DEPARTMENT OF FINANCE

FACULTY OF MANAGEMENT AND FINANCE

UNIVERSITY OF RUHUNA, MATARA

BBA 12043 – INTRODUCTORY FINANCE

LECTURER: K. R. K. HARSHANA WEEK 02

TIME VALUE OF MONEY (TVM)

What is Time Value of Money?

Time value of money is that a sum of money received today is worth more than if the same is received
after sometime. A result to this concept is also the concept that money received in future is less valuable
than what is today.

What is the time preference for money?

If an individual behaves rationally, he would not value the opportunity to receive a specific amount of
money how equally with the opportunity to have the same amount at some future date. Most individuals
value the opportunity to receive money now higher than waiting for one or more years to receive the
same amount.

What are the reasons for time value of money?

Money has a time value (time preference for money) because of the following three reasons.

1. Risk or Uncertainty
As an individual is not certain about future cash receipts, he prefers receiving cash now.

2. Preference for consumption

Most people have subjective preference for present consumption over future consumption of
goods and services, either because of the urgency of their present wants or because of the risk of
not being in a position to enjoy future consumption that may be caused by illness or death, or
because of inflation.

3. Investment opportunities
As money is the means by which individuals acquire most goods and service, they may prefer
to have money now. Further, most individuals prefer present cash to future cash because of the
available opportunities to which they can put present cash to earn additional cash.

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Time preference rate and required rate of return
The time preference for money is generally expressed by an interest rate. This rate will be positive even
in the absence of any risk. It may therefore be called the risk-free rate. In reality, an investor will be
exposed to some degree of risk. Therefore, he would require a rate of return from the investment, which
compensates him for both time and risk. His required rate of return will be:

Required rate of return = Risk free rate + Risk premium

What are the concepts of time value of money?

We have discussed two common methods of adjusting cash flows for time value of money. There are;

1. Future value concept/ Compound value

2. Present value concept/ Discounting value

1. Future Value
In this concept, the interest earned on the initial principal becomes a part of the principal at the end of
the compound period.

2. Present Value
The present value of a future cash inflow (or outflow) is the amount of current cash that is of equivalent
value to the decision marker. The process of determining the present value of a future payment (or
receipts) or a series of future payment (or receipts) is called discounting. The compound interest rate
used for discounting cash flows is also called the discount rate.

FUTURE VALUE CONCEPT/ COMPOUND VALUE

Concepts of future value of money and their cash flows

1. Future value of lump sum
2. Future value of an annuity
3. Future value of an annuity due
4. Sinking fund
5. Future value of uneven periodic sum
6. Multi- period compounding
7. Multi- period compounding series of cash flows

01. Future value of lump sum

How much future sum would you receive after certain period? Future value of lump sum helps to answer
this question.

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 𝑭𝑽 = 𝑷𝑽 (𝟏 + 𝒊)𝒏 ------------------------------ Equation 01

𝑭𝑽 = 𝑷𝑽 (𝑭𝑽𝑭𝒏,𝒊 ) ------------------------------ Equation 02

Example 01: You deposit Rs. 01 million in a bank for the five years at 12% rate of interest per annum.
Calculate the future value of the lump sum.

02. Future value of an annuity

An annuity is a fixed payment (or receipt) each year for a specified number of years. If you rent a flat
and promise to make a series of payments over an agreed period, you have created an annuity. The equal
installment loans from the house financing companies or employers are common examples of

annuities.

(𝟏+𝒊)𝒏 − 𝟏
FV = A [ ] ------------------------------ Equation 01
𝒊

𝑭𝑽 = 𝑷𝑽 (𝑭𝑽𝑨𝑭𝒏,𝒊 ) ------------------------------ Equation 02

Example 02: Nimal deposits Rs. 200,000 at the end of each year for five years at 12% rate of interest.
Calculate future value of the annuity at the end of the five years.

03. Future value of an annuity due

An annuity due is s a fixed payment (or receipt) at the beginning of each year for a specified number of
years.

The formula for the future value an annuity due is;

(𝟏+𝒊)𝒏 − 𝟏
FV = A [ ] (𝟏 + 𝒊) -------------------------------- Equation 01
𝒊

𝑭𝑽 = 𝑷𝑽 (𝑭𝑽𝑨𝑭𝒏,𝒊 ) (𝟏 + 𝒊) ------------------------------ Equation 02

Example 03: You deposit Rs. 50,000 in a savings account at the beginning of each year for 5 years to
earn 12% interest per annum. Calculate the future value of annuity due at the end of 5 years.

