amount required for the car?
What is the maximum amount that you can borrow to meet your payment restriction if
the loan is to be paid off in 5 years?

Suppose that you are limited to paying Rs. 375 per month but you want to pay the
loan off in 4 years and not 5 years. What is the maximum amount that you can borrow?
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