TIME VALUE OF MONEY (TVM)

The time value of money (TVM) is the concept that money available at the present
time is worth more than the identical sum in the future due to its potential earning
capacity. This core principle of finance holds that provided money can earn
interest, any amount of money is worth more the sooner it is received. TVM is also
sometimes referred to as present discounted value.

The time value of money draws from the idea that rational investors prefer to
receive money today rather than the same amount of money in the future because
of money's potential to growth in value over a given period of time. For example,
money deposited into a savings account earns a certain interest rate and is therefore
said to be compounding in value. 

NEED/REASONS FOR TIME VALUE OF MONEY

1. Risk and Uncertainty- Future
2. Preference for Consumption- Present Consumption rather than Future
Consumption
3. Investment Opportunities- In profitable option
4. Inflationary Economy- Purchasing power is more than purchasing power in
inflationary economy.

The value of money declines due to the combined impact of the following:

1. Inflation in the economy;

2. Risks involved in delayed receipts of cash or financial transactions; and
3. Opportunity cost of capital delayed.

PRESENT VALUE OF MONEY

It is the present value of money to be received in the future. The present value
formula quantifies how fast the value of money declines. This formula shows you
how much once single cash payment (FV) received in a future time period (t) is
worth in today’s terms (PV).
FV = the future value of money
PV = the present value
t = the number of years to take into consideration
r= rate of interest

Q. Find the present value of Rs. 25000 due in 6 years compounded annually at
12% per annum rate of interest
Ans.

PV= FV/ (1+ r)n

= 25000/ (1+0.12)6
= 25000/ (1.12)6
= 25000/ 1.97382
= 12665.80

Q. Find the present value of Rs. 6000 due in 10 years compounded semi annually
at 5% per annum rate of interest

Ans.

As value will be calculated semi annually, therefore interest will be 5%/2 = 2.5%
and time will be 10years x 2= 20 years

PV= FV/ (1+ r)n

= 6000/ (1+0.025)20
= 6000/ (1.025)20
= 6000/ 1.6386
= 3661.662

FUTURE VALUE OF MONEY

Future value is amount that is obtained by enhancing the value of a present
payment or a series of payments at the given interest rate to reflect the time value
of money.
FV = the future value of money
PV = the present value
i = the interest rate or other return that can be earned on the money
n = the number of compounding periods of interest per year

Q. Calculate the Future Value of Rs.100 invested today at 7% rate of interest

compounded annually for 3 years?

Ans.

FV = PV (1+i)n
= 100 (1+0.07)3
= 100 x 1.225
= 122.5

Q. Calculate the Future Value of Rs.100 invested today at 7% rate of interest

compounded annually for 5 years?

Ans.

FV = PV (1+i)n
= 100 (1+0.07)5
= 100 x 1.402
= 140.25

Q. Calculate the Future Value of Rs.100 invested today at 7% rate of interest

compounded annually for 10 years?

Ans.

FV = PV (1+i)n
= 100 (1+0.07)10
= 100 x 1.967
= 196.71
LOAN AMORTIZATION

Amortization is the process of spreading out a loan (such as a home loan or auto loans)
into a series of fixed payments. To amortize a loan usually means establishing a series of
equal monthly payments that will provide the lender with:
 An interest payment based on the unpaid principal balance as of the beginning of
the month
 A principal payment that will cause the unpaid principal balance to decrease each
month so that the principal balance will be zero at the time of the final payment

Although the total amount of each monthly payment remains the same, interest and
principal payments will be changing as follows:

 The interest component of each monthly payment will be decreasing (because of

the monthly decline in the principal balance)
 The principal component of each monthly payment will be increasing
A listing of each month's interest and principal payments along with the remaining,
unpaid principal balance after each payment is known as an amortization schedule.
For example:

On a loan of Rs.10,00, 000 the interest is charged at the rate of 10%. The
repayment of loan is scheduled to start at the end of the 3rd year from now for 6
years. Calculate the Annuity Amount to be repaid.

Ans. FV=PV (1+r)n

= 1000000 (1+.10)2
=12,10,000
The PV of the annuity at 10% interest rate is Rs. 12,10,000.
Following equation may be used for calculating PVAF, the annuity amóunt:

PV =Annuity Amount X PVAF(r, n)

PV =Annuity Amount X PVAF(10%,6)

= Annuity Amount (4.355)
= Therefore, Annuity Amount = R12,10,000/4.355 =2,77,840
=Annuity amount is R2,77,840, which needs to be paid every year with effect
from 3rd year for 6 years.

Additional Question:

On loan of Rs.15000, interest is charged at 10%. The repayment of loan is scheduled to start at the end
of 5th year from now. Loan should be paid in 3 years after that. Calculate the Annuity Amount to be
repaid along with loan amortization schedule.