The Time Value of Money
Which would you rather have -- Rs1,000 today
or Rs 1,000 in 5 years?
Obviously, Rs 1,000 today.
today
Money received sooner rather than later allows
one to use the funds for investment or
consumption purposes. This concept is referred
to as the TIME VALUE OF MONEY!!
MONEY
August, 2000
Why TIME?
TIME allows one the opportunity to
postpone consumption and earn
INTEREST.
INTEREST
NOT having the opportunity to earn
interest on money is called
OPPORTUNITY COST.
August, 2000
How can one compare amounts
in different time periods?
One can adjust values from different time
periods using an interest rate.
Remember, one CANNOT compare
numbers in different time periods without
first adjusting them using an interest rate.
0 1 2 3 4 5
8%
COF5,000 CIF10,000
Techniques of Adjusting Time
Value of Money
Compounding Technique – Convert Present
Value to Future Value
Discounting Technique – Convert Future
Value to Present Vale
Single Amount
Even Series - Annuity
Uneven Series
Compounding Technique
Future Value: Single Amount
If you invested Rs 2,000 today in an account that
pays 6%
6 interest, with interest compounded
annually, how much will be in the account at the
end of two years if there are no withdrawals?
0 1 2
6%
Rs 2,000
FV
August, 2000
Future Value –Single Amount
(Formula)
FV1 = PV (1+i)n = 2,000 (1.06)2
= 2,247.20
FV = future value, a value at some future point in time
PV = present value, a value today which is usually designated as time 0
i = rate of interest per compounding period
n = number of compounding periods
August, 2000
Future Value – Multiple
Compounding Periods
Quarterly (4) , half-yearly (2), monthly (12)
and Yearly (1).
FV = PV*(1+(i/m))
PV* (m*n)
August, 2000
Effective Rate of Interest in Case
of Multi-Period Compounding
When the frequency of interest
compounding is more than once a year, it is
so because the actual rate of interest
realised, called Effective Interest Rate
(EIR).
EIR =((1+i/m)m)-1
Future Value of Uneven Series
FV = R1 (1+i)n-1 + R2 (1+i)n-2 + R3 (1+i)n-3 + …..
Future Value of Even Series:
Annuity
Deferred Annuity: When the cashflow occur at the end
of each year
FV(A) = R ((1+i)n-1 + (1+i)n-2 + (1+i)n-3 + …))
or Annuity Due: When the cashflow occur at the
beginning of each year
FV(A) =R ((1+i)n -1)/i) * (1+i)
Discounting Technique
August, 2000
Present Value
Since FV = PV(1 + i)n.
PV = FV / (1+i)n.
Discounting is the process of translating a
future value or a set of future cash flows
into a present value.
Present Value
(Graphic) – Single Amount
Assume that you need to have exactly 4,000 saved 10
years from now. How much must you deposit today
in an account that pays 6% interest, compounded
annually, so that you reach your goal of 4,000?
0 5 10
6%
4,000
PV0
August, 2000
Present Value
(Formula)
PV0 = FV / (1+i)n
PV0 = FV / (1+i)n = $4,000 / (1.06)10 = $2,233.5
0 5 10
6%
$4,000
PV0
Present Value : Uneven Series
PV =R1/(1 + i)1 +R2/(1 + i)2 +Rn/(1 + i)n
Present Value : Even Series
Deferred Annuity: When the cashflow occur at the end of
each year
PV(A) = R [∑ (1/(1 + i)t )]
or Annuity Due: When the cashflow occur at the beginning
of each year
PV(A) = R [∑ (1/(1 + i)t )] (1+i)