Time value of money

 Individuals

value more the opportunity to receive money in the present than receiving the same amount some time in the future.  There are three reasons that explain the concept of time value of money:  Investment opportunities: Money can be productively employed to earn real returns.

 Risk or uncertainty: As the future is characterized by uncertainty.for present consumption: In an inflationary period. individuals prefer current consumption to future consumption. a rupee today has a higher purchasing power than a rupee in the future. In situations where an individual forgoes the present consumption of a particular amount for  Preference .

he expects a risk premium to be given to him to compensate for the uncertainty associated with the future. .  Hence. the nominal or market interest rate can be expressed as  Nominal rate= Real rate of interest + expected rate of inflation + risk premiums to compensate for uncertainty.future consumption.

m is the frequency of compounding per year.  r= .Effective Interest rate (1+ k/m)m 1  where.

The future value factors are used to find the value of money at the end of year n (in future) at a particular rate of interest. .Future Value of a Single Flow  The method of compounding helps us to find the worth of money at some time in the future.

000 (which we have invested now).  The formula to be used in such a situation is  Future value = Present value (1+k)n  Example: . at the end of 3 years given that the rate of interest earned by it is 4%.Find the value of Rs 1.

(i.e .Future Value of Multiple flows  The above formula computes future value for a single outflow of money.e multiple flows). Let us consider another example where we have to calculate the future value of more than one cash outflow (i.

2.000 at the beginning of the second year and Rs 5. What will be the accumulated value of all these cash outflows at the end of the third year? .000 at the beginning of third year at a rate of interest 5% per annum. Rs. Example: Ram invests Rs 1500 at the beginning of the first year(or in other words at the end of 0th year).

.Present Value of a Single Flow  We apply the technique of discounting to the future cash flows in order to find their present value because the value of an amount (say Re. 1) in future may be less than the value of the same amount at the present moment because of factors like inflation etc.

 Present value = Future value x 1/(1+k)n  Example: . We need to find out the present value of this cash inflow of Rs 2000 that is got at the end of three years with the interest rate being 5%.Suppose a particular investment opportunity provides us Rs 2000 at the end of three years.

Present Value of Multiple Cash Flows A person invested certain amount of money in a project. Rs 2. The project generates an inflow of Rs 1500 at the end of the first year.000 at the end of the third year. What is the present value of these future cash inflows given that the rate of interest is 5%? .000 at the end of the second year and Rs 4.

What is the present value of this annuity of Rs 2000 at 5% interest rate?  The formula that has to be used for computing the present value of an annuity is  Example: . second and third year.Present Value of an Annuity A person invested certain amount of money in a project. The project generates an inflow of Rs 2000 at the end of first.

Annuity)=P.Vx[(1 1)/[k(1 + k)n].  FVIFA(Future Value Investment Factor of an Annuity)=P.(Present (Present Value Investment Factor of an Annuity) = F.Vx[(1 + k)nAnnuity) F.V.V.x [(1 + k)n-1)/k].x  PVIFA .

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