THE TIME VALUE OF MONEY

The recognition of the time value of money and risk is extremely vital in financial decision-
making. If the timing and risk of cash flows is not considered, the firm may make decisions that
may allow it to miss its objective of maximizing the owners’ welfare.
TIME PREFERENCE FOR MONEY OR THE TIME VALUE OF MONEY
If an individual behaves rationally, he or she would value the opportunity to receive money now
higher than waiting for one or more time periods to receive the same amount. Like if you have an
opportunity to receive Rs. 10000 today and in another option Rs. 10000 a year after tomorrow.
TPM or TVM for an Individual
Time preference for money or Time Value of Money (TVM) is an individual’s preference for
possession of a given amount of money now, rather than the same amount at some future time.
Three reasons may be attributed to the individual’s time preference for money:
1. Risk OR Uncertainty: As an individual is not certain about future cash receipts, he or
she prefers receiving cash now.
2. Preference for present or current consumption than future consumption: Most
people have subjective preference for present consumption over future consumption of
goods and services either because of the urgency of their present wants or because of the
risk of not being in a position to enjoy future consumption that may be caused by illness
or death, or because of inflation.
3. Investment opportunities: Most individuals prefer present cash to future cash because
of the available investment opportunities to which they can put present cash to earn
additional cash.

TPM or TVM for a Firm

1. Investment opportunities: In case of the firms, the justification for time preference for
money lies simply in the availability of investment opportunities. In financial decision-
making under certainty, the firm has to determine whether one alternative yields more
cash or the other.
2. In case of a firm, Risk and Preference for present consumption than future consumption
are not sufficient justification.
Required Rate of Return: The time preference for money or time value of money is generally
expressed by an interest rate.

 The required rate of return (RRR) or Expected Rate of Return (ERR) will be calculated
as:
  Required Rate of Return (RRR) or Expected Rate of Return (ERR) = Risk-free rate +
Risk Premium
 The risk-free rate compensates for time while risk premium compensates for risk.
 The required rate of return may also be called the opportunity cost of capital in
comparable risk. It is called so because the investor could invest his money in assets or
securities of equivalent risk.
Like individuals, firms also have required rates of return and use them in evaluating the
desirability of alternative financial decisions.

 How does knowledge of the required rate of return (or simply called the interest rate or
opportunity cost of capital) help an individual or a firm in making investment decision?
 It permits the individual or the firm to convert cash flows occurring at different times to
amounts of equivalent value in the present, that is, a common point of reference.
There are five (5) variables that you need to know in order to understand the time value of
money concept thoroughly:
1. Present value (PV) - This is your current starting amount.  It is the money you have in
your hand at the present time, your initial investment for your future. 
2. Future value (FV) - This is your ending amount at a point in time in the future. It should
be worth more than the present value, provided it is earning interest and growing over
time.
3. The number of periods (N) - This is the timeline for your investment (or debts). It is
usually measured in years, but it could be any scale of time such as quarterly, monthly, or
even daily.
4. Interest rate (I) - This is the growth rate of your money over the lifetime of the
investment. It is stated in a percentage value, such as 8% or .08.
5. Payment amount (PMT) OR Annuity - These are a series of equal, evenly-spaced cash
flows.
FUTURE VALUE:
Compounding is the process of finding the future values of cash flows by applying the
concept of compound interest.

Future Value of a Lump Sum Amount OR Single Cash Flow

 1. If you deposited 55,650 in a bank, which was paying a 15 per cent rate of interest on
a ten-year time deposit, how much would the deposit grow at the end of ten years?

 Future Value = Present Value x (FVIF) r%, n

 Present Value (PV) = 55650

 Interest Rate(r% or i% or k %) = 15%

 n= nper = No. of Period = 10 Years

 Future Value =??

 Future Value = Present Value x (FVIF)r%,n years

 Where, FVIF = Future Value Interest Factor at r% rate of percent and for n number of
periods. Also called as CVF = Compounding Value Factor at r% rate of percent and for
n number of periods.

 FVIF at 15% and 10 Years = 4.0456

 FV after 10 years at 15% = 55650 X 4.0456 = 225137.64

Future Value of an Annuity Amount

Annuity is a fixed amount (payment or receipt) each year for a specified number of years.
If you rent a flat and promise to make a series of payments over an agreed period, you have
created an annuity. The equal-installment loans from the house financing companies or
employers are common examples of annuities.

2. A firm deposit 5, 000 at the end of each year for four years at 6 per cent rate of
interest. How much would this annuity accumulate at the end of the fourth year?

 Future Value of an Annuity = Present Value of Annuity x (FVIFA) r%, n

 Where, FVIFA = Future Value Interest Factor for Annuity at r% rate of percent and for n
number of periods. Also called as CVFA = Compounding Value Factor for Annuity at r
% rate of percent and for n number of periods.