04. Sinking fund

Sinking fund is a fund which is created out of fixed payments each period to build up to a future sum
after a specified period.

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 𝑭𝑽
A= (𝟏+𝒊)𝒏 − 𝟏 -------------------------------- Equation 01
( 𝒊
)

𝑭𝑽
𝑨= ------------------------------ Equation 02
(𝑭𝑽𝑨𝑭𝒏,𝒊 )

Example 04: Sajith wants Rs.66, 100 at the end of five years from now at interest rate of 14%. How
much should he deposit at the end of each year?

05. Future value of an uneven periodic sum

In the investment decisions of a firm, one would not frequently get a constant periodic sum. In most
instances, the firm receives a stream of uneven cash inflows. The following equation can be used to
calculate the compound value of uneven cash flows.

𝑭𝑽 = 𝑨𝟏 (𝑭𝑽𝑭𝒏,𝒊 ) + 𝑨𝟐 (𝑭𝑽𝑭𝒏,𝒊 ) + 𝑨𝟑 (𝑭𝑽𝑭𝒏,𝒊 ) + 𝑨𝟒 (𝑭𝑽𝑭𝒏,𝒊 ) + -------- + 𝑨𝒏 (𝑭𝑽𝑭𝒏,𝒊 )

Example 05: Wimal has an opportunity of receiving following cash flows.

Year Cash flow

1 20,000 (end of the year)
2 10,000 (beginning of the year)
3 10,000 (middle of the year)
4 15,000 (end of the year)
5 25,000 (beginning of the year)

If the interest rate is 10%, calculate the future value of uneven cashflow at the end of 05 years

06. Multi -period compounding

Interest can be compounded even more than once in a year. For calculating the multiple compounded
value, above logic can be extended. For instance, in case of semiannual compounding interest is paid
twice a year but at half the annual rate. For the purpose of calculation semi-annual compounding implies
that there are two periods of six months. Similarly, in the case of quarterly, there are four periods of
three months. We can use the following formula for computing the future value of a sum in the case of
the multi-period compounding.

𝒊 𝒏𝒙𝒎
𝑭𝑽 = 𝑷𝑽 (𝟏 + )
𝒎

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Example 06: Saman deposits Rs 250,000 in the bank at interest rate being 16% per annum. If
compounded annually, semi-annually, quarterly and monthly, calculate the future value for 2 years.

07. Multi-period compounding of series of cashflows

The transactions in real life are not limited to one. Investing money in installments may wish to know
the value of this saving after ‘n’ years.

Example 07: Nimali invests Rs.120, 000, Rs.320,000, Rs.140,000 and Rs. 240,000 at the beginning of
each year at interest rate being 12% per annum. If compounding annually, semi-annually and quarterly,
calculate the future value at the end of four years.

PRESENT VALUE CONCEPT/ DISCOUNTING VALUE

Concepts of present value of money and their cashflows.
1. Present value of a lump sum
2. Present value of an annuity
3. Present value of an annuity due
4. Capital recovery and loan amortization
5. Present value of a perpetuity
6. Present value of an uneven periodic sum

08. Present value of a Lump sum

The present value of a lump sum, is the present value of a future cash inflow or outflow.

𝟏
𝑷𝑽 = 𝑭𝑽 ((𝟏+𝒊)𝒏 ) ------------------------------ Equation 01

𝑷𝑽 = 𝑭𝑽 (𝑷𝑽𝑭𝒏,𝒊 ) ------------------------------ Equation 02

Example 08: Lasith will receive Rs. 01 million after five years from now at the interest rate of 10%.
Calculate the present value of the lump sum

09. Present value of an annuity

An investor may have an opportunity to receive a constant periodic amount (an annuity) for a certain
number of years at the end of each year.

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 𝟏
𝟏− (𝟏+𝒊)𝒏
𝑷𝑽 = 𝑨 [ 𝒊 ] ------------------------------ Equation 01

𝑷𝑽 = 𝑨 (𝑷𝑽𝑨𝑭𝒏,𝒊 ) ------------------------------ Equation 02

Example 09: Saliya receives Rs.120,000 at the end of each for five years. If the rate of interest is 12%,
calculate the present value of the annuity.

