CH-3: TIME VALUE OF MONEY

CH: 3 TIME VALUE OF MONEY

CHAPTER STRUCTURE:
3.1. TIME VALUE OF MONEY
3.2. IMPORTANCE OR SIGNIFICANCE OF TIME VALUE OF MONEY
3.3. COMPOUNDING AND DISCOUNTING
3.4. ANNUITY AND ANNUITY DUE
3.5. EFFECTIVE RATE AND NOMINAL RATE

LIST OF FORMULA:
I. FOR SINGLE PAYMENT CASH FLOW (COMPOUNDING/DISCOUNTING)
1. Future Value
୧ ୬∗୫
FV= PV x FVIFi%,n or PVሺ1 + iሻ୬ or PV ቀ1 + ୫ቁ
2. Present Value
ଵ ଵ
PV= FV x PVIFi%,n or FV x ሺଵା௜ሻ೙ or FV x ೔ ೙∗೘
ቀଵା ቁ
೘

II. FOR UNIFORM CASH FLOW (ANNUITES)

1. Future Value of Annuity
ሺ1+iሻn -1
FVA= PMT x FVIFAi%,n or PMTx i
2. Future Value of Annuity due
ሺ1+iሻn -1
FVA, due= PMT x FVIFAi%,n x (1+i) or PMTx i
x (1+i)
3. Present Value of Annuity
భ
ଵିሺభశ೔ሻ೙
షభ
PVA= PMT x PVIFAi%,n or
௜
4. Present Value of Annuity , due
భ
ଵିሺభశ೔ሻ೙
షభ
PVA, due= PMT x PVIFAi%,n x (1+i) or ௜
x (1+i)
Where,
i. PV= Present Value
ii. FV= Future Value
iii. PMT= Installment Payment
iv. i= Interest Rate (compound rate or discount rate)
v. n= Number of years (maturity)
vi. m= No. of periods in a year (i.e m=12 for monthly, m =2 semi annually)
vii. PVIFi%,n =Present Value Interest Factor for i% and n period
viii. FVIFi%,n = Future Value Interest Factor for i% and n period
ix. PVIFAi%,n =Present Value Interest Factor of Annuity for i% and n period
x. FVIFAi%,n = Future Value Interest Factor of Annuity for i% and n period

Course: MGT 215 (Fundamentals of Financial Management), Chanakya College,BBS2nd year.

By: Lecturer, Punya Ram Sujakhu (9841395153)
Page 1 of 4
 CH-3: TIME VALUE OF MONEY

3.1 TIME VALUE OF MONEY

Time value of money is the most importance concepts in finance. It means that the value of
a rupee received in one year from now is not the same as the value of a rupee received
today. In other words, most of us would prefer to received cash sooner rather than later and
to spend later rather than sooner. Money has time value because it earns interest on the
principal and also on the previously earned interest. As a result, a rupee invested today can
grow a rupee plus interest and interest on interest at some future date.

For example, if we invest Rs. 1000 at the rate of 10 percent, annually it becomes Rs 1100 in
one year later. Hence, Rs 1000 is called present value of Rs 1100. It means, the future value
Rs 1100 is the result of present value Rs 1000.

Money has time value because

i. Inflation: Money in hand today has more purchasing power.
ii. Risk factor: the present is certain as comparing to future, so it is required to compensate
the uncertainty.
iii. Time preference: it is human behavior that every one prefers to receive money as earlier
as possible.
iv. Liquidity preference: Capital can be employed productively.

3.2 IMPORTANCE OR SIGNIFICANCE OF TIME VALUE OF MONEY

1. For Evaluation of securities
The time value of money concepts is important and widely used in valuation of securities
because the values of any assets is the present values of the expected future cash flows
from the assets. So, it is important to investors as well as to financial mangers.

2. For Capital budgeting

Capital budgeting is the process of acquiring (purchasing) the fixed assets that need huge
amount of investment. It is compulsory to evaluate the project and expected cash inflow to
make a decision about investment. So, time value of money concept is used for presence
decision.

