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Time Value of Money Time Value of Money

Lecture Prepared By Lecture Prepared By
Dr. N S Dr. N S Bohra Bohra
Assistant Professor Assistant Professor
Faculty of Management Faculty of Management
GEU GEU
Time Preference for Money Time Preference for Money
Time preference for money is an individual Time preference for money is an individual s s
preference for possession of a given amount preference for possession of a given amount
of money of money now now, rather than the same amount , rather than the same amount
at some future time. at some future time.
Three reasons may be attributed to the Three reasons may be attributed to the
individual individual s time preference for money: s time preference for money:
Risk Risk
Preference for consumption Preference for consumption
Investment opportunities Investment opportunities
Required Rate of Return Required Rate of Return
The time preference for money is generally The time preference for money is generally
expressed by an interest rate. This rate will expressed by an interest rate. This rate will
be positive even in the absence of any risk. It be positive even in the absence of any risk. It
may be therefore called the risk may be therefore called the risk- -free rate. free rate.
An investor requires compensation for An investor requires compensation for
assuming risk, which is called risk premium. assuming risk, which is called risk premium.
The investor The investor s required rate of return is: s required rate of return is:
Risk Risk- -free rate + Risk premium. free rate + Risk premium.
Time Adjustment of Money Time Adjustment of Money
Two most common methods of adjusting cash Two most common methods of adjusting cash
flows for time value of money: flows for time value of money:
Compounding Compounding the process of calculating the process of calculating future future
values values of cash flows and of cash flows and
Discounting Discounting the process of the process of calculating calculating present present
values values of cash flows. of cash flows.
Future Value Future Value
Compounding Compounding is the process of finding the future is the process of finding the future
values of cash flows by applying the concept of values of cash flows by applying the concept of
compound interest. compound interest.
Compound interest Compound interest is the interest that is received on is the interest that is received on
the original amount (principal) as well as on any interest the original amount (principal) as well as on any interest
earned but not withdrawn during earlier periods. earned but not withdrawn during earlier periods.
Simple interest Simple interest is the interest that is calculated only on is the interest that is calculated only on
the original amount (principal), and thus, no the original amount (principal), and thus, no
compounding of interest takes place. compounding of interest takes place.
Future Value Future Value
The general form of equation for The general form of equation for
calculating the future value of a calculating the future value of a
lump sum after lump sum after n n periods may, periods may,
therefore, be written as follows: therefore, be written as follows:
The term (1 + The term (1 + i i) )
n n
is the is the
compound value factor ( compound value factor (CVF CVF) of a ) of a
lump sum of Re 1, and it always lump sum of Re 1, and it always
has a value greater than 1 for has a value greater than 1 for
positive positive i i, indicating that , indicating that CVF CVF
increases as increases as i i and and n n increase. increase.
n
n
i P F ) 1 ( + =
= CVF
n n,i
F P
2
Future Value of an Annuity Future Value of an Annuity
Annuity is a fixed payment (or Annuity is a fixed payment (or
receipt) each year for a receipt) each year for a specified specified
number of years. If you rent a number of years. If you rent a
flat and promise to make a series flat and promise to make a series
of payments over an agreed of payments over an agreed
period, you have created an period, you have created an
annuity. annuity.
The term within brackets is the The term within brackets is the
compound value factor for an compound value factor for an
annuity of Re 1, which we shall annuity of Re 1, which we shall
refer as refer as CVFA CVFA
(1 ) 1
n
n
i
F A
i
( +
=
(

= CVFA
n n,i
F A
Sinking Fund Sinking Fund
Sinking fund is a fund, which Sinking fund is a fund, which
is created out of fixed is created out of fixed
payments each period to payments each period to
accumulate to a future sum accumulate to a future sum
after a specified period. For after a specified period. For
example, companies generally example, companies generally
create sinking funds to retire create sinking funds to retire
bonds (debentures) on bonds (debentures) on
maturity. maturity.
The factor used to calculate The factor used to calculate
the annuity for a given future the annuity for a given future
sum is called the sum is called the sinking fund sinking fund
factor factor ( (SFF SFF
=
(1 ) 1
n
n
i
A F
i
(
(
+

