Chapter 4: The Time Value of Money

 Money has time value.

 A dollar today is more valuable than a year
hence (after)…..Inflation, uncertainty.
 It is on this concept “the time value of
money” is based.
 The recognition of the time value of money
and risk is extremely vital in financial decision
making.
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 The principles of time value analysis have
many applications, including retirement
planning, loan payment schedules, and
decisions to invest (or not) in new equipment.
 Of all the concepts used in finance, none is
more important than the time value of money
(TVM), also called discounted cash flow (DCF)
analysis.
Time value of money is central to the concept
of finance.
 It recognizes that the value of money is
different at different points of time.
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 Reasons for Time Value of Money
 Money has time value because of the following
reasons:
1. Risk and Uncertainty : Future is always
uncertain and risky. Outflow of cash is in our
control as payments to parties are made by us.
There is no certainty for future cash inflows. Cash
inflows is dependent on our Creditor, Bank,
interest rate, policy issues, global situation,
investment climate etc. As an individual or firm is
not certain about future cash receipts, it prefers
receiving cash now.

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2. Inflation: In an inflationary economy, the
money received today, has more purchasing
power than the money to be received in
future. In other words, a dollar today
represents a greater real purchasing power
than a dollar a year hence.
3. Consumption: Individuals generally prefer
current consumption to future consumption.
4. Investment opportunities: An investor can
profitably employ a dollar received today, to
give him a higher value to be received
tomorrow or after a certain period of time.
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• Future Values ????
 A dollar in hand today is worth more than a
dollar to be received in the future.
 If we had the dollar now we could invest it,
earn interest (if we save), and end up with
more than one dollar in the future (investment
in real products).
The process of going forward, from present
values (PVs) to future values (FVs), is called
compounding.

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4.1: Techniques of Time Value of Money

There are two techniques for adjusting time

value of money. They are:
1.Compounding Techniques/Future Value
Techniques
2.Discounting/Present Value Techniques: The
value of money at a future date with a given
interest rate is called future value. Similarly,
the worth of money today that is receivable or
payable at a future date is called Present Value.

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 1. Compounding Techniques/Future Value
Technique. In this concept, the interest earned
on the initial principal amount becomes a part
of the principal at the end of the compounding
period.
 The process of investing money as well as
reinvesting interest earned there on is called
Compounding.

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 A generalized procedure for calculating the future
value of a single amount compounded annually is as
follows:
Formula:
FVn = PV(1 + r)n
 In this equation (1 + r)n is called the future value
interest factor (FVIF).
where, FVn = Future value of the initial flow n year
after:
PV = Initial cash flow
r = Annual rate of interest
n = number of years.
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 Numerical Example
• Suppose that you have invested 1000 $ for three
years in a saving account that pays 10 per cent
interest per year for 3 years.
• If you let your interest income be reinvested, your
investment will grow as follows:
 By taking into consideration, the above formula, we
get the result as.
FVn = PV (1 + r)n = 1,000 (1+.10)3
• FVn = PV (1 + r)n = 1,000 (1.10)3
FVn = $1331
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 Example 2

2. If you deposit $55,650 in a bank which is paying

a 12 per cent rate of interest on a ten-year time
deposit, how much would the deposit grow at the
end of ten years?
 Solution:
FVn = PV(1 + r)n or FVn = PV(FVIF12%,10 yrs)
• FVn = $55, 650 (1.12)10
• = ` 55,650 × 3.106 = $172,848.90

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 2. Multiple Compounding Periods

 Interest can be compounded monthly,

quarterly and half-yearly.
 If compounding is quarterly, annual interest
rate is to be divided by 4 and the number of
years is to be multiplied by 4.
 Similarly, if monthly compounding is to be
made, annual interest rate is to be divided by
12 and number of years is to be multiplied by
12.
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 The formula to calculate the compound value
FVn = PV [1 +r/m]m.n
where,
FVn = Future value after ‘n’ years
PV = Cash flow today
r = Interest rate per annum
m = Number of times compounding is done
during a year
n = Number of years for which compounding is
done.

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 Numerical Example 1
 Calculate the compound value when $1000 is
invested for 3 years and the interest on it is
compounded at 10% p.a. semi-annually.
Solution:
FVn = PV [1 +r/m]m.n
1000[1 +.10/2] 2x 3 = 1000x1.340
= $1340

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 Numerical example 2
Calculate the compound value when $ 10,000 is
invested for 3 years and interest 10% per
annum is compounded on quarterly basis.
Solution:
FVn = PV [1 +r/m]m.n
 10,000[1 +.10/4] 4x 3 = = 10,000 [1 + 0.025]12
= $13,448.89

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 Example 3
 Assume that an investor invests $500,
$1,000, $1,500, $ 2,000 and $2,500 at the end
of each year. Calculate the compound value at
the end of the 5th year, compounded
annually, when the interest charged is 5% per
annum.
What will be Statement of the compound value
at the end of 5th year?

