Time Value of Money

Premise

The value of money DOES NOT remain static with time

The value of money CHANGES with time

 Reasons

Inflation
Opportunity cost
Uncertainty about future
Delaying consumption
 Important prerequisites
Timeline:
A timeline is a horizontal line representing periods
equidistant from one another.
 Rate of interest (Single freq)
Basically, rate of interest (expressed in percentage terms) is the
rate offered by a bank (or an investment) to its investor for
undertaking the risk of investing commensurate to the degree of
riskiness of the investment.

The rate of interest is mostly expressed in terms of annual frequency

e.g. 10% compounded annually means that the interest (10%) would
accrue only once in a year at the end of the year.
Rate of interest (Multiple freq)
 Compounding
The process of compounding involves the accumulation of interest amount with
the
principal amount at the end of a period. Thus, the principal amount for the
following period becomes the sum of principal amount of the previous period and
the interest accumulated.

This process of moving forward on the timeline that leads to finding future value is
called as compounding.
 Discounting
The process of discounting involves the removal of the interest component from
the future value of principal. Thus, the principal amount for the previous period
becomes the deduction of interest from the principal amount of the following
period.
This process of moving backwards on the timeline that leads to finding present
value is called as discounting.
Period Value at period Principal amount Interest rate (10%)
5 FV5 16,105
4 FV4 14,641 16,105 / (1.1)
3 FV3 13,310 16,105 / (1.1 * 1.1)
2 FV2 12,100 16,105 / (1.1 * 1.1 * 1.1)
1 FV1 11,000 16,105 / (1.1 * 1.1 * 1.1 * 1.1)
0 PV 10,000 16,105 / (1.1 * 1.1 * 1.1 * 1.1 * 1.1)
 Types of cash flow

Lump Sum

Annuity

Annuity due
Perpetuity

Growing perpetuity

Uneven cash flow