CHAPTER

TIMEVALUEOFMONEY

CONTENTS

TimeValueofMoney Anintroduction

Compounding

Discounting

Annuity

FutureValueofAnnuity

PresentValueofAnnuity

ContinuousCompounding&Discounting
p
g
g

EffectiverateofInterest

Equated Monthly Instalments

EquatedMonthlyInstalments

TIME VALUE OF MONEY

CHAPTER 4

TIME VALUE OF MONEY

(TVM)- A N I NTRODUCTION

Valueofmoneyvarieswithtime.

Notonlyistheamountofmoneyimportant,equallyimportantis
Not
only is the amount of money important equally important is
thetimewhenisitreceivedorpaid.

Oneofthemostimportantconceptsusedinfinancialdecision
One of the most important concepts used in financial decision
making.

Applicationsinclude:
o

Personalfinance

Capitalbudgeting

Valuation

Derivativesandriskmanagement.

TIME VALUE OF MONEY

CHAPTER 4

T IME VALUE

OF

M ONEY

A N I NTRODUCTION

Valueofmoneyvarieswithtimedueto:

Presenceofinflation

Preferenceforcurrentconsumption

Investmentopportunitiesavailable

Does not account for the investment risks.

Doesnotaccountfortheinvestmentrisks.

Presentcashflowsarecompounded tofind
their Future values.
theirFuturevalues.

FutureCashflowsarediscountedtoarriveat
their Present values.
theirPresentvalues.
TIME VALUE OF MONEY

CHAPTER 4

C OMPOUNDING

Applicationofinterestoverinterestis
k
knownascompounding.
di

Presentcashflows,P
Present cash flows P arecompoundedto
are compounded to
theirfuturevalues,F foranestimatedtime
period n atanexpectedrateofinterest,r.
period,n
at an expected rate of interest r

Futurevalueinterestfactor(FVIF
(
r n))
r,n
F P x ( 1 r)n
FVIF ( r , n ) (1 r)n
TIME VALUE OF MONEY

CHAPTER 4

C OMPOUNDING A ND R ATE

Effectofcompoundingincreaseswiththe
increase in interest rates
increaseininterestrates.
10.00
9.00
8.00

Futurre Value

7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
1

2
at 5%

TIME VALUE OF MONEY

4
at 10%

5
at 15%

7
at 20%

8
at 25%

Time (yrs)

CHAPTER 4

C OMPOUNDING A ND T IME

Effectofcompoundingincreasesasthetime
lengthens.
lengthens
(Rs. 1 at 12%)
3.50

3 106
3.106
2.773

3.00

Future Va
alue

2.476

2.50
2.00
1.50

1.120

1.254

1.405

1.574

1 762
1.762

1.974

2.211

1.00
0.50
0.00

TIME VALUE OF MONEY

Time (yrs)

CHAPTER 4

D ISCOUNTING

Valueofthemoneyreceivedorpaidlateris
lesser than what it is today
lesserthanwhatitistoday.

Theprocessofreductioninvalue
eliminatingtheinterestthatcouldhave
li i ti th i t
t th t
ld h
accruedisknownasdiscounting.

Futurecashflows(F)arediscountedto
theirpresentvalues(P)foranestimated
timeperiod(n)atanexpectedrateof
( )
f
interest(r).
1
P F

TIME VALUE OF MONEY

( 1 r)

n
CHAPTER 4

D ISCOUNTING

Present value interest factor (PVIFr,n

Presentvalueinterestfactor(PVIF
)
r n)

TIME VALUE OF MONEY

1
( 1 r) n

CHAPTER 4

D ISCOUNTING A ND R ATE

10

Severityofdiscountingincreaseswiththe
increase in the rate of discounting
increaseintherateofdiscounting.
1.00
0.90
0.80

Presen
nt Value

0.70
0.60
0.50
0.40
0.30
0.20
0 10
0.10
0.00
1

2
at 5%

TIME VALUE OF MONEY

3
at 10%

5
at 15%

7
at 20%

Time (yrs)

at 25%

CHAPTER 4

D ISCOUNTING A ND T IME

11

Effectofdiscountingincreasesasthe
time lengthens
timelengthens.
(Rs. 1 at 12%)

Present Value

1.00

0 893
0.893

0.90
0.80

0.797
0.712

0.70
0.60

0.636

0.567

0.507

0.50

0 452
0.452

0.404

0.40
0.30

0.361

0.322

0.20
0 10
0.10
0.00

Time (yrs)

TIME VALUE OF MONEY

CHAPTER 4

A NNUITY

12

Equalamountsofcashflowsspaced
uniformly over time normally a year
uniformlyovertime,normallyayear.

