Unit: 3 Time value of money
C.J. Timalsena
Concept
Time value of money refers the relationship between time and value of money. It is an idea that money
available at the present time is worth more than the same amount in the future. It means a rupee in hand
today is more valuable than tomorrow. Time value of money concept is the core principle of finance.
Basically, earning power of money (reinvestment opportunity), inflation and individual's preference for
current consumption are the major reasons for the time value of money.
Significance of time value of money
Time value of money is a widely used concept in finance. Financial decision models based on finance
theories basically deal with shareholders' wealth maximization. The time value of money concept
contributes more to this aspect to a greater extent. Time value of money is very useful in the areas of
investment decision and financing decision. It is useful for the valuation of securities (financial assets)
and other assets, capital budgeting, cost of capital, working capital management, lease analysis and so
forth.
Cash flow time line
Cash flow time line is graphical presentation of cash flows. It is divided into equal periods such as days,
weeks, months, quarters, years etc. It is an important tool to understand the timing of cash flows.
Techniques of computing time value of money
Present value and discounting: Present value is the value at present of future sum of money or
cash flow. It means the discounted value of the future sum of money is present value. Discounting
is the process of computing or determining present value.
PV = FVn × PVIFi,n
FVn
PV = (1+𝑖)𝑛
Note: please write FVn instead of 𝑭𝑽𝒏 and (1+i)n instead of (𝟏 + 𝒊)𝒏
Where,
PV = Present value
FVn = Future value at the end of the year n.
PVIFi,n = Present value interest factor at i percentage in year n.
n = No. of years
i = Simple interest rate
Future value and compounding: Future value is the sum of beginning principal and interest
earned. Compounding is the process of computing future value.
FVn = PV(1+ i )n
Or, FVn = PV × FVIFi,n
Where,
PV = Present value
FVn = Future value at the end of the year n.
FVIFi,n = Future value interest factor at i percentage in year n.
i = Simple interest rate
n = No. of years.
Annuity
An annuity is a series of equal amount of cash flows at a fixed time interval for a specified period
of time. Mainly there are two types of annuity.
a. Ordinary Annuity b. Annuity due
Ordinary annuity: Ordinary annuity is an annuity in which receipts or payments are made at the
end of each period.
Present value of an ordinary annuity (PVA)
PVA = PMT × PVIFAi,n
Or, PVA = PMT [{1-1/(1+i)n}/i]
Where,
PVA = Present value of an ordinary annuity
PMT = Periodic payments
PVIFAi,n = Present value interest factor of an annuity at i percentage in year n.
n = No. of years
i = Simple interest rate
Future value of an ordinary annuity (FVA)
FVA = PMT × FVIFAi,n
Or, FVA = PMT [{(1+i)n -1}/i]
Where,
FVA= Future value of an annuity due
PMT = Periodic payments
FVIFAi,n = Future value interest factor of an annuity at i percentage in year n.
n = No. of years
i = Simple interest rate
Annuity Due: Annuity due is annuity in which receipts or payments are made at the beginning of
each period. The value of annuity due is always higher than the value of ordinary annuity.
Present value of an annuity due (PVAdue)
PVAdue = PMT × PVIFAi,n × (1 +i)
Future value of an annuity due (FVAdue)
FVAdue = PMT × FVIFAi,n × (1+i)
Or, FVAdue = PMT [{(1+i)n -1}/i] × (1+i)
Where,
FVAdue = Future value of an annuity due
PMT = Periodic payments
PVIFAi,n = Present value interest factor of an annuity at i percentage in year n.
FVIFAi,n = Future value interest factor of an annuity at i percentage in year n.
n = No. of years
i = Simple interest rate
Perpetual Annuity (Perpetuity): It is a special type of annuity in which receipts or payments are
made for the infinite period of time.
𝑃𝑀𝑇
PVperpetuity = 𝑖
Where,
PVperpetuity = Present value of perpetual annuity
PMT = Periodic payment
i = Simple interest rate
Uneven Cash flow stream: If the size of cash flow of the given series differ from period to period
is called uneven cash flow.
Present value of uneven cash flow stream
CF1 𝐶𝐹2 𝐶𝐹𝑛
𝑃𝑉 = (1+𝑖)1 + (1+𝑖)2, + ⋯ + (1+𝑖)𝑛
Note: please write CF1, CF2, CFn instead of CF1, CF2, CFn and (1+i)1, (1+i)2, (1+i)n instead of (1 + 𝑖)1,
(1 + 𝑖)2 , (1 + 𝑖)𝑛 .
Or, PV = CF1× PVIFi,1 + CF2× PVIFi,2 +………. + CFn× PVIFi,n
Future value of uneven cash flow stream
FVn = CF1(1+i)n-1 + CF2 (1+i)n-2 + .............+ CFn (1+i)n-n
Or, FVn = CF1 ×FVIFi, n-1 + CF2 ×FVIFi, n-2 + .............+ CFn ×FVIFi,n-n
Where,
CF1, CF2, CFn = Cash flow at the end of the year 1, 2 and so on.
i = Simple interest rate
n = No. of years
Semiannual and other compounding: In all preceding tools and techniques we assumed that
interest is compounded annually. This interest rate is called simple or quoted rate. But in many
cases, interests are paid in semiannually, quarterly, monthly or daily. It is called periodic rate.
Interest is compounded two or more than two times within a year. For any compounding period
less than one year we should make following two changes in all present and future value
calculations. We should divide interest rate and multiply number of years by number of
compounding periods within a year.
For example: If interest is compounded semiannually
PV is calculated as follows:
PV = FVn × PVIFi/2,n×2
Hint: follow the same techniques for other compounding too (divide ‘i’ and multiply ‘n’ by 4 in
quarterly, by 12 in monthly and so on).
Continuous compounding
FVn = PV × ei×n
PV = FVn/(ei×n)
Where,
FVn = Future value at the end of year n.
PV = Present value
e = The exponential (mathematical) function, Which has a value of 2.7183
i = Simple interest rate
n = No of years
Annual percentage rate (APR) and Effective annual interest rate (EAR)
The interest rate that quoted in all borrowings and lending is simple annual rate. It is also called annual
percentage rate (APR).
APR = Periodic interest rate × m
Effective annual interest rate (EAR) is an annual equivalent rate of borrowings and lending. It is
the annualized rate of interest actually earned on an investment or paid on a loan as a result of
compounding effect.
𝑖
EAR = (1 + )m – 1
𝑚
EAR = (1 + periodic rate)m – 1
Where,
i = simple interest rate
m = No. of compounding period within a year
𝑖
Periodic rate = 𝑚
Effective annual interest rate under continuous compounding
EAR = ei – 1
Amortized loan: Amortized loan is a loan that is to be repaid in equal installments including both
interest and principal at equal time intervals throughout the given loan period.
Determining the annual payment (Annual installment)
𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑙𝑜𝑎𝑛
PMT = 𝑃𝑉𝐼𝐹𝐴𝑖,𝑛
PMT = Amount of loan /PVIFAi,n
Amortization schedule: It is a schedule of equal payments repay loan. It shows all details of repaying
loan including the allocation of each payment to interest and principal.
Amortization schedule format
Year ( Period) Beginning Installment Interest Repayment of Remaining
principal principal balance
1
2
...
....
n -