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End of the Amount Number Compounde Future
year deposited of Years d Interest value
(FVIFr, n)
(1) (2) (3) (4) (2)x (4)
1 500 4 1.216 608.00
2 1000 3 1.158 1,158.00
3 1500 2 1.103 1,654.50
4 2000 1 1.050 2,100.00
5 2500 0 1.00 2,500.00
Amount at the end of 5th year is Future Value = 8020.50

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 4.2: Annuity
So far we have dealt with single payments, or
“lump sums.”
However, assets such as bonds provide a series
of cash inflows over time, and obligations such
as auto loans, student loans, and mortgages
call for a series of payments.
 If the payments are equal and are made at
fixed intervals, then we have an annuity.
 For example, $100 paid at the end of each of
the next 3 years is a 3-year annuity.
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 Necessary conditions for Annuity
We define a sequence of deposits as an annuity if it
satisfies the following three conditions:
1. The deposits are of the same amount, known as
level deposits in each period
2. The deposits must be made at equidistant intervals.
For example, every year, every month, every ten
minutes, etc
3. If it is a compound rate of interest problem then
compounding interval must synchronize with
deposit intervals.
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 If payments occur at the end of each period,
then we have an ordinary (or deferred)
annuity.
 For example, payments on mortgages, car
loans, and student loans are generally made at
the ends of the periods and thus are ordinary
annuities.
 If the payments are made at the beginning of
each period, then we have an annuity due.
 For example, rental lease payments, life
insurance premiums, and lottery payoffs are
examples of annuities due.
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 1. Single-Payment Compound 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.
 The formula to obtain the single-payment
compound amount is
F = P(1 + i)n = P(F/P, i, n)
where, (F/P, i, n) is called single-payment
compound amount factor.
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 Example 1.1: A person deposits a sum of $ 20,000 at
the interest rate of 18% compounded annually for 10
years. Find the maturity value after 10 years.
Solution:
 P = $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)……0.18
 = 20,000 (5.234) = $ 1,04,680
 The maturity value of $ 20,000 invested now at 18%
compounded yearly is equal to $ 1,04,680 after 10 years.

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 2. Single-Payment Present Worth Amount

 Here, the objective is to find the present

worth amount (P) of a single future sum (F)
which will be received after n periods at an
interest rate of i compounded at the end of
every interest period.
 The formula to obtain the present worth is
P = F/(1 + i)n = F(P/F, i, n)
where, (P/F, i, n) is termed as single-payment
present worth factor.
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 Example 2: A person wishes to have a future sum of $100,000
for his son’s education after 10 years from now. What is the
single-payment that he should deposit now so that he gets the
desired amount after 10 years? The bank gives 15% interest rate
compounded annually.
Solution:
F = $100,000
i = 15%, compounded annually
n = 10 years
P = F/(1 + i)n = F(P/F, i, n)
= 1,00,000 (P/F, 15%, 10)
= 100,000 (0.1229)
= $12,290
 The person has to invest $ 12,290now so that he will get a sum of
$100,000 after 10 years at 15% interest rate compounded annually.
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3. Equal-Payment Series Compound Amount

 In this type of investment mode, 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 i compounded at
the end of each interest period.
 The formula to get F is
F = A (1 + i)n – 1 = A (F/A, i, n)
i
A = equal amount deposited at the end of each interest period
n = number of interest periods
i = rate of interest
F = single future amount
where, (F/A, i, n) is termed as equal-payment series compound amount
factor.
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 Example 3: A person who is now 35 years old is
planning for his retired life. He plans to invest an
equal sum of $ 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 = $10,000
n = 25 years
i = 20%
F=?
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 = A(F/A, i, n)
 = 10,000(F/A, 20%, 25)
 = 10,000 (471.981)
 = $4,719,810
 The future sum of the annual equal payments
after 25 years is equal to $ 4,719,810.

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 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.
The formula to get F is
• A= F i = F(A/F, i, n)
(1 + i)n − 1
Where, (A/F, i, n) is called equal-payment series of
sinking fund factor
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• Example 4: A company has to replace a present
facility after 15 years at an outlay of $ 500,000. 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 = $500,000
n = 15 years
i = 18%
A=?
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 = F(A/F, i, n)
 = 500,000(A/F, 18%, 15)
 = 500,000 (0.0164)
 = $ 8,200
 The annual equal amount which must be
deposited for 15 years is $ 8,200.

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5. Equal-Payment Series Present Worth Amount

• The objective of this mode of investment is to find the

present worth of an equal payment made at the end of
every interest period for n interest periods at an interest
rate of i compounded at the end of every interest period.
• The formula to compute P is
P = A (1+i)n -1 = A(P/A, i, n)
i(1+i)n
P = present worth
A = annual equivalent payment
i = interest rate
n = number of interest periods
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 Example 5: A company wants to set up a
reserve which will help the company to have an
annual equivalent amount of $1,000,000 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 = $ 1,000,000
i = 15%
n = 20 years
P=?
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P = A (1+i)n -1 = A(P/A, i, n)
i(1+i)n
= 1,000,000 (P/A, 15%, 20)
= 1,000,000 ( 6.2593)
= $6,259,300
 The amount of reserve which must be set-up
now is equal to $6,259,300.

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 4.3. 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.

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• The formula to compute A under this situation
is:
A = A1 + G (1+i)n-i-1)
(1+i)n-1)
= A1 + G (A,G, i, n)
Where, (A/G, i, n) is called uniform gradient
series factor.

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• Example7: 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 $ 4,000, at the end of the first year, and
thereafter he wishes to deposit the amount with an annual
increase of $ 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.
Solution:
Here, A1 = $ 4,000
G = $500
i = 15%
n = 10 years
A=?&F=?
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 A= A1 + G(A/G, i, n)
= 4,000 + 500 (A/G, 15%, 10)
= 4,000 + 500 (0.3832)
= $ 4,191.60
• This is equivalent to paying an equivalent amount of $
4,191.60 at the end of every year for the next 10 years.
 The future worth sum of this revised series at the end of the
10th year is obtained as follows:
F = A(F/A, i, n)
= A(F/A, 15%, 10)
= 5,691.60 (20.304)
= $115,562.25
 At the end of the 10th year, the compound amount of all his
payments will be $ 115,562.25.
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