FM - Module II Notes
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spc29180FM - Module II Notes
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spc29180III Sem B.
Com
Financial Management
Module II: Time Value of Money
Introduction to Time Value of Money
The Time Value of Money (TVM) is a fundamental concept in finance that
recognizes the idea that a sum of money holds different values at different points
in time. In simple terms, a rupee today is worth more than a rupee tomorrow, due to
its potential earning capacity. TVM helps in understanding how money grows over
time through compounding, or how future sums can be adjusted to present value
using discounting. It forms the foundation for various financial decisions such as
investments, loans, savings, annuities and capital budgeting. By applying TVM,
individuals and businesses can make informed financial choices by comparing the
value of cash flows received or paid at different times.
Meaning of Time Value of Money
The Time Value of Money refers to the concept that money available today is worth
more than the same amount in the future due to its earning potential. This core
principle of finance is based on the idea that money can grow over time when
invested, making it more valuable now than later.
Definition of Time Value of Money
According to James C. Van Horne, “The time value of money is the relationship
between the value of a cash flow received or paid at different points in time.”
Significance/Importance of Time Value of Money
1. Investment Decision
• TVM helps investors evaluate whether the future returns from an investment
are worth the present cost.
• By discounting future cash inflows, investors can compare projects and select
the one with the highest present value or return.
• Example: Choosing between a bond that pays annually and a stock with
expected dividends.
2. Loan and Credit Analysis
• In lending, TVM is used to calculate EMIs, interest charges, and repayment
schedules.
• It helps both lenders and borrowers understand the real cost of borrowing.
• Example: A loan of ₹5,00,000 repaid over 5 years with interest must be
evaluated in present value terms.
Pg. 1 DSCASC Compiled By: Prof. Anusha Kalburgikar
III Sem [Link]
Financial Management
Module II: Time Value of Money
3. Capital Budgeting
• Businesses apply TVM concepts such as Net Present Value (NPV), Internal
Rate of Return (IRR), and Payback Period to decide on long-term projects.
• It ensures that only projects with higher discounted cash inflows than outflows
are accepted.
• Example: Deciding whether to build a new factory.
4. Retirement & Financial Planning
• TVM is crucial in estimating how much money one should save today to meet
future retirement needs.
• It accounts for compounding returns on investments and inflation.
• Example: A person planning to accumulate ₹1 crore for retirement needs to
calculate today’s required savings using TVM.
5. Valuation of Financial Instruments
• Bonds, stocks, and derivatives are valued based on the present value of
expected future cash flows (dividends, coupons, maturity value).
• Investors and analysts rely on TVM to determine fair prices.
• Example: A bond worth ₹1,000 maturing in 5 years with annual interest
payments must be discounted to find its current price.
6. Inflation Adjustment
• TVM accounts for the decline in purchasing power of money due to inflation.
• Future cash flows must be adjusted for inflation to determine their real value.
• Example: ₹10,000 received after 10 years is worth much less today if inflation
is 6% annually.
7. Risk Management
• Higher risk investments require higher returns; TVM helps discount future
uncertain cash flows at a risk-adjusted rate.
• It allows comparison of risky vs. safe investments in present value terms.
• Example: A startup’s projected cash inflows may be discounted at a higher rate
than a government bond.
8. Comparison of Alternatives
• TVM provides a common basis for comparing projects, investments, or loans
that have different timelines and cash flow patterns.
• By converting all options into present value, the best alternative can be chosen.
• Example: Choosing between a lump-sum payment now vs. equal annual
payments over 5 years.
Pg. 2 DSCASC Compiled By: Prof. Anusha Kalburgikar
III Sem [Link]
Financial Management
Module II: Time Value of Money
Techniques of Time Value of Money
1. Present Value / Discounting Technique
• Meaning:
Present Value (PV) is the process of determining the current worth of a sum
of money that is to be received in the future, by discounting it at a certain
interest/discount rate.
• Concept:
A rupee today is worth more than a rupee in the future because of its earning
potential. Hence, to compare future cash inflows/outflows with present ones,
we bring them back to today’s value.
2. Future Value / Compounding Technique
• Meaning:
Future Value (FV) is the process of finding out how much a sum of money
invested today will grow to, after earning interest over time.
• Concept:
Money invested today grows due to compounding (earning interest on both
principal and accumulated interest).
Comparison between Present Value and Future Value
Basis Present Value Future Value
The current value of a future The value of a current sum of
Meaning
sum of money money at a future date
To determine what future To estimate how much current
Purpose
money is worth today money will grow in future
Time Looks backward from the Looks forward from the
Orientation future to the present present to the future
Interest Factor Uses a discounting factor Uses a compounding factor
Used in discounted cash
Used in investment planning,
Use Case flows, bond pricing, NPV
savings growth, wealth goals
analysis
Usually less than the future Usually more than the present
Value Nature
value value
Key Question "How much is this future “What will my money be wort
Answered amount worth today?" h in the future?"
Pg. 3 DSCASC Compiled By: Prof. Anusha Kalburgikar
III Sem [Link]
Financial Management
Module II: Time Value of Money
Reference Links
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