Financial Management

Unit-1

CHAPTER 2
 Time Value or Preference for
2
Money
 Time value or preference for money is an
individual’s preference for possession of a given
amount of money now, rather than the same
amount at some future time.
 Three reasons may be attributed to the individual’s
time preference for money:
 risk
 preference for consumption
 investment opportunities

Financial Management, 12e I M Pandey

 Required Rate of Return
3

 The time preference for money is generally

expressed by an interest rate. This rate will be
positive even in the absence of any risk. It may be
therefore called the risk-free rate.
 An investor requires compensation for assuming
risk, which is called risk premium.
 The investor’s required rate of return is:
Risk-free rate + Risk premium.

Financial Management, 12e I M Pandey

 Required Rate of Return
4

 Would an investor want ₹ 100 today or after one year?

 Cash flows occurring in different time periods are not comparable.
 It is necessary to adjust cash flows for their differences in timing and
risk.
 Example : If preference rate =10 percent
 An investor can invest if ₹. 100 if he is offered ₹ 110 after one year.
 ₹ 110 is the future value of ₹ 100 today at 10% interest rate.
 Also, ₹ 100 today is the present value of ₹ 110 after a year at 10%
interest rate.
 If the investor gets less than ₹. 110 then he will not invest. Anything
above ₹. 110 is favourable.

Financial Management, 12e I M Pandey

 Time Value Adjustment
5

 Two most common methods of adjusting cash

flows for time value of money:
 Compounding—the process of calculating future values
of cash flows and
 Discounting—the process of calculating present values of
cash flows.

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 Future Value
6

 Compounding is the process of finding the future values of

cash flows by applying the concept of compound interest.
 Compound interest is the interest that is received on the
original amount (principal) as well as on any interest earned
but not withdrawn during earlier periods.
 Simple interest is the interest that is calculated only on the
original amount (principal), and thus, no compounding of
interest takes place.

Financial Management, 12e I M Pandey

 Future Value
7

Financial Management, 12e I M Pandey

 Future Value
8

In Microsoft Excel: Use FV function.

FV(rate,nper,pmt,pv,type)

Where: rate= interest rate. nper= n periods,

pmt= annuity value, pv= present value, type=
1 for beginning of the period and 0 for end for
end of period.

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 Future Value: Example
9

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 Future Value of an Annuity
10

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 Future Value of an Annuity:
11
Example

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 Sinking Fund
12

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 Present Value
13

 Present value of a future cash flow (inflow or

outflow) is the amount of current cash that is of
equivalent value to the decision-maker.
 Discounting is the process of determining present
value of a series of future cash flows.
 The interest rate used for discounting cash flows is
also called the discount rate.

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 Present Value of a Single Cash Flow
14

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 Example
15

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 Present Value of an Annuity
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 Example
17

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 Capital Recovery and Loan
18
Amortisation

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 Loan Amortisation Schedule
19

End Payment Interest Principal Outstanding

of Year Repayment Balance
0 10,000
1 3,951 900 3,051 6,949
2 3,951 625 3,326 3,623
3 3,951 326 3,625* 0

Financial Management, 12e I M Pandey

 Present Value of an Uneven
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Periodic Sum
 In most instances the firm receives a stream of
uneven cash flows. Thus, the present value factors
for an annuity cannot be used.
 The procedure is to calculate the present value of
each cash flow and aggregate all present values.

Financial Management, 12e I M Pandey

 PV of Uneven Cash Flows: Example
21

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 Present Value of Perpetuity
22

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 Present Value of a Perpetuity:
23
Example

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 Present Value of Growing Annuities
24

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 Example
25

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 Example
26

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 Value of an Annuity Due
27

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 Future Value of An Annuity:
28
Example

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 Example
29

 The present value of Re 1 paid at the beginning of

each year for 4 years is

1 × 3.170 × 1.10 = ₹ 3.487

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 Multi-Period Compounding
30

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 Effective Interest Rate: Example
31

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 Continuous Compounding
32

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 How to Read the Table
The interest rates are given on the horizontal axis and the years are given on the
vertical axis.

Suppose we have to find PVIF at 10% and 5 years. We will follow the following
steps:

 Open the present value interest factor of Re 1 table

 On the top horizontal axis locate 10% interest column
 Now move through the 10% column , from top to downwards
 On the vertical left hand side see the different rows representing different years.
Now locate the 5 year row

Note down the value exhibited by 10% column at 5 year row.

The value comes out to be .621
 How to Read the Table (Contd)

Suppose we have to find FVIF at 10% and 5 years. We will follow the following steps:

 Open the future value interest factor of Re 1 table

 On the top horizontal axis locate 10% interest column
 Now move through the 10% column , from top to downwards
 On the vertical left hand side see the different rows representing different years. Now
locate the 5 year row

Note down the value exhibited by 10% column at 5 year row.

The value comes out to be 1.611