TIME VALUE OF MONEY

INTRODUCTION

You must have heard that a rupee today is worth more than a rupee
tomorrow. Do you know why is it so? Now, let us take an example.
Sriram's grandfather decided to give a gift of Rs. One lakh at the
end of the fifth year; and gave him a choice of having Rs. 75,000
today. Had you been in Sriram's place what choice would you have
made?
Do you accepted Rs. 100,000 after five years or Rs. 75,000 today?
What do you say? Rs. 75,000 today is much more attractive than
Rs. 100,000 after five years because the present is more certain
than the future. You could invest Rs. 75,000 in the market and earn
a return on this amount. Rs. 100,000 at the end of five years would
have less purchasing power due to inflation.
We hope you got the message that a rupee today is worth more than
a rupee tomorrow. But the matters of money are not so simple. The
time value of money concept will unravel the mystery of such
choices that all of us face in our daily life.
In our day-to-day life, several investment decisions involve cash
flow occurring at different points in time. Therefore, recognition of
the time value of money is very important.

FUTURE VALUE

Future value (FV) is the value of a current asset at a future date

based on an assumed rate of growth. The future value is important
to investors and financial planners, as they use it to estimate how
much an investment made today will be worth in the future.
Knowing the future value enables investors to make sound
investment decisions based on their anticipated needs. However,
external economic factors, such as inflation, can adversely affect
the future value of the asset by eroding its value.

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Determining the FV of an asset can become complicated,
depending on the type of asset. Also, the FV calculation is based
on the assumption of a stable growth rate. If money is placed in a
savings account with a guaranteed interest rate, then the FV is easy
to determine accurately.

To understand the core concept, however, simple and compound

interest rates are the most straightforward examples of the FV
calculation. Future value is what a sum of money invested today
will become over time, at a given rate of interest.

CALCULATION OF FUTURE VALUE

There are two types of future value calculations:

• The “future value of a lump sum” is the value of a single

deposit, like a bank fixed deposit over time.

• The “future value of an annuity” is the value of a series of

payments, like payment of insurance premium at regular
intervals, over time. The term "annuity" refers to a series of
payments of constant amounts.

The easiest way to calculate future value is to use one of the many
free calculators on the internet, or a financial calculator app such
as the HP 12C Financial Calculator available on Google Play and
in the Apple App Store. Most spreadsheet programs have future
value functions as well, but for the purpose of this course we are
going to refer to present value, future value and annuity tables
which are provided in this course.

The FV formula assumes a constant rate of growth and a single up-

front payment left untouched for the duration of the investment.
The FV calculation can be done one of two ways, depending on
the type of interest being earned.

i) Using Simple Annual Interest

If an investment earns simple interest, then the FV formula is:
FV = P × (1 + R × T)
Where,
FV= Future Value

P = Principal amount or Investment Amount

R = Interest rate

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 T = Number of years
FV= Future value or final amount
For example, assume a Rs.1,000 investment is held for five
years in a savings account with 10% simple interest paid
annually.
In this case, the FV of the Rs.1,000 initial investment is
Rs1,000 × [1 + (0.10 x 5)], or Rs.1,500.

ii) Compounded Annual Interest

With simple interest, it is assumed that the interest rate is
earned only on the initial investment. With compounded
interest, the rate is applied to each period’s cumulative account
balance.

In the example above, the first year of investment earns 10%

× Rs.1,000, or Rs.100, in interest. The following year,
however, the account total is Rs.1,100 rather than Rs.1,000;
so, to calculate compounded interest, the 10% interest rate is
applied to the full balance for second-year interest earnings of
10% × Rs.1,100, or Rs.110.

The formula for the FV of an investment earning compounding

interest is:
FV = P × (1 + R) t
Where,
P = Principal amount or
Investment amount R = Interest
rate t = Number of years
Using the above example, the same Rs.1,000 invested for five years
in a savings account with a 10% compounding interest rate would
have an FV of Rs.1,000 × [(1 + 0.10)5], or Rs.1,610.51.

Future Value of an Annuity Example

A common use of future value is planning for a financial goal, such
as funding a retirement savings plan. Future value is used to
calculate what you need to save and invest each year at a given rate
of interest to achieve that goal.

In general terms the future value of an Annuity is given has the

following formula:

FV An= A [(1 + r) n − 1]/ r

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 Where,
= Future Value of annuity
= Constant Periodic flows
= Interest rate period
= duration of annuity

Example 1
If you contribute Rs. 2,400 every year to a retirement account and
want to calculate what that account will be worth in 30 years; you
could use the future value of an annuity formula. For this example,
you assume a 7% annual rate of return:

= . 2,400 × [(1 + 0.07) − 1]/0.07

. 2,400 × [7.612 − 1]/0.07
. 2,400 × 94.461
. 226,706
Over 30 years, you would contribute a total of Rs. 72,000, but
because of the time value of money and the power of compounding
interest, your account would be worth Rs. 226,706 (with an annual
7% rate of return), or more than three times the amount you
invested.
Future value is also useful to decide the mix of stocks, bonds, and
other investments in your portfolio. The higher the rate of interest,
or return, the less money you need to invest to reach a financial
goal. Higher returns, however, usually mean a higher risk of losing
money.
The term [(1 + r) n − 1]/r is referred to as the future value interest
factor for an annuity (FVIFAr, n) and the value of this factor for
several combinations of r and n can be found out from the annuity
table.

