Time Value of Money

Mathematics of finance
Time value of money

❑ Money has different value at different points

in time
❑ A person prefers higher money if it is to be
received after some more time
– The same person might accept lesser money
if it is to be received earlier than scheduled
❑ This time preference is due to –
– Uncertainty in future
– Pressing present needs
– Investment opportunities
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The Timeline
❑ Represents the timing of cash flows

❑ Helps in visualizing the problem

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Constructing the Timeline
Suppose you must pay tuition of Rs.
50,000 per year for the next two
years. Your tuition payments must be
made in equal instalments at the
start of each semester. What is the
timeline of your tuition payments?

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Three rules of time travel
1. It is only possible to compare or
combine values at the same point
in time.
2. To move a cash flow forward in
time, you must compound it.
3. To move a cash flow backward in
time, you must discount it.
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The 1st Rule of Time Travel
❑ A rupee today and a rupee in one year are
not equivalent.
❑ It is only possible to compare or combine
values at the same point in time.
– Which would you prefer: A gift of Rs. 1,000
today or Rs. 1,210 at a later date?
– To answer this, you will have to compare the
alternatives to decide which is worth more.
One factor to consider: How long is “later?”

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The 2nd Rule of Time Travel
❑ To move a cash flow forward in time, you
must compound it.
– Suppose you have a choice between
receiving Rs. 1,000 today or Rs. 1,210
in two years. You believe you can earn
10% on the Rs. 1,000 today, but want
to know what the Rs. 1,000 will be
worth in two years.

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Compounding Example

Suppose you have a choice between

receiving Rs.5,000 today or
Rs.10,000 in five years. You believe
you can earn 10% on the Rs.5,000
today, but want to know what the
Rs.5,000 will be worth in five years.

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The 3rd Rule of Time Travel
❑ To move a cash flow backward in time, you
must discount it.
– Suppose you have a choice between
receiving Rs. 1,000 today or Rs. 1,210
in two years. You believe you can earn
10% on the Rs. 1,000 today, but want
to know what the Rs. 1,210 will be
worth now.

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Exercise

You are considering investing in a savings

bond that will pay Rs. 15,000 in 10 years.

If the competitive market interest rate is

fixed at 6% p.a., what is the bond worth

today? Narain
Example

You need money to buy a new car. Your uncle

will lend you the money so long as you agree to
pay him back within 4 years. You offer to pay
him the rate of interest that he would otherwise
get by putting his money in a savings account
(6%). Based on your earnings and living
expenses, you think you will be able to pay him
Rs. 50,000 in one year and then Rs. 80,000
each year for next three years. How much can
you borrow from him?
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Exercise

❑ 10 annuity payments of Rs. 10,000 will start 5

years from now. Find the present value of
annuity now if interest rate is 10%.

❑ A person receives Rs. 1 lac on retirement and

deposits it in a bank @10%. How much can
he withdraw annually for a period of 10
years?
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CASE DISCUSSION