Time value of money

 Individuals value more the opportunity to

receive money in the present than receiving
the same amount some time in the future.
 There are three reasons that explain the
concept of time value of money:
 Investment opportunities: Money can be
productively employed to earn real returns.
 Preference for present consumption: In an
inflationary period, a rupee today has a higher
purchasing power than a rupee in the future.
 Risk or uncertainty: As the future is
characterized by uncertainty, individuals prefer
current consumption to future consumption. In
situations where an individual forgoes the
present consumption of a particular amount
for
 future consumption, he expects a risk
premium to be given to him to compensate
for the uncertainty associated with the
future.
 Hence, the nominal or market interest rate
can be expressed as
 Nominal rate= Real rate of interest +
expected rate of inflation + risk premiums to
compensate for uncertainty.
 r= (1+ k/m)m – 1 
    where, m is the frequency of
compounding per year.
 Future Value of a Single
Flow
 The method of compounding helps us to
find the worth of money at some time in
the future. The future value factors are
used to find the value of money at the end
of year n (in future) at a particular rate of
interest.
 Example: Find the value of Rs 1,000
(which we have invested now), at the end
of 3 years given that the rate of interest
earned by it is 4%.
 The formula to be used in such a situation
is
 Future value = Present value (1+k)n
 Future Value of Multiple
flows
 The above formula computes future value
for a single outflow of money. Let us
consider another example where we have
to calculate the future value of more than
one cash outflow (i.e multiple flows).
 Example: Ram invests Rs 1500 at the
beginning of the first year(or in other
words at the end of 0th year); Rs. 2,000 at
the beginning of the second year and Rs
5,000 at the beginning of third year at a
rate of interest 5% per annum. What will
be the accumulated value of all these cash
outflows at the end of the third year?
 Present Value of a Single
Flow 
 We apply the technique of discounting to
the future cash flows in order to find their
present value because the value of an
amount (say Re. 1) in future may be less
than the value of the same amount at the
present moment because of factors like
inflation etc.
 Example: Suppose a particular
investment opportunity provides us Rs
2000 at the end of three years. We need
to find out the present value of this cash
inflow of Rs 2000 that is got at the end of
three years with the interest rate being
5%.
 Present value = Future value x 1/(1+k)n 
 Present Value of Multiple
Cash Flows 
 A person invested certain amount of
money in a project. The project generates
an inflow of Rs 1500 at the end of the first
year, Rs 2,000 at the end of the second
year and Rs 4,000 at the end of the third
year. What is the present value of these
future cash inflows given that the rate of
interest is 5%?
Present Value of an Annuity

 Example: A person invested certain

amount of money in a project. The project
generates an inflow of Rs 2000 at the end
of first, second and third year. What is the
present value of this annuity of Rs 2000 at
5% interest rate?
 The formula that has to be used for
computing the present value of an annuity
is
 PVIFA (Present Value Investment
Factor of an Annuity) = F.Vx[(1 + k)n-
1)/[k(1 + k)n].