SHANXI UNIVERSITY OF FINANCE AND ECONOMICS

FINAL EXAM: FINANCIAL MANAGEMENT

SUBMITTED BY: MARYAM ALI KAZMI (穆蕊)

(MBA 2020)

Table of Contents
1. ABSTRACT 3
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 1.1 Keywords: 4

2. Introduction: 5

3. Basic concept: 6

4. Reasons why time has an impact on value of money: 6

5. Present value: 7

5.1 Role of Present Value in financial decisions: 8

5.2 Advantages of using NPV: 9

5.3 Disadvantages: 10

6. Future value: 10

7. Calculations: 11

7.1 Standard calculations 12

8. Formulas: 13

8.1 Formula Table: 14

9. Computation Tools for Time Value of Money: 15

10. Utility of time value of money concept: 17

11. Conclusion: 20

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 TIME VALUE OF MONEY

1. ABSTRACT

One dollar today derives more from future dollars because today's dollars can be applied to earn
interest while future dollars are placed under the control of another. This paper introduces the
key concepts of Time Value of Money (TVM), the tools used for computation, and some
practical applications for the use of time value of money formulas. TVM is a major factor in
business and economic decisions. The use of TVM in business is essential to assist people in
making investment decisions and to evaluate the fluctuating options in cash flow patterns from
time to time. For example, the compound interest (or rate of return) calculation is used to
determine the annual percentage rate (APR) of account holders and banking regulators or a
financial institution for the disclosure of exemptions in the valuation of shares unlike the
compounding used in Bonds, business ventures, real estate and capital expenditure projects.
There are many applications of time value of money in finance. The time value of money is
related to the concept of opportunity cost in economics. The cost of any decision includes the
cost of alternative opportunity options that are rejected.

Major Components/Elements:

Rates

Time periods

Present value

Future value

Payments

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1.1 Keywords:

Annuity: Money paid at regular intervals every year

Cash flow: Cash collected and amount paid over a specified period of time

Compound: To pay interest based on principal and already accrued interest

Discount: Withdraw interest to reduce today's dollar from future amount

Interest: Payment of "rent" for the use of money for a period of time

The following variables are used to calculate the time value of money:

i = interest rate (rate of return)

I = amount invested at the beginning of the period

T = specified period of time

n = number of time periods

PMT = Payment

CF = Cash Flow (Subscribers T & 0 means Time T and Time Zero respectively)

PV = Present Value (PVA = Present Value of Annuity)

FV = future value of invested amount (FVA = future value of annuity)

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2. Introduction:

Time value of money can be referred as cash received at a later date is not equal to the same
amount that is currently in hand. Cash on hand has earning power and can be invested for
growth. The time value of money is the mathematics of finance with four basic approaches: the
future value (FV) of a single amount, the value of a future annuity (FVA), the present value of a
single amount (PV), and the present value of an annuity (PVA). The time value of money
arithmetic determines the value of a dollar through time based on the interest rate earned or the
rate of return on investment, and is used in many areas of finance such as calculating compound
interest on a savings account. , Calculating the annual rate of return on a mutual fund, long-term
bonds, amortization or valuation of leases, assessment of future cash flows from a capital project,
etc. Time money concepts are divided into two areas: future value and present value. Future
Value describes the process of finding out what investments will grow today in the future.
Present value describes the process of determining what the value of future cash flows will be in
today's dollars.

Since money has a time value, we must take this time value of money into consideration when
making financial decisions. We do this by restoring wealth values through time with time value
of money calculations. The time value is used in calculating money to move dollar values
through time. They can be used to state future dollar flows in current price terms, or to restore
present value quantities to future dollar values. Calculations are the most powerful tools
available for making financial and business decisions. Once methods of restoring money values
through time are mastered, they can be used to restore cash flow in such a way as to make them
comparable in the process of creating financial flows. The calculation of current values is the
foundation for many financial decisions facing both individuals and managers in all types of
firm. This process allows multiple calculations related to interest earnings, non-interest returns
on investments, debt related problems, capital budget decision processes, insurance
programming problems, and almost any business asset purchase or investment decision. They
also provide the foundation for some of the most commonly used valuation concepts and
valuation models employed in finance.