PRESENT VALUE vs FUTURE VALUE

We can also measure the present value of money which is going to

be received in future. Using it, you can calculate the worth of
something today when you know its value in the future. This
process is also referred to as "discounting" because, for any
positive rate of return, the present value will be less than what it is
worth in the future.

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The interest rate used to calculate the present value of a future
return cash flow is called the "discount rate." To illustrate present
value, let’s look at a example. The future value of Rs. 1,000
deposited for one year into an account earning an annual 2%
interest rate is Rs. 1,020:

FV = 1000 × (1+.02)1 = Rs. 1,020

We also know that the present value of that Rs. 1,020 is Rs. 1,000
because it’s what we started with. Present value is the mirror image
of future value.

The relationship between Present Value and Future

Value

PV = . The factor is called the discounting factor

or the present value interest factor (PVIF r, n).

Some common uses for present value include:

• Calculating the value of pension annuity payments versus

taking a lump sum
• Determining whether a business owner’s investment will meet
profit expectations.
• Valuing a business

TIME VALUE OF MONEY AND ITS

SIGNIFICANCE

The time value of money is very important to all for financial

planning, from the decision you make to buy or lease an asset to a
financial decision to invest in new equipment. The future value
determines the effect of time on money. Using future value and
other measures can help you make sound financial decisions.

From the standpoint of financial management, the importance of

time value of money can be seen as follows:

i) For expansion and growth companies deploy a mix internal

funds (equity and retained earnings) and external funds (debt).
The time value of money will assist us in determining the

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 impact and effect of debt owed by businesses on earning and
profits.

ii) Because the future is unknown, the time value of money is

essential for managing funds and generating profits from a
corporation.

The time value of money is significant because it can aid in

financial decision-making. An investor, for example, has the option
of choosing between two projects: Project ‘A’ and Project ‘B’. The
only difference between the two initiatives is that Project ‘A'
promises Rs.1 million cash reward in year one, while Project ‘B'
promises Rs.1 million cash payout in year five. If the investor does
not grasp the time value of money, both projects may appear to be
equally appealing. In reality, because Project ‘A' has a higher
present value than Project ‘B,' the time value of money mandates
that Project ‘A' is more appealing.

CALCULATION OF TIME VALUE OF MONEY

The Time Value of Money can be calculated in two ways. The following
formula can be used to calculate the present value (PV) of future cash flows:

PV = FV × (1 + r)-n or FV= PV × (1+r)n

Where:
PV — Present Value.
FV — Future Value.
r — interest rate.
n — number of periods.
Notice the negative sign of the power n which allows us to remove
the fractions from the equation.The following formula allows us to
calculate the future value FV) of cash flow from its present value.

FV = PV × (1 + r )n

Where:
FV — Future Value.
PV — Present Value.
r — interest rate.

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 n — number of periods.
Effect of Compounding Periods on Future Value
The number of compounding periods used in time value of money
estimates can have a significant impact. If the number of
compounding periods is raised to quarterly, monthly, or daily in
the Rs.10,000 example above, the concluding future value
calculations are:

• Quarterly Compounding: FV = Rs. 10,0000 × [1 + (10%/4)]× = Rs. 11,038

• Monthly Compounding: FV = Rs. 10,0000 × [1 + (10%/12)]× = Rs. 11,047

• Daily Compounding: FV = Rs. 10,0000 × [1 + (10%/365)]× = Rs. 11,052

This demonstrates that the time value of money is determined not
just by the interest rate and time horizon, but also by the number
of times the compounding computations are performed each year.

In cases where we have more than one compounding period of

interest per year, we can tweak the formula, to make sure we are
using the appropriate portion of annual interest:

Where:
FV — Future Value.
PV — Present Value.
r — interest rate (annual).
n — no. of periods (years).
t — no. of compounding periods of interest per year. If it is
quarterly t=4, for half yearly t=2 and for monthly t=12.

The time worth of money is a key concept in determining Net

Present Value (NPV), Compound Annual Growth Rate (CAGR),
Internal Rate of Return (IRR), and other financial calculations.

The general formulas of the concept can be applied to any series of

cash flows. One can use financial calculators or a spreadsheet
program like Excel to calculate the metrics surrounding the time
value of money. One can learn more about business functions or
look for the following specific ones in the office Excel - PV, FV,
IRR, NPV.

