TIME VALUE OF MONEY

Background of Time value with Money:

The time value of money shows mathematically how the timing of cash flows, combined with the opportunity costs of capital, affect financial asset values. A thorough understanding of these concepts gives a financial manager powerful tool to maximize wealth.

Time value of money

The time value of money serves as the foundation for all other notions in finance. It impacts business finance, consumer finance and government finance. Time value of money results from the concept of interest. This overview covers an introduction to simple interest and compound interest, illustrates the use of time value of money tables, shows a approach to solving time value of money problems and introduces the concepts of intra year compounding, annuities due, and perpetuities. A simple introduction to working time value of money problems on a financial calculator is included as well as additional resources to help understand time value of money.

Preface
In order to understand how to deal with money the important idea to know is the time value of money. Time Value of Money (TVM) is the simple concept that a rupee that someone has now is worth more than the rupee that person will receive in the future, this is because the money that the person holds today is worth more because it can be invested and earn interest. The following paper will explain how annuities affect TVM problems and investment outcomes. The issues that impact TCM will also be discussed: Interest rates and compounding (with two problems), present value, future value, opportunity cost, annuities and the rule of '72. The idea of TVM allows managers or investors the capability to understand the advantages and future cash flow of the cost of an investment or project. TVM is an important concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities "Interest is the cost of borrowing money. An interest rate is the cost stated as a percent of the amount borrowed per period of time, usually one year" An interest rate is a very important factor in all financial decisions. The two types of interest rates are simple and compound (Brealey, Myers & Marcus, 2003). A simple interest rate for example, occurs when a person borrows money from a lender and he or she will have to pay the lender a fee, this fee is the simple interest rate (Brealey, Myers & Marcus, 2003). Simple interest is normally used for a single period of less than a year, such as 30 or 60 days [simple interest = p x i x n]. For example, a calculation for this problem would be: Say you borrow Rs 50,000 for 60 days at 5% simple interest per year (assuming the year is calculated at 360 days per year). Interest = p x i x n = 50,000 x .05 x (60/360) = 416.667

Hypothesis of the study:

If you're like most people, you would choose to receive the $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 or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.

Future Value Basics If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the future value of your investment at the end of the first year is $10,450, which of course is calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount: Future value of investment at end of first year: = ($10,000 x 0.045) + $10,000 = $10,450

Present Value Basics If you received $10,000 today, the present value would of course be $10,000 because present value is what your investment gives you now if you were to spend it today. If $10,000 were to be received 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.

Present Value of a Future Payment Let's add a little spice to our investment knowledge. What if the payment in three years is more than the amount you'd receive today? Say you could receive either $15,000 today or $18,000 in four years. Which would you choose? The decision is now more difficult. If you choose to receive $15,000 today and invest the entire amount, you may actually end up with an amount of cash in four years that is less than $18,000. You could find the future value of $15,000, but since we are always living in the present, let's find the present value of $18,000 if interest rates are currently 4%. Remember that the equation for present value is the following:

Data Used
There were mainly two sources of data collection y Primary data: o Survey method o Personal interaction with financial managers of the projects & finance management professor of NICMAR Secondary data: o Literature available on Websites o Literature available with colleagues

Time value of money The universal preference for a rupee today over a rupee at some future time is because of the following reasons: Alternative uses/ Opportunity cost Inflation Uncertainty