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The TVM calculation has five major components. These are: present value, future value, number
of periods, interest rate and a principal payment amount. Providing you with information on four
of these values, you can rearrange the TVM formulas to calculate the fifth.

A simple example takes the amount of $10,000 invested at 10%. At the end of a year, that
$10,000 is worth $12,000 (the original $10,000 plus the $2,000 earned in interest). The $20,000
held today can be referred to as the present value of $12,000 which will be received a year from
today.

3. Basic concept:

The concept of time value of money is simple to understand and explain. The value of money
affected with the passage of time is called the time value of money. The value of the currency
increases during the period of deflation while it is reversed in the case of the inflation period.
Purchasing power is the only thing. It is a means of transaction. It is a medium of exchange.
Currency serves the purpose of exchange because it is a measurement of value. Value is the
purchasing power of money which makes it a powerful commodity. Furthermore, if a
comparison is to be made in the values of money, some rules must be followed. First of all the
unit should be the same, as all the values should be in the same currency. Secondly, the prices
should be at the same time. This means that 100 rupees cannot be considered equal to 100 rupees
as on date. The value of money varies at different points in time such that today it has a specific
value and after one year it will have a different value and after two years it will have a different
value. Usually, with the passage of time, the value of money decreases. The reasons for the same
are described in the following paragraphs. It is pertinent to note here that the difference between
the value of money in today's date and the value of the same money in future date is called the
value of money.

4. Reasons why time has an impact on value of money:

Time has an impact on the value of money for four reasons. The first one is the rate of inflation.
Inflation is a universal economic phenomenon. In general, inflation is an economic situation
where commodity prices rise over time. This leads to either buying a small amount of the same
amount or paying more money for the same quantity of the commodity. Thus, it is said that
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during the period of inflation, the purchasing power of the currency decreases. The effect of
inflation is the elimination of the purchasing power of money and the value of money is higher
today than it is at a future date. The second reason for the effect of time on money is the risk
involved in holding money. Stupidly placed money is more vulnerable to such risk. The third
reason is the consumer's preference for consumption. An individual consumer has a preference
to consume today over future consumption because the future is unknown. The priority of
consumer consumption also has its effect on the flow of money in the future and hence on the
value of money. All consumers try to locate a tradeoff between current and future consumption.
Everyone wishes that they meet their needs today and not in the future. Current consumption is
postponed only in anticipation of increased amount at a future date. If money is not consumed
today, it can also be employed to earn some returns. This means that money can be invested in a
proper investment avenue today. And thus, the fourth reason is the availability and
attractiveness of investment opportunities in the economy. If there are no attractive
investment opportunities available in the economy, then the consumer will prefer to consume the
money and if there are investment opportunities available in the economy, the funds will be
invested in the future date in the want of increased amount. In this case, the consumer will
postpone the current consumption and for some time depart from their money, to invest in a
suitable investment avenue for a reasonable return. Investment means the return of current
consumption. All these reasons have their effect on the time value of money. Once the concept of
time value of money is understood, the next step will be to understand the meaning of present
value and future value.

5. Present value:

Currently for dollar amounts, we use the term "present value" or "PV". Present value describes
the process of determining what the value of future cash flows will be in today's dollars.
Therefore, the present value of future cash flows today represents the amount of money that, if
invested at a specific interest rate, would increase the amount of future cash flows at that point in
time. The process of finding current values is called discounting and the interest rate used to
calculate current values is called discounting rate. For example, the present value of $ 100
received over a year is $ 90.91 if the discount rate is 10% annually. (Present Value)
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5.1 Role of Present Value in financial decisions:

The calculation of present values is the foundation of many financial decision making processes
including the area of capital budgeting decisions and other business investments.

