Lecture 4

Time Value of Money & Interest Rate

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 Time Value of Money(TVM)
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 Time Value of Money (TVM)
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 Example
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 Example
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 Discounting
Generally, financial flows (streams of expenditures and income)

from projects do not occur during the project evaluation.

They occur after a year, a few years, or often after many years.

Annual cash flows are the difference between money received and

money paid out, each year.

Cash flows or financial flows (outlays) occurring at different times

cannot be readily added, since £1 today is different from £1 next
year, and very different from £1 in 20 years’ time.

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 Discounting
Therefore, an important factor to recognise in project evaluation is
the time value of money.

There are many reasons for this.

• Future incomes are eroded by inflation; therefore the purchasing

power of a pound today is higher than a pound in a year’s time.

• The existence of risk, an income or expenditure that occurs today,
is a sure amount.
• The need for a return; by undertaking investment and foregoing
expenditure today, an investor expects to be rewarded by a return in
the future.
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 Discounting
Even if inflation is allowed for, or ignored, money today will still

remain more valuable than tomorrow’s money because of risk and

expectation of a reward by forgoing today’s expenditure.

To an investor, £1 today is more valuable than tomorrow’s £1,

because it can be invested immediately and can earn a real income,

that is, a return higher than inflation.

Today’s £1 will equal tomorrow’s £1 plus a real value.

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 Discounting
Present valuing (discounting) is central to the financial and

economical evaluation process.

Since most of the project costs, as well as benefits, occur in the

future, it is essential that these should be discounted to their present

value (worth) to enable proper evaluation.

The discount factor is a function of the discount rate (r), which is

the reward that investors demand for accepting a delayed payment.

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 Discounting
It is also referred to as the rate of return or opportunity cost of

capital, so that present value (PV) = discount factor × F1

where discount factor = 1/(1+r).

The discount factor is sometimes called the present worth factor.

It is defined as how much a pound in the future is worth today.

Therefore, with a discount rate (expected rate of return) of 10%
annually, the discount factor for the first year’s financial outlay will
be 1/(1 + 0.1) = 0.909, and £110 materialising after one year will
equal to 0.909 × £110 = £100 today.
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 Discounting
Similarly, an outlay at year 2 will have to be multiplied by 1/(1 + r)2

and that occurring at a year n will have a discount factor of 1/(1+r)n.

Therefore, the discount factor, in year n, is equal to discount factor =

1/(1 + r)n and present value = Fn × discount factor = Fn × [1/(1 + r)n].

Therefore, £1000 occurring after 5 years, with a discount rate of 10

per cent, will have a present value equal to £1000 × [1/(1 + 0.1)5] =
£620.92 today.

Similarly, £1000 occurring after 30 years will be equal to £1000.0 ×

[1/(1 + 0.1)30] = £57.31 today.

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 Discounting
In the same way, the process of discounting can be converted to a
process of compounding when it is required to present value past
payments.

The compound factor is the reciprocal of the discount factor and is

equal to (1 + r)n.

Therefore, a financial outlay that occurred one year earlier has a

present worth equal to (1 + r) of the value of that outlay today.

A payment of £1000 that occurred a year from now, will have a

present value of £1000(1 + 0.1) = £1100 today.

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 Interest Rate (IR)
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 Interest Rate (IR)
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 Rate of Return (ROR)
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 Interest Rate and Rate of Return
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 Interest Rate and Rate of Return
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 Interest Rate and Rate of Return
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 Simple Interest
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 Interest Rate and Rate of Return
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 Compound Interest
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 Compound Interest Factor
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 Compound Interest Factor
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 Compound Interest Factor
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 Compound Interest Factor
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 Single Payment Compound Amount Factor
(SPCAF)
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 Single Payment Compound Amount Factor
(SPCAF)
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 Single Payment Compound Amount Factor
(SPCAF)
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 Single Payment Present Worth Factor (SPPWF)
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 Single Payment Present Worth Factor (SPPWF)
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 Uniform Series Present worth Factor (USPWF)
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 Uniform Series Present worth Factor (USPWF)
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 Uniform Series Present worth Factor (USPWF)
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 Capital Recovery Factor (CRF)
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 Capital Recovery Factor (CRF)
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 Uniform Series Compound Amount Factor
(USCAF)
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 Uniform Series Compound Amount Factor
(USCAF)
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 Sinking Fund (SF)
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 Sinking Fund (SF)
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 Sinking Fund (SF)
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 Sinking Fund (SF)
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 Net present value (NPV)
Along the life of the project there will be two financial streams: one
is the costs stream (which includes capital and operational cost (C))
and the other is the benefits stream (B).

The two streams must contain all costs and benefits for the same
estimated life frame of the project.

The costs stream, being outward-flowing cash, is regarded as

negative.

The difference between the two streams is the cash flows – the ‘net
benefits stream’.
The values of the net benefits in certain years can be negative,
particularly during construction and the early years of the project.
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 Net present value (NPV)
Discounting the net benefits stream into its present value, by

multiplying each year’s net benefits by that year’s discount factor,

will present the net present value (NPV) of the project as detailed in

the example in Table below, which utilises a discount rate of 10%.

Notice that outward-flowing cash (costs) are negative whereas

inward-flowing cash (income) is positive:

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 Net present value (NPV)
NPV – real terms

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 Net present value (NPV)
Usually projects are undertaken because they have a positive net

present value.

That is, their rate of return is higher than the discount rate, which is

the opportunity cost of capital.

The calculation of NPV is the most important aspect in project

evaluation and its positive estimation, at the designated discount

rate, is essential before undertaking a project.

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 Quantifying alternatives for decision making
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 Quantifying alternatives for decision making
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 Quantifying alternatives for decision making
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 Quantifying alternatives for decision making
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Thank you !!!

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