____________________________________________________________________________________________________

Subject

Paper No and Title Paper No 8: Financial Management

Module No and Title Module No 4: Time value of money

Module Tag COM_P8_M4

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3.Techniques of TVM
3.1 Compounding
3.2 Discounting
4. Perpetuity
5. Annuity Due
6. Some Applications of TVM
6.1 Sinking Fund
Commerce PAPER NAME: Financial Management
MODULE No: Time Value of Money
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6.2 Capital Recovery

6.3 Deferred Payments
7. Summary

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MODULE No: Time Value of Money
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1. Learning Outcomes
After studying this module, you shall be able to learn:

· The meaning of Time Value of Money (TVM)

· The motives behind TVM
· How to calculate the Present value and the Future value using the discounting and
compounding techniques of TVM
· The difference between Nominal and Effective rate of interest.
· Practical applications of TVM

2. Introduction

Concept and Relevance

The concept of Time Value of Money (TVM) holds considerable importance while taking
financial decisions. It refers to the fact that money received today carries more value than the
same amount of money received at some other date in future. This is based on the English
proverb, “A Bird in Hand is better than the two in Bush” which means that a rational
individual always hold a preference for possession of a given sum of money today rather than
possessing the same sum of money tomorrow. Such time preference for money arises because
of a number of reasons:

1. Risk associated with future: The future is uncertain and because of the risk involved due
to this uncertainty, an individual prefers to have current money rather than receiving the
same in future. For instance, he may have an apprehension that probably the person from
whom the payment is to be received become insolvent or run away.
2. Preference for Present consumption: Every individual has a preference for present
consumption as compared to future consumption, because the present money can be used
to make purchases of some consumer durable or other requirements and also the
purchasing power of money decreases with time due to inflationary conditions prevalent
in the economy.
3. Reinvestment opportunities: even when an individual does not need money for
consumption purposes, he always has an opportunity to reinvest and earn some return on
it. For instance, if an individual has been given a choice to receive Rs. 100 either today or
after one year and the rate of interest offered by bank on deposits is 8% p.a., he would
definitely prefer to get Rs. 100 today because he can deposit the same in bank and earn
Rs. 8 on it. So, at the end of the year, he would have Rs. 108 (100+8)

Because of all above stated reasons, individuals have time preference for money. It is very
important for the finance manager to take into account time preference for money; otherwise he
will make incorrect decisions.
In most of the financial decisions, there is a series of cash inflows and outflows occurring at
different points of time. So, in order to make them comparable, TVM helps in converting the
monies received at different points of time into equivalent values at a particular point of time.
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3. Techniques of TVM

There are two techniques of time value of money:

1. Compounding
2. Discounting

3.1 Compounding

The compounding technique helps in finding out the future value of present money. It can be
explained under the following two heads:
(i) Future value of a single sum of money
= 1+
.........................................(1)
Where, FV = Future value
PV = Present value
r = rate of interest
n = number of years for which compounding is done

Example: Mr. X deposits Rs. 5000 today in a Bank at 12% rate of interest compounded annually
for two years. Find out the Future value of the deposit.
= 1+
= 5000 1 + 0.12
= 5000 ∗ 1.2544
= . 6272
The future value of present money can also be found out by multiplying the present value by a
compound value factor that can be obtained from “Compound value of a given amount (CVF)
Table”. From CVF table, one can obtain compound value factor for several combinations of r
and n. So, in the above example, Future value can be calculated as:
= ∗ ( %, )
.......................................(2)
= 5000 ∗ ( %, )
= 5000 ∗ 1.254
= . 6270

§ Non-Annual Compounding

If the time period ‘n’ is not annual, then the formula for calculating the future value will be
modified as follows:
∗
= 1+ /
.........................................(3)
Where, m = number of times of compounding per year

Example: Find out the future value in the above example if the rate of interest is compounded
quarterly.
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MODULE No: Time Value of Money
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= 5000 1 + 0.12/4 ∗
= 5000 1 + 0.03
= 5000 ∗ 1.26677
= . 6335
We can observe that future value is higher when compounding is done quarterly rather than
annually. Thus, more frequently the compounding is made, higher the future value.

§ Nominal and Effective Rate of Interest

There is no difference between Nominal and Effective rate of interest if the compounding is done
annually. However, if there is ‘m’ times compounding every year, the effective rate can be
calculated as:
1+ = (1 + / )
.................................(4)
Where, = Effective rate of interest
r = Nominal rate of interest
In the above example, Effective rate can be calculated as:

1+ = (1 + 0.12/4)
1+ = (1 + 0.03)
= 1.1255088 − 1
= 0.1255088 12.55%

(ii) Future value of a series of Equal cash flows or an Annuity

A series of equal cash flows occurring every year for a number of years continuously is called an
Annuity.

Example: Suppose Mr. X open a recurring account in a Bank where he deposits Rs. 1000 every
year for 10 years at 10% p.a. The future value of his annuity can be found out by multiplying the
annuity amount by compound value annuity factor that can be obtained from “Compound Value
Annuity Factor Table” (CVAF Table).

= ∗ %,
..................................(5)
= 1000 ∗ %,
= 1000 ∗ 15.937
= . 15,937

3.2 Discounting

The discounting technique helps in finding out the present value of future money. It is the reverse
of compounding technique which helps in finding out the future value of present money. It can be
explained under the following two heads:

(i) Present value of a single sum of money

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MODULE No: Time Value of Money
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=
(1 + )
.......................................(6)
Where, PV = Present value
FV = Future value
r = rate of interest
n = Number of years for which discounting is done

Example: Suppose Mr. A is to receive Rs. 50,000 at the end of 5 years from now. If the required
rate of return is 10%, find out the present value.
50,000
=
1 + 0.10
50,000
=
1.61051
= . 31,046

The present value of a future sum can also be found out by multiplying the future value by a
present value factor that can be obtained from “Present Value of a Given Amount Table” (PVF
Table). From PVF Table, one can obtain present value factor for several combinations of r and n.