All business investment decisions must be based on discounted cash flow (DCF) decision
instruments such as Net Present Value (NPV). Once the after-tax cash flow associated with an
investment project is identified, the process of calculating NPV is nothing more than a series of
PV $ and PV of annuity calculations that help answer the following questions:

Does the project have a positive net present value?

Does the project have a percentage return that exceeds our cost of capital?

If we undertake this project, will we increase the economic value of our firm?

Does the incremental benefit of the project outweigh the incremental costs?

All automobile loans, equipment loans, home mortgage loans, and credit card loans that require
periodic payments (such as monthly payments) in which both interest payable and payments on
the loan principal are often called debt amortization problems. They are, in fact, nothing more
than the PV of the annuity problem.

From Exhibit 1, it can be understood that if one has to find out the future value of any present
sum of money, the technique of compounding is to be used and if the present value of any future
sum is to be calculated, then technique of discounting is used. In the following example, Rs 1100
is the future value of Rs 1000 today and Rs 1000 is the present value of Rs 1100 to be received
after one year @ 10%. Similarly Rs 1210 is the future value of Rs 1000 invested for two years @
10% and Rs 1000 is the present value of Rs 1210 to be received after two years, invested @
10%.

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 Exhibit 1
Rs 1000 invested for 1 year @ 10
Multiply by 1.10
Present Value Future value
Rs 1000 Rs 1100
Multiply by 0.909 (or Divide by 1.10)
Exhibit 2
Rs 1100 invested for 1 year @ 10%
Multiply by 1.10
Present Value Future value
Rs 1100 Rs 1210
Multiply by 0.909 (or Divide by 1.10)

As shown in Exhibit 1 and 2, when Rs 1000 is invested for two years @ 10%, the future amount
is Rs 1210. This process can go on for n number of years. Instead of going year by year,
following formula can be used to arrive at the future value of an invested sum or the present
value of a future sum.

FV = PV (1 + r) n
FV = 1000 (1 + 10/100)2
FV = 1210
The concepts of present value and future value are simple to understand and apply as only simple
calculations are involved.

5.2 Advantages of using NPV:

 Time value of money

The primary benefit of using NPV is that it considers the concept of the time value of
money i.e., a dollar today is worth more than a dollar tomorrow owing to its earning

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 capacity. The computation under NPV considers the discounted net cash flows of an

investment to determine its viability. 

 Decision making
The NPV method enables decision-making processes for companies. This not only helps
in evaluating projects of the same size, but also helps to identify whether a particular
investment is profitable or loss-making.
5.3 Disadvantages:
 No set guidelines to calculate required rate of return
The entire calculation of NPV rests on discounting future cash flows, which flow to their
present value using the required rate of return. However, there are no guidelines as to the
determination of this rate. This percentage value is left to the discretion of the companies,
and there may be instances in which the NPV was incorrect due to an incorrect rate of
return.
 Cannot be used to compare projects of different sizes:
Another disadvantage of NPV is that it cannot be used to compare projects of different
sizes. NPV is a complete figure and not a percentage. Therefore, the NPV of larger
projects will inevitably be higher than that of smaller projects. The return of a small
project may be higher than its investment, but the NPV value may be lower overall.
 Hidden costs
NPV only takes into account the cash flow and outflow of a particular project. It does not
consider any hidden costs, sinking costs or other initial costs about the specific project.
Therefore, the profitability of the project may not be highly accurate.

6. Future value:

For dollar amounts at some point in the future, we use the term "future value" or initial "FV".
Money may increase over time due to interest or other types of returns (i.e., dividends or
depreciation). Practical applications of the future value of a single amount include estimating the
value of a 401K on the day you retire or 529 plans when a child starts college, the amount of a
US savings bond will be due in 10 years, and your Estimated value home five years from now.

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Under compound interest, the interest is earned not only on the initial principal, but also on the
accumulated interest. Interest begins to be paid as soon as it is deposited, which is at the end of
each compounding period. This is in contrast to simple interest, under which interest is earned
only on the initial principal. An annuity is a series of similar cash flows for a fixed period of
time. A fixed rate home mortgage is an annuity.

