Financial Management 20MBA22

Module - 2 Time Value of Money

Time value of Money:

The money you have in hand at the moment is worth more than the same
amount you ‘may’ get in future.
The value of money declines due to the combined impact of the following:
Inflation in the economy;
Risks involved in delayed receipts of cash or financial transactions; and
Opportunity cost of capital delayed.

Simple Interest
It may be defined as interest that is calculated as a simple percentage of the
original principal amount.

Formula of Simple Interest:

SI = P0(i)(n)

Where,
SI = Simple Interest
Po=Original Principal
i= Rate of interest
N= Number of time periods

If we add Simple interest to the Principal we get Total Future value.

FV = Po + Po(i)(n)

Compound Interest
It is the interest that is received on the original amount(Principal)as well as on
any interest earned but not withdrawn during the earlier periods. When
interest is calculated on total of previously earned interest and the original
principal it is called compound interest.

Compound interest can be calculated:

 Annually
 Semi-annually
 Quarterly
 Monthly
 Daily

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Formula to calculate Compound Interest

Annually Semi-annually Quarterly Monthly
A= P(1+r)n A= P(1+r)n*2 A= P(1+r)n*4 A = P(1+r)n*12
2 4 12

Where,
A= Compound Amount
P = Original Amount
R= Rate of interest
N= Number of time periods

Present Value
It is the value of money that you currently have.It is the money you have
currently that is equal to a future one-time disbursal or several part-payments
– discounted by a suitable rate of interest.

Future Value
Future Value is the sum of money that any saving scheme with a compounded
interest will build to by a pre-decided future date. It applies to both lumpsum
as well as recurring investments like SIP.

Annuity
It is a fixed payment (Or receipt)each year for a specified number of years. In
other words it is series of equal Cash flow arising up to a specific period of
time.
Two types :
Deferred Annuity : Cash flow arising at the end of each period.
Annuity Due : Cash flow arising at the beginning of each period.

Perpetuity
Perpetuity is an infinite series of periodic payments of equal face value. In
other words, perpetuity is a situation where a constant payment is to be made

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periodically for an infinite amount of time. It as an annuity having no end and

that is why the perpetuity is sometimes called as perpetual annuity.

Time value money Techniques

1. Present Value ( Discounting Techniques)

2. Future Value(Compounding Techniques)

Future Value
FUTURE VALUE OF A SINGLE CASH FLOW

FV = PV × (1 + r) n

Where,
FV = Future Value
PV = Present Value
R=Rate of Interest
N=Period(Number of Years)

FUTURE VALUE OF A MULTIPLE UNEQUAL CASH FLOW

FV = Summation of PV × (1 + r) n

Where,
FV = Future Value
PV = Present Value
R=Rate of Interest
N=Period(Number of Years)

FUTURE VALUE OF DEFERRED ANNUITY

FV= A * (FVIFA i,n) OR A *(1+r)n - 1

r

FUTURE VALUE OF ANNUITY DUE

FV= A * (FVIFA i,n) (1+r) OR A *(1+r)n - 1 (1+ r)

r

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Present Value
PRESENT VALUE OF A SINGLE CASH FLOW

PV = FV
(1+r)n

Where,
PV=Present Value
FV=Future Value
R=Rate of interest
N=Period(Number of years)

PRESENT VALUE OF MULTIPLE UNEQUAL CASH FLOW

PV = Summation of FV
(1+r)n

PRESENT VALUE OF MULTIPLE EQUAL CASH FLOW (If problem is silent,

always assume DEFERRED ANNUITY)

Deferred Annuity

PV = CF*(PVAF(R, N)) OR PV = CF * 1 – 1
(1+r) n
r

Where,
CF= Annual Cash Flow
PVAF = Present Value Annuity Factor
R = Rate
N= Period

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Annuity Due

PV= CF*(1+PVAF(R, N-1))

Where,
CF= Annual Cash Flow
PVAF = Present Value Annuity Factor
R = Rate
N= Period

PREPETUITY
Present value of Equal cash flow arising up to infinity/perpetuity

PV = Annual Cash Flow

Discount Rate

Present value of growing cash flow up to Infinity

PV = Cash Flow

Discount Rate - Growth Rate

CAPITAL RECOVERY

If we make an investment today for a given period of time at a specified rate of

interest, we may like to know the annual income.

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).

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P = A * PVFAn,i

Therefore,

A = P *[1/PVFAn,i)]

LOAN AMORTISATION

Amortizing loan is a loan where the principal of the loan is paid down over the
life of the loan (that is amortized) according to an amortization schedule,
typically through equal payments. It will determine the amount that needs to
be paid annually in order to repay the loan. The Annual payment (includes
interest (which is calculated on the outstanding balance) and principal
repayment).

Format of loan Amortization Schedule/ Loan repayment schedule

Year Annual Interest Principal repayment Outstanding Balance

Installment

Present Value= CF * PVFA(i,n)

Therefore ,

Cash flow / Annual installment = Present Value

PVFA(i,n)

MONTHLY EQUATED INSTALLMENT

EMI = CF
PVAF

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