The manner in which these three determinants combine to determine the rate of interest can be represented symbolically as: Nominal or market rate of interest rate = Real rate of interest + Expected rate of Inflation + Risk of premiums to compensate uncertainty Basics Evaluating financial transactions requires valuing uncertain future cash flows. Translating a value to the present is referred to as discounting. Translating a value to the future is referred to as compounding. The principal is the amount borrowed. Interest is the compensation for the opportunity cost of funds and the uncertainty of repayment of the amount borrowed; that is, it represents both the price of time and the price of risk. The price of time is compensation for the opportunity cost of funds and the price of risk is compensation for bearing risk. Interest is compound interest if interest is paid on both the principal and any accumulated interest. Most financial transactions involve compound interest, though there are a few consumer transactions that use simple interest (that is, interest paid only on the principal or amount borrowed). Under the method of compounding, we find the future values (FV) of all the cash flows at the end of the time horizon at a particular rate of interest. Therefore, in this case we will be comparing the future value of the initial outflow of Rs. 1,000 as at the end of year 4 with the sum of the future values of the yearly cash inflows at the end of year 4. This process can be schematically represented as follows: PROCESS OF DISCOUNTING Under the method of discounting, we reckon the time value of money now, i.e. at time 0 on the time line. So, we will be comparing the initial outflow with the sum of the present values (PV) of the future inflows at a given rate of interest. Translating a value back in time -- referred to as discounting -- requires determining what a future amount or cash flow is worth today. Discounting is used in valuation because we often want to determine the value today of future value or cash flows. The equation for the present value is: Present value = PV = FV / (1 + i) Where: PV = present value (today's value), FV = future value (a value or cash flow sometime in the future), i = interest rate per period, and n = number of compounding periods And [(1 + i) ] is the compound factor. We can also represent the equation a number of different, yet equivalent ways:
n n n

Present Value = PV = FV/ (1+i) = FV * 1/ (1+i) = FV * (1/1+i)

=FV (Discount factor for i & n) = FV (PVIF )

i, n

Where PVIFi,n is the present value interest factor, or discount factor. In other words future value is the sum of the present value and interest:

Future value = Present value + interest

From the formula for the present value you can see that as the number of discount periods, n, becomes larger, the discount factor becomes smaller and the present value becomes less, and as the interest rate per period, i, becomes larger, the discount factor becomes smaller and the present value becomes less. Therefore, the present value is influenced by both the interest rate (i.e., the discount rate) and the numbers of discount periods. Example 1 Suppose you invest 1,000 in an account that pays 6% interest, compounded annually. How much will you have in the account at the end of 5 years if you make no withdrawals? After 10 years? Answer:
5

FV5 = Rs 1,000 (1 + 0.06) = Rs 1,000 (1.3382) = Rs 1,338.23

10

FV10 = Rs 1,000 (1 + 0.06) = Rs 1,000 (1.7908) = Rs 1,790.85 What if interest was not compounded interest? Then we would have a lower balance in the account: FV5 = Rs 1,000 + [Rs 1,000(0.06) (5)] = Rs 1,300 FV10 = Rs 1,000 + [Rs 1,000 (0.06) (10)] = Rs 1,600 Example 2 Suppose you are faced with a choice between two accounts, Account A and Account B. Account A provides 5% interest, compounded annually and Account B provides 5.25% simple interest. Consider a deposit of Rs 10,000 today. Which account provides the highest balance at the end of 4 years? Answer: Account A: FV = Rs 10,000 (1 + 0.05) 4 = Rs 12,155.06
4

Account B: FV = Rs 10,000 + (Rs 10,000 (0.0525) (4)] = Rs 12,100.00

4

Account A provides the greater future value. Example 3 Suppose that you wish to have Rs 20,000 saved by the end of five years. And suppose you deposit funds today in account that pays 4% interest, compounded annually. How much must you deposit today to meet your goal? Answer: Given: FV = Rs 20,000; n = 5; i = 4%
5

PV = Rs 20,000/ (1 + 0.04) = Rs 20,000/1.21665 PV = Rs 16,438.54 1. You invest Rs 5,000 today. You will earn 8% interest. How much will you have in 4 Years? (Pick the closest answer) Rs 6,802.50 Rs 6,843.00 Rs 3,675