7. Calculations:

The time value of money problems involves the net worth of cash flows at various points.

In a specific case, the variables can be: a balance (the real or nominal value of a loan or a
financial asset in terms of monetary units), a periodic rate of interest, a number of periods, and a
series of cash flows. (In the case of a loan, cash flows are payments against principal and
interest; in the case of a financial asset, these contribute to the contribution or withdrawal from
the balance.) Generally, cash flows may not be periodic, but specified can be done. Personally.
Any of these variables can be the independent variable (the answer sought) in a problem. For
example, one might know that: interest is 0.5% per term (per month, say); the number of periods
is 60 (months); the initial balance (of the loan, in this case) is 25,000 units; and the final balance
is 0 units. The unknown variable may be the monthly payment that the borrower must pay.

For example, investing £ 100 for a year, earning 5% interest, would be worth £ 105 after one
year; therefore, £ 100 is now paid and £ 105 is exactly the same value after one year both to a
recipient, who expects a 5% interest that inflation will be zero percent. That is, the £ 100
invested for a year at 5% interest estimates inflation to be zero percent.

This principle allows for the valuation of a likely stream of income in the future, in such a way
that annual incomes are discounted and then added together, thus providing a lump-sum "present
value" of the entire income stream; all of the standard calculations for time value of money
derive from the most basic algebraic expression for the present value of a future sum,
"discounted" to the present by an amount equal to the time value of money. For example, the
future value sum to be received in one year is discounted at the rate of interest to give the present
value sum:

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7.1 Standard calculations:

Some standard calculations based on the time value of money are:

 Present value: The current worth of a future sum of money or stream of cash flows,
given a specified rate of return. Future cash flows are "discounted" at the discount rate; the
higher the discount rate, the lower the present value of the future cash flows. Determining
the appropriate discount rate is the key to valuing future cash flows properly, whether they
be earnings or obligations.
 Present value of an annuity: An annuity is a series of equal payments or receipts that
occur at evenly spaced intervals. Leases and rental payments are examples. The payments or
receipts occur at the end of each period for an ordinary annuity while they occur at the
beginning of each period for an annuity due.
Present value of a perpetuity is an infinite and constant stream of identical cash flows.

 Future value: The value of an asset or cash at a specified date in the future, based on the
value of that asset in the present.
 Future value of an annuity (FVA): The future value of a stream of payments (annuity),
assuming the payments are invested at a given rate of interest.

There are several basic equations that represent the equality listed above. The solution (in most
cases) can be found using formulas, a financial calculator, or a spreadsheet. Formulas are
programmed in most financial calculators and many spreadsheet functions (such as PV, FV,
RATE, NPER, and PMT).

For any of the equations given below, the formula can be rearranged to determine one of the
other unknowns. In the case of a standard annuity formula, there is no closed-form algebraic
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solution to the interest rate (although financial calculators and spreadsheet programs can rapidly
determine solutions through trial and error algorithms).

These equations are often combined for special uses. For example, bonds can be easily priced
using these equations. A typical coupon bond is made up of two types of payments: a stream of
coupon payments similar to an annuity, and a lump sum return of capital at the end of the bond's
maturity — that is, future payments. Two formulas can be combined to determine the present
value of the bond.

An important note is that the interest rate for the period concerned is i. For an annuity paying per
year, I will have an annual interest rate. For an income or payment stream with a different
payment schedule, the interest rate must be converted to the relevant periodic interest rate. For
example, the monthly rate of a mortgage with monthly payments requires that the interest rate be
divided by 12 (see example below). For details on the conversion between different periodic
interest rates, see Compound Interest.

The rate of return in the calculation can be solved for either variable, or a predefined variable
that measures the discount rate, interest, inflation, rate of return, cost of equity, cost of debt or
any number of other analogous concepts. Choosing the appropriate rate is important for exercise,
and using an incorrect discount rate will make the results meaningless.