Present Value Present Value
Present value of a future cash flow (inflow or Present value of a future cash flow (inflow or
outflow) is the amount of current cash that is outflow) is the amount of current cash that is
of equivalent value to the decision of equivalent value to the decision- -maker. maker.
Discounting is the process of determining Discounting is the process of determining
present value of a series of future cash flows. present value of a series of future cash flows.
The The interest rate interest rate used for discounting cash used for discounting cash
flows is also called the flows is also called the discount rate discount rate. .
Present Value of a Single Cash Flow Present Value of a Single Cash Flow
The following general formula The following general formula
can be employed to calculate can be employed to calculate
the present value of a lump the present value of a lump
sum to be received after some sum to be received after some
future periods: future periods:
The term in parentheses is the The term in parentheses is the
discount factor or present discount factor or present
value factor ( value factor (PVF PVF), and it is ), and it is
always less than 1.0 for always less than 1.0 for
positive positive i i, , indicating that a indicating that a
future amount has a smaller future amount has a smaller
present value present value
(1 )
(1 )
n n
n n
F
P F i
i

( = = +

+
,
PVF
n ni
PV F =
Present Value of an Annuity Present Value of an Annuity
The computation of the present The computation of the present
value of an annuity can be value of an annuity can be
written in the following general written in the following general
form form: :
The term within parentheses is The term within parentheses is
the present value factor of an the present value factor of an
annuity of Re 1, which we would annuity of Re 1, which we would
call call PVFA PVFA, and it is a sum of , and it is a sum of
single single- -payment present value payment present value
factors. factors.
( )
1 1
1
n
P A
i
i i
(
= (
+ (

= PVAF
n,i
P A
Capital Recovery and Loan Amortisation Capital Recovery and Loan Amortisation
Capital recovery Capital recovery is the is the
annuity of an annuity of an
investment made today investment made today
for a specified period for a specified period
of time at a given rate of time at a given rate
of interest. Capital of interest. Capital
recovery factor helps in recovery factor helps in
the preparation of a the preparation of a
loan amortisation loan amortisation (loan (loan
repayment) repayment) schedule. schedule.
,
1
=
PVAF
n i
A P
(
(

= CRF
n,i
A P
3
Present Value of Perpetuity Present Value of Perpetuity
Perpetuity Perpetuity is an annuity that occurs is an annuity that occurs indefinitely indefinitely. .
Perpetuities are not very common in financial Perpetuities are not very common in financial
decision decision- -making: making:
Perpetuity
Present value of a perpetuity
Interest rate
=
Present Value of Growing Annuities Present Value of Growing Annuities
The present value of a The present value of a
constantly growing constantly growing
annuity is given. annuity is given.
Present value of a Present value of a
constantly growing constantly growing
perpetuity is given by a perpetuity is given by a
simple formula as follows: simple formula as follows:
1
= 1
1
n
A g
P
i g i
(
+ | |

(
|
+
\
(

=

A
P
i g
Value of an Annuity Due Value of an Annuity Due
Annuity due is a series of Annuity due is a series of
fixed receipts or payments fixed receipts or payments
starting at the beginning starting at the beginning
of each period of each period for a for a
specified number of specified number of
periods. periods.
Future Value of an Future Value of an
Annuity Due Annuity Due
Present Value of an Present Value of an
Annuity Due Annuity Due
,
= CVFA (1 )
n n i
F A i +
= PVFA (1+ )
n,i
P A i
Multi Multi- -Period Compounding Period Compounding
If compounding is done If compounding is done
more than once a year, more than once a year,
the actual annualised rate the actual annualised rate
of interest would be of interest would be
higher than the nominal higher than the nominal
interest rate and it is interest rate and it is
called the effective called the effective
interest rate interest rate
= EIR 1 1
n m
i
m

(
+
(

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