Time Value of Money

To: Prof. A.S. Khalsa (Iper, Bhopal) By: Dinesh Parmar

The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received.

Time Value of Money by taking a very simple scenario.

If you offered the choice between having Rs. 10,000 today and having Rs. 10,000 at a future date, you will usually prefer to have Rs. 10,000 now. Similarly, if the choice is between paying Rs. 10,000 now or paying the Rs. 10,000 at a future date, you will usually prefer to pay Rs. 10,000 later.

It is simple common sense.

In the first case by accepting Rs. 10,000 early, you case simply put the money in the bank and earn some interest.

Similarly in the second case by deferring the payment, you can earn interest by keeping the money in the bank.

There fore the time gap allowed helps us to some money. This incremental gain is time value of money.

Money has time value because of the following reasons: Risk and Uncertainty Inflation Consumption Investment opportunities

Future is always uncertain and risky. Outflow of cash is in our control as payments to parties are made by us. There is no certainty for future cash inflows. Cash inflows is dependent out on our Creditor, Bank etc. As an individual or firm is not certain about future cash receipts, it prefers receiving cash now.

In an inflationary economy, the money received today, has more purchasing power than the money to be received in future. In other words, a rupee today represents a greater real purchasing power than a rupee a year hence.

Individuals generally prefer current consumption to future consumption.

An investor can profitably employ a rupee received today, to give him a higher value to be received tomorrow or after a certain period of time.

There are two techniques for adjusting time value of money. They are: 1. Compounding Techniques/Future Value Techniques 2. Discounting/Present Value Techniques
The value of money at a future date with a given interest rate is called future value. Similarly, the worth of money today that is receivable or payable at a future date is called Present Value.

Present Value is the current value of a Future Amount. It can also be defined as the amount to be invested today (Present Value) at a given rate over specified period to equal the Future Amount. The present value of a sum of money to be received at a future date is determined by discounting the future value at the interest rate that the money could earn over the period. This process is known as Discounting.

Formula to calculate the present value of a lump sum to be received after some future periods.

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. PV = Fn X PVFn,I In MS Excel use PV function PV(rate,nper,pmt,fv,type) Where: rate= interest rate. nper= n periods, pmt=annuity value, fv= future value,

Suppose that an investor want to find out the present value of Rs. 1,00,000 to be received after 20 year, here interest rate is 10 percent. So, PV = Fn X PVFn,I PV = 1,00,000 x PVF20,0.10 = 1,00,000 x 0.1486 = Rs.14860

MS Excel use PV function: =PV(rate,nper,pmt,fv,type) =PV(0.10,20,0,100000,0) =($14,864.36)

If we Invest Rs. 10,000 every year at the rate or 25% for 25 year. P= Ax PVAFn,i = 10,000 x 3.9849 = Rs. 39849

MS Excel use PV function: =PV(rate,nper,pmt,fv,type) =PV(0.25,25,10000,0,0) =($39,848.88)

The value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today.

The general form of equation for calculation the future value of a lump sum after n periods may, therefore, be written as follows: Fn = P(1+ i)n 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 1, indicating that CVF increases as i and n increase.

Fn =P x CVFn.i 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

If you deposited Rs. 60,000 in a bank, which was paying a 20 % rate of interest on a 15 year time deposit, how much would the deposit grow at the end of 15 year? So,

Fn =P x CVFn.i FV = 60,000 x CVF15,0.20 = 60,000 x 15.407 = Rs.9,24,420 MS Excel use PV function: =PV(rate,nper,pmt,pv,type) =FV(0.2,15,0,60000,0) =($924,421.29)

Annuity is a fixed payment(or receipt) each year for a specified number of years.

The term within brackets of the Compound Value factor an Annuity of Re 1, which we shall refer as CVFA. Fn = Ax CVFA

Annuity is a fixed payment(or receipt) each year for a specified number of years.

The term within brackets of the Compound Value factor an Annuity of Re 1, which we shall refer as CVFA. Fn = Ax CVFA

Suppose that a firm deposits Rs. 10,000 at the end of each year 5 year at 10 % rate of interest. How much would this Annuity Accumulate at the end of the fifth year?

Fn = A x CVFA = 10,000 x 6.1051 = Rs.61,051 MS Excel use FV function: FV(rate,nper,pmt,pv,type) =FV(0.1,5,10000,0,0) =($61,051.00)

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.

Consider that an investor has an opportunity of receiving Rs. 15,000, Rs. 20,000, Rs. 7,000, Rs. 10,000 and Rs. 13,000 respectively as the end of one through 5 year. Find out the value of this stream of uneven cash flows. The investors required interest is 10% ? The present value is calculated by Excel as follows: PV of Uneven CF Year 1 2 3 4 5 Amount 15000 20000 7000 10000 13000 $50,326.60