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Time value of money

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17 views5 pages

Time value of money

Uploaded by

lalisst9905
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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role of time value in finance

TIME VALUE OF MONEY:

The ‘time value of money’ means that the value of a unit of money is different in different
time periods. The sum of money received in future is less valuable than it is today.

Since a rupee received today has more value, rational investors would prefer current receipt
to future receipts. The time value of money can also be referred to as time preference for
money.

The main reason for the time preference for money is to be found in the reinvestment
opportunities for funds which are received early. The funds so invested will earn a rate of
return; this would not be possible if the funds are received at a later time. The time
preference for money is, therefore, expressed generally in terms of a rate of return or more
popularly as a discount rate.

The capital budgeting decision generally involves the current cash outflows in terms of the
amount required for purchasing a new machine or launching a new project and the
execution of the scheme generates future cash inflows during its useful life.

TECHNIQUES:

As time value of money is of crucial significance. This requires the development of


procedures and techniques for evaluating future incomes in terms of the present. To have
logical and meaningful comparisons between cash flows that result in different time periods
it is necessary to convert the sums of money to a common point in time. There are two
techniques for doing this:

(1) Compounding, and


(2) Discounting

Compounding Techniques:

Annual Compounding:

Interest is compounded when the amount earned on an initial deposit (the initial principal)
becomes part of the principal at the end of the first compounding period. The term principal
refers to the amount of money on which interest is received.

This compounding procedure will continue for an indefinite number of years. The
compounding of interest can be calculated by the following equation:

A = P (1 + i) n

Where,

A = amount at the end of the period


P = principal at the beginning of the period
i = rate of interest
n = number of years
The compound interest phenomenon is most commonly associated with various savings
institutions. These institutions emphasise the fact that they pay compound interest on
savings deposited with them.
Two important observations can be made:
 First is that as the interest rate increases for any given year, the compound interest
factor also increases. Thus, the higher the interest rate, the greater is the future sum.
 Second point is that for a given interest rate, the future sum of a rupee increases
with the passage of time. Thus, the longer the period of time, the higher is the
compound interest factor.

Semi-annual and Other Compounding Periods


Very often the interest rates are compounded more than once in a year. Savings institutions,
particularly, compound interests semi-annually, quarterly and even monthly.

Semi-annual Compounding:
Semi-annual Compounding means that there are two compounding periods within the year.
Interest is actually paid after every six months at a rate of one-half of the annual (stated) rate
of interest.

Quarterly Compounding:
Quarterly Compounding means that there are four compounding periods within the year.
Instead of paying the interest once a year, it is paid in four equal instalments after every
three months. There will be eight compounding periods. In case of 6% interest p.a. the rate
of interest for each compounding period will be 1.5 per cent, that is (1/4 of 6 per cent).

The effect of compounding more than once a year can also be expressed in the form of a
formula:

Where,
m is the number of times per year compounding is made. For semi-annual compounding, m
would be 2, while for quarterly compounding it would equal 4 and if interest is compounded
monthly, weekly and daily, would equal 12, 52 and 365 respectively.

Example: Mr X places his savings of Rs 1,000 in a two-year time deposit scheme of a bank
which yields 6 per cent interest

Future/Compounded Value of a Series of Payments


So far we have considered only the future value of a single payment made at time zero. In
many instances, we may be interested in the future value of a series of payments made at
different time periods like 500 at the end of 1st year, 1000 at the end of 2nd year,1500 at the
end of 3rd year and so on. Future value of a series of payments can be calculated using the
formula
Where CFt is the cash flow occurring at time t, i is the interest rate per period and n is the
number of periods.

Compound Sum of an Annuity


An annuity is a stream of equal annual cash flows. Annuities involve calculations based upon
the regular periodic contribution or receipt of a fixed sum of money. Annuity tables are of
great help in the field of investment banking as they guide the depositors and investors as to
what sum an amount (X) paid for number of years, n, will accumulate to at a stated rate of
compound interest.

