Time Value of Money

Time Value of Money

Time value of money means that the value of a unit of money is
different in different time periods. Money has time value. A rupee
today is more valuable than a rupee a year hence. A rupee a year
hence has less value than a rupee today. Money has, thus, a
future value and a present value. Although alternatives can be
assessed by either compounding to find future value or
discounting to find present value, financial managers rely
primarily on present value techniques as they are at zero time (t =
0) when making decisions.

Techniques
1. Compounding Techniques
2. Discounting Techniques
1. Compounding Techniques
Interest is compounded when the amount earned on an initial deposit (the initial
principal) becomes part of the principal at the end of the first compounding period.
The term principal refers to the amount of money on which interest is received.
Example 1
If Mr X invests in a saving bank account Rs 1,000 at 5 per cent interest
compounded annually, at the end of the first year, he will have Rs 1,050 in his
account. This amount constitutes the principal for earning interest for the next
year. At the end of the next year, there would be Rs 1,102.50 in the account. This
would represent the principal for the third year. The amount of interest earned
would be Rs 55.125. The total amount appearing in his account would be Rs
1,157.625.
Semi-annual Compounding
Semi-annual compounding means two compounding periods within a
year.
Example 2: Assume Mr X places his savings of Rs 1,000 in a two-year
time deposit scheme of a bank which yields 6 per cent interest
compounded semi-annually. He will be paid 3 per cent interest
compounded over four periods—each of six months’ duration.

Quarterly Compounding
Quarterly compounding means four compounding periods in a year.
There will be eight compounding periods and the rate of interest for each
compounding period will be 1.5 per cent, that is (1/4 of 6 per cent).Table 3
presents the relevant calculations regarding the amount he will have at the end of
two years, when interest is compounded quarterly. At the end of the first year, his
savings will accumulate to Rs 1,061.363 and at the end of the second year he will
have Rs 1,126.49.
Future/Compounded Value of a Series of Payments  

For simplicity, we assume that the compounding time period is

one year and payment is made at the end of each year. Suppose,
Mr X deposits each year Rs 500, Rs 1,000, Rs 1,500, Rs 2,000 and
Rs 2,500 in his saving bank account for 5 years. The interest rate
is 5 per cent. He wishes to find the future value of his deposits at
the end of the 5th year.
Compound Sum of an Annuity
Annuity is a stream of equal annual cash flows.
Example 3: Mr X deposits Rs 2,000 at the end of every year for 5 years in his
saving account paying 5 per cent interest compounded annually. He wants to
determine how much sum of money he will have at the end of the 5th year.

Present Value or Discounting Technique  

Present Value Present value is the current value of a future amount . The amount to
be invested today at a given interest rate over a specified period to equal the future
amount
Discounting Discounting is determining the present value of a future amount.

4. Mr X has been given an opportunity to receive Rs 1,060 one year from

now. He knows that he can earn 6 per cent interest on his investments. The
question is: what amount will he be prepared to invest for this opportunity?
Example 5
Mr X wants to find the present value of Rs 2,000 to be received 5 years from now,
assuming 10 per cent rate of interest.

Present Value of a Series of Cash Flows  

So far we have considered only the present value of a single receipt at some
future date. In many instances, especially in capital budgeting decisions, we
may be interested in the present value of a series of receipts received by a firm
at different time periods.
Mixed stream is a stream of cashflows that reflects no particular pattern.
Example 6
In order to solve this problem, the present value of each individual cash flow discounted
at 10 percent for the appropriate number of years is to be determined. The sum of all
these individual values is then calculated to get the present value of the total stream. The
present value factors required for the purpose are obtained from Table A-3. The results
are summarised in Table 7.
Year Cash flows
1 Rs 500
2 1,000
3 1,500
4 2,000
5 2,500

Example 7
Mr X wishes to determine the present value of the annuity consisting of cash
inflows of Rs 1,000 per year for 5 years. The rate of interest he can earn from his
investment is 10 per cent.
Example 8 The ABC company expects to receive Rs 1,00,000 for a period of 10
years from a new project it has just undertaken. Assuming a 10 per cent rate of
interest, how much would be the present value of this annuity?
Example 9 If ABC company expects cash inflows from its investment proposal it
has undertaken in time period zero, Rs 2,00,000 and Rs 1,50,000 for the first two
years respectively and then expects annuity payment of Rs 1,00,000 for the next
eight years, what would be the present value of cash inflows, assuming a 10 per
cent rate of interest?