Handout-2 Time Value of Money Spring-2023

Time Value of Money: central concept in finance theory

In general, the concept of the time value of money refers to the idea that the value of money
received today is greater than the value of money received a few days later or that the value of
money received in the future is less than the value of money received now.
From a financial standpoint, the value of money changes with time, so a $100 now and a $100 four
years later is not the same. A hundred dollars of that time is more valuable. It’s a concept known
as the time value of money.

The Importance of Time Value of Money

1. Understanding the time value of money is important when dealing with future
uncertainties. Because the firm is unsure of its future cash receipts, it prioritizes current
cash receipts.
2. Businesses must compare the current project cost and the expected income or money inflow
from investment to assess a long-term project.
3. We all know that the present and future values of money are not the same. We can’t make
long-term decisions without converting the project’s expected income into a present value.
4. If money is invested in one project, it must be foregone to invest in another. It’s known as
“Opportunity Cost” in finance. An organization uses the “Time Value of Money” equations
to calculate this opportunity cost.
5. In today’s world, inflation is common. Inflation reduces the purchasing power of money
over time. There is a distinction between today’s $1 and tomorrow’s $1. As a result of the
inflation, people are interested in obtaining current money.

Timeline:
When it comes to the time value of money, the timeline is very important.
The timeline shows the amount of money that is currently deposited, the amount of money that
will be available after a certain period in the future, or the amount of money that needs to be
deposited each year, every month, or in installments to receive a certain amount of money in the
future. A timeline is a line used to present a list of current and future received and payments.

Present Value:
The present value is the current monetary value of a future amount—the amount of money that
would have to be invested today at a given interest rate over a specified period to equal the future
amount.

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Handout-2 Time Value of Money Spring-2023

People prefer current value to future value because the future is unpredictable. And, as a result of
the uncertainty, interest or opportunity costs are incurred.

Features of Present Value:

1. Discounting is a method of calculating present value.
2. The value of money decreases according to the present value.
3. If the interest rate is higher, the present value will be lower.
4. The money received after a longer period will have a lower present value.

Future Value:
The amount of money available after a certain period in the future if you deposit a certain
amount of money now is known as future value or compound value.
If the number of years is greater, compound interest is calculated on the interest. Future value is
also referred to as compound value and marginal value.
The future value of a present amount is calculated by compounding interest over a specified
period.

Features of Future Value:

5. The future value is determined by adding interest to the current value.
6. The value of money increases according to the future value.
7. If the number of compounds increases, the amount of future value will increase.
8. If the number of years increases, the amount of value will increase in the future.
9. The higher the interest rate, the higher the future value.

Annuity:
An annuity is the receipt or payment of a fixed sum of money over a specified period. In other
words, an annuity is the flow of an equal amount of money at a specified time.
The time between multiple successive money flows and the amount of money flow must be
equal for an annuity to exist. If these conditions are not met, no money flow can be referred to as
an annuity.
An annuity is a continuous stream of equal cash flows. This cash flow can include inflows of
investment returns or outflows of funds invested to earn a future return.

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Handout-2 Time Value of Money Spring-2023

Features of an Annuity:
1. Making the same deposit and receiving the same amount of money.
2. The time interval is the same.
3. In the case of the current price, if the amount of time is longer, People will deposit a
smaller amount of money.
4. In the case of future value, if the amount of time is shorter, People will deposit a greater
proportion of the money.
5. Prices fluctuate over time.

Ordinary Annuity:
Answer: An ordinary annuity is received or deposited at the end of each year, month, or
installment. Ordinary annuities are available in both current and future value.
An ordinary annuity is one in which the cash flow occurs at the end of each year or each period.

Annuity Due:
An annuity due is a sum of money deposited or received at the beginning of each year, month, or
installment.
In the case of an annuity due, a cash flow occurs at the beginning of each period.
PVAD= PMT [{1-1/ (1+i) ^n}/i] (1+i)
FVAD= PMT {(1+i) ^n-1/i} (1+i)

Key Element in Determining the Time Value of Money:

The key element in determining the time value of money is the interest rate. The change in the
value of money as time changes is called the time value of money.
Depending on the interest rate, the future value or current value of the money is determined.

Compound Interest:
Compound interest is the interest computed on the principal and any interest earned that has not
been paid or withdrawn.
Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other
words, interest on interest. It results from reinvesting interest rather than paying it out, so interest
in the next period is earned on the principal sum plus previously accumulated interest.

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