TIME VALUE OF MONEY

The time value of money is the principle that the purchasing power of money can vary over
time; money today might have a different purchasing power than money a decade later. The
value of money at a future point in time might be calculated by accounting for interest earned or
inflation accrued. The time value of money is the central concept in finance theory.
Which would you prefer -- $10,000 today or $10,000 in 5 years?
Obviously, $10,000 today.
This is what we call time value of money.
Time allows you the opportunity to postpone consumption and earn interest.

INTEREST: Money (paid) or earned on the use of money is called interest.

SIMPLE INTEREST: Simple interest is interest that is paid (earned) on only the original
amount, or principal, borrowed (lent).

Formula SI = P0 (i) (n)

SI: Simple Interest
P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
EXAMPLE:
Q: Assume that you deposit $1,000 in an account earning 7% simple interest for 2 years. What is
the accumulated interest at the end of the 2nd year?
Solution:
SI = P0(i)(n)

= $1,000(.07)(2)
= $140

COMPOUND INTEREST: compound interest, interest payments are added to the principal and
both then earn interest for subsequent periods.
Hence interest is compounded. The greater the number of periods and the more times a period
interest is paid, the greater the compounding and future value.

ANNUITY:
An annuity is a series of cash receipts of the same amount over a period of time.
Annuity can be
 Ordinary annuity
 Annuity due
 Deferred annuity
Ordinary annuity:
Payments or receipts occur at the end of each period.

Annuity due:
In this a series of payments or receipts occur at the beginning of the time period.
COMPOUNDING:
The process of converting present value into future value is called Compounding.

DISCOUNTING:
The process of converting future value into present value is called Discounting.

FUTURE VALUE:
The value at some future time of present amount of money, or a series of payments evaluated at a
given interest rate.

FV= PV (1 + i) n
PRESENT VALUE:
The current value of a future amount of money, or a series of payments, evaluated at a given
interest rate.
Present value, also known as present discounted value, is a future amount of money that has
been discounted to reflect its current value, as if it existed today. The present value is always less
than or equal to the future value because money has interest-earning potential, a characteristic
referred to as the time value of money Time value can be described with the simplified phrase,
“A dollar today is worth more than a dollar tomorrow”. Here, 'worth more' means that its value is
greater. A dollar today is worth more than a dollar tomorrow because the dollar can be invested
and earn a day's worth of interest, making the total accumulate to a value more than a dollar by
tomorrow. Interest can be compared to rent. Just as rent is paid to a landlord by a tenant, without
the ownership of the asset being transferred, interest is paid to a lender by a borrower who gains
access to the money for a time before paying it back. By letting the borrower have access to the
money, the lender has sacrificed their authority over the money, and is compensated for it in the
form of interest. The initial amount of the borrowed funds (the present value) is less than the
total amount of money paid to the lender.

PV= FV/ (1+ i) n

Where,
FV = future value
PV= present value
N = number of years
i= interest rate
DISCOUNT RATE:
Interest rate used to convert future values into present values is called discount rate.

RULE OF 72:
How long does it take to double $5,000 at a compound rate of 12% per year (approx.)?
To find this we use rule of 72.

Rule of 72 says that “divide 72 by interest rate” you will get the desired result.
Solution:
= 72 / 12
= 6 years