TIME VALUE AND MONEY

OBJECTIVE
• To Know the basis of mathematics of finance
• To Recognition of time value of money in financial decision making which is
extremely important

WHY TIME VALUE OF MONEY IS IMPORTANT ?

• Since Wealth maximization is superior to Profit maximization in Financial
management so Financial decisions taken today has implications for a number of
years it spreads into the future.
• In order to acquire assets Funds have to be procured from different sources such as
raising of capital through new issues, bank borrowings, term loans from financial
institutions, sale of debentures etc. These involve a cash inflow at the time of
raising funds as well as an obligation to pay interest /dividend and return the
principal in future. It is on basis of cash inflow and outflow the financial decisions
are made.
• The two variables cash inflow and outflow must strictly comparable for
incorporation of time element in the calculations.
DEFINITION-
Time Value of Money means that the value of a unit of money is different in
different time periods. Time value of money can also be referred to as Time
Preference for Money.
The main reason for time preference for money is to be found in the
reinvestment opportunities for funds which are received early. The funds so
invested will earn a rate of return this would not be possible if the funds are
received at a later time. The time preference for money is, therefore expressed
generally in terms of a Rate of return or more popularly as a Discount rate.

TECHNIQUES
The preceding has revealed that in order to have logical and meaningful
comparisons between cash flow that result in different time periods it is necessary
to convert the sums of money to a common point in time. There are two techniques
for doing this
1. Compounding Technique
2. Discounting Technique
1. COMPOUNDING TECHNIQUE
(i) ANNUAL COMPOUNDING.
(ii) SEMI-ANNUAL COMPOUNDING .
(iii) QUARTERLY COMPOUNDING.
(iv) COMPARISION OF ANNUAL,SEMI,QUATERLY COMPOUNDING
(v) FUTURE/COMPOUNDED VALUE OF A SERIES OF PAYMENTS

2. PRESENT VALUE OR DISCOUNTING TECHNIQUE

(i) PRESENT VALUE OF A SERIES OF CASH FLOWS.
(ii) PRESENT VALUE OF UNEVEN CASH INFLOWS HAVING ANNUITY.
(iii) PRESENT VALUE OF AN INFINITE LIFE ANNUITY( PERPETUITIES)
COMPOUNDING TECHNIQUES
Interest is Compounded( Future value) when the amount earned on an initial deposit
(principal value) becomes part of the principal at the end of the first compounding
period. The Term Principle refers to the amount of money on which interest is received.
The compounding procedure will continue for an indefinite number of years. The
compounding of interest can be calculated by the following equation.
A =P(1+i) n
A = amount at the end of the period.
P=Principle at the beginning of the period.
i= rate of interest
n= number of years.

TWO IMPORTANT OBSERVATIONS ON COMPOUND INTEREST FORMULA

1. The interest rate increases for any given year, the compound interest factor also
increases. Thus higher the interest rate, the greater is the future sum.
2. For the given rate of interest, the future sum of a rupee increases with the passage of
time. Thus , the longer the period of time, the higher is the compound interest factor.
NOTE : When i=0 , A=P.
 Frequent Compounding of Interest:
What if interest is paid more frequently?
Annual Compounding, Semi- Annual Compounding ,Quarterly compounding ,
Monthly compounding etc are few examples.

(i) ANNUAL COMPOUNDING

It means compounding at the end of the year.
Annually = P × (1 + i)

(ii) SEMI ANNUAL COMPOUNDING

It means two compounding periods within a year. Interest is actually paid after
every six months at a rate of one-half of the annual(stated) rate of interest.
Semi Annually= P(1+i/2) nx2
(iii) QUARTERLY COMPOUNDING
It means four compounding periods in a year. Interest is actually paid equal four installments after
every three months .
Quaterly= P(1+i/4) (4 * n)

(iv)COMPARISION OF ANNUAL,SEMI,QUATERLY COMPOUNDING

The effect of Compounding more than once a year can also be expressed in the form of a formula.
A = P (1+i/m) (m*n)

(v) FUTURE/COMPOUNDED VALUE OF A SERIES OF PAYMENTS

So far we have considered only the future value of a single payment made at the time zero. In
many instances we may be interested in the future value of a series of payment made at different
time periods.
A = P(1+i)n-1 + P(1+i)n-2 + P(1+i)n-3 ..............P(1+i)0
PRESENT VALUE OR DISCOUNTING TECHNIQUES
The concept of present value is the exact opposite of that of Compound value.
While in the latter approach money invested now appreciates in value because
compound interest is added , in the former approach ( present value approach )
money is received at some future date and will be worth less because the
corresponding interest is lost during the period .
In other words present value of rupee that will be received in the future
will be less than the value of a rupee in hand today.
In contrast to the compounding approach where we convert present sums
into future sums, in present value approach future rupees will always be lower.
Therefore, that the procedure of finding present value is commonly called
Discounting.
Formula : P = A/(1+i)n
P=is the present value for the future sum to be received or spent
A=is the sum to be received or spent in future,
i=interest rate,
n=number of years.
 Present value interest factor(PVIF) : is the multiplier used to calculate at a
specified discount rate the present value of an amount to be received in a future
periods.
P=A(PVIF)
Present Value of a series of Cash Flows : In order to determine the present value
of such a mixed stream of cash in flows, all that is required is to determine the
present value of each future payment and then to aggregate them to find the total
present value of the stream of cash flows.
Formula :
P=c1/(1+i) + c2/(1+i)2+c3/(1+i)3 ………….+cn /(1+i)n

Mixed stream -is a stream of cash flows that reflects no particular pattern.

P= the sum of the individual present values of separate cash flows c1,c2,c3….cn refer
to cash flows in time periods 1,2,3…..n.
PRESENT VALUE OF AN INFINITE LIFE ANNUITY(PERPETUITIES) An annuity that goes
on for ever is called perpetuity. The Present value of a perpetuity of C amount is
given by the formula = C/I
Perpetuity : is an annuity with an indefinite life, making continuous annual
payments.