Financial Management

Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation

UNIT 2: Time Value of Money

Money loses its value over time which makes it more desirable to have it now rather than later. There are
several reasons why money loses value over time. Most obviously, there is inflation which reduces the
buying power of money. But quite often, the cost of receiving money in the future rather than now will be
greater than just the loss in its real value on account of inflation. The opportunity cost of not having the
money right now also includes the loss of additional income that you could have earned simply by having
received the cash earlier. Moreover, receiving money in the future rather than now may involve some risk
and uncertainty regarding its recovery. For these reasons, future cash flows are worth less than the present
cash flows.

Concept of Time Value of Money refers to the fact that the money received today is different in its worth
from the money receivable at some other point in future.

“A bird in hand is worth two in the bush” meaning, it's better to be content with what you have than to risk
losing everything by seeking to get more. So, this preference for current money as against future money is
known as Time Value of Money.

Time Value of Money concept attempts to incorporate the above considerations into financial decisions by
facilitating an objective evaluation of cash flows from different time periods by converting them into
present value or future value equivalents. This ensures the comparison of 'like with like'.

Let us take another view. People earn money for satisfying their various needs. After satisfying those needs
some people may have some savings. People may invest their savings in debentures or lend to other person
or simply deposit it into bank. In this way they can earn interest on their investment.
To sum up, the three reasons why money can be more valuable today than in the future are:

(i) Pr ef er ence f or Pr esent Consum pt i on: Individuals have a preference for current
consumption in comparison to future consumption. In order to forego the present consumption for a future
one, they need a strong incentive. Say for example, if the individual's present preference is very strong then
he has to be offered a very high incentive to forego it like a higher rate of interest and vice versa.

( i i ) Inflation: Inflation means when prices of things rise faster than they actually should. When there
is inflation, the value of currency decreases over time. If the inflation is more, then the gap between the value
of money today to the value of money in future is more. So, greater the inflation, greater is the gap and vice
versa.
( i i i ) Risk: Risk of uncertainty in the future lowers the value of money. Say for example, non-receipt of
payment, uncertainty of investor's life or any other contingency which may result in non-payment or reduction
in payment.

Now question arises as to why lenders charge interest for the use of their money. There are a variety of
reasons. We will now discuss those reasons.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
1. Time value of money: Time value of money means that the value of a unity of money is different in
different time periods. The sum of money received in future is less valuable than it is today. In other words
the present worth of money received after some time will be less than a money received today. Since a
money received today has more value rational investors would prefer current receipts to future receipts. If
they postpone their receipts they will certainly charge some money i.e. interest.

2. Opportunity Cost: The lender has a choice between using his money in different investments. If he
chooses one he forgoes the return from all others. In other words lending incurs an opportunity cost due to
the possible alternative uses of the lent money.

3. Inflation: Most economies generally exhibit inflation. Inflation is a fall in the purchasing power of
money. Due to inflation a given amount of money buys fewer goods in the future than it will now. The
borrower needs to compensate the lender for this.

4. Liquidity Preference: People prefer to have their resources available in a form that can immediately be
converted into cash rather than a form that takes time or money to realize.

5. Risk Factor: There is always a risk that the borrower will go bankrupt or otherwise default on the loan.
Risk is a determinable factor in fixing rate of interest. A lender generally charges more interest rate (risk
premium) for taking more risk.

Example

Suppose that you have earned a cash bonus for an outstanding performance at your job during the last year.

Your pleased boss gives you 2 options to choose from:

● Option A: Receive Rs.10,000 bonus now

● Option B: Receive Rs.10,800 bonus after one year

Further information which you may consider in your decision:

- Inflation rate is 5% per annum.

- Interest rate on bank deposits is 12% per annum.

Solution

Although in absolute terms Option B offer the higher amount of bonus, Option A gives you the choice of
receiving bonus one year earlier than Option B. This can be beneficial for the following reasons:

• To start with, you can buy more with $10,000 now than with $10,800 in one year's time due to
the 5% inflation.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
• Secondly, if you receive the bonus now, you could invest the cash in a bank deposit and earn a
safe annual return of 12%. in contrast, you stand to lose this interest income if you choose Option
B.
• Thirdly, future is uncertain. In worst case scenario, the company you work for could become
bankrupt during the next year which would significantly reduce your chances of receiving any
bonus. The probability of this happening might be remote, but there would be a slim chance none
the less.

The above considerations must be incorporated into the decision analysis by factoring them into a
discount rate which will then be used to calculate the future values and present values as illustrated below.

Discount Rates

As the interest rate on bank deposits is higher than the rate of inflation, we should set the discount rate at
12% for our analysis because it represents the highest opportunity cost for receiving the bonus in one
year's time rather than today.

For this example, we may assume that the risk of not getting the bonus after one year (e.g. due to the
company becoming bankrupt) is minimal and is therefore ignored. If such a risk is considered significant,
we would have to increase the discount rate to reflect that risk.

Using the 12% discount rate, we could either calculate future value or present value of the 2 options to
assess which option is better in financial terms. Both are included here for completeness sake although
they shall lead to the same conclusion.

Future Values

The future value of Option A will be the amount of bonus plus the interest income of 12% which could be
earned for one year.

Option A
Bonus Rs.10,000
Interest Income Rs.1,200 (Rs.10,000 x 12%)
Future Value Rs.11,200 after 1 year (Rs.10,000 + Rs.1,200)

Option B
Bonus Rs.10,800
Interest Income - *
Future Value Rs.10,800 after 1 year
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
* No interest income shall accrue on Rs.10,800 as it shall be received after one year.

Based on the future values, Option A is preferable as it has the highest future value.

