TIME

VALUEOF
MONEY
1
CONCEPT
Arupee,whichisreceivedtodayismorevaluable
thanarupeereceivableinfuture.
Theamountthatisreceivedinearlierperiodcanbe
reinvestedanditcanearnanadditionalamount.
Individualsprefervalueopportunitytoreceivemoney
nowratherthanwaitingforoneormoreyearsto
receivethesame.
Therearethreereasons,thatmaybeattributedto
theindividualstimepreferenceformoney:
Uncertainty
CurrentConsumption
PossibilityofinvestmentOpportunity
2
SIMPLEINTEREST
Simpleinterestistheinterestpaid(earned)onthe
originalamount,orprincipalborrowed(lent).
Simpleinterestisthefunctionofthreecomponents
suchasprincipalamountborrowedorlent,interest
perannumandnumberofyearsforwhichtheinterest
rateiscalculated.
Simpleinterestiscalculatedasfollows:

SI=Pxnxr
P=Principalamount
n=No.ofyears
r=Rateofinterest

Futurevalue:
FVn=P+SI 3
COMPOUNDINTEREST
Thereisasignificantdifferencebetweensimpleand
compoundinterest.
Insimpleinterestthereisnoopportunitytoearn
interestoninterestwhereasincompoundinginterest
eachinterestpaymentis(reinvested)havingan
opportunitytoearninterestoninterest.
Compoundinterestistheinterestearnedonagiven
depositandhasbecomeapartofprincipalattheend
ofthespecificperiod.
Compoundinginterestisalsoreferredtoasfuture
value.
4
 Itcanbecalculatedasfollows:
FVn=P0(1+r)
FVn=CompoundValueattheendofnyear
P0=Principalamount
n=No.ofyears
r=Rateofinterest

Variablecompoundingperiods
FVn=P0[1+r/m]m*n
FVn=CompoundValueattheendofnyear
P0=Principalamount
n=No.ofyears
r=Rateofinterest
m=no.oftimescompoundedinayear. 5
 Compoundedvalueofaseriesofcashflows:
UnevenCashflows:

FVn=P1(1+r)n1+P2(1+r)n2+..+Pn1(1+r)+Pn

FVn=CompoundValueattheendofnyear
P1=Paymentattheendofyearone
P2=Paymentattheendofyeartwo
Pn=Paymentattheendofyearn
n=No.ofyears
r=Rateofinterest

6
 EvenCashflows:
Annuityisaseriesofevencashflows(inflowsor
outflows)ofafixedamountforaspecifiednumberof
years.

Cashflowsmayhappeneitherattheendoftheyear
orbeginningoftheyear.

Ifcashflowshappenatthebeginningoftheyear,itis
calledasanannuitydue,whereaswhencashflows
happenattheend,itiscalledasaregularordeferred
annuity.

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 CompoundvalueofDeferredAnnuity:

FVn=P(1+r)n1
r
CompoundvalueofAnnuityDue:

FVn=P(1+r)n1(1+r)
r

8
PRESENTVALUE
Presentvalueisexactlycontrarytocompoundvalue.

Compoundvalueishelpfultoknowtheinterestadded
toprincipalamountatagivencompoundinterestrate
andgivennumberofyears,whereasinthepresent
valueweknowthepresentvalueofasumthatis
receivableinthefuture.

Insimplewords,undercompoundedapproachthe
suminvestedwillappreciatewhereasinpresentvalue
thesumreceivableinfuturewilldepreciatedueto
discounting.
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 Theprocessesofdeterminingpresentvalueofafuture
cashflows(inflowsandoutflows)iscalleddiscounting.

Thepresentvalueofafuturecashflow
(inflow/outflow)istheamountofcurrentcashthatisof
equivalentvaluetothepresentvalue.
Itcanbecalculatedasfollows:

PV=FVn 1
(1+r)n

PV=PresentValue
FVn=FutureValuereceivableattheendofnyear
n=No.ofyears
r=RateofinterestorDiscountingFactor
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 Presentvalueofaseriesofcashflows:
UnevenCashflows:

PV=CIF1+CIF2+..+CIFn
(1+r)1(1+r)2 (1+r)n

PV=PresentValue
CIF=CashFlows
n=No.ofyears
r=RateofinterestorDiscountingfactor

11
PRESENTVALUEOFANNUITY
Presentvalueofannuitydeferred
PVAn=FV(1+r)n1

r(1+r)n

Presentvalueofannuitydue

PVAn=FV(1+r)n1(1+r)
r(1+r)n

12

PRESENTVALUEOF
GROWINGANNUITY
Growingannuitymeansthecashflowthatgrows
ataconstantrateforaspecifiedperiodoftime.

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SINKINGFUNDFACTOR
Financialmanagermayneedtoestimatethe
amountofannualpaymentssoastoaccumulate
apredeterminedamountafterfuturedateto
purchaseassetsortopayaliability.

Ap=FVAn_r___
(1+r)n1

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PRESENTVALUEOF
PERPETUITY
Perpetuityisanannuityofinfiniteduration.
PV=CIF_
r

Presentvalueofgrowingperpetuity:
PV=CIF_
rg
PV=PresentValueofperpetuity
CIF=Cashinflow
r=Rateofinterestordiscountingrate
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g=Growthrateperyear
LOANAMORTIZATION
Loanisanamountraisedfromoutsidersatan
interestandrepayableataspecificperiod(lump
sumorininstallments).
Paymentofloanisknownasamortization.

LI=PAr(1+r)n
(1+r)n1

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EQUATEDMONTHLY
INSTALLMENTS
EMIreferstothemonthlypaymenttowards
interestandprincipalamountbytheborrowerto
thelender.

EMIiscalculatedusingaformulathatconsiders
loanamount,interestrateandloanperiodas
variable.

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SHORTERDISCOUNTING
PERIODS
Generally,cashflowsarediscountedonceinayear,
butsometimescashflowshavetobediscountedless
thanoneyeartime,like,semiannually,quarterly,
monthlyordaily.

PV=FVn____1___
(1+r/m)nm

PV=PresentValue
FVn=FutureValuereceivableattheendofnyear
n=No.ofyears
r=RateofinterestorDiscountingFactor
18

EFFECTIVEVS.NOMINALRATE
Nominalrateofinterestorrateofinterestper
yearisequal.
EffectiveandNominalrateareequalonlywhen
thecompoundingisdoneyearlyonce,butthere
willbeadifference,thateffectiverateisgreater
thanthenominalrateforshortercompounding
periods.

ERI=1+_r_m1
m
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DOUBLINGPERIOD
Rulef72:
Dp=72r

Ruleof69:
Dp=0.35+69r

20
COMPOUNDGROWTHRATE
Compoundgrowthratecanbecalculatedasfollows:

gr:V0(1+r)n=Vn
gr:=Growthrateinpercentage

V=Variableforwhichthegrowthrateisneededtobefound

V0=Variablevalueattheendoftheyear1

Vn=Variablevalueattheendofyearn
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(1+r)n=Growthrate