3. For The cost of capital

Any company needs the long term capital or permanent capital to achieve the goal of the
company. So, it is necessary to know about the cost of capital used by the firm for various
sources of long term capital. For this, a time value of money is used to calculate the cost of
those capitals.

4. For Working capital management

Working capital is very important to operate the daily activities. Hence, time value of money
is used to manage the working capital that make a decision on the opportunity cost and
profitability.

Course: MGT 215 (Fundamentals of Financial Management), Chanakya College,BBS2nd year.

By: Lecturer, Punya Ram Sujakhu (9841395153)
Page 2 of 4
 CH-3: TIME VALUE OF MONEY

5. For trade off between risk and return

Company needs fixed assets to generate sales revenue. For this, the company either
purchase or lease the project. A time value on money concepts is used for decision on lease
versus purchase that trade off between risk and return on the investment.

3.3 COMPOUNDING AND DISCOUNTING

In general, compounding is the process of finding future value of a cash flow or a series of
cash flow. The compounded amount equals to the present value plus the interest earned.
The interest rate and time period is known compounding rate and compounding
period which is used to convert the present value into future value.

Whereas, discounting is the process to findings present value of a cash flow or a series of
cash flow. Discounting is the reciprocal or reverse of compounding. The interest rate is
called discounts rate and time period is called discounts period which is used to
convert the future value into present value .

3.4 ANNUITY AND ANNUITY DUE

An annuity is a series of equal amount of payment made of each year. It is
popularly known as installment .If equal amount of payment is made at the end of
the year it is called simply annuity or ordinary annuity. If equal amount of payment is
made at the beginning of each year then it is called annuity due . An annuity whose
payments occur forever is called perpetuity.

3.5 NOMINAL AND EFFECTIVE INTEREST RATE

Nominal interest rate is the annual quoted interest rate which does not considers the
compounding effect. It is also known as simple interest rate. Nominal annual rate is always
given.

On other hand,Effective interest rate is the annual equivalent interest rate which considers
the compounding effect. It gives the greater interest rate than nominal rate because of
compound interest. Effective annual rate is calculated by
m
 i
EAR = 1 +  − 1
 m
Where, m = No. of compounding periods in a year.

Course: MGT 215 (Fundamentals of Financial Management), Chanakya College,BBS2nd year.

By: Lecturer, Punya Ram Sujakhu (9841395153)
Page 3 of 4
 CH-3: TIME VALUE OF MONEY

Problem and Solution:

You are thinking about buying a car, and a local bank is willing to lend you $20,000 to buy
the car. If the nominal interest rate be 12 percent. What would be the effective rate of
interest on the loan?
a. If interest paid annually. ie m =1 [12%]
b. If interest paid semiannually. ie m =2 [12.36%]
c. If interest paid quarterly. ie m =4 [12.55%]
d. If interest paid bimonthly. ie m =6 [12.62%]
e. If interest paid monthly. ie m =12 [12.68%]
f. If interest paid daily. ie m =365 [12.75%]
g. If interest paid perpetually (continuous). ie m = ∞ [ei-1=12.75%]

SOME IMPORTANT QUESTIONS AND THEIR ANSWER

1. "A rupee in hand today is worth more than a rupee to receive next year." explain.
Yes, it is absolutely true; A rupee in hand today is worth than a rupee to receive next year.
Money has time value because it earns interest on the principal and also on the previously
earned interest. As a result, a rupee invested today can grow a rupee plus interest and
interest on interest at some future date. In an inflation period, a rupee received today has
more purchasing power than money to be received in future.

For example, if we invest Rs. 1000 at the rate of 10 percent, annually it becomes Rs 1100 in
one year later. Hence, Rs 1000 is called present value of Rs 1100. It means, the future value
Rs 1100 is the result of present value Rs 1000.

Course: MGT 215 (Fundamentals of Financial Management), Chanakya College,BBS2nd year.

By: Lecturer, Punya Ram Sujakhu (9841395153)
Page 4 of 4