Present Values

The present value of Option B will be the amount required today that shall equal to Rs.10,800 in one
year's time after having accrued an interest income of 12%.

Option A
Bonus Rs.10,000
Interest Income 1.0 *
Present Value Rs.10,000 (Rs.10,000 x 1.0)

*No need to discount as Rs.10,000 is already stated in its present value terms.

Option B
Bonus Rs.10,800
Interest Income 0.8928 (1 ÷ [1 + 0.12] )
Present Value Rs.9,642* (Rs.10,800 x 0.8928)

*The present value of Rs.9,642 represents the amount of cash that, if invested in a bank deposit @ 12%
p.a., shall equal to Rs.10,800 in one year. This can be confirmed as follows:

Rs.9,642 x 1.12 ≈ Rs.10,800

Based on the present values, Option A is preferable as it has the highest present value.

Note

Both present and future value analysis lead to the same conclusion (i.e. Option A is preferable over
Option B). This is because both methods are a mirror image of the other.

The present or future value of cash flows is calculated using a discount rate (also known as cost of capital,
WACC and required rate of return) that is determined on the basis of several factors such as:

● Rate of inflation – Higher the rate of inflation, higher the return that investors would require on their
investment.

● Interest Rates – Higher the interest rates on deposits and debt securities, greater the loss of interest
income on future cash inflows causing investors to demand a higher return on investment.

● Risk Premium – Greater the risk associated with future cash flows of an investment, higher the rate of
return required by an investors to compensate for the additional risk.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
Types of interests

1. Simple Interest - Simple interest is the interest computed on the principal for the entire period of
borrowing. Itis calculated on the outstanding principal balance and not on interest previously earned.
Itmeans no interest is paid on interest earned during the term of loan.

2. Compound interest - is the interest that accrues when earnings for eachspecified period of time added
to the principal thus increasing the principal base on whichsubsequent interest is computed.

3. Effective rate of return - If interest is compounded more than once a year the effective interest rate for
a year exceedsthe per annum interest rate.

Suppose you invest Rs.10,000 for a year at the rate of 6% per annum compounded semi-annually. Effective
interest rate for a year will be more than 6% perannum since interest is being compounded more than once
in a year. For computing effectiverate of interest first we have to compute the interest. Let us compute the
interest.

Interest for first six months = Rs.10,000 × 6/100 × 6/12= Rs.300

Principal for calculation of interest for next six months
= Principal for first period one + Interest for first period
= Rs.(10,000 + 300)
= Rs.10,300

Interest for next six months = Rs.10,300 × 6/100 × 6/12 = Rs.309

Total interest earned during the current year
= Interest for first six months + Interest for next six months
= Rs.(300 + 309) = Rs.609
Interest of Rs.609 can also be computed directly from the formula of compound interest.

Therefore, 6.09% is the effective rate of interest.

Thus if we compound the interest more than once a year effective interest rate for the year willbe more than
actual interest rate per annum. But if interest is compounded annually effectiveinterest rate for the year will
be equal to actual interest rate per annum.So, effective interest rate can be defined as the equivalent annual
rate of interest compoundedannually, if interest is compounded more than once a year.

4. Annuity – In many cases you must have noted that people have to pay an equal amount of
moneyregularly like every month or every year. For example payment of life insurance premium, rentof
house (if stay is in a rented house), payment of housing loan, vehicle loan etc. In allthese cases they pay a
constant amount of money regularly. Time period between twoconsecutive payments may be one month,
one quarter or one year.

Sometimes some people received a fixed amount of money regularly like pension rent of houseetc. In these
entire cases annuity comes into the picture. When we pay (or receive) a fixed amountof money periodically
over a specified time period we create an annuity.Thus annuity can be defined as “a sequence of periodic
payments (or receipts) regularly over a specified period of time”.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
To be called annuity a series of payments (or receipts) must have following features:
(1) Amount paid (or received) must be constant over the period of annuity and

(2) Time interval between two consecutive payments (or receipts) must be the same.

Future value –

Future value is the cash value of an investment at some time in the future. It is tomorrow’svalue of today’s
money compounded at the rate of interest. (Compounding means going from present to future).

Suppose you invest Rs.1,000 in afixed deposit that pays you 7% per annum as interest.

At the end of first year you will have Rs.1,070. This consist of the original principal of Rs.1,000 and the
interest earned of Rs.70. Rs.1,070is the future value of Rs.1,000 invested for one year at 7%. We can say
that Rs.1000 today is worth Rs.1070 in one year’s time if the interest rate is 7%.

Now suppose you invested Rs.1,000 for two years. How much would you have at the end of thesecond
year. You had Rs.1,070 at the end of the first year. If you reinvest it you end up having Rs.1,070(1+0.07)=
Rs.1144.90 at the end of the second year. Thus Rs.1,144.90 is the future value of Rs.1,000 invested for two
years at 7%.

Present Value –

We have read that future value is tomorrow’s value of today’s money compounded at someinterest rate.
We can say present value is today’s value of tomorrow’s money discounted at theinterest rate. Future value
and present value are related to each other in fact they are the reciprocalof each other.

Let’s go back to our fixed deposit example. You invested Rs.1000 at 7% and get Rs.1,070 at the end of the
year. If Rs.1,070 is the future value of today’s Rs.1000 at 7% then Rs.1,000is present value of tomorrow’s
Rs.1,070 at 7%. We have also seen that if we invest Rs.1,000 fortwo years at 7% per annum we will get
Rs.1,144.90 after two years. It means Rs.1,144.90 is the future value of today’s Rs.1,000 at 7% and Rs.1,000
is the present value of Rs.1,144.90 where timeperiod is two years and rate of interest is 7% per annum.