TIME VALUE OF MONEY
The value/ purchasing power of a money at a particular time is
called time value of money. A rupee today is worth more than a
rupee will be received tomorrow. The present money income
expected at a future date is lower than the money held today.
Money has time value. Money today is valued more because.
•(i) Money gives liquidity, and an opportunity to invest it and
earn return (interest) on it.
•(ii) Individuals, in general prefer current consumption to future
consumption because the future is always uncertain and involves
risk.
•(iii) Capital can be employed productivity to generate positive
returns.
•(iv) In an inflationary period a rupee represents a greater real
purchasing power than a rupee a year hence.
Since money has earning as well as purchasing power, money has
time value.
Since money has earning as well as
purchasing power, money has time value.
For example, suppose you have deposited
Rs. 200/- in a bank with 10% rate of
interest. After one year the interest would
be 20 and the amount will become Rs.
220/- at the end of the year. It follows that
Rs. 220/- expected one year hence in
worth only Rs. 200/- today.
TECHNIQUES FOR ADJUSTING TIME VALUE OF
MONEY OR INTEREST FORMULAS
Interest rate can be classified into simple interest rate, and compound
interest rate. In simple interest, the interest is calculated, based on the
initial deposit for every interest period. In compound interest, the
interest for the current period is computed based on the amount
(principal plus interest up to the end of the previous period) at the
beginning of the current period. The notations which are used in
various interest formulae are as follows:
P = principal amount
n = No. of interest periods
i = interest rate (It may be compounded monthly, quarterly,
semiannually or annually)
F = future amount at the end of year n
A = equal amount deposited at the end of every interest period
G = uniform amount which will be added/subtracted period after
period to/ from the amount of deposit A1 at the end of period 1
1. Single-Payment Compound Amount
/ Future value of an amount
Here, the objective is to find the-single
future-sum (F) of the initial payment (P) made
at time 0 after n periods at an interest rate i
compounded every period.
Cash flow diagram of single-payment compound
amount.
The formula to obtain the single-payment
compound amount is
F = P(1+i)^n
Or F = P(F/P,i,n)
Where, (F/P, i, n) is called as single-payment
compound amount factor.
EXAMPLE
A person deposits a sum of Rs.
20,000 at the interest rate 18%
compounded annually for 10 years.
Find the maturity value after 10
year.
Solution ?
Solution
P = Rs. 20,000
i = 18% compounded annually
n = 10 years
F=P(1+i)^n = P(F/P, i, n)
= 20,000 (F/P, 18%, 10)
= 20,000 x 5.234 = Rs. 1,04,680
The maturity value of Rs. 20,000 invested
now at 18% compounded yearly is equal to
Rs.1,04,680 after 10 years.
2. Single Payment present
worth amount
Here, the objective is to find the present
worth amount (P) of a single future (F) which
will be received after n periods at an interest
rate of compound at the end of every interest
period.
The corresponding cash flow diagram is ….
The formula to obtain the present worth is
P= F/(1+i)^n
Or P=F(P/F,i,n)
Where, (P/F,i,n) is called as single-payment
present worth amount factor
Example 2
A person wishes to have a future sum of
Rs. 1,00,000 for his son’s education after
10 years from now. What is the single-
payment that the deposit now so that he
gets the desired amount after 10 years?
The bank gives 15% interest rate
compounded annually.
Solution
F = Rs.1,00,000
i = 15%, compounded annually
n = 10 years
p= F/(1+i)^n = F(P/F, i, n)
= 1,00,000 (P/F, 15%, 10)
= 1,00,000 x 0.2472
= Rs. 24,720
The person has to invest Rs.24,720 now so that
he will get a sum of Rs.1,00,000 after 10 years at
15% interest rate compounded annually.
3. Equal-Payment Series Compound
Amount / Future value of an annuity
The objective is to find the future worth of n
equal payments which are made at the end
of every interest period till the end of the
nth interest period at an interest rate of
compounded at the end of each period.
The corresponding cash flow diagram is shown in Fig
The formula to get F is
F= A[(1+i)^n -1] / i
Or F= A(F/A,i,n)
Where (F/A,i,n) is termed as equal-payment series
compound amount factor.
Example 3
A person who is now 35 years old is
planning for his retired life. He plans
to invest an equal sum of Rs.10,000
at the end of every year for the next
25 years starting from the end of the
next year. The bank gives 20%
interest rate, compounded annually.
Find the maturity value of his
account when he is 60 years old.
Solution
A = Rs. 10,000
n = 25 years
i = 20%
F = A (F/A, i, n)
= 10,000 (F/A, 20%, 25)
= 10,000 x 471.981
= Rs. 47,19,810
The future sum of the annual equal payments
after 25 years is equal to Rs. 47,19,810.
4. Equal-Payment Series
Sinking Fund
In this type of investment mode, the
objective is to find the equivalent amount
(A) that should be deposited at the end of
every interest period for n interest periods
to realize a future sum (F) at the end of the
nth interest period at an interest rate of i.
Cash flow diagram of equal payment series sinking fund
A= F[i / (1+i)^n - 1]
Or A= F(A/F,i,n)
where (A/F, i, n) is called as equal-payment series sinking fund
factor.
