Time Value of Money

Money makes money, and the money that money makes, makes more money. - Benjamin Franklin

Time Value of Money

Money has a time value associated with it and therefore, a rupee received today is worth more than a rupee received in the future.

Time Value of Money

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. Interest is the cost of money a cost to the borrower and an earning to the lender

Time Value of Money

Four Values Future value of a single amount Present value of a single amount Future value of an annuity Present value of an annuity

Future Value of a Single Amount

The future value of a single amount is the amount of money that a dollar will grow to at some point in the future. Assume we deposit Rs. 1,000 for three years that earns 10% interest compounded annually.
Rs. 1,000 1.10 = 1,100 and Rs. 1,100 1.10 = 1,210 and Rs. 1,210 1.10 = 1,331

Future Value of a Single Amount

Writing in a more efficient way, we can say . . . . Rs. 1,331 = 1,000 [1.10]
3

FV = PV (1 +
Future Value Amount Invested at the Beginning of the Period

n i)

Number of Compounding Periods

Interest Rate

Present Value of a Single Amount

Instead of asking what is the future value of a current amount, we might want to know what amount we must invest today to accumulate a known future amount. This is a present value question.

Present value of a single amount is todays equivalent to a particular amount in the future.

Present Value of a Single Amount

Remember our equation? FV = PV (1 + i)
n

We can solve for PV and get . . . . PV = FV n (1 + i)

Solving for Other Values

FV = PV (1 +
Future Value Present Value

n i)
Number of Compounding Periods

Interest Rate

There are four variables needed when determining the time value of money. If you know any three of these, the fourth can be determined.

Basic Annuities
An annuity is a series of equal periodic payments.

Period 1
$10,000

Period 2
$10,000

Period 3
$10,000

Period 4
$10,000

Ordinary Annuity
An annuity with payments at the end of the period is known as an ordinary annuity.
Today

1
$10,000
End of year 1

2
$10,000

3
$10,000

4
$10,000

End of year 2
End of year 3 End of year 4

Ordinary Annuity
Today

1
$10,000
End of year 1

2
$10,000
End of year 2

3
$10,000

4
$10,000

End of year 3

End of year 4

C C C C C n ] PV [ 1 (1 r ) (1 r ) (1 r ) 2 (1 r ) 3 (1 r ) n r
Assuming Interest rate to be 10%, the PV of the cash flows of the above problem = (10,000/0.1)*[1-(1.1)-r ]= 31,698.65

Bonds
Definitions: Bonds are formal certificates of debt that include: 1. a promise to pay interest in cash at specified coupon rate 2. a promise to pay the face value at the maturity date Face Value: The amount that the company must repay Coupon Rate: The rate of interest that the company must pay Maturity: The date when the company repays the face value at full The bond proceeds depend on the market rate of return that prevails for an investment of similar risk on the issuance day

Bonds
Bonds are sold for cash and are issued at: Par (coupon rate = market rate) Premium (coupon rate > market rate) Discount (coupon rate < market rate)

Bonds
Consider a 10%, 3 year bond with a face value of 1,000 issued 1/1/2011. Assume that the prevailing market rate is 10% the day bond is issued. PV of the annuity = 100/0.1*[1-(1.11)-3] = 248.69 PV of the lump sum = 1,000 * (1.1)-3 = 751.31 Therefore, total PV = 248.69+751.31 = 1,000

The chief value of money lies in the fact that one lives in a world in which it is overestimated. HL Mencken