FINANCIAL MANAGEMENT 18MBA22

UNIT: 02

TIME VALUE OF MONEY

Introduction:

The time value of money (TVM) is the concept that money available at the present time is worth more
than the identical sum in the future due to its potential earning capacity. This core principle of finance holds
that provided money can earn interest, any amount of money is worth more the sooner it is received

The concept TVM refers to the facts that the money received today is different in its worth from the
money receivable at some other time in future.

TVM is an important concept in financial management it can be used to compare investment

alternatives and to solve problems involving loans, mortgages, leases, savings and annuities.

Concept of TVM:

 A single sum of money or a series of equal events spaces payments or receipts promised in the future
can be converted to an equality value today.
 Conversely, you can determine the value to which a single sum or a series of future payments will grow
to at some future date.
Interest:

Interest is the cost of borrowing money an interest rate is the cost stated as a percent of the amount
borrowed per period of time, usually one year.

 Risk and uncertainty

 Preference for consumption
 Investment opportunities
 Inflationary economy
Techniques of TVM:

There are two techniques for adjusting time value of money under the concept of valuation.

1. Compounding or future value concept

2. Discounting or present value concept

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 Compounding or future value concept: the value of money at a future date with a given interest rate is
called future value. Future value is the amount of money that an investment made today will grow to by
some of future date. Since the money has time value, we naturally expect the future value to be greater
than the present value. The concept of compounding is used to find out the future value of present money.
The compounding techniques to find out the future value of present money are as follows:

a. FV of single cash flow: The future value of single cash flow is defined in terms of equation

FV=PV (1+r) n
Where:
FV- Future Value
PV- Present Value
r- % of Rate of Interest
n- Time Gap or Number of Compounding Periods
b. FV of an annuity: an annuity is a series of equal payments or receipts that occur at evenly spaces
intervals e.g: leases, rental payments. The payment or receipts that occur at the end of each period for an
ordinary annuity, while they occur as the beginning of each period for an annuity due.
 Future value of ordinary annuity: It is the vale that a stream of expected or promised future payments
will grow to offer a given number of periods at a specific compounded interest.

FVoa =PMT [((1+i) n-1)/ i ]

Where:
PMT- amount of each payment
i- Interest rate per period
n- Number of periods

 FV of a multiple flows:
FVAn=A [(1+r)n-1 /r]

Where:

FVAn- future value of an annuity which has duration of N years

A-Constant periodic cash flow

r- Interest rate per period

n- Duration of the annuity

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FINANCIAL MANAGEMENT 18MBA22

 Discounting or present value concept: The concept of discounting is the reverse of compounding
techniques. Present value is an amount today that equals to a future payment or series of payments that has
been discounted by an appropriate interest rate.
Since money has time value the present value of a promised future amount is worthless the linger
you have to wait to receive it

PV=FV/ (1+r) n

Where:

PV- Present Value

FV- Future Value
r- % of Rate of Interest
n- Number of years for which discounting is done
The discounting techniques to find of the present value are:

a. PV of single cash flow/ future sum:

The present value of future sum will be worthless than the future sum because one for goes the
opportunity to invest and thus forgoes the opportunity to earn interest during that period expectation of
receiving the money in future means that the money is not available presently and one has forgoes the
interest which could be earned had the money been available now.
The present value of future sum or single cash flow can be calculated with the help of following
formula:

PV=FV n (1/1+r) n

Where:
FVn- future value of n year hence
r- Rate of interest per annum
n- Number of year / discounting periods
b. PV of annuity: the present value of an ordinary annuity (PVAn) is the value of a stream of expected or
promised future payments that have been discounted to a single equivalent value today. The amount you
must invest today at specific rate of interest so that when you withdraw an equal amount each period. The
original principal and all accumulated interest will be completely exhausted at the end of the annuity.

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FINANCIAL MANAGEMENT 18MBA22

PVoa=PMT [(1-(1/(1+i)n))/i]
Where:
PVoa- presents value of an ordinary annuity
PMT- amount of each payment
i- Interest rate per period
n- Number of periods

PVAn= A[(1+r)n-1/r(1+r)n]
Where:
PVAn- Present value of annuity which has duration

a- Constant period flow

r- Discounted

c. PV of perpetuity: no fixed maturity date. Perpetuity may be defined as infinite services of equal cash
flows accounting at regular intervals.
It has indefinitely long life. In order to find out the PV of perpetuity the PV of cash of the infinite
number of cash flows should be added.
𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰
PVp= (𝟏+𝐫)𝟏
+ (𝟏+𝐫)𝟐
+...........+ (𝟏+𝐫)∞
Where:
PVp - Present value of perpetuity
r – Rate of interest
Deferred annuity: an annuity which commences only after a lapse of some specified time after the final
purchase premium has been paid.

SIMPLE INTEREST:

Interest is the cost of borrowing money or is the amount of you receives from lending money. To
calculate, you take the amount of the loan known as the principal and multiply it by the rate. Which is the
annual percentage being changed. Multiply the result by the time to maturity.

SI = (Principal X Rate ) X Time

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The interest paid on original amount or principal amount.

𝐏𝐓𝐑
SI =
𝟏𝟎𝟎

Where:

P- Principal amount

T- No. of years for which interest is calculated.

R- Rate of interest

If the investors wants to know its total future value but the end of ‘n’ year.

𝐏𝐓𝐑
FV = P+
𝟏𝟎𝟎

COMPOUNDED INTEREST:

Compound interest occurs is most instances and is generated from the ability of re invested earnings or
the remaining capital to earn interest on investment.

The interest that is earned and a given deposit and has become part of principal at the end of a specific
period.

Compounding value of a single amount:

CV = P (1+r) n

CAPITAL RECOVERY:

Capital recover must occur before a company can earn a profit on its investments. The earning back of
the initial funds put into an investment.

One may be interested to find out the equal annual amount paid in order to redeem a loan of a specified
amount over a specific period together with the interest at a give rate for that period.

PV = Annuity Amount X PVAF(r, n) or Annuity Amount = PV/PVAF(r, n)

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LOAN AMORTIZATION:

Amortization is the process of spreading out a loan into a series of fixed payments over time. You will
be paying off the loan's interest and principal in different amounts each month, although your total payment
remains equal each period.

Amortization is a method for repaying a loan in equal installments. Part of each period and the
remainder is used to reduce the principal. As the balance of the loan gradually reduced, a progressively larger
portion of each payment goes towards reducing principal.

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