Chapter-3

TIME VALUE OF
MONEY

Time Preference for Money

Time preference for money is an
individuals preference for possession of
a given amount of money now, rather
than the same amount at some future
time.It means that the money received
today is more important than value of
same amount of money received after a
certain period of time

Three reasons may be attributed to the

individuals time preference for money:
risk
preference for consumption
investment opportunities

Time Value Adjustment

Two most common methods of
adjusting cash flows for time value of
money:
Compoundingthe process of calculating
future values of cash flows and
Discountingthe process of calculating
present values of cash flows.

Future Value
Compounding is the process of finding the
future values of cash flows by applying the
concept of compound interest.
Compound interest is the interest that is
received on the original amount (principal) as
well as on any interest earned but not
withdrawn during earlier periods.
Simple interest is the interest that is calculated
only on the original amount (principal), and
thus, no compounding of interest takes place.

Future Value
The general form of equation for calculating the future
value of a lump sum after n periods may, therefore, be
written as follows:

F .V P (1 i ) n
The term (1 + i)n is the compound value factor
(CVF) of a lump sum of Re 1, and it always has a
value greater than 1 for positive i, indicating that CVF
increases as i and n increase.

Fn =P CVFn,i

Q. Rs.1000 is invested at 10% compounded

annually for three years. Calculate the
compound value after three years

Example
If you deposited Rs 55,650 in a bank, which
was paying a 15 per cent rate of interest on a
ten-year time deposit, how much would the
deposit grow at the end of ten years?
We will first find out the compound value
factor at 15 per cent for 10 years which is
4.046. Multiplying 4.046 by Rs 55,650, we get
Rs 225,159.90 as the compound value:
FV 55,650 CVF10, 0.12 55,650 4.046 Rs 225,159.90

Whats the FV of an initial

$100 after 3 years if i = 10%?
0

10%

100

FV = ?

Finding FVs (moving to the right

on a time line) is called compounding.

After 1 year:
FV1 = PV + INT1 = PV + PV (i)
= PV(1 + i)
= $100(1.10)
= $110.00.
After 2 years:
FV2 = FV1(1+i) = PV(1 + i)(1+i)
= PV(1+i)2
= $100(1.10)2
= $121.00.

After 3 years:
FV3 = FV2(1+i)=PV(1 + i)2(1+i)
= PV(1+i)3
= $100(1.10)3
= $133.10.
In general,
FVn = PV(1 + i)n.

Whats the FV of a 3-year

ordinary annuity of $100 at
10%?
0

10%

100

100

3
100
110
121
FV = 331

Future Value of an Annuity

Annuity is a fixed payment (or receipt) each year
for a specified number of years. If you rent a flat and
promise to make a series of payments over an
agreed period, you have created an annuity.
(1 i ) n 1
Fn A

The term within brackets is the compound value

factor for an annuity of Re 1, which we shall refer
as CVFA.
Fn =A CVFA n, i

Example
Suppose that a firm deposits Rs 5,000 at the
end of each year for four years at 6 per cent
rate of interest. How much would this annuity
accumulate at the end of the fourth year? We
first find CVFA which is 4.3746. If we multiply
4.375 by Rs 5,000, we obtain a compound
value of Rs 21,875:

F4 5,000(CVFA 4, 0.06 ) 5,000 4.3746 Rs 21,873

FV Annuity Formula
The future value of an annuity with n
periods and an interest rate of i can be
found with the following formula:
n

(1 i) 1
PMT
i
3

(1 0.10) 1
100
331.
0.10

Q. Mr. X deposited Rs.5000 at the beginning of each

year for 5years in a bank and the deposits earns a
compound interest @8% p.a.
Q Determine how
much money he will have at the end of 5 years?

Present Value
Present value of a future cash flow
(inflow or outflow) is the amount of current
cash that is of equivalent value to the
decision-maker.
Discounting is the process of
determining present value of a series of
future cash flows.
The interest rate used for discounting
cash flows is also called the discount rate.

Present Value of a Single Cash

Flow

The following general formula can be employed to

calculate the present value of a lump sum to be
received after some future periods:
P

Fn
n

F
(1

i
)
n
n
(1 i )

The term in parentheses is the discount factor or

present value factor (PVF), and it is always less
than 1.0 for positive i, indicating that a future
amount has a smaller present value.
PV Fn PVFn ,i

Example
Suppose that an investor wants to find
out the present value of Rs 50,000 to
be received after 15 years. Her
interest rate is 9 per cent. First, we will
find out the present value factor, which
is 0.275. Multiplying 0.275 by Rs
50,000, we obtain Rs 13,750 as the
present value:
PV = 50,000 PVF15, 0.09 = 50,000 0.275 = Rs 13,750

Whats the PV of this ordinary

annuity?
0

100

100

100

10%

90.91
82.64
75.13
248.69 = PV

Present Value of an Annuity

The computation of the present value of an
annuity can be written in the following general
form:
1
1
P A

n
i i 1 i

The term within parentheses is the present

value factor of an annuity of Re 1, which we
would call PVFA, and it is a sum of singlepayment present value factors.
P = A PVAFn, i

PV Annuity Formula
The present value of an annuity with n
periods and an interest rate of i can be
found with the following formula:
1
1n
(1 i)
PMT
i
1
13
(1 0.10)
100
248.69
0.10

Whats the PV of $100 due in

3 years if i = 10%?
Finding PVs is discounting, and its
the reverse of compounding.
0
PV = ?

10%

3
100

Solve FVn = PV(1 + i )n for PV:

PV =

FVn
1

n = FVn
1+ i
1+ i

1.10
= $100 0.7513 = $75.13.

PV = $100

Present Value of Perpetuity

Perpetuity is an annuity that occurs
indefinitely. Perpetuities are not very
common in financial decision-making:
Present value of a perpetuity

Perpetuity
Interest rate

Value of an Annuity Due

Annuity due is a series of fixed
receipts or payments starting at the
beginning of each period for a specified
number of periods.
F = A CVFA (1 i)
Future Value of an Annuity Due
n

n,i

P = A PVFA n, i (1 + i )

Present Value of an Annuity Due

Find the FV and PV if the

annuity were an annuity due.
0

10
0

10
0

10%

10
0

PV and FV of Annuity Due

vs. Ordinary Annuity
PV of annuity due:
= (PV of ordinary annuity) (1+i)
= (248.69) (1+ 0.10) = 273.56

FV of annuity due:
= (FV of ordinary annuity) (1+i)
= (331.00) (1+ 0.10) = 364.1

Present Value
Present Value

Discount Factor

Value today of a
future cash
flow.

Present value of
a $1 future
payment.
Discount Rate

Interest rate used

to compute
present values of
future cash flows.