TIME

VALUE OF MONEY
SHENAL RAJAKARUNANAYAKE
DEPARTMENT OF INDUSTRIAL MANAGEMENT
FACULTY OF BUSINESS
UNIVERSITY OF MORATUWA
Learning Outcomes
On completion of this chapter, you should
be able to
1. Understand the concepts of time value of
money, compounding, and discounting.
2. Calculate the present value and future
value of various cash flows using proper
mathematical formulas.
Single-Payment Problems

If you have the option of receiving

Rs.1000 today, or Rs. 1000 a year from
now, what will you choose?
You will choose to get the money now.
Why?
Single-Payment Problems (Cont’d)
First, we can use the money and spend it on basic human needs
such as food and shelter. (clothes, books, or transportation)
Second, we can invest the money that we receive today, and
make it grow. If we do not want to risk the money in stocks, we
may buy riskless Treasury securities.
Third, there is a threat of inflation. Thus, the Rs.1000 we receive a
year from now may not buy the same amount of goods and
services that Rs.1000 can buy today. We can avoid this erosion of
the purchasing power of the rupee due to inflation if we can
receive the money today and spend it.
Single-Payment Problems (Cont’d)
Fourth, human beings prefer to get pleasurable things as early
as possible, and postpone unpleasant things as much as
possible.
(We can use the Rs. 1000 that we receive today buy new clothes, or to go out for dinner. If you are
going to get the money a year from now, you may also have to postpone all these nice things. )

Then there is the uncertainty of not receiving the money at all

after waiting for a year. People are risk-averse, meaning, they
do not like to take unnecessary risk. To avoid the uncertainty,
or the risk of non-payment, we would like to get the money as
soon as possible.
Single-Payment Problems (Cont’d)
If we deposit a sum of money with the present value PV in a bank that
pays interest at the rate r, then after one year it will become PV(1 + r). Let
us call this amount its future value FV. We may write it as;
FV = PV (1 + r)
We may also think of (1 + r) as a growth factor. Continuing this process for
another year, compounding the interest annually, the future value will
become;
Single-Payment Problems (Cont’d)
FV = PV (1 + r) n is valid for annual compounding. If we do the
compounding quarterly, the amount of interest credited will
be only at the rate r/4, but there will also be 4n compounding
periods in n years.
Similarly, for monthly compounding, the interest rate is r/12
per month and the compounding occurs 12n times in n years.
Thus, the above equation becomes;
Single-Payment Problems (Cont’d)
At times, it is necessary to find the present value of a sum of
money available in the future.

This gives the present value of a future payment.

Discounting is the procedure to convert the future value of a sum of
money to its present value. Discounting is a very important concept
in finance because it allows us to compare the present value of
different future payments.
Single-Payment Problems (Cont’d)
In a nut shell,
FV = the future value of a sum of money
PV = the present value of the same amount
r = the interest rate, or the growth rate per period
n = number of periods of growth
If we know any three of the quantities, we can always find
the fourth one.
Multiple-Payment Problems
In many financial situations, we have to deal with a stream
of payments, such as rent receipts, or monthly pay cheques.
The loan that you take out and then pay back in monthly
instalments can also be referred as an example.
Such series of cash payments, even for monthly or weekly
payments are called as annuities.
Multiple-Payment Problems (Cont’d)
If there is a cash flow C at the end of first, second, third...
period, then the sum of discounted cash flows is given by;
Multiple-Payment Problems (Cont’d)
Types of Annuities

If you opt for an immediate annuity you begin to receive

payments soon after you make your initial investment.
The deferred annuity accumulates money while the
immediate annuity pays out. Deferred annuities can also be
converted into immediate annuities when the owner wants to
start collecting payments.
Perpetuity
Many insurance companies give the proceeds of a life
insurance policy either as a lump sum, or in the form of an
annuity. This is called as perpetuity.
A perpetuity is a stream of payments that continues forever
Loan Amortization
Amortization is the process of spreading out a loan into a
series of fixed payments over time.
You'll be paying off the loan's interest and principal in
different amounts each month, although your total payment
remains equal each period.
This most commonly happens with monthly loan payments.
The Present Value of The Present Value of the
=
the Loan all future payments