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TIME VALUE OF MONEY

PRESENTED BY : DIPTENDU BASU EXECUTIVE MBA(2012-2014) PRN NO : 001

affect the firm‟s cash flows in different time periods. A rupee today is more valuable than a year hence.  Cash flows become logically comparable when they are appropriately adjusted for their differences in timing and risk. The recognition of the time value of money and risk is extremely vital in financial decision-making.INTRODUCTION  Money has time value.  Thus. 2 . The recognition of the time value of money and risk is extremely vital in financial decision making.  Most financial decisions such as the purchase of assets or procurement of funds. It is on this concept “the time value of money” is based. we conclude that time value of money is central to the concept of finance. It recognizes that the value of money is different at different points of time.

REASONS FOR TIME VALUE OF MONEY Risk and Uncertainty : Future is always uncertain and risky. the money received today. In other words. There is no certainty for future cash inflows. a rupee today represents a greater real purchasing power than a rupee a year hence. Out flow of cash is in our control as payments to parties are made by us. Bank etc. it prefers receiving cash now. Inflation: In an inflationary economy. 3 . has more purchasing power than the money to be received in future. Cash inflows is dependent out on our Creditor. As an individual or firm is not certain about future cash receipts.

to give him a higher value to be received tomorrow or after a certain period of time. “Thus.REASONS FOR TIME VALUE OF MONEY Consumption: Individuals generally prefer current consumption to future consumption. Investment opportunities: An investor can profitably employ a rupee received today. is worth more than if the same is received after a certain period of time.” 4 . a sum of money received today. the fundamental principle behind the concept of time value of money is that.

5 . 4. 3.THE EIGHT PRINCIPLE OF TIME VALUE 1. 2. A rupee received today is greater than a rupee received tomorrow because money has time value. The time value of money is a compensation for postponement of consumption of money. The value of money is the rate of return expected from a comparable investment alternative. Time value of money is the aggregate of inflation rate. the real rate of return on risk free investment and the risk premium.

6 .. Higher the risk. 6. higher will be time value of money. A safer rupee is greater in value than a risk rupee.THE EIGHT PRINCIPLE OF TIME VALUE(CONTD. Time value of money can be different for different people because each person has a different desired compensation for postponing the consumption of money. The value of an asset is the present value of the future cash flows to be received across the life of the asset discounted at the appropriate time value of money. The time value of money can be different for the same individual with reference to differing investments because the risk profile is different for different investments. 7.) 5. 8.

LETS PROCEED TO PUT IT TO PRACTICAL USE. there is one inflow and one outflow. THIS CAN BE A SINGLE CASH FLOW OR MULTIPLE FLOWS. TO DO THAT WE MUST UNDERSTAND THE FOLLOWING TEN ISSUES: EVERY PROJECT HAS A CASH FLOW STREAM.MANY VALUES AND MONEY VALUES NOW WE KNOW ABOUT TIME VALUE OF MONEY.e. 7 . SINGLE FLOW: This means that there is only one cash flow ..i.

It is same thing as the “amount” that we learnt in the compounded interest formula at school. (1+r)n IS CALLED FUTURE VALUE FACTOR. 8 . FORMULA . It is tomorrows value of today‟s money compounded at TVM.ISSUE 1 : FUTURE VALUE OF A SINGLE CASH FLOW   Future value is the cash value of an investment at some time in the future.1 FV = PV X (1+TVM)n FV = TODAY’S INVESTMENT X FVF FV – FUTURE VALUE PV – PRESENT VALUE FVF – FUTURE VALUE FACTOR WHERE INVEST FOR n YEARS AT r % OUR INVESTMENT WILL GROW TO (1+r)n.