Examplesinclude:

Premiumofinsurancepolicy

EMIofaloan
f l

Depositstoarecurringdepositaccount.

TIME VALUE OF MONEY

CHAPTER 4

F UTURE VALUE O F A NNUITY

13

Futurevalueofannuity(FVAr,n)depends
upon:

Amountofcashflow(i.e.annuity)

Rateofinterestperperiod

Numberofperiods.
( 1 r)n 1
FVAr,n Annuity
r

Futurevalueinterestfactorforannuity
FVIFA r,n
TIME VALUE OF MONEY

( 1 r) n 1

CHAPTER 4

P RESENT VALUE O F A NNUITY

14

Presentvalueofannuity(PVAr,n)likeits
future value depends upon:
futurevaluedependsupon:

Amountofcashflow(i.e.annuity)

Rateofinterestperperiod

Numberofperiods.
PVA r , n

(1 r ) n 1
Annuity
r (1 r ) n

Presentvalueinterestfactorforannuity
PVIFA
TIME VALUE OF MONEY

r ,n

(1 r ) n 1

r (1 r ) n
CHAPTER 4

C ONTINUOUS C OMPOUNDING

15

Valueofcompoundingordiscounting
p
g
g
dependsuponitsfrequency.

Thevaluerises/fallsexponentiallyincase
The al e rises/falls e ponentiall in case
ofcontinuouscompounding.
Future Value, F = P x e rt
1
Present Value, P = F x rt = F x e - rt
e

TIME VALUE OF MONEY

CHAPTER 4

E FFECTIVE R ATE O F
I NTEREST

16

Theeffectiveratemaybefoundfora
The
effective rate may be found for a
givenannualrate(r)andfrequencyof
compounding(m)
compounding (m) inayear.
in a year
m

r
Effective
Eff
ti
I t
Interest
t R ate
t = 1 1
m

TIME VALUE OF MONEY

CHAPTER 4

E QUATED M ONTHLY
I NSTALMENTS

17

LoansarerepayablenormallyinEquated
Loans
are repayable normally in Equated
MonthlyInstallments(EMIs).

EMIsareaformofannuity.
EMIs are a form of annuity

EachEMIcanbebifurcatedintointerest
andprincipalrepaymentcomponents.
d i i l

TheinterestcomponentofEMIsdeclines
whiletheprincipalcomponentincreases
withsuccessiveEMIs.

TIME VALUE OF MONEY

CHAPTER 4

18

F INDING EMI I N A DVANCE

TIME VALUE OF MONEY

CHAPTER 4

S EGREGATING EMI S

19

TIME VALUE OF MONEY

CHAPTER 4

E QUATED M ONTHLY
I NSTALMENTS

20

Acarloanfor3yearsforRs10,00,000
A
car loan for 3 years for Rs 10 00 000
at12%.

FindEMIinadvanceandinarrears

Find interest amount for the first year

Findinterestamountforthefirstyear.

TIME VALUE OF MONEY

CHAPTER 4

21

F INDING EMI I N A DVANCE

TIME VALUE OF MONEY

CHAPTER 4

S EGREGATING EMI S

22

Period Outstanding
0
10 00 000 00
10,00,000.00
1
9,67,114.54
2
9,43,900.23
3
9,20,453.78
9 20 453 78
4
8,96,772.86
5
8,72,855.14
6
8,48,698.23
7
8,24,299.76
8
7,99,657.30
9
7,74,768.42
10
7,49,630.65
11
7,24,241.50
TOTALIst Year
TIME VALUE OF MONEY

EMI
32 885 46
32,885.46
32,885.46
32,885.46
32,885.46
32 885 46
32,885.46
32,885.46
32,885.46
32,885.46
32,885.46
32,885.46
32,885.46
32,885.46
3,94,625.46

Interest
000 00
000.00
9,671.15
9,439.00
9,204.54
9 204 54
8,967.73
8,728.55
8,486.98
8,243.00
7,996.57
7,747.68
7,496.31
7,242.42
93,223.92

PrincipalRepaid
32 885 46
32,885.46
23,214.31
23,446.45
23,680.92
23 680 92
23,917.73
24,156.90
24,398.47
24,642.46
24,888.88
25,137.77
25,389.15
25,643.04
3,01,401.54
CHAPTER 4