For an annuity-related calculation, it must be decided whether the payment is made at the end of
each period (known as a simple annuity), or at the beginning of each period (known as an annual
liability is). When using a financial calculator or spreadsheet, it can usually be set for either
calculation. The following formulas are for a simple annuity. Due to the answer to the present
value of the annuity, the PV of a simple annuity can be multiplied by (1 + i).

8. Formulas:

The following formula use these common variables:

 PV is the value at time zero (present value)

 FV is the value at time n (future value)
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 A is the value of the individual payments in each compounding period
 n is the number of periods (not necessarily an integer)
 i is the interest rate at which the amount compounds each period
 g is the growing rate of payments over each time period.

8.1 Formula Table:

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9. Computation Tools for Time Value of Money:
A number of computational tools can be used to calculate future value, present values, annuities,
and rates of return. The long, more difficult method is manual calculations using the formulas as
shown in Figure 1. The most basic are financial tables located in the back of the textbook
(Excerpt of FV shown in Table 1). Spreadsheet functions, like Microsoft Excel are easiest to use
(Microsoft Excel Object shown in Table 2). There are also financial calculators that can help
compute time value of money, such as the Hewlett Packard HP-12C which is a standard
handheld calculator in use for more than 25 years.

TVM calculation tools

Table 1. Excerpt of FV Financial Table

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Table 2. Excel Spreadsheet to calculate TVM. Double click to open worksheet and type
information in yellow highlighted cells to calculate value for table above and amount.

Interest # of time
TVM Formula Amount
Rate (i) periods (n)
PV=1/(1+i) n $ 20,000 10% 1
0.90909
$ 18,181.82

FV=1*(1+i) n $ 20,000 10% 1

$ 1.10000
$ 22,000.00

$ 8,000 8% 5
n)
PVA=1-(1/(1+i) /i 3.99271
$ 31,941.68

$1,760,000 9% 5
FVA=(1+i)n-1/i 5.98471
$10,533,091

$ 1,760,000 9% 5

PVAD=PVA*(1+i) 4.23972
$ 7,461,906.98

$ 1,760,000 9% 5
FVAD=FVA*(1+i) 6.52333
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 Figure 1

10. Utility of time value of money concept:

As it has been observed that traditionally the value of money was considered to be the same at all
points. A hundred rupee note was always considered a hundred rupee note. There was no
perceived effect of time on money. With the development of knowledge, it is understood that
time has an effect on the value of money. This led to the development of the concept of time
value for money. Consideration of the present value of money and the future value of money
gave useful insights into the effect of time on the value of money. Whenever one has to receive