To find the sum of the annuity, the annual amount must be multiplied by the sum of the
appropriate compound interest factor annuity (CVIFA). Such calculations are available for a
wide range of i and n in the standard table.

Sn = CVIFA*A

where A is the value of annuity, and CVIFA represents the appropriate factor for the sum of
the annuity of Re 1 and Sn represents the compound sum of an annuity.

Example: (for understanding the calculation)


Mr X deposits Rs 2,000 at the end of every year for 5 years in his saving account paying 5 per
cent interest compounded annually. He wants to determine how much sum of money he will
have at the end of the 5th year. (values in column 4 are from standard table)

Amount at the end of 5 years =


Rs 2,000 (1.216) + Rs 2,000 (1.158) + Rs 2,000 (1.103) + Rs 2,000 (1.050) + Rs 2,000 (1.000)
= Rs 2,000 (5.527) = Rs 11,054

Present Value or Discounting Technique


 The concept of the present value is the exact opposite of that of compound value. In
contrast to the compounding approach where we convert present sums into future
sums, in present value approach future sums are converted into present sums.
 Given a positive rate of interest, the present value of future rupees will always be
lower. It is for this reason, therefore, that the procedure of finding present values is
commonly called discounting.
 It is concerned with determining the present value of a future amount, assuming
that the decision maker has an opportunity to earn a certain return on his money.
 This return is designated in financial literature as the discount rate, the cost of capital
or an opportunity cost.
Since finding present value is simply the reverse of compounding, the formula for
compounding of the sum can be readily transformed into a present value formula. The
compounding formula,
A = P(1 + i)n becomes:

Where, P is the present value for the future sum to be received or spent; A is the sum to be
received or spent in future; i is interest rate, and n is the number of years.

Present Value of a Series of Cash Flows


In case of present value of a series of receipts received by a firm at different time periods like
500 at the end of 1st year, 1000 at the end of 2nd year,1500 at the end of 3rd year and so on..
Like compounding, in order to determine the present value of such a mixed stream of cash
inflows, all that is required is to determine the present value of each future payment and
then to aggregate them to find the total present value of the stream of cash flows.

in which P = the sum of the individual present values of separate cash flows; C1, C2, C3 ... Cn,
refer to cash flows in time periods.

in which IF1, IF2, IF3, ... IFn represents relevant present value factors in different time periods
1,2,3…n

Annuity
We have already defined an annuity as a series of equal cash flows of an amount each time.
the present value of an annuity can be found by multiplying the annuity amount by the sum
of the present value factors for each year of the life of the annuity.
The sum of present values for an annuity (PVIFA)/annuity discount factor (ADF) of Re 1 for
wide ranges of interest rates, i, and number of years, n. The method of determining present
value is

P = C (ADF)
Where, C is the Annuity amount and ADF is the Annuity Discount factor from standard table.

Present Value of an Infinite Life Annuity (Perpetuities)


An annuity that goes on for ever is called a perpetuity. The present value of a perpetuity of
Rs C amount is given by the formula:
C/i
This is because as the length of time for which the annuity is received increases, the annuity
discount factor also increases but if the length goes on extending, this increase in the annuity
factor slows down. In fact, as annuity life becomes infinitely long (n ), the annuity discount
factor approaches an upper limit. Such a limit is 1/i. In other words, the appropriate factor is
found by merely dividing 1 by the discount rate.

Example (for understanding)


Mr X wishes to find out the present value of investments which yield Rs 500 in perpetuity,
discounted at 5 per cent. The appropriate factor can be calculated by dividing 1 by 0.05. The
resulting factor is 20. That is to be multiplied by the annual cash inflow of Rs 500 to get the
present value of the perpetuity, that is, Rs 10,000. This should, obviously, be the required
amount if a person can earn 5 per cent on investments. It is so because if the person has Rs
10,000 and earns 5 per cent interest on it each year, Rs 500 would constitute his cash inflow
in terms of interest earnings, keeping intact his initial investments of Rs 10,000.

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