Unit 3: Time Value of Money and Interest
Rates
1. Understanding the Time Value of Money (TVM)
What Is It?
The Time Value of Money (TVM) is the idea that a rupee today is worth more than a
rupee in the future.
Why? Because money today can be invested to earn interest and grow over time.
Example:
If you have ₹100 today and put it in a bank at 10% interest, after one year you’ll have ₹110.
But ₹100 received one year later is just ₹100 — it cannot earn interest in the meantime.
Therefore, money now > money later.
Why the Value of Money Changes
Earning Potential: Money today can earn interest or returns.
Inflation: Prices rise over time, so future money buys less.
Uncertainty: Future income is uncertain — there’s risk involved.
Example: ₹100 in 2000 could buy much more than ₹100 today. That’s why money loses
value over time.
TVM Helps Us:
Compare the value of money across time (today vs future).
Decide between options like:
“Should I take ₹1 lakh now or ₹1.2 lakh after 5 years?”
→ TVM provides the right way to compare.
2. Key Components of TVM
Concept Meaning Example
Interest Rate The cost of borrowing money or the A 10% loan means paying ₹10 for
(r) reward for saving it. every ₹100 borrowed per year.
Present Value The current value of future money, after ₹1,000 received next year is worth
Concept Meaning Example
(PV) discounting for interest or inflation. less than ₹1,000 today.
Future Value The amount to which today’s money will ₹10,000 at 8% for 5 years →
(FV) grow if invested. ₹14,693.
Number of The total years or months the money is
Periods (n) invested or borrowed for.
3. Simple and Compound Interest
Simple Interest
Interest is calculated only on the original principal amount.
Simple Interest=P × r × t
Example:
₹1,000 at 10% for 3 years = ₹1,000 × 0.10 × 3 = ₹300 interest.
Total = ₹1,300.
✅ Easy to calculate, but grows slowly.
Compound Interest
Interest is calculated on both the principal and accumulated interest.
Compound Interest=P ¿
Example:
₹1,000 at 10% for 3 years = ₹1,000 × (1.1)^3 = ₹1,331.
Interest = ₹331.
✅ Shows how money “earns interest on interest” — grows faster over time.
Comparison
Type Grows Faster? Interest Applied On
Simple Slower Only on principal
Compound Faster On principal + past interest
4. Future Value (FV) Calculation
The Future Value tells how much your money today will become after earning interest.
FV =PV ׿
Example:
You invest ₹10,000 at 8% for 5 years.
FV =10,000 ׿
✅ Meaning: ₹10,000 today will grow to ₹14,693 in five years.
This is used to plan savings, investments, or long-term goals.
5. Present Value (PV) Calculation
The Present Value tells you how much a future amount is worth today.
FV
PV =
¿¿
Example:
You expect ₹15,000 after 4 years. Discount rate = 7%.
15,000
PV =
¿¿
✅ Meaning: ₹15,000 in 4 years is equivalent to ₹11,718 today.
Why PV Matters
Helps compare future payments or investments today.
Used for valuing assets, bonds, and loans.
Shows that future money is always worth less due to inflation and opportunity cost.
6. The Link Between TVM and Financial Assets
Most financial assets — like bonds, loans, or shares — promise future payments.
But since a rupee tomorrow is worth less than a rupee today, we discount future payments to
find their present value.
Rule:
“The price of a financial asset = Present Value of all expected future payments.”
Example:
If a bond pays ₹1,000 in one year and the interest rate is 10%,
Price today = ₹1,000 ÷ (1 + 0.10) = ₹909.
✅ No one will pay more than ₹909 today, because investing ₹909 in a bank at 10% also gives
₹1,000 in a year.
7. Debt Instruments
Debt instruments are contracts where borrowers promise to repay money with interest.
They are also called fixed-income instruments because payments are predictable.
Types of Debt Instruments
Type Description Example
Borrower repays full principal + ₹10,000 borrowed, ₹11,000
1. Simple Loan
interest at once. repaid after one year.
2. Discount Bond Bought at less than face value; repaid Buy ₹1,000 bond for ₹900;
(Zero-Coupon Bond) in full later. get ₹1,000 back later.
Pays regular interest (coupon) + face ₹1,000 bond paying ₹100
3. Coupon Bond
value at maturity. yearly + ₹1,000 at end.
4. Fixed-Payment Equal monthly/annual payments
Home or car loans (EMI).
Loan including both interest & principal.
8. Nominal, Effective, and Real Interest Rates
Type Meaning Example
Nominal The stated interest rate — doesn’t consider
12% per year.
Rate inflation or compounding.
Effective The actual rate after compounding is 12% nominal compounded
Rate considered. quarterly = 12.55% effective.
The rate after adjusting for inflation — 10% nominal – 6% inflation = 4%
Real Rate
shows true gain or cost. real return.
9. Why Understanding TVM and Interest Rates Matters
Smart Borrowing: Helps you pick the lowest-cost loans.
Better Investing: Lets you compare savings, bonds, or deposits fairly.
Inflation Awareness: Reminds you that money loses value over time.
Long-Term Planning: Essential for education, retirement, or business decisions.
Asset Pricing: Core tool for valuing bonds, shares, and other investments.
10. Summary Table
Concept Meaning Key Formula / Idea
TVM Money today > money in future Money earns interest over time
Simple Interest Fixed interest on principal SI =P× r ×t
Compound Interest Interest on principal + interest FV =P ¿
Future Value Value of present money in future FV =PV ¿
FV
Present Value Value today of future money PV =
¿¿
Nominal Rate Stated rate 10% annual
Real Rate Adjusted for inflation Nominal − Inflation
Discounting Converting future to present value Used in asset pricing
Debt Instruments Promises of future payments Bonds, loans, EMIs
Key Insight Time gives money value Plan early, invest smartly
11. Key Takeaway
The Time Value of Money is the foundation of finance.
It teaches that:
Money has time-based value.
Wise financial decisions require comparing present and future values.
Understanding interest rates helps grow wealth and control debt.
In simple words:
“Make your money work for you — the earlier you invest, the more it grows.”