FINANCIAL MANAGEMENT

MODULE TWO : TIME VALUE OF MONEY

• Time Value of Money
• Compounding and Discounting
• Annuities and Non-Annuities
 TIME VALUE OF MONEY
● Value of money changes with time
● Value of Money Received today is more than value of
money received tomorrow, or
● PRESENT VALUE of future money is always LESS

● Reason for Time Preference for money:

● High Risk : future receipt of money is uncertain
● Reinvestment Opportunity : money received now can be
reinvested to earn more returns

So preference is for immediate receipt of money

All future receipts are less worthy – so is DISCOUNTED
 TIME VALUE OF MONEY
● Time Value Concept is important for business firms as well
● Why ?
● INVESTING DECISIONS
● Assets acquired for long-term, benefits arise for long-term
● FINANCING DECISIONS
● Funds raised for long-term, costs incurred for long-term

FM decisions on investing/financing are based on COST-

BENEFIT analysis
Costs and Benefits spread over a very long-tem period are NOT
comparable….
● So bring in the concept of TIME VALUE in calculations
● Convert all cash flows into a COMMON TIME POINT
 TIME VALUE OF MONEY
● Conversion of cash flows into a COMMON TIME POINT
can be done by 2 techniques :
● COMPOUNDING TECHNIQUE : Future Value
● DISCOUNTING TECHNIQUE : Present Value

Both techniques are OPPOSITE in nature.

● In compounding, money GROWS –you end up with more
money
● In discounting, money SHRINKS –you end up with less
money

ANNUITY FLOWS : means a stream of EQUAL annual flows

Unequal annual streams are called NON-ANNUITIES
 COMPOUNDING or FUTURE VALUE

● Initial investments are made to generate a particular return

● Returns generated in first year end is reinvested for the
second year
● This RETURNS and RE-INVESTEMENT OF RETURNS can
continue for indefinite period of time
Year 1 2 3
Interest 0.05 0.05 0.05
Initial Amount 1000 1050 1102.50
Interest 50 52.50 55.125
Ending Amount 1050 1102.50 1157.625

Direct Equation for Compounding is

 COMPOUNDING /FUTURE VALUE OF SERIES OF PAYMENTS

Assume we make a series of payments/investments annually at

different time periods at a particular rate of return
What will all these payments grow to at the end of time period ?

Assume investment period is 3 years. Rate of return is 5 %

Annual payments at year-end is Rs. 500 [1 year], Rs. 1000 [2
year]

Rs. 500 will compound for 2 years A= P[1+r]n = Rs. 551.25

Rs. 1000 will compound for 1 year A = P[1+r]n = Rs. 1050

Total Value of Investments at end of 3 years is Rs. 1,601.25

COMPOUNDING /FUTURE VALUE OF SERIES OF PAYMENTS
 COMPOUNDING /FUTURE VALUE OF SERIES OF PAYMENTS

Assume Interest Rate is 5 % following investments are made:

Year Investment Years Factor Future
End compounded [1+r]n Value
1 500 2 1.1025 551.25
2 1000 1 1.05 1050
3 500 0 1 500
TOTAL 2000 2101.25

Compounding factor can be found from Table

“Compound Value of One Rupee” with given Return and
Time
 COMPOUNDING /FUTURE VALUE OF ANNUITY PAYMENTS
Suppose investment is made for three years with same amount
every year-end at Interest rate of 5%
Year End Investment Years Factor Future
compounded [1+r]n Value
1 2000 2 1.1025 2205
2 2000 1 1.05 2100
3 2000 0 1 2000
TOTAL 2000 3.1525 6305
Simplifying calculations,
2000 [1.1025 + 1.050 + 1] = 2000 x 3.1525 = 6305
Compounding factor can be found from Table
“Compound Value of Annuity of One Rupee” with given
Return and Time
COMPOUNDING /FUTURE VALUE USING TABLES
COMPOUNDING /FUTURE VALUE USING TABLES
 DISCOUNTING or PRESENT VALUE

● Money is received in the FUTURE periods

● Value of money received in future is less worthy than
received now – because re-investment opportunity is lost
● Convert future flows into its equivalent PRESENT VALUE
Year 1 2 3
Interest Opportunity 0.05 0.05 0.05
Money Received 1000 500 2000
Year End
Interest Lost 48 46 272
Present Value 952 454 1728
Direct Equation for Discounting is
DISCOUNTING or PRESENT VALUE
 DISCOUNTING/PRESENT VALUE OF SERIES OF RECIEPTS

Suppose Interest Opportunity rate as 5% following are

receipts:
Year Receipts Years to be Factor Present
End discounted 1/[1+r]n Value
1 500 1 0.952 476
2 1000 2 0.907 907
3 1500 3 0.864 1296
TOTAL 3000 2679

Discounting factor can be found from Table

“Present Value of One Rupee” with given Return and Time
 DISCOUNTING/PRESENT VALUE OF ANNUITY RECIEPTS

Suppose investment is made for three years with same

amount every year-end
Year End Receipts Years Factor Future
discounted 1/[1+r]n Value
1 2000 1 0.952 1904
2 2000 2 0.907 1814
3 2000 3 0.864 1728
TOTAL 2000 2.723 5446

Simplifying calculations,
2000 [0.952 + 0.907 + 0.864] = 2000 x 2.723 = 5446
Discounting factor can be found from Table
“Discount Value of Annuity of One Rupee” with given
Return and Time
DISCOUNTING/PRESENT VALUE USING TABLES
DISCOUNTING/PRESENT VALUE USING TABLES