 Present Value of Annuity = 5000

 Interest Rate(r% or i% or k %) = 6%

 n= nper = No. of Period = 4 Years

  Future Value =??

 (FVIFA) r%, n years = 4.3746

 FV of Annuity after 4 years at 6% = 5000 X 4.3746 = 21873

Sinking Fund
Sinking fund is a fund, which is created out of fixed payments each period to accumulate to a
future sum after a specified period. For example, companies generally create sinking funds to
retire bonds (debentures) or loan on maturity.
The factor used to calculate the annuity for a given future sum is called the sinking fund
factor (SFF). It is equal to the reciprocal of the compound value factor for an annuity.

 Future Value of an Annuity = Present Value of Annuity x (FVIFA) r%, n

 Present Value of Annuity (A) = Future value of annuity after n years / (FVIFA) r%, n

 Present Value of Annuity (A) = Future value of annuity after n years X Sinking Fund
Factor at r%, n years
3. A firm wants to accumulate 21,873 at the end of four years from now. How much
they should deposit each year at an interest rate of 6 per cent so that it grows to
21,873 at the end of fourth year?

 Present Value of Annuity (A) = Future value of annuity after n years / (FVIFA) r%, n

 = 21873 / 4.3746 = 5000

PRESENT VALUE
Discounting is the process of finding the present values of future cash flows by applying a
discount rate.
Present Value of a Single Cash Flow
 Present Value= Future Value x (PVIF) r%, n

 Where, PVIF = Present Value Interest Factor at r% rate of percent and for n number of
periods. Also called as PVF = Present Value Factor at r% rate of percent and for n
number of periods.
 4. An investor wants to find out the present value of 50,000 to be received after 15
years. The interest rate is 9 per cent.

 Present Value=??

 Future Value = 50000

 (PVIF) 9 %, 15 years = 0.2745

 Present Value= 50000 x 0.2745 = 13725

Present Value of an Annuity

An investor may have an investment opportunity of receiving an annuity—a constant periodic
amount—for a certain specified number of years.
 Present Value of an Annuity = Future Value of Annuity x (PVIFA) r%, n

 Where, PVIFA = Present Value Interest Factor for Annuity at r% rate of percent and for
n number of periods. Also called as PVIFA = Present Value Factor for Annuity at r%
rate of percent and for n number of periods.

5. A person receives an annuity of 5,000 for four years. If the rate of interests 10 per
cent, the present value of 5,000 annuity will be??

 Present Value of an Annuity = Future Value of Annuity x (PVIFA) r%, n

 (PVIFA) 10%, 4 years = 3.1699

 = 5000 X 3.1699 = 15849.5

Capital Recovery Factor

Capital recovery is the annuity of an investment made today, for a specified period of time, at a
given rate of interest.
The reciprocal of the present value annuity factor is called the capital recovery factor
(CRF).
 6. An investor plans to invest 10,000 today for a period of four years. If your interest
rate is 10 per cent, how much income per year should you receive to recover your
investment?

 Future Value of Annuity = Present Value / (PVIFA) r%, n

 = 10000 / 3.1699 = 3154.67

Capital recovery factor helps in the preparation of a loan amortization schedule or loan
repayment schedule.
Loan Amortization
7. An investor had borrowed a 3-year loan of 10,000 at 9 per cent from your employer
to buy a motorcycle. If your employer requires three equal end-of-year repayments,
then what will be the annual installment??

 Future Value of Annuity = Present Value / (PVIFA) r%, n

PV= 10000
PVIFA at 9% and 3 year loan = 2.5313
Annuity = 10000 / 2.5313 = 3950.54 = 3951
Loan Amortization Schedule
End of Payment OR Interest Principal Outstanding
Year Annuity Prepayment Balance
0 - - - 10000
1 3951 900 3051 6949
2 3951 625 3326 3623
3 3951 326 3949 0

Present Value of Perpetuity

Perpetuity is an annuity that occurs indefinitely. Perpetuities are not very common in financial
decision making. But one can find a few examples. For instance, in the case of irredeemable
preference shares (i.e., preference shares without a maturity), the company is expected to pay
preference dividend perpetually. By definition, in a perpetuity, time period, n, is so large
(mathematically approaches infinity, ∞) that the expression (1 + I) n

8. An investor expects a perpetual sum of 500 annually from his investment. What is
the present value of this perpetuity if interest rate is 10 per cent?
  Present value of Annuity = 500 / 0.10 = 5000

Present Value of an Uneven Cash Flow

Investments made by a firm do not frequently yield constant periodic cash flows (annuity). In
most instances the firm receives a stream of uneven cash flows. Thus the present value factors
for an annuity cannot be used. The procedure is to calculate the present value of each cash flow
and aggregate all present values.
9. An investor has an opportunity of receiving 1,000, 1,500, 800, 1,100 and 400
respectively at the end of one through five years. Find out the present value of this
stream of uneven cash flows, if the investor’s required interest rate is 8 per cent.

