Time value of Money

Prepared by:
Arvinder Kaur
Faculty of
management

Concept of Time value of

Money
A RUPEE TODAY IS WORTH MORE THAN A RUPEE

TOMORROW.
One of the most fundamental concepts in finance

is that money has a time value, i.e. , Money in

hand today is worth more than money that is
expected to be received in the future.
The REASON is straightforward, i.e. , A rupee that

you receive today can be invested such that you

will have more than a rupee at some future time.

Example

A wins a prize contest and he has got two

options:
Option 1: Receive Rupees 10,000 now.
Option 2: Receive Rupees 10,000 in three years.
WHICH OPTION SHOULD A CHOOSE ?

Answer of Example
If A is a rational person he would choose to

receive Rupees 10,000 NOW.

After all, three years is a long time to wait. Why

would any Rational person defer payment into the

future when he could have the same amount of
money now?

 For most of us, taking the money in the present is

just natural. So at the most basic level, the time

value of money demonstrates the concept of time
value as:
A RUPEE TODAY IS WORTH MORE THAN A RUPEE
TOMORROW.
Time value of money results somewhere from the
concept of Interest.

Reasons Behind the

Concept of Time Value of
money
There are four primary reasons why a rupee

received in the future is worth less than a rupee

received now:
INFLATION
INTEREST EARNINGS
UNCERTAIN FUTURE
HUMAN PREFERENCES

INFLATION

Presence of positive rate of inflation reduce the

PURCHASING POWER of rupees through time.

FOR EXAMPLE:
One year back ONE apple was available for Rupees 10

and a dozen of apple cost Rupees 120.

Now one apple costs Rupees 15 and a dozen of apples

cost rupees 180.

Now with Rupees 120 we can buy only 8 apples instead

of 12 apples.

INTEREST EARNINGS

A rupee today is worth more today than in the

future because of the opportunity cost of the lost

earnings, i.e. , It could have been invested and
earned a return between today and a point of
time.

UNCERTAIN FUTURE

Thirdly, all future values are in some sense only

PROMISES and contain some uncertainty about

their occurrence.
As a result of the risk of default or non

performance of an investment, a rupee in hand is

worth more than an expected rupee in future.

HUMAN PREFERENCES

Finally, human preferences typically involve

impatience or the preference to consume goods

and services now rather than in future.

USES OF TIME VALUE OF

MONEY
The concept of time value of money is used to

calculate the values of various cash flows such as:

Future value of cash flow (Compounding

technique)
Present value of cash flow (Discounting technique)

CALCULLATION OF FUTURE
VALUE OF A LUMP SUM
FUTURE VALUE of a lump sum refers to the value

after a certain period of time at a given rate of

interest.
FORMULA:

FUTURE CASH FLOW = PV * (1+R)t

Here, PV refers to Present value of cash flow, R
refers to the rate of interest and t refers to the
numbers of years of investment.

Example

QUESTION: Find maturity value of Rupees 10,000 which has

been given on 15% interest for five years, while the required
rate of return is 10%.

SOLUTION:
FUTURE VALUE = PV * (1+r)t
= 10,000 * (1+0.15)5
= 10,000 * (1.15)5
= 10,000 * 2.011357
FUTURE VALUE = Rupees 20,113.57

Question For Practice

Question: Mr. B wants to have a sum of Rupees

5,800 after 2 years. He has two alternative

investment options to select one for his
investment objective.
Option 1: Rate of interest @ 8% p.a.

Option 2: Rate of interest @ 6% p.a.

If Mr. B has Rupees 5,000 to invest for 2 years,
which investment option will meet his objective?

Compounded value of an
Annuity
An annuity is a series o equal payments lasting for

some specified duration. The premium payments of

life insurance company are annuity payments.
Here, FUTURE VALUE = CASH FLOW * (ACFi,n)
ACF refers to annuity compound factor taken from

annuity compound factor table.

CALCULATION OF PRESENT
VALUE
PRESENT VALUE (PV) refers to the current worth of

a future sum of money or stream of cash flows

given a specified rate of return.

FORMULA:
PV = FUTURE CASH FLOW
(1+r)t

Example
Question: Find present value of Rupees 80,000 to be

received after five years when required rate of

return is 10%

Solution:
PV = Cash flow/(1+r)t
= 80,000/(1+0.10)5
=

80,000/1.61051

= Rupees 49,674

Present value of a cash

flow stream
It refers to the present value of a series of cash flow

occurred in different years.

For Example: Find the present value of a series of cash

flows occurred in different years when the required rate

of return is 10%
PERIOD

FUTURE CASH
FLOWS

RUPEES 80,000

RUPEES 70,000

RUPEES 50,000

RUPEES 30,000

SOLUTION
As we know, PV = Future cash flow/(1+r)t
PV = {80,000/(1+0.10)1} + {70,000/(1+0.10)2} +

{50,000/(1+0.10)3} + {30,000/(1+0.10)4}
= (80,000/1.10) + (70,000/1.21) + (50,000/1.331) +
(30,000/1.4641)
= 72727 + 57851 + 37566 +20490
= Rupees 1,88,634

Present value of an annuity

An annuity is a series of equal payments lasting

for some specific period.

PV = Future cash flow * (ADFi,n)

ADF refers to annuity discount factor taken from

annuity discount factor table.

NET PRESENT VALUE

NPV is the difference between the sum total of Present

values of all the future cash inflows and outflows.

NPV = ( PRESENT VALUE OF CASH INFLOWS)

( PRESENT VALUES OF CASH OUTFLOWS)

HERE, CASH INFLOW = CASH INFLOW + SALE OF

SCRAP + INFLOW FROM WORKING CAPITAL

CASH OUTFLOW = INITIAL INVESTMENT +

ADDITIONAL OUTFLOW

QUESTION FOR PRACTICE

A Co. has invested Rupees 8,00,000 in a business and expected a

series of cash flow as per under given details:
YEAR

CASH INFLOW

ADDITIONAL
CASH
OUTLOW

RUPEES 2,50,000

RUPEES NIL

RUPEES 4,20,000

RUPEES
1,05,000

3
RUPEES 3,50,000
RUPEES NIL
At the end of the fourth year Co. made a sale of scrap for Rupees
4
RUPEES 2,50,000
RUPEES 10,000
2,40,000 and realized rupees 30,000 from working capital.

Find NPV if the required rate of return is 10%.

Thank you