17
money in future, it is beneficial to calculate its present value and analyze it in terms of current
cash outflow and required rate of return. It compares cash outflows and cash flows at the same
time, which is otherwise not comparable, at least on a time basis. The concept of time value of
money is really useful when analyzing the cash flows of different points. This makes cash flow
comparable. If the cash flows are spread over a few years, it becomes difficult to compare them.
Thus, the biggest advantage of the concept of time value of money is that it brings cash flow to
different points at the same time, which makes it comparable. Now, bringing all cash flows to
par has many uses in itself, especially in analyzing projects where cash flow is uneven and the
life of the project is years. Organizations use the concept of time value for money in analyzing,
ranking, comparing, short listing and selecting or rejecting various projects and capital
investment opportunities. In such cases, it is very important to bring the cash flow at the same
time. Here, the concept of present value and future value comes to light. Thus, another utility of
the concept of time value of money is the calculation of the present value of any future amount
and vice versa. This makes it easy to take decisions regarding investment. For example, if you
get 1080 rupees after one year from today, if 1000 rupees is invested, then it becomes easy to
compare these amounts, if the value of 1080 rupees is found as of date. To find the current price
of Rs 1080, a discount rate will be required. If the discount rate is 8%, then there is no earnings
and if the discount rate is below 8%, then the earning occurs and if the discount rate is above 8%,
then the loss occurs. Now, this calculation is based on the concept of time value of money.
Individual investors use the time value of money concept to analyze the various investment
opportunities available to them. Once understood, the time value of the currency concept is
simple for analysis of investment possibilities. Investment opportunities need to be analyzed
because we know that the return on investment is negatively related to the amount of risk
associated with the investment. If the investor wants to invest his fund in bank fixed deposits or
government securities in the form of gilt aided securities, he will get minimum returns, as these
are the safest investment route in terms of repayment of principal amount and payment of
interest. As the investor moves forward on the continuum of risk, in the desire for increased
return, he needs to analyze the investment opportunity from different angles, as the probability of
getting higher returns increases as the risk increases and not a return in itself. Thus, an individual
investor needs to analyze the investment opportunity available to him before making any
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investment with the help of the time value of the currency concept. Another utility of the concept
of the time value of money is the valuation of securities of financial assets. A bond proceeding
that is to be received after five years or seven years or after fifteen years and the bond is still to
be purchased today. Now, a decision has to be made about the purchase of the bond. This is done
using the concept of time value of money. The cash flow from the bond is discounted and
compared with the current purchase price of the bond and a decision is made. Similarly, the
concept of value for money is used in the valuation of other financial securities when the time
period is maturity. If a person is to know about his retirement fund, the concept of the time value
of money is to be used for the purpose. Considering the time effect of money, a specific amount
needs to be collected at the time of retirement to help calculate the monthly amount. The time
value of money is also used along with calculating the EMI of long-term loans. Today the same
amount is disbursed and this recovery is done in equal monthly installments. Thus, the concept
of time value of money is used in case of creation of sinking fund and in case of capital recovery.
This concept is also useful in calculating the estimated rate of return of a project. This is the rate
a project is going to earn for itself. This rate of return is compared to the required rate of return,
to further analyze the project. In business and economics, the concept of time value of money has
great utility as the number of N projects is available for investment and the firm has difficulty
deciding on which to place its bets on. Here, various capital budgeting techniques are used by
organizations to finalize promising projects. Yet another utility of the time value concept of
money lies in the evaluation of the firm or business. It is useful at the time of sale and purchase
of a firm or business. In such cases, the present value of the future stream of profits arising from
the business should be calculated and compared with the asking price for the firm or business. A
similar analysis is also needed in the case of mergers and acquisitions. When two organizations
merge or when one organization acquires the other, the number of shares, ratio of profits, etc. are
decided on the basis of generating profit in future. These expected flows of profits in the future
and following the current terms and conditions are analyzed to arrive at various decisions about
the stake in new business, etc. The concept of time value is useful in mortgage cases. This helps
in calculating the monthly mortgage payment. The time value of the currency concept is useful in
all situations where cash flow is required at different points in time to make a decision.

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11. Conclusion:
In a nutshell we can conclude that Time value of money is an important concept in financial
management. This concept says that the money has different value at different points of time.
Traditionally, the money was assumed to have the same value at all points of time meaning that a Rs
100 note was assumed to be always having purchasing power of Rs 100. With knowledge development,
it is understood that the purchasing power of currency is affected and in most of the economies, it is
reduced basically due to the effect of inflation along with other reasons as well. The change in
purchasing power of the currency with the passage of time is known as the time value of money. Time
value of money concept is useful for individuals as well as for corporate. An individual utilizes the
concept of time value of money for analyzing investment opportunities, to calculate sinking funds and to
study capital recovery options. Corporate entities utilize the concept of time value of money to analyze
various projects available for capital investment. Capital budgeting techniques are utilized by the firms
to short list and select various capital investment projects. Time value of money concept is also utilized
for the purpose of valuation of firms at the time of buying and selling of businesses. The calculation of
present and future value of goodwill of any business can be improvised using time value of money
concept. This concept is also useful in case of valuation of firms at the time of mergers and acquisitions
in order to decide upon the share of old firms in new firm, share in profits, decision making power etc.
The organizations also use this concept for the purpose of calculation of sinking fund, monthly payouts
in the cases of mortgage, lease or rental agreements etc.

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