Time value of money

The notion that money has time value is one of the basic concepts of finance. Most financial decisions at the firm level and individual level involve exchanging money now with the money in future. Financial decisions at firm level : Two important financial decisions are a) Investment decision : In these decisions a big initial cash outflow is followed by a series of expected cash inflows over long period in future. b) Financing decisions : These decisions involve raising money from banks, financial institutions, debentures, shares etc. in these decisions an initial inflows is followed by a series of outflows in the form of interest, dividend and repayment of principal.
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Financial decisions at individual level : These are

a) Saving deployment decisions :Such decisions involve putting money in banks, mutual fund schemes, insurance companies, post offices, chit funds and finance companies, shares or debentures. These decisions involve trade off between a certain cash outflow today with uncertain cash inflows in future. Borrowing decisions : Such decisions involve raising money to finance a house , to finance the purchase of a car or any other household durable, to provide for child education or some family function. In these decisions we get the money today which is to be repaid in future.

b)

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As most financial decisions affect the cash flows over a long period of time, the explicit recognition of the time value of money becomes important for rational and optimal decisions. Conceptually time value of money means that the value of a sum of money received today is more than the same amount received at some future date or conversely the sum of money to be received in future is less valuable than the same sum received today. The main reasons for this time preference (or time value of money) are : I. II. III. IV. Preference for current consumption over future consumption. Possibility of Risk free returns on the money invested. Premium for the risk and uncertainty. Premium for inflation
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In order to overcome this time preference, the individuals or firms are to be suitably rewarded. This reward is known by the various names of interest, cost of capital, required rate of return or cost of financing.
An explicit consideration of interest rate helps the individual or a firm to translate different amounts offered at different time periods to their equivalent value at present. An understanding of mathematics of interest is therefore important to understand most financial transactions at individual and corporate level which involve cash flows over a period of time.
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In any time value situation, the following parameters are important

I. Cash inflows or outflows : These could either be either in the form of single period cash flow or in the form of an annuity or a stream of uneven cash flows. II. Rate of interest or the time value of money. III. Time period over which cash flows occur. IV. Frequency of the cash flows. In most time value situations we have to solve for one of the above parameters.
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Following concepts are important in this regard : Compound interest : The word compound refers to the periodic
i. addition of interest earned to the principal amount. This is used in the following situations : Future value of a single cash flow :

FVn = P( 1+r )n

---------------- (i)

Where FVn = Future or compound value at the end of n years. P = Principal or original amount invested r = Interest rate. n = number of years for which compounding occurs.

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ii.

Compounding with non-annual periods : Effective vs. nominal rate of interest.

FVn = P( 1+r/m )mn

---------------- (ii)

where m = frequency of compounding or the numbers of compounding in a year. The frequency of compounding effects the effective rate of interest. As interest is earned on interest more frequently as the length of compounding period declines, there is a direct relation between the frequency of compounding and effective rate of interest. The higher the frequency of compounding in a year the higher is the effective rate of interest. We can also say that it is inversely related with the compounding period. The higher the length, the lower is the effective rate of interest.
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Table showing the relationship between effective rate of interest and nominal rate.
Frequency of compounding Nominal rate of interest(%) Effective rate of interest(%) Growth of one million (Rs.)

1 (annual) 2 (semi-annual) 4 (quarterly) 12 (monthly) 52 (weekly) 365 (daily)

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12 12 12 12 12 12

12 12.36 12.55 12.68 12.73 12.75

1120000 1123600 1125506 1126825 1127340 1127474

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iii. Doubling period :

FVn = P( 1+r )n ( 1+r )n = FVn / P = 2/1 = 2.00 Given r we can look for factor 2 in compound interest table and find out n. iv Rules of thumb for doubling : a) Rule of 72. b) More accurate rule is n = 0.35 + 69/ r

v. Finding growth rate in financial variables : for example finding the average compound growth rate of profits, sales, dividends or some other financial variable.

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vi. Finding the future value of a series of cash flows.

Present or discounted value : It is the inverse of

compounding. Here we move the money backward in time. We find out the present value of a sum or a series of sums to be received in future.

FVn = PV( 1+r )n PV = FVn / ( 1+r )n ---------------- (iii)

The above equation can be used for : i.) To find the present value of a single cash flow. ii.) to find the present value of an uneven stream of future cash flows

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Annuities : An annuity is a series of constant cash flows

(payments or receipts) occurring at regular intervals of time.( it may be annual, half-yearly, quarterly, monthly or daily.) Examples of annuities : a) Annual Premium paid to insurance company. b) Regular payments into recurring deposits. c) Equal money saved regularly to purchase a capital asset, provide for child education, for old age pension or provide for family function. d) Equal repayments for housing, car or any other loan. Types of annuities : i.) Deferred annuity : when the cash flows occur at the end of each period, the annuity is called an ordinary annuity or a deferred annuity.
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ii.) Annuity due : when the cash flows occur at the

beginning of each period, the annuity is called an annuity due or a prepaid annuity. Future value of an annuity :
n-1

FVAn
Where

= A [ (1+ r)t ] ------------- (iv)

t =0

FVAn = is the future value of an annuity.

A n = fixed periodic amount. = time period for which the annuity run = applicable rate of interest.

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Applications of future value of annuity : i. Knowing what lies in store for you : You deposit your money in some savings scheme and you are interested in knowing as to how much it will grow. How much you should save perioically. Annual deposits in a sinking fund : how much should be set aside annually and invested every year to redeem a debt or replace a capital asset. Finding the implicit interest rate. How long you should wait.

ii. iii.

iv. v.

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Present value of an annuity

n

PVAn

= A [ 1 / (1+ r)t ] ------------- (iv)

t =1

Applications of present value of annuity : i. How much we can borrow for a house or car etc. ii. Period of loan amortization. iii. Determining the loan amortization schedule. iv. Finding the implicit interest rate. v. Determining the periodic withdrawal.
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Annuity due value = ordinary annuity value x(1+r)

Present value of perpetuity :

= (A / r) Where PVP = present value of perpetuity.

A r = = constant annual cash flow. rate of interest.

PVP

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