Financial Management (FM1)

TIME VALUE OF MONEY

 Time value of money

Money has time value. Reasons:

✔Preference for current consumption
✔Opportunity cost
✔Inflation
 Time line notations

A time line shows the timing and amount of each

cash flow in a cash flow stream
End of the year cash flows
1 5
0 2 3 4

10000 10000 10000 10000 10000

Beginning of the year cash flows

0 2 3 4 5
1

10000 10000 10000 10000 10000

PV: Present value
FVn : Future value of n years hence
C: cash flows
r: interest rate/discount rate
n: no. of periods over which cash flows will occur
Simple interest and Compounding interest
Simple interest is a method to calculate the amount of interest
charged on a sum at a given rate and for a given period of time.
In simple interest, the principal amount is always the same.
Investment grows as follows

Future value= Present value(1+ Number of years 🗶 Interest rate)

Question :An investment of Rs.1000,if invested at 12 % simple

interest rate, will in 5 years time.
Compound interest is interest earned from the original
principal plus accumulated interest. The process of investing
money as well as reinvesting the interest earned thereon is
called compounding. The future value of an investment after n
years that is compounded is

FVn = PV(1+r) n
Question : The sale of Manhattan Island in 1626.It was sold by
Red Indians to Peter Minuit for $24.Looking at the New York real
estate prices today, it appears that Peter Minuit got a real
bargain. But consider the future value of $24 in 2010 if Red
Indians had invested for 384 years (2010-1626) at an interest
rate of 3.5% per year.