10. Present value of an annuity due

An investor may have an opportunity to receive a constant periodic amount (an annuity) for a certain
number of years at the beginning of each year.
The formula for the present value of an annuity due is;
𝟏
𝟏− (𝟏+𝒊)𝒏
𝑷𝑽 = 𝑨 [ 𝒊 ] (𝟏 + 𝒊) ------------------------------ Equation 01

𝑷𝑽 = 𝑨 (𝑷𝑽𝑨𝑭𝒏,𝒊 ) (𝟏 + 𝒊) ------------------------------ Equation 02

Example 10: Himali deposits 50,000 at the beginning of each year for the five years, the interest rate
being 12%. Calculate the present value of this annuity due.

11. Capital recovery and loan amortization

If you make an investment today for a given period of time at a specified rate of interest, you may like
to know the annual income. Capital recovery is the annuity of an investment for a specified time at a
given rate of interest.

(a) Capital recovery

The reciprocal of the present value annuity factor called the Capital Recovery Factor (CRF).

𝟏
𝑪𝑹𝑭 =
(𝑷𝑽𝑨𝑭𝒏,𝒊 )

𝑷𝑽
𝑨= -------------------------------- 𝐄𝐪𝐮𝐚𝐭𝐢𝐨𝐧 𝟎𝟏
𝟏
𝟏−
(𝟏 + 𝒊)𝒏
[ ]
𝒊

BBA 12043 – Introductory Finance | Time Value of Money | K. R. K. Harshana Page | 6

 𝑷𝑽
𝑨= [ ] ------------------------------------ 𝑬𝒒𝒖𝒂𝒕𝒊𝒐𝒏 𝟎𝟐
𝑷𝑽𝑨𝑭𝒏,𝒊

Example 11: Chandi invests Rs. 01 million today for a period of five years. If interest rate is 12%, how
much income per year should he receive to recover his investment?

(b) Loan amortization

Capital recovery factor helps in the preparation of a loan-amortization (loan-repayment) schedule.

𝑷𝑽
𝑨= [ ]
𝑷𝑽𝑨𝑭𝒏,𝒊

Example 12: You obtain a loan of Rs. 01 million at 12% interest rate from a bank to buy a motor car.
The bank requires five equal installments at the end-of-each year repayments.

Required: Calculate the annual installment and prepare the loan amortization schedule.

12. Present value of a perpetuity

Perpetuity is an annuity that occurs indefinitely. Perpetuities are not very common in financial decision
making. But one can find an example instance, in the case of irredeemable preference shares, the
company is expected to pay preference dividend perpetually. The formula for perpetuity simply
becomes:
𝑨
𝑨=
𝒊

Example 13: Ranil expects a perpetual sum of Rs.80,000 annually from his investment. What is the
present value of this perpetuity if his interest rate is 12%?

13. Present value of an uneven periodic sum.

In the investment decisions of a firm, one would not frequently get a constant periodic sum. In most
instances, the firm receives a stream of uneven cash inflows. The following equations can he used to
handle the present value of uneven cash flows.
𝑨𝟏 𝑨𝟐 𝑨𝟑 𝑨𝟒 𝑨𝒏
𝑷𝑽 = 𝟏
+ 𝟐
+ 𝟑
+ 𝟒
+ ------- + ------------- 𝑬𝒒𝒖𝒂𝒕𝒊𝒐𝒏 𝟎𝟏
(𝟏 + 𝒊) (𝟏 + 𝒊) (𝟏 + 𝒊) (𝟏 + 𝒊) (𝟏 + 𝒊)𝒏

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𝑷𝑽 = 𝑨𝟏 (𝑷𝑽𝑭𝒏,𝒊 ) + 𝑨𝟐 (𝑷𝑽𝑭𝒏,𝒊 ) + 𝑨𝟑 (𝑷𝑽𝑭𝒏,𝒊 ) + 𝑨𝟒 (𝑷𝑽𝑭𝒏,𝒊 ) + ---- + 𝑨𝒏 (𝑭𝑽𝑭𝒏,𝒊 ) -- Equation 2

Example 14: Darshana has an opportunity of receiving following cash flows.

Year Cash flow
1 30,000 (end of the year)
2 20,000 (beginning of the year)
3 10,000 (middle of the year)
4 20,000 (beginning of the year)
5 40,000 (end of the year)

If the interest rate is 12%. you are required to calculate the present value of uneven cash flows.

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Present Value and Future Value Tables

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