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 Selecting the appropriate rate of return is one of the most important
aspects of the time value of money assessments (discount rate).
Apart from interest on the debt, the Weighted Average Cost of
Capital is a popular rate option (WACC). It is critical to understand
that making the wrong rate decision will almost certainly ruin the
entire procedure rendering it meaningless and can have a severely
adverse impact on our decision-making process.
In practice, there are two sorts of the time value of money notions,
which are described below:
i) Time Value of Money for a One-Time Payment
You invest INR 10000 for 5 years in a bank that offers 10% annual
interest. You allow it to grow cumulatively.
After 5 years, you will have accumulated a total value of Rs.16,110.
The question now is whether Rs.10,000 is worth more than
Rs.16,110. This is dependent on the rate of inflation, interest rate,
and risk involved. It is a loss if the inflation rate rises. If the interest
rate falls, then it is a gain.

ii) Time Value of Money -Doubling the Period

To calculate when the amount of money will double, consider
another scenario. The rule of 72 is used to estimate the doubling
period. Doubling period can be estimated by dividing 72 by
interest rate. This is also known as rate of 72. For example, if you
invest Rs. 10,000 for 5 years at an interest rate of 8%, it will take 9
years to double the present value of your money.
Example-1: Assume a sum of Rs.10,000 is invested for one year at
10% interest. The future value of that money is:

= . 10,0000 × [1 + (10%/1)× = . 11,000

The formula can also be altered to get the present-day value of the
future total. For instance, the value of Rs.5,000 to be received after
year's time, compounded at 7% interest, is:

Example-2:
We will use the following example to demonstrate the notion of
the time value of money. We intend to invest in a machine that will
provide us with annual cash flow of Rs. 38,500 for the next ten

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years. The device will cost Rs. 250,000 to purchase, and after its
useful life has expired, we will be able to sell it for Rs. 140,000.

Time Value of Money – NPV Calculation (in Rs)

Investment Opportunity
Initial CAPEX 250,000
Annual Benefit 38,500

Resale value of an asset after 10 years 140,000

We can build a simple schedule to represent our cash flows per

period. To keep the example, compact we will assume inflation is
at 0% over the period. We start with the initial CAPEX and list the
cash benefit per annum.
Year 0 1 2 3 4

31.12.2019 31.12.2020 31.12.2021 31.12.2022 31.12.2023

Cash out-flows (250,000)

(investment)

Cash in-flows (incl. 38,500 38,500 38,500 38,500

release value)

Net cash flow (2,50,000) 38,500 38,500 38,500 38,500

5 6 7 8 9 10

31.12.2024 31.12.2025 31.12.2026 31.12.2027 31.12.2028 31.12.2029 Total

(2,50,000)

38,500 38,500 38,500 38,500 38,500 38,500+1,40,000 3,80,500

38,500 38,500 38,500 38,500 38,500 1,78,500 5,25,500

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At the end of our table, cash inflow at the end of 10 year is Rs. 178,500
which includes Rs. 140,000 of resale of assets.

When we look at it in absolute terms, we can see that we will

get back twice as much as we put in throughout the years.
However, we must include the Time Value of Money to get a
clearer understanding.
The company's Weighted Average Cost of Capital (WACC) can be
used as a discount rate because it best represents the enterprise's
real cost of capital. We can now compute the Net Present Value
of the cash flows using Excel's more advanced NPV calculation.

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 Discount Factor (WACC) 10 %
Net Present Value (NPV)
40,622.5 The cash flows of Rs.38,500 here can be considered as
an annuity of 10 years of Rs.38,500 and the resale value of
Rs.1,40,000 is to be discounted to the present value.
Here we have to find the present value of an annuity of Rs.38,500
of 10 years tenure value occurring after 10 years. Here the discount
factor is going to be the weighted average cost of capital (WACC)
which is 10%. Now putting the values in the formula

This value can be found from the present value interest factor for
annuity for 10% discount rate and 10 years, and is 6.145.
Therefore, present value of annuity of Rs.38,500 would be 6.145
× 38,500 = 236,582.50.

Now let us find the present value of Rs.140,000 going to be

received ten years hence from now.

The present value in first factor for discount rate of 10% for 10
years is 0.386, therefore present value of Rs.140,000 is going to be:

140,000 × .386 = 54,040

The present value of cash flows would be Rs. 236,582.50 + Rs.
54,040= Rs.
290,622.50
The net present value would be:
290,622.5 – 250,000 = 40,622.5
Since NPV is positive investment can be accepted.

Example-3: Present Value of Uneven Cash Flows:

You may often get uneven cash flow streams. An example is a
dividend on equity shares. A man invests in a mutual fund that
promises following cash flows for five years. The discount rate is
10%. Find the present value.

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Year Cash flow (Rs.)
1 1,000
2 2,000
3 2,000
4 3,000
5 3,000

First, see the present value table to the present value factor.
Year Cash flows (Rs.) P.V. factor P.V. of each
cash flow (Rs.)
1 1,000 0.9091 909.1

2 2,000 0.8264 1652.8

3 2,000 0.7513 1502.6

4 3,000 0.6830 2049.0

5 3,000 0.6209 1862.7

Total P.V. Rs. 7,976.2

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