BUS104: Introduction to Finance

Prepared by:
Shajedul Alam
Senior Lecturer, USB

What Is the Time Value of Money (TVM)?

The time value of money (TVM) is the concept that a sum of money is worth more now
than the same sum will be at a future date due to its earnings potential in the interim.

This is a core principle of finance. A sum of money in the hand has greater value than the
same sum to be paid in the future.

The time value of money is also referred to as present discounted value.

Important points

 Time value of money means that a sum of money is worth more now than the
same sum of money in the future.
 This is because money can grow only through investing. An investment delayed
is an opportunity lost.
 The formula for computing the time value of money considers the amount of
money, its future value, the amount it can earn, and the time frame.
 For savings accounts, the number of compounding periods is an important
determinant as well.

Understanding the Time Value of Money (TVM)

Investors prefer to receive money today rather than the same amount of money in the
future because a sum of money, once invested, grows over time. For example, money
deposited into a savings account earns interest. Over time, the interest is added to the
principal, earning more interest. That's the power of compounding interest.

If it is not invested, the value of the money erodes over time. If you hide $1,000 in a
mattress for three years, you will lose the additional money it could have earned over that
time if invested. It will have even less buying power when you retrieve it because
inflation has reduced its value.

As another example, say you have the option of receiving $10,000 now or $10,000 two
years from now. Despite the equal face value, $10,000 today has more value
and utility than it will two years from now due to the opportunity costs associated with
the delay.

In other words, a payment delayed is an opportunity missed.

Interests

There two types of interest. Simple interest and compound interest. Let’s examine them
with examples:

Bank or financial institutions use the exponential terms and logarithm in their calculations
to find the future value, principal, rate or loan tenure.
Simple interest:
Interest, I = Prt
Where, P= Principal
r= rate
t= time (Expressed in year)
Future value, F= P + I = P + Prt = P(1+rt)
Compound interest
Future value, F = P (1 + r)n

Example:
Find the interest on $1460 for 72 days at 10% interest using a) the exact method and b) the
ordinary method
Here, P= $1460, r= 10%= 0.1
a) I (exact method) = Prt = (1460)(0.1)(72/365) =$28.8
b) I (Ordinary method) = Prt = (1460)(0.1)(72/360)= $29.2

The ordinary interest in always greater than the exact interest.

73
*Ordinary interest = (72)(Exact interest)

Example:
If Tk. 1 is deposited in an account earning 6% compounded annually, then after n years the
account will contain
F= P(1+r)n= 1.(1+6%)n=1. (1+ 0.06)n = 1.06n [n= 20 years; 1.0620 =3.207]
If you have deposited Tk. 1,000 in a 12-month deposit account which yields 6% per annum.
How much money will you have after one year? If you re-invest the total amount for another
year at the same rate what will you have after two years?
Solution
For the first year, F = 1000 (1+0.06)1= 1000 x 1.061 = Tk. 1060
 After the second year, F= 1060 x 1.061 = Tk. 1123.60
After third year, F= 1123.60 x 1.061 = 1191.02
After fourth year, F = 1191.02 x 1.061 = 1262.48
**What if $1000 is en-cashed directly after 4 years = 1000(1+0.06)4 = 1262.48
If the original investment amount was Tk. 100,000 then what would be the maturity value
after 2 years?

Exercise
John has $1,000 to invest and finds that interest rate is 6% per annum compounded annually.
John wants to know how many years will it take for the investment to grow from $1,000 to
$2,000. (Money double scheme).
We know,
F= P(1+r)n
2000= 1000 (1+6%)n
Or, (1+0.06)n = 2000/1000
Or, (1.06)n = 2
Or, ln (1.06)n = ln 2 [Taking ln in both sides]
Or, n ln(1.06) = ln 2
ln 2
Or, n = ln 1.06 = 11.896 years = 11.9 years

Exercise
Find the future value if $20,000 is invested at 6% simple interest for 3 months.
3
Future value, F= P(1+rt) = 20000 (1 + 0.06 x 12 ) = 20000 (1 + 0.015)=$20,300
Exercise
Joly received $50 loan in December 1, 2019 and a month later paid $53.50 to repay the loan.
Find the interest rate.
1
Here, P= $50, F=$53.50, n= 12 year
F= P(1+rt)
1
Or,53.50 = 50 (1+r x 12)
53.5 𝑟
Or, = (1 + 12)
50
𝑟
Or, 1.07 = 1 + 12
𝑟
Or, 1.07- 1 = 12
𝑟
Or, 0.07 = 12
Or, r= 0.07 x 12 = 0.84= 84%