ISSUE 2 : PRESENT VALUE OF A SINGLE CASH FLOW         Future value is tomorrows value of today's money compounded at time value of money. In others words future value and present value are related to each other in fact they are reciprocal to each other. FV = Today's investment x FVF We know that today's investment is called Present Value Hence FV = Present Value x FVF Or FV x 1/ FVF = Present Value 1/FVF is called the present value factor Hence PV = Tomorrows Value x PVF Or PV = Single sum x PVF Present value factor also called the discount factor. It is also the Time Value of Money 9 . Twist that around and we can say present value is today's value of tomorrows money discounted at the time value of money.

MANY VALUES AND MONEY VALUES MULTIPLE FLOW Still we were talking about single cash flow. There are two kinds of annuity – Annuity Regular and Annuity Immediate. The world of investment is however not that simple. In Annuity Immediate the first receipt or payment takes place immediate. we will be faced with multiple cash flows. (Issue 3 and 4)  Annuity means cash flows in various years are uniform and constant. In Annuity Regular the first payment or receipt takes place at the end of one period.  Uneven cash flows means that cash flows in the various years are not uniform. (Issue 8 and 9) 10 . (Issue 5 to 7)  Perpetuity is a special kind of annuity where the cash flow is for ever. These multiple cash flows can either be uneven cash flows or even cash flows or perpetual even cash flows. In all probability.

Step – 1 : Decide the future date. 11 . Step – 2: Aggregate. Compute future value of each cash flow.ISSUE 3 : FUTURE VALUE OF UNEVEN CASH FLOW In this case we simply have to compute the future value of cash flow as at specified date and then add them.

12 . Step – 2: Aggregate the present values.ISSUE – 4 : PRESENT VALUE OF UNEVEN CASH FLOW So how does one can calculate the present value of an uneven cash flow stream? While there are several methods we can do as following: Step – 1: Compute the present value of each of the cash flow separately.

Step – 2: FVA = Annuity x FVAF 13 .ISSUE –5: FUTURE VALUE OF AN ANNUITY REGULAR Step – 1 : Compute Future Value Annuity Factor(FVAF) using the formula : FVAF = [ FVF-1]/R or by referring to the FVAF table.

ISSUE –6: PRESENT VALUE OF AN ANNUITY REGULAR Step – 1: Compute PVAF using the formula : PVAF = [1-PVF]/R or by referring PVF table Step – 2: Present value of annuity = Annuity x PVAF 14 .

Calculating the annuity due involves two steps: Step – 1: Calculate the future value as though it were an ordinary annuity Step – 2: multiply the result by (1+r) 15 . When the first receipt or payment is made today it is called Annuity due or Annuity immediate.ISSUE –7 ANNUITY DUE OR ANNUITY IMMEDIATE Annuity regular assumed that the first receipt or the first premium is made a year later.

We would like to do so because we would like to compare this with alternative options. However we can compute a future value of the perpetuity.ISSUE – 8 & 9 PERPETUITY AND GROWING PERPETUITY Perpetuity is a special kind of annuity where the annual receipt or payment takes place forever. Since the payment is for ever we cant compute a future value. PV of perpetuity = Perpetuity/ Time value of money Growing perpetuity is in that case where we take inflation into account PV of perpetuity = Perpetuity/ (Time value of moneyInflation rate) 16 .

if monthly compounding is to be made. The formula to calculate the compound value is 17 . COMPOUNDING AT FASTER FREQUENCY(MULTIPLE COMPOUNDING PERIOD) Interest can be compounded monthly. If compounding is quarterly.ISSUE – 10 . annual interest rate is to be divided by 12 and number of years is to be multiplied by 12. Similarly. quarterly and half-yearly. annual interest rate is to be divided by 4 and the number of years is to be multiplied by 4.

FVn = Future value after „n‟ years PV = Cash flow today r = Interest rate per annum m = Number of times compounding is done during a year n = Number of years for which compounding is done.ISSUE – 10 . COMPOUNDING AT FASTER FREQUENCY(MULTIPLE COMPOUNDING PERIOD) where. 18 .

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