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Time Value of Money

Compounding & Discounting


Would you prefer to have Rs 1 million now or Rs 1 million - 5
years from now?
Time preference for money is an individuals preference for
possession of a given amount of money now, rather than the same
amount at some future time.
Following reasons may be attributed to the individuals time
preference for money:
risk
preference for consumption
investment opportunities
inflation
Money has a time value because it can earn more money over time
(earning power).
Money has a time value because its purchasing power changes
over time (inflation).
Time value of money is measured in terms of interest rate.
What is Time Value of Money
Delaying Consumption
Account Value Cost of Refrigerator
Case 1: Inflation exceeds
earning power
N= 0 Rs 100
N = 1 Rs 106
(earning rate = 6%)
N= 0 Rs 100
N = 1 Rs 108
(inflation rate = 8%)
Case 2: Earning power
exceeds inflation
N= 0 Rs 100
N = 1 Rs 106
(earning rate = 6%)
N= 0 Rs 100
N = 1 Rs 104
(inflation rate = 4%)
You have three choices:
Rs 20,000 received today
Rs 31,000 received in 5 years
Rs 3,000 per year indefinitely
To make such comparisons, we must be able to compare the value
of money at different point in time.
To do this, we need to develop a method for reducing a sequence
of benefits and costs to a single point in time.
Cannot directly compare Rs 1 today with Rs 1 to be received at
some future date
Money received today can be invested to earn a rate of return.
Thus Rs1 today is worth more than Rs1 to be received at some
future date.
Choosing from Different Alternatives
Two most common methods of adjusting cash flows for
time value of money:
Compoundingthe process of calculating future values
of cash flows and
Discountingthe process of calculating present values
of cash flows.
Abbreviations
PV - Present value
FV - Future value
Pmt - Per period payment amount
N - Either the total number of cash flows or the number
of a specific period
i - The interest rate per period

A timeline is a graphical device used to clarify the
timing of the cash flows for an investment.






Future value
Future value of lump sum
The general form of equation for calculating
the future value of a lump sum after n
periods be written as :


The term (1 + i)
n
is the compound value
factor (CVF) of a lump sum of Re 1, and it
always has a value greater than 1 for
positive i, indicating that CVF increases as i
and n increase.


n
n
i P F ) 1 ( + =
= CVF
n n,i
F P
Suppose that you have an extra Rs 100 today that you wish to
invest for one year. If you can earn 10% per year on your
investment, how much will you have in one year?



If you deposit Rs 55,650 in a bank, which was paying a 15 per cent
rate of interest on a ten-year time deposit, how much would the
deposit grow at the end of ten years?
We will first find out the compound value factor at 15 per cent for
10 years which is 4.046. Multiplying 4.046 by Rs 55,650, we get Rs
225,159.90 as the compound value.
Future value of a Lumpsum
10, 0.12
FV 55,650 CVF 55,650 4.046 Rs 225,159.90 = = =
Compound Value factor of a lumpsum of Re 1
Annuities
An annuity is a series of nominally equal payments equally
spaced in time
Annuities are very common:
Rent
Mortgage payments
Car payment
Pension income
The timeline shows an example of a 5-year, $100 annuity

(1 ) 1
n
n
i
F A
i
( +
=
(

= CVFA
n n, i
F A
What will be the future value of Rs 100 annuity for 5 years? Rate
of interest is 10% per annum.





Suppose that a firm deposits Rs 5,000 at the end of each year for
four years at 6 per cent rate of interest. How much would this
annuity accumulate at the end of the fourth year?
We first find CVFA which is 4.3746. If we multiply 4.375 by Rs
5,000, we obtain a compound value of Rs 21,875:
Future value of an Annuity
4 4, 0.06
5,000(CVFA ) 5,000 4.3746 Rs 21,873 F = = =
Present value of a Single Cash Flow
Present value of a future cash flow (inflow or outflow) is the
amount of current cash that is of equivalent value.


The term in parentheses is the discount factor or present value
factor (PVF), and it is always less than 1.0 for positive i, indicating
that a future amount has a smaller present value.

Suppose that an investor wants to find out the present value of Rs
50,000 to be received after 15 years. Interest rate is 9 %.
First, we will find out the present value factor, which is 0.275.
Multiplying 0.275 by Rs 50,000, we obtain Rs 13,750.






PRESENT VALUE
(1 )
(1 )
n
n
n
n
F
P F i
i

(
= = +

+
,
PVF
n n i
PV F =
15, 0.09
PV = 50,000 PVF = 50,000 0.275 = Rs 13,750








( ) ( ) ( ) ( ) ( )
PV
A
= + + + + =
100
110
100
110
100
110
100
110
100
110
379 08
1 2 3 4 5
. . . . .
.
Present value of annuity
Formulae for Present Value of Annuity is:
Present value of Rs 100 annuity for 5 years at 10% is:
Find out the present value of a 4 year annuity of Rs 20,000
discounted at 10%.

Present value of an annuity
Uneven Cash Flows: Example
Assume that an investment offers the following cash
flows. If your required return is 7%, what is the maximum
price that you would pay for this investment?
0 1 2 3 4 5
100 200 300
( ) ( ) ( )
PV = + + =
100
107
200
107
300
107
51304
1 2 3
. . .
.