Chapter: 3

Time value of money

Time value of money

The phrase time value of money refers to the fact that a same amount of money in hand today is more worth than the same amount of money some
time in future because you can earn interest on present money by depositing it in a bank or you can use it for some important purposes.

Following sumbols are defined in this article

r = Rate of interest or Discount rate
n = Number of years
PV0=Present value at time period 0
FVn= Future value at the end of n years.
FVAn=Future value of an (ordinary) Annuity for n years.
FVADn=Future value of an Annuity due for n years.
PVAn =Present value of an (ordinary) Annuity for n years.
PVADn=Present value of an Annuity due for n years.
R =Constant Yearly payment /periodic payment or Constant Yearly receipt /periodic
receipt under annuity plan.
m= Number of times compounded or discounted in a year
= Infinite (Never finish)
PVA=Present value of (ordinary) Annuity, which occur forever=Perpetuity

Interest rate
The amount charged, expressed as a percentage ofprincipal, by alenderto a borrower for the use of cash or otherassets. Interest rates are typically noted on an annual basis, known as the annual percentage rate(APR). The assets borrowed could include, cash,consumer goods, large assets, such as a
vehicle or building.

Further interest rates are two types:

Simple Interest: It is paid or earned on only original/Principal money borrowed or lent.
Compound Interest: It is paid or earned on original/Principal money borrowed or lent & as well as on previous reinvested accumulated interest amount.

Future value or Compound value or Terminal value:

When present sum of money is compounded at a given interest rate for certain years, then it is called Future value.
Future value techniques typically measure cash flows at the end of a projects life.

Present value or discount value:

When future sum of money is discounted at a given interest rate at time zero, then it is called present value.
Present value technique typically measures cash flows at the start of a projects life (i.e. at time zero).The present value is just like cash in hand today.

The following types of transactions

occur in Time value of money:
1.Single cash flows
2.Annuities
3.Mixed or uneven cash streams
4.Perpetuity

1.Single cash flows

When payment/deposit or receipt occurs one
time only.
For example, you paid/deposited a certain
sum of money in a bank one time only or
receipt occurs one time only at a interest rate
of r after n years
Future value=Fvn=PV0 (1+r)n

Present value=PV0 = FVn

(1+r)n

2. Annuities
When series of equal payments/deposits or receipts occur
at regular interval of time over a specified years or
periods.
Further Annuities are divided into the following two
categories:
(a). Ordinary Annuity: When each payment or receipt
occurs at the end of the year or period.
(b) Annuity due: When each payment or receipt occurs
at the beginning of the Year or period
(a). Ordinary Annuity:[Formula]
Future value of (ordinary) Annuities=FVAn= R
(1+r)n 1
r
Present value of (ordinary) Annuities=PVAn= R
(1+r)n -1

3. Uneven or mixed cash flows

When the cash flows are uneven.
Future value of Uneven cash flows[Formula]
-> [If cash is deposited at year end]
Future value=FVn= Y1Cash inflows(1+r)n-1 + Y2
Cash inflows(1+r)n-2 + Yn Cash inflows(1+r)n-n
= Rs xx

Present value of Uneven cash flows[Formula]

-> [If cash is received at year end]
Present value= Pvo = Y1 Cash inflows + y2 Cash
inflows +..
(1+r)
(1+r)2
+ Yn Cash inflows =Rs.xx
9
n
(1+r)

4.Perpetuity.
Present value of Perpetuity:
It is an ordinary Annuity, whose first receipt starts at
the end of first period, but continues for indefinite
time period. For examples, Interest on Perpetual
Bonds, Dividend on Preferred stocks, etc.
Present value of Perpetuity = PvA = R r

10

Other advance topics in Time value of

Money
1. Compounding more than once a year
Up to now, we have assumed that interest is paid
annually; but practically Interest is often
compounded more than once a year. Banks for
example compound semi annually, quarterly,
monthly oe even on daily basis.
If interest rate is compounded m times a year,
then in each above respective interest rate r will be
divided by m & power n will be multiplied by m
Thus those all above Formulas will become as
under, if compounding more than once in a
year:
oIf single cash flow:
11
Future value= FVn=PV0(1+r/m)mn

oSimilarly in case of Annuities:

Future value of (ordinary) Annuities=FVAn= R
(1+r/m)mn 1
r/m
Present value of (ordinary) Annuities=PVAn=
R (1+r/m)mn -1
r/m (1+r/m)mn
2.Effective Annual Interest Rate(EAR)
If Annual percentage rate (APR) is compounded more
than once in a year (i.e. Semi annually, Quarterly,
Monthly, Weekly, etc.), then the actual rate will be
higher than the APR, which is called Effective Annual
Interest Rate.
12

3. Amortizing a loan
In simple terms, the process of reducing the
balance of a loan by a yearly or periodic
payment amount .It is repaid in equal periodic
installments. Examples: Auto loan, mortgage loan,
etc.
Each time you make a payment on a loan you pay
some interest along with a part of the principal. By
making regular yearly or periodic payments, the
principal gradually decreases, and finally it reaches
zero. The payments can be made monthly, quarterly,
semiannually, or yearly.
Yearly payments of present loan can be found out by
present value of annuity formula.
If the loan is to be repaid at the end of the year,
then we can determine yearly installment by the
present value of annuity formula.]
n

13

If the loan is to be repaid at the beginning of the

year, then we can determine yearly installment by
the present value of annuity formula.]
PVAn =R (1+r)n -1 X (1+ r)
r(1+r)n
Note: If installment is paid m times a year, then
the above formula will be changed as discussed
above
To compute Interest payment and principle payment
in each installment, we have to prepare a
amortization schedule for this purpose. It is given as
under:
. Amortization schedule

Years/Periods Installment
Principal at yr end

Interest

Principal

14

Application of Time Value of money

Time value of money has numerous applications in
financial and investment decisions, as discussed
above. These are summarized as under:
1. Finding out the future value of present sum
deposits.
2. Finding out the present value of future sum.
3. Amortization of a loan
4. Effective annual rate of interest.
5. Finding out the Bonds/stock s cost and value.
6. Capital budgeting techniques, etc.

.. .

15

The end

16

Presented by
S.Z.Jafar

17