EXAMPLE
A company has to replace a present
facility after 15 years at an outlay of
Rs.5,00,000. It plans to deposit an equal
amount at the end of every year for the
next 15 years at an interest rate of 18%
compounded annually. Find the equivalent
amount that must be deposited at the
end of every year for the next 15 years.
Solution
F = Rs. 5,00,000
n = 15 years
i = 18%
A= ?
A= F[i / (1+i)^n - 1]
Or A= F(A/F,i,n)
= 5,00,000 (A/F, 18%, 15)
= 5,00,000 X 0.0164
= Rs.8,200
The annual equal amount which must be deposited for 15 years
is Rs.8,200.
5. Equal Payment Series Present
worth amount
The objective of this mode is investment is to find
the present worth of an equal payment made at
the end of every interest period for n interest
periods at interest rate of i compounded at the
end of every interest period.
Cash flow diagram of equal-payment series
present worth amount
The formula to compute P is
P= A [(1+i)^n -1 / i(1+i)^n]
Or F= A(P/A,i,n)
where (P/A,i,n) is called equal-payment series
present worth factor.
EXAMPLE
A company wants to set up a reserve
which will help the company to have an
annual equivalent amount of Rs.
10,00,000 for the next 20 years towards
its employees welfare measures. The
reserve is assumed to grow at the rate
of 15% annually. Find the single-payment
that must be made now as the reserve
amount.
Solution
A = Rs.10,00,000
i = 15%
n = 20 years
P=?
P= A [(1+i)^n -1 / i(1+i)^n]
Or F= A(P/A,i,n)
= 10,00,000 X (P/A, 15%, 20)
= 10,00,000 X 6.2593
= Rs.62,59,300
The amount of reserve which must be set-up
now is equal to Rs.62,59,300.
6. Equal-Payment Series Capital
Recovery Amount
The objective of this mode of investment is to
find the annual equivalent amount (A) which is to
be recovered at the end of every interest period
for n interest periods for a loan (P) which is
sanctioned now at an interest rate of i
compounded at the end of every interest period
Cash flow diagram of equal-payment series capital
recovery amount.
A= P [i(1+i)^n / (1+i)^n - 1]
Or A=P(A/P,i, n)
where, (A/P, i, n) is called equal-payment series
capital recovery factor.
EXAMPLE
A bank gives a loan to a company to
purchase an equipment worth Rs.
10,00,000 at an interest rate of 18%
compounded annually. This amount
should be repaid in 15 yearly equal
installments. Find the installment
amount that the company has to
pay to the bank.
Solution
P= Rs. 10,00,000
i = 18%
n = 15 years
A=?
A= P [i(1+i)^n / (1+i)^n - 1]
Or A=P(A/P,i, n)
=1000000(0.1964)
=196400
The annual equivalent to be paid by the company to
the bank is Rs. 196400
7. Uniform Gradient Series Annual
Equivalent Amount
The objective of this mode of investment is to find the
annual equivalent amount of a series with an amount A1
at the end of the first year and with an equal increment
(G) at the end of each of the following n – 1 years with
an interest rate i compounded annually.
Cash flow diagram of uniform gradient series annual equivalent amount.
The formula to compute A under this situation is
A = A1+ G {[(1+i)^n - in - 1] / [i(1+i)^n - i]}
= A1 + G (A/G, i, n)
where (A/G, i, n) is called uniform gradient series factor
Example
A person is planning for his retired life.
He has 10 more years of service. He
would like to deposit 20% of his salary,
which is Rs. 4,000, at the end of the first
year, and thereafter he wishes to deposit
the amount with an annual increase of Rs.
500 for the next 9 years with an interest
rate of 15%. Find the total amount at the
end of the 10th year of the above series.
Example
A person is planning for his retired life. He
has 10 more years of service. He would like
to deposit Rs. 8,500 at the end of the first
year and thereafter he wishes to deposit the
amount with an annual decrease of Rs. 500
for the next 9 years with an interest rate of
15%. Find the total amount at the end of the
10th year of the above series.
Effective Interest Rate
Let i be the nominal interest rate compounded
annually. But, in practice, the compounding may occur
less than a year. For example, compounding may be
monthly, quarterly, or semi-annually. Compounding
monthly means that the interest is computed at the
end of every month. There are 12 interest periods in a
year if the interest is compounded monthly. Under
such situations, the formula to compute the effective
interest rate, which is compounded annually, is
Effective interest rate, R = (1 + i/C)^C – 1
where, i = the nominal interest rate
C = the number of interest periods in a year.
EXAMPLE
A person invests a sum of Rs. 5,000 in a bank
at a nominal interest rate of 12% for 10 years.
The compounding is quarterly. Find the
maturity amount of the deposit after 10 years.
Solution
P = Rs. 5,000
n = 10 years
i = 12% (Nominal interest rate)
F=?
METHOD 1
No. of interest periods per year = 4
No. of interest periods in 10 years =10 *4 = 40
Revised No. of periods (No. of quarters), N = 40
Interest rate per quarter, r = 12%/4 = 3%, compounded
quarterly.
F = P(1 + r)^N = 5,000(1 + 0.03)40
= Rs. 16,310.19
METHOD 2
No. of interest periods per year, C = 4
Effective interest rate, R = (1 + i/C)^C – 1
= (1 + 12%/4)^4 – 1
= 12.55%, compounded annually.
F = P(1 + R)^n = 5,000(1 + 0.1255)^10
= Rs. 16,308.91