 PV = 1000 X (PVIF)8%,1 year + 1500 X (PVIF)8%, 2 year + 800 X (PVIF)8%, 3 year +

1100 X (PVIF)8%, 4 year + 400 X (PVIF)8%, 5 year

 = 1000 X 0.926 + 1500 X 0.857 + 800 X 0.794 +1100 X 0.735 + 400 X 0.681 = 3927.60

Present Value of Growing Annuity

In financial decision-making there are numbers of situations where cash flows may grow at a
constant rate. For example, in the case of companies, dividends are expected to grow at a
constant rate.
10. Assume that to finance your post-graduate studies in an evening college, you
undertake a part-time job for 5 years. Your employer fixes an annual salary of 1,000
at the end with the provision that you will get annual increment at the rate of 10 per
cent. It means that you shall get the following amounts from year 1 through year 5.

End of the Amount of Salary

Year
1 1000 1000 X 1.100 1000
2 1000 X 1.10 1000 X 1.101 1100
3 1100 X 1.10 1000 X 1.102 1210
4 1210 X 1.10 1000 X 1.103 1331
5 1331 X 1.10 1000 X 1.104 1464

Present Value of Salary

Year Salary Amount PVIF @ 12% PV of Salary
End
1 1000 0.893 893
2 1100 0.797 877
3 1210 0.712 862
4 1331 0.636 847
5 1464 0.567 837
Total 6105 4309
Present Value of Growing Perpetuities
Constantly growing perpetuities are annuities growing indefinitely. How can we value a
constantly growing perpetuity?

11. A company paid a dividend of `60 last year. The dividend stream commencing from
year one is expected to grow at 10 per cent per annum for 15 years and then end. If
the discount rate is 21 per cent, what is the present value of the expected series?
Suppose dividends of `66 after year one are expected to grow at 10 per cent
indefinitely.

 A = 66

 I = 0.21

 g = 0.10

 P = 0.66 / (0.21 – 0.10) = 600

VALUE OF AN ANNUITY DUE

Annuity due is a series of fixed amount (receipts or payments) starting at the beginning of
each period for a specified number of periods.
When you buy a fridge on an installment basis, the dealer requires you to make the first payment
immediately (viz. in the beginning of the first period) and subsequent installments in the
beginning of each period. It is common in lease or hire purchase contracts that lease or hire
purchase payments are required to be made in the beginning of each period. Lease is a contract to
pay lease rentals (payments) for the use of an asset. Hire purchase contract involves regular
payment (installments) for acquiring (owning) an asset.
Future Value of an Annuity Due

You can see that the compound value of an annuity due is more than of an annuity because it
earns extra interest for one year.
FV of Annuity Due = A X (FVIFA) i%, n years X (1+i)
12. What would be the compound value of 1 rupee deposited at the beginning of each
year for 4 years at the rate of 6%?
  = 1 × 4.375 × 1.06 = 4.637

Present Value of an Annuity Due

The present value of an annuity due would be higher than the present value of an annuity. Note
that if the first payment is made immediately, then its present value would be the same (i.e., `1)
and each year’s cash payment will be discounted by one year less.

PV of Annuity Due = A X (PVIFA) i%, n years X (1+i)

13. What would be the present value of 1 rupee paid at the beginning of each year for 4
years at the rate of 10%?

 = 1 X 3.170 X 1.10 = 3847

 Time Value of Money Table Clues

• If PV of single Cash Flow & Calculating FV as a single sum.

Table: FVIF

• If FV of single Cash Flow & Calculating PV as a single sum.

Table: PVIF

• If PV of Annuity / Installment & Calculating FV as a single sum.

Table: FVIFA

• If FV of Annuity / Installment & Calculating PV as a single sum.

Table: PVIFA

• If PV of single Cash Flow & Calculating FV of Installment / Annuity (Loan

Amortization / Borrowed Money to be paid in future installments)

Table: PVIFA (Inverse/ Reciprocal) / Capital Recovery Factor

A X PVIFA @ R%, T Periods = Present value of Sum

A = Present value of Sum / PVIFA @ R%, T Periods

• If FV of single Cash Flow & Calculating PV of Installment / Annuity (Creating a

future fund or pool of funds or kitty)

Table: FVIFA (Inverse/ Reciprocal) / Sinking Fund Factor

A X FVIFA @ R%, T Periods = Future Value of a Sum

A = Future Value of Sum / FVIFA @ R%, T Periods

Time Value of Money Table Formulae