So, in the above example,

= ∗ %,
= 50,000 ∗ %,
= 50,000 ∗ 0.621
= . 31,050

(ii) Present value of a series of Equal future cash flows or an Annuity

The present value of an annuity can be found out by multiplying the annuity amount by present
value annuity factor that can be obtained from “Present Value Annuity Factor Table” (PVAF
Table).
= ∗ %,
.....................................(7)
Example: Suppose Mr. A has to pay 5 installments of Rs.4000 each at the end of each year for the
next five years. How much Mr. A should pay today as a lump sum amount, if he does not want to
start an installment plan? Required rate of return is 10%.
= 4000 ∗ %,
= 4000 ∗ 3.791
= . 15,164

4.Perpetuity

Perpetuity consists of an infinite series of equal cash flows occurring at regular intervals for an
indefinite period of time. The present value of such perpetuity can be calculated as follows:

= + + + ……………+
(1 + ) (1 + ) (1 + ) (1 + ) ∞
Where, A = Amount invested per period

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MODULE No: Time Value of Money
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1 1
= 1+ + + ……………
1+ 1+ 1+
1
+
1+ ∞

This is an infinite Geometric Progression (G.P.) Sum of an Infinite G.P. is ( )

1
= ∗
1+ 1−
(1 + )
= ∗
1+

=
.................................................(8)
Example: Suppose Mr. A invests Rs. 2000 every year indefinitely in a recurring bank deposit
account, which earns him 5% p.a. Find out the Present value of such perpetuity.
2000
=
0.05
= . 40,000

5. Annuity Due

Annuity due is different from ordinary annuity in the sense that under annuity due, the cash
flows occurs at the beginning of each period instead of occurring at the end of each period.
Till now, we have calculated the future and present value of ordinary annuity under which the
cash flows occur at the end of each period. The calculation of future and present value of
annuity due is different and can be explained as follows:
Future Value of Annuity Due

= ∗ %, ∗ 1+
..........................................(9)
Where, A = Annuity amount

Example: Suppose Mr. A deposits Rs. 4000 in the beginning of every year for 10 years at the rate
8% p.a. How much will he get after the expiry of 10 years?

= 4000 ∗ %, ∗ 1 + 0.08
= 4000 ∗ 14.487 ∗ 1 + 0.08
= . 62,584

Present Value of Annuity Due

= ∗ %, ∗ 1+
............................................(10)

Example: In the above example, what is the present value of such deposits?
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= 4000 ∗ % , ∗ 1 + 0.08
= 4000 ∗ 6.710 ∗ 1 + 0.08
= . 28,987
Therefore, we can say
Annuity Due = Normal Annuity * (1+r)

6. Some Applications of TVM

The concept of TVM has got a lot of practical importance. It is often used by finance manager for
a variety of financial management decisions such as capital budgeting decisions, valuation of
securities and so on.

6.1 Sinking Fund

Often a finance manager is faced with a decision to accumulate a certain specified sum of money
after the expiry of a fixed period of time in order to replace an asset or to repay a liability such as
redemption of debentures. In such a case, a fixed amount of money is kept every year for a fixed
period which will be invested for the remaining period at a certain rate so that the total
accumulation at the end of fixed period becomes equal to the target sum. It is similar to an
annuity.
= ∗ %,
or

=
%,
...............................................(11)
Where, A = annuity amount
1
=
%,
............................................(12)

Example: Suppose a company has to replace an existing machine by a new modernised machine
worth Rs. 10 Lacs at the end of five years from now. How much the company should accumulate
every year at 10% rate of interest so that it becomes Rs. 10 Lacs after five years?

=
%,
10,00,000
=
%,
10,00,000
=
6.105
= . 1,63,800

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MODULE No: Time Value of Money
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6.2 Calculation of Installments for repayment of Loan/

Amortization of Loan/ Capital Recovery
Sometimes, a firm needs to find out the equal annual installments in order to repay a specified
amount of loan together with interest, taken today. Therefore the formula for calculating the
equal annual installments at a given rate of interest can be seen as:

= ∗ %,

=
%,
..........................................(13)
Where, A = annuity amount
1
=
%,
...........................................(14)
Example: Suppose a company borrows Rs. 5,00,000 today to be repaid in five equal annual
installments at the end of each year. The interest charged on such loan is 12% p.a. Find out the
size of each installment.
5,00,000
=
%,
5,00,000
=
3.605
= . 1,38,696

6.3 Deferred payments

Sometimes, the payment of installments to repay the loan does not start immediately, but after a
gap of certain years. This is known as deferred payment or in other words, the repayments which
are delayed for some time. In this case, although the repayments start after some years but the
borrower needs to pay the interest for that period also when no installments for are made for the
repayment of loan i.e., the time gap between the date of loan to the date of first payment.

Example: Suppose Mr. X took a loan of Rs. 5,00,000 to be repaid in five equal annual
installments beginning three years from now. The rate of interest charged by bank is 10% p.a.
find out the annual installment.

Step 1:
= ∗ %,
= 5,00,000 ∗ %,
= 5,00,000 ∗ 1.21
= . 6,05,000

Step 2: This Rs. 6,05,000 is the present value of annuity of five years.
6,05,000
=
%,
6,05,000
=
3.791

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MODULE No: Time Value of Money
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= . 1,59,589

Therefore, Mr. X needs to pay Rs. 1,59,589 every year for five years beginning three years from
now in order to repay his loan of Rs. 5,00,000 taken today.

7. Summary

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MODULE No: Time Value of Money