Time Value of Money

The TVM

Which would you prefer -- $10,000 today or $10,000 in 5 years? Obviously, $10,000 today. You already recognize that there is TIME VALUE TO MONEY!! TVM is based on the concept that a dollar that you have today is worth more than the promise or expectation that you will receive a dollar in the future.

Importance of TVM

Time Value of Money (TVM) is an important concept in financial management. It is one of the important tools used in project appraisals to compare various investment alternatives, and solve problems involved in loans, mortgages, leases, savings, and annuities.

Time value of money defined:

The relationship that exists between the value of money receivable at present and the value of money receivable at future is referred as time value of money.

Value of money at present =

Value of money receivable at future

+
Time Value of money Thus, the money at present shall have more value than the same amount of money at future

Why TIME?
Why is TIME such an important element in your decision??? TIME allows you the opportunity to postpone consumption and earn INTEREST.

What is Interest?
Interest is an amount that accrues on the money borrowed / lent at present for a particular period of time. Rate at which amount of interest accrues is referred as interest rate.

Types of Interest

Simple Interest

Interest paid (earned) on only the original amount, or principal, borrowed (lent).

Compound Interest
Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent).

Simple Interest Formula

Formula SI = P0(r)(t)
SI: Simple Interest P0: Deposit today r: Interest Rate per Period t: Number of Time Periods

Simple Interest Example

Assume that you deposit $1,000 in an account earning 7% simple interest for 2 years. What is the accumulated interest at the end of the 2nd year?

Future value(FV)

What is the Future Value (FV) of the deposit?

FV = P0 + SI FV=P + Prt FV=P(1 + rt) Future Value is the value of a present amount of money, or a series of payments at some future time, evaluated at a given interest rate.

Present Value (PV)

What is the Present Value (PV) in the previous problem?

The Present Value is simply the $1,000 you originally deposited. That is the value today! Present Value is the current value of a future amount of money, or a series of payments, evaluated at a given interest rate.

Why Compound Interest?

Future Value of a Single $1,000 Deposit
20000 15000 10000 5000 0 1st Year 10th Year 20th Year 30th Year 10% Simple Interest 7% Compound Interest 10% Compound Interest

Future Value Single Deposit ( Compounding Formula)

FV1 = P0 (1+i)1 You earned $70 interest on your $1,000 deposit over the first year. This is the same amount of interest you would earn under simple interest.

FV1 = P0 (1+i)1

= $1,000 (1.07)
= $1,070

FV2 = FV1 (1+i)1

= P0 (1+i)(1+i) = P0 (1+i)2 = $1,000(1.07)(1.07) = $1,000(1.07)2 = $1,144.90
You earned an EXTRA $4.90 in Year 2 with compound over simple interest.

Generalized Future Value Formula

FVn = P0 (1+r)n or FVn = P0 (FVIFi,n) Where FVn = Future value of the initial flow in n years hence P0 = Initial Cash Flow r = Annual rate of interest n = Life of investment FVIFi,n = Future value interest factor

Example:
Michel wants to know how large his deposit of $10,000 today will become at a compound annual interest rate of 10% for 5 years.

 Calculation

based on general formula:

FVn = P0 (1+i)n FV5 = $10,000 (1+ 0.10)5 = $16,105.10

Calculation

FV5

based on Table I: = $10,000 (FVIF10%, 5) = $10,000 (1.611) = $16,110

Methods of TVM
Compounding Technique Discounting Technique

Compounding Technique

The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. Determining the FV of present amount. Interest is compounded when the amount earned on the initial deposit becomes the part of the principal at the end of the first compounded period. Compound interest is always assumed in TVM problems

When compounding is done more than once a year

If the initial amount invested is P, rate of interest is r, number of compounding is n times a year and maturity period is m years then FV of Re 1 after m years = [{1 +(r/n)n

Discounting Technique

Just opposite of compounding. Determining the PV of future amount.

Present Value of a Single Amount

Bill Gates promised you $10,000 5 years hence at a discount rate of 10%.What is the present value of this amount? Calculation based on general formula: PV = FVn / (1+i)n Where PV = Present Value FVn = Amount i = Interest rate n = Number of years

Present Value of Uneven Series of Cash Flows

The dividend stream associated with an equity share is usually uneven and perhaps growing. PV = A + A +.+A = A
1 2 t t

(1+r)

(1+r)

(1+r)

(1+r)

Double Your Money

Quick! How long does it take to double $5,000 at a compound rate of 12% per year (approx.)?

We will use the Rule-of-72.

The Rule-of-72
Approx. Years to Double = 72 / i%
72 / 12% = 6 Years
[Actual Time is 6.12 Years]

Increased frequency of compounding

We get more interest if compounding is done on a frequent basis. The generalized formula for shorter compounding period is: FVn = PV (1+i/m)n*m Where , FV = future value after n years PV = present value of cash flow i = Interest rate n = Number of years m = No. of times compounding is done

Types of Annuities
An

Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods.

Examples of Annuities: Student Loan Payments Car Loan Payments Insurance Premiums Mortgage Payments Retirement Savings

Future Value of Annuity

The future value of a regular annuity for a period of n years at i rate of interest is :
n

FVAn = A{(1+i)-1} / i or FVAn = A (FVIFAi%,n) Where FVAn = Accumulation at the end of n years A = Amount deposited at the end of every year for n years FVIFAi% = Future Value Interest Factor for Annuity

Present Value of Annuity

The present value of a regular annuity for a period of n years at i rate of interest is : PVAn = A{(1+i)-1} / i(1+i)
n n

or PVAn = A (PVIFAi%,n) PVIFA = Present Value Interest Factor for Annuity

Present Value of Perpetuity

An annuity for an infinite time period is perpetuity. It occurs indefinitely and enables one to receive constant return year after year. PV = A/i

Effective Interest Rate

is a rate at which money held at present actually increases in a year when interest is compounded more than once a year. The actual rate of interest earned (paid) after adjusting the nominal rate for factors such as the number of compounding periods per year. r = (1 + [ i / m ] )m - 1 Where, r = Effective rate of interest i = Nominal Rate m = frequency of compounding

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