TIME VALUE OF MONEY

Time Preference for Money

• Time preference for money is an individual’s preference
for possession of a given amount of money now, rather
than the same amount at some future time.
• Reasons may be attributed to the individual’s time
preference for money:
– risk
– investment opportunities / purchasing power
Much Of Corporate Finance Involves Finding
Future And (Especially) Present Values

Central To All Financial Valuation

Techniques

Techniques Used By Investors &

Firms Alike
 Present Values
Discount Factor = DF = PV of Rs1

1
DF = (1+ r ) t

Discount Factors can be used to compute

the present value of any cash flow.
 Present Values

C1
PV = DF × C1 =
1 + r1

1
DF = (1+ r ) t

Discount Factors can be used to compute

the present value of any cash flow.
 Present Values

Ct
PV = DF × C t = t
(1 + r )

Replacing “1” with “t” allows the formula

to be used for cash flows that exist at any
point in time
 Present Values
PVs can be added together to evaluate
multiple cash flows.

C1 C2
PV = (1+ r ) 1 + (1+ r ) 2 +....
 Present Values
PVs can be added together to evaluate
multiple cash flows.

100 200
PV = (1+.07 )1
+ (1+ 077) 2
= 265.88
 Present Values
200

100

Present Value Year

0 1 2
Year 0

100/1.07 = 93.46
200/1.072 = 172.42
Total = 265.88
Perpetuity
Perpetuity
Perpetuity
Growing Perpetuity
Growing Perpetuity
Growing Perpetuity
Annuity
 Annuity
Annuity – Periodic CF for a finite Period of time.

Asset Year of Payment Present Value

1 2…..t t+1 C
Perpetuity (first
payment in year 1) r

C  1
Perpetuity (first payment   t
in year t + 1)  r  (1 + r )

Annuity from year  C   C  1 

  −   
t 
1 to year t  r   r  (1 + r ) 
 Time Value Adjustment
• Two most common methods of adjusting cash
flows for time value of money:
– Compounding—the process of calculating future
values of cash flows and
– Discounting—the process of calculating present
values of cash flows.
 Future Value and Present Value of an
Ordinary Annuity
Compounding

Future
Value

1,000 1,000 1,000 1,000 1,000

0 1 2 3 4 5

End of Year

Present
Value

Discounting
 Capital Recovery and Loan Amortisation
• Capital recovery is the annuity of an investment
made today for a specified period of time at a given
rate of interest. Capital recovery factor helps in the
preparation of a loan amortisation (loan
repayment) schedule.
 1 
A= P 
 PVAFn ,i 

• The reciprocal of the present value annuity factor is

called the capital recovery factor (CRF).

A = P × CRFn,i
 Inflation
Inflation - Rate at which prices as a whole
are increasing.

Nominal Interest Rate - Rate at which

money invested grows.

Real Interest Rate - Rate at which the

purchasing power of an investment
increases.
 Inflation
1+nominal interest rate
1 + real interest rate = 1+inflation rate

approximation formula

Real int. rate ≈ nominal int. rate - inflation rate