Time Value of Money

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Agenda

In this video we will discuss ….

• Concept of time value of money

• Relationship between time and money
• Compounding
• Discounting
• Rule 72
• Perpetuity
• Growing perpetuity

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What is time value of money?
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Discounting

Think ! ! !
OPTION - 1 OPTION - 2

Collect the amount of Rs. 10,000 Collect the amount of Rs. 10,000
TODAY A year later

Which option would you choose? Why ?

A. Default risk
B. Inflation risk
C. Re-investment opportunities

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Time value of money cont..

Therefore,
– The rupee earned today will have more value than the rupee
that would be earned tomorrow.
– The rupee saved today will have more value than the rupee
that would be saved tomorrow.
– The rupee invested today will have more value than the rupee
that would be invested tomorrow.

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 Time value of money – two broad areas

The topic can be discussed further under two broad areas.

Discounting
Conversion of future value of money into present value of
money.

Compounding
Conversion of present value of money into future value of
money.

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Discounting
Conversion of future value of money into present of value

Present value of money can be calculated using the equation shown below:
𝑭𝑽
𝑷𝑽 = 𝒏
𝟏+𝒓
Where,

FV indicates the future value of money to be received

r indicates the reference rate or discount rate for the year

n indicates the period or number of years

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Discounting
Hypothetical case on discounting
Let us assume that, your reporting manager is impressed with the performance of the team during the
last quarter. In order to encourage the team, the management has decided to offer an “employment
continuance incentive”. Let us say the management offers incentive with three alternatives.

Alternative 1: Receive Rs.1,00,000 at the end of three years;

Alternative 2: Receive Rs.32,000 at the end of each year for the next three years;
Alternative 3: Receive Rs.36,000 at the end of the 1st year, Rs. 32,000 at the end of the second year and
Rs 28,000 at the end of third year.
The management gives team a day’s time to decide on the alternative they want to opt for.

If you are part of this team, then which option would you choose and why?

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Discounting
Alternative 1: Receive Rs.1,00,000 at the end of three years
The present value of a single cash flow can be calculated using the equation:

FV
PV = n
1+r

Given: FV = ₹1,00,000; r = 6.5%; n = 3 years

On substitution of the above values in the equation, we get
1,00,000
PV = = ₹82,784.91
(1 + 0.065)3

Therefore, ₹82,784.91 today is equivalent to having ₹1,00,000 after 3 years.

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 Discounting
Alternative 2: Receive Rs.32,000 at the end of each year for the next 3 years

[Present Value of a Multiple Even Cash Flows]

Present Value (₹)
FV
Discount Table Value PV =
1+r n
Year Cash Flow (₹) Rate
(A) (B) (C) (D) (E)

‘n’ ‘FV’ ‘r’ ‘PV’

1 32,000 6.50% 30,046.95
2 32,000 6.50% 28,213.10
3 32,000 6.50% 26,491.17
Total 96,000 - 84,751.12
Therefore, ₹84,751.12 today is Proprietary
equivalent to having ₹1,00,000 after 3 years.
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Discounting
Alternative 3: Receive Rs.36,000 at the end of the 1st year, Rs. 32,000 at the end of the
second year and Rs. 28,000 at the end of third year
FV
Table Value PV =
1+r n
Year Cash Flow (₹) Discount Rate
(A) (B) (C)
(D) (E)

‘n’ ‘FV’ ‘r’ ‘PV’

1 36,000 6.50% 32,863.85
0.938967

2 32,000 6.50% 28,213.10

0.881659

3 28,000 6.50% 23,179.77

0.827849
Total 96,000 - 84,256.72
₹84,256.72 today is equivalent to having ₹1,00,000 after 3 years.
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 Discounting
Decision Time….
Discounted Cash
Alternatives Options to choose
flows (₹)
Receive Rs.1,00,000 at the end of
1 82,784.91
three years
Receive Rs.32,000 at the end of each
2 84,751.12
year for the next 3 years

Receive Rs.36,000 at the end of the

1st year, Rs 32,000 at the end of the
3 84,256.72
second year and Rs 28,000 at the end
of third year

ALTERNATIVE 2 : ₹ 84,751.12
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Compounding - Future value of money

• Refers to an increasing value of an asset due to the interest earned on both a principal
and accumulated interest.
• Conversion of present value of money to future value of money
• While calculating compound interest, the number of periods makes a significant
difference to the overall value of your investment.

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Compounding Formula
Future Value Formula Compounding Table

FVn = PV (1+r) n
FVn = PV * FVIFr,n

Where, Where,
FV = Future value FV = Future value
PV = Present value PV = Present value
r = Discount rate r = Discount rate
n = Number of years n = Number of years
FVIFr,n Future value interest factor

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 Compounding
Example 1
What is the future value of ₹1,000 deposited for 3 years with a financial
institution offering 8% return per year?

Solution:
Given: PV = ₹1000; r = 8% = 0.08; n = 3 years FVn = PV (1+r) n

FVn = PV (1+r) n FVn = 1000 (1+0.08) 3

₹1,260 FVn = PV * FVIFr,n
Alternatively,
you can refer to the FVIF table, where you can look for n = 3 and move
horizontally, till we reach 8% where you will get the factor value. On substituting
this value in the equation we get:
FV = PV × FVIF r, n
FV = 1000 × FVIF 8%, 3 = 1000 × 1.26 = ₹1,260
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Compounding
Example 2
Let us consider that you are a popular financial consultant in Bengaluru . A customer comes to you
for a financial advice. You are thinking about recommending your client to invest in gold that costs
₹85,000. You are certain that next year the gold will be worth ₹91,000 and assure ₹6,000 gain. Given
that the guaranteed interest rate in a bank is 10%, should the client undertake investment in gold?

Given that FV=PV(1+r)n

PV= Rs 85,000 = 85000(1+0.1)1
r = 10% FV = Rs 93,500
n= 1 year Since future value of Rs 93,500 is greater than
Rs 91,000, it is advisable for the client to invest
money in the bank.
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Rule 72

• How many years it will take for your money to become double at a specified rate of interest.
• The number(72) should be divided by the prevailing interest rates in the market
• Applied to anything that increases exponentially (GDP,Inflation)
• Will it work really?

72
𝑌𝑒𝑎𝑟𝑠 𝑡𝑜 𝐷𝑜𝑢𝑏𝑙𝑒 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒

Rule of 72=ln(e)=1

where:
e=2.718281828
Variations 69,70 and 72
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Rule 72
Example
Suppose you want to invest Rs 1,00,000 today at the compounded annual interest rate is 8%.
How long will it take for your money to become double?

72
𝑌𝑒𝑎𝑟𝑠 𝑡𝑜 𝐷𝑜𝑢𝑏𝑙𝑒 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒

72
=
8
Years to double = 9 Years

Therefore, your money (Rs. 1,00,000) will be doubled in 9 years

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Summary

Here is a quick recap of what we have learned so far:

• The value of money depreciates over a period of time due to inflation effect.
• Compounding refers to conversion of present value of money to future value of money
• Discounting refers to conversion of future value of money to present value of money.
• The rupee earned today will have more value than the money that would be earned tomorrow.
• The rupee saved today will have more value than the money that would be saved tomorrow.
• The rupee invested today will have more value than the money that would be invested tomorrow.
• Perpetuity refers to a constant stream of cash flows with no end.
• Growing perpetuity refers to a cash flow that is not only expected to be received for indefinite
period of time, but also grow with the same rate of growth forever.

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