Time value of money:

The time value of money concept refers to the fact that money received today is worth more
than the receipt of the same amount some time in the future. The fact that money has time
value means that it is meaningless to compare or combine cash flows that occur at different
points in time. To compare or combine cash flows that occur at different points in time, you
first need to value them at the same point in time.

The concept of Time Value of Money (TVM) has a large applicability in the financial
management of companies, in banking, on the capital market and in day to day life. There are
three reasons why a dollar tomorrow is worth less than a dollar today:

Individuals prefer present consumption to future consumption. To induce people to give up

present consumption you have to offer them more in the future.

 When there is monetary inflation, the value of currency decreases over time. The greater
the inflation, the greater the difference in value between a dollar today and a dollar tomorrow.

 If there is any uncertainty (risk) associated with the cash flow in the future, the less that
cash flow will be valued” But why is TVM concept necessary in banking?

4.  People with spare funds and the desire to invest them could decide to directly lend them
to borrowers in exchange for periodic repayments of the principal and interests. However,
this would involve resources and costs for both the lender and the borrower: (1) On the one
hand, it is extremely difficult for the lender to have an accurate pictures of the borrower’s
situation in terms of guarantee, so lender would have to monitor the borrower so as to assess
the security of the investment; (2) On the other hand, the borrower might want a larger loan
than the lender is able to provide or perhaps needs the money for a longer period of time than
the lender can afford. The concept of TVM is used in financial management and within the
selections methods of investment projects.

Future value and compounding

Future value is the amount of money a cash flow will grow to at some time in the future by
earning interest at some interest rate. The process of calculating the future value of a cash
flow is known as compounding.

Future value of a present sum (Compound Interest)

• When we are dealing with the future value of a single amount of money, we use compound
interest, or the future value of a present sum.

The future value of a present sum is calculated using equation (1): FV =PV(1+i)n (1 ) Where:
FV = Value in period n (n periods in the future) PV = Value in period 0 (now) =Interest rate
per conversion period n =Number of conversion periods If each period is a year, n is the
number of years into the future on which the value is to be calculated, and i is the annual
interest rate. In this case, the formula results in normal compound interest with annual
compounding. If payments are made more frequently than annually, i is the annual rate
divided by the number of payments per year and n is the number of payments per year
multiplied by the number of years.

Present Value of a Future Sum

Present value of a future sum is used to calculate the amount that one could receive now that
would be equal in value to the receipt of a specified single amount at some point in the future.
Remember, the compound interest formula told us the future value of a current sum. Well, the
present value of a sum tells us the current value of a future sum. We can modify the
compound interest formula, FV = PV(1+i)n by dividing both sides by (1+i)n, to get the
present value formula. PV= Vn ( I +r) n .This can be reformulated as: PV =FV (1+i)"n

Present value and discounting :

The calculation of a present value is the reverse of the future value calculation. When
calculating present values we are asking “what amount would we need to invest today to have
a certain amount in the future”. The process of calculating the present value of a future cash
flow is known as discounting.

Present value, also called "discounted value," is the current worth of a future sum of money
or stream of cash flow given a specified rate of return. Future cash flows are discounted at the
discount rate; the higher the discount rate, the lower the present value of the future cash
flows. Determining the appropriate discount rate is the key to properly valuing future cash
flows, whether they are earnings or obligations. If you received $10,000 today, the present
value would be $10,000 because present value is what your investment gives you if you were
to spend it today. If you received $10,000 in a year, the present value of the amount would
not be $10,000 because you do not have it in your hand now, in the present. To find the
present value of the $10,000 you will receive in the future, you need to pretend that the
$10,000 is the total future value of an amount that you invested today. In other words, to find
the present value of the future $10,000, we need to find out how much we would have to
invest today in order to receive that $10,000 in the future.

To calculate present value, or the amount that we would have to invest today, you must
subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can
discount the future payment amount ($10,000) by the interest rate for the period. In essence,
all you are doing is rearranging the future value equation above so that you may solve for P.
The above future value equation can be rewritten by replacing the P variable with present
value (PV) and manipulating the equation as follows:
Annuities
An annuity is a finite stream of equal cash flows paid at regular intervals. Annuities are
amongst the most common kinds of financial instruments. For example, many car loans,

leases, pensions, and bonds are annuities.

A t-period annuity can be viewed as equivalent to a perpetuity with the first payment made at
the end of the first period less another perpetuity whose first payment is made at the end of
period t+1. The immediate perpetuity net of the delayed perpetuity provides exactly t-periods.

We can obtain the future value of a t-period annuity directly from the present value of a t-
period annuity. After obtaining the present value of the annuity we then multiply it by (1 + r)
^t to obtain the future value.

Present value of an annuity

The present value of an annuity is the current value of future payments from an annuity,
given a specified rate of return or discount rate. The annuity's future cash flows are
discounted at the discount rate. Thus, the higher the discount rate, the lower the present
value of the annuity.

TAhe formula for the present value of an ordinary annuity, as opposed to an annuity due, is
as follows:

P = PMT x ((1 - (1 / (1 + r) ^ n)) / r)

Where:

P = the present value of an annuity stream

PMT = the dollar amount of each annuity payment

r = the interest rate (also known as the discount rate)

n = the number of periods in which payments will be made

Future value of an annuity:

The future value of an annuity formula is used to calculate what the value at a future
date would be for a series of periodic payments.
The future value of an annuity formula assumes that

1. The rate does not change

2. The first payment is one period away
3. The periodic payment does not change
If the rate or periodic payment does change, then the sum of the future value of each
individual cash flow would need to be calculated to determine the future value of the
annuity. If the first cash flow, or payment, is made immediately, the future value of
annuity due formula would be used.
The future value of an annuity is the future value of a series of cash flows. The formula
for the future value of an annuity, or cash flows, can be written as