2. You have Rs 450,000 to invest. If you think you can earn 7%, how much could you accumulate in 10 years?(Pick the closest answer) Rs 25,415 Rs 722,610 Rs 722,610 3. If a commodity costs Rs500 now and inflation is expected to go up at the rate of 10% per year, how much will the commodity cost in 5 years? Rs 805.25 Rs 3,052.55 Cannot tell from this information In what period of time money will be doubled? Investor most of the times want to know that in what period of time his money will be doubled. For this the rule of 72 is used. Suppose the rate of interest is 12%, the doubling period will be 72/12=6 yrs. Apart from this rule we do use another rule, which gives better results, is the rule of 69 = .35 + 69/int rate = .35 + 69/12 = .35 + 5.75 = 6.1 yrs

Multiple Cash Flows: Now, a more realistic and complex setting Most investments generate multiple cash flows over time
Special cases: Annuities: same cash flow repeated for a fixed number of periods Perpetuities: same cash flow repeated periodically, forever Growing annuities and perpetuities Objective: understand Discounted Cash Flow (DCF) and Net Present Value (NPV) so as to: value and price securities and companies evaluate projects: capital budgeting Present and Future Value: Multiple Cash Flows Net Present Value and Investment Projects Net Present Value is a measure of the difference between the market value of an investment and its cost. If the NPV is positive, this indicates a profitable investment (if the NPV < 0, the investment should not be made. Estimating Net Present Value

Discounted cash flow (DCF) valuation consists of finding the market value of assets or their benefits by taking the present value of future cash flows, i.e., by estimating what the future cash flows would trade for in today's dollars.

The generalized formula for these shorter compounding periods is

MN

FVn = PV (1+ K/M)

Where
FVn= future value after n years PV = cash flow today K = Nominal Interest rate per annum M = Number of times compounding is done during a year N = Number of years for which compounding is done. Effective vs. Nominal Rate of interest We have seen above that the accumulation under the semi-annual compounding scheme exceeds the accumulation under the annual compounding scheme compounding scheme, the nominal rate of interest is 10% per annum, under the scheme where compounding is done semi annually, the principal amount grows at the rate of 10.25 percent per annum. This 10.25 percent is called the effective rate of interest which is the rate of interest per annum under annual compounding that produces the same effect as that produced by an interest rate of 10 percent under semi annual compounding. The general relationship between the effective a nominal rates of interest is as follows: m

= (1+k/m) 1
r = Effective rate of interest k = Nominal Rate of interest m = Frequency of Compounding per year Example
Find out the effective rate of interest, if the nominal rate of interest is 12% and is quarterly compounded? Answer:
m

Effective rate of interest = (1 + K/m) 1

4

= (1 + 0.12/4) 1
4

= (1+ 0.03) 1 = 0.126 = 12.6% p.a compounded quarterly The Present Value of one rupee PVIF IMPORTANT The inverse of FVIF is PVIF i.e. inverse of FVIF is PVIF.

Conclusion:
The basic idea of the time value of money is that money received in the future is not as valuable as money received today. The time value of money is a critical factor in many financial and investment applications such as finding the amount of deposits to accumulate a future sum and the periodic payment of an amortized loan. The development of the time value of money concept permits comparison of sums of money that are available at different points in time. This chapter developed two basic concepts: future value and present value. It showed how these values are calculated and can be applied to various financial and investment situations. By now we have examined and should understood time-value-of-money calculations so that we can plan cash collections and disbursements in a way that enables companies to earn maximum value from their money. The time-value techniques measure a company s value and evaluate the potential impact of various events and decisions on the company. we should understand the time-value-of-money techniques and be able to apply them in order to make intelligent, value-creating decisions. You have also examined the relationship between risk and return and how to measure that relationship in order to evaluate data and translate those data into decisions that will increase the value of the company. The cost of capital encompasses the time value of money and the fundamental principles of risk and return in order to assess the acceptability and relative ranking of proposed long-term investments. Learnt how to calculate the NPV by discounting estimated cash flows at a given discount rate. That discount rate is also called the cost of capital. In a sense, the corporate valuation model is the culmination of all the material we have covered thus far, because it draws together financial statements, cash flows, financial projections, time value of money, risk, and the cost of capital