FIN2370

Lesson 03: Time Value of Money (TVM)

1. Introduction to Time Value of Money (TVM)

The concept that money available today is worth more than the same amount in the
future due to its potential earning capacity.

• Key Idea: A rupee today is worth more than a rupee tomorrow because it can be
invested and earn interest.

• Applications: TVM is used in various financial decisions, such as investments,

loans, retirement planning, and valuation of assets.

2. Reasons for Time Value of Money

• Individual's Preference for Early Consumption: People prefer to consume goods
and services now rather than later.
• Alternative Uses of Money: Money can be invested to earn returns, so having
money today allows for investment opportunities.
• Risk and Uncertainty: Future cash flows are uncertain, so money today is more
certain and valuable.
• Inflation: The value of money decreases over time due to inflation, so money today
has more purchasing power.

3. Compounding and Discounting

• Compounding: The process of earning interest on both the initial principal and the
accumulated interest from previous periods.

Where:
o FV = Future Value
FV = PV × (1+r) n o PV= Present Value
o r = Interest Rate
o n= Time Period

• Example: If you invest Rs. 100,000 at 10% per annum for 5 years, the future value
is: FV = 100,000×(1+0.10)5 =161,051

• The process of determining the present value of a future cash flow.

PV = FV (1+r) -n
 • Example: If you will receive Rs. 200,000 in 3 years and the discount rate is 10%, the
present value is: PV=200,000(1+0.10)-3 = 150,262

4. Future Value of Single Cash Flow

• The value of a single investment at a future date, considering compound interest.

FV = PV × (1+r) n
• Example: If you deposit Rs. 250,000 in an account earning 12% per annum for 5
years, the future value is: FV=250,000×(1+0.12)5=440,585

Effect of Compounding Frequency on Future Value

𝐹𝑉 = 𝑃𝑉 (1 + 𝑟/ 𝑚) mn
With continuous compounding, m becomes very large. As m approaches infinity, the
value of (1+r/m) mn goes to e r.n . Thus,

𝐹𝑉𝑛 = 𝑃𝑉 𝑒𝑟𝑛 𝐴𝑃𝑌 = 𝑒𝑟 − 1

5. Present Value of Single Cash Flow

• The current value of a future amount of money, discounted at a specific rate.

PV=FV(1+r)-n
• Example: If you will receive Rs. 675,000 in 10 years and the discount rate is 12%,
the present value is: PV = 675,000(1+0.12)10 = 217,000

6. Future Value of Multiple Cash Flows

The total future value of a series of cash flows, calculated by summing the future
values of each individual cash flow.

• Example: If you deposit Rs. 20,000, Rs. 40,000, Rs. 15,000, Rs. 65,000, and Rs.
80,000 over 5 years in an account earning 15% per annum, the future value at the
end of 5 years is calculated by finding the future value of each cash flow and
summing them up.

7. Present Value of Multiple Cash Flows

• The total present value of a series of future cash flows, calculated by summing the
present values of each individual cash flow.
 • Example: If you will receive Rs. 20,000, Rs. 40,000, Rs. 15,000, Rs. 65,000, and Rs.
80,000 over 5 years, and the discount rate is 15%, the present value is calculated
by discounting each cash flow and summing them up.

8. Annuities
• A series of equal payments made at regular intervals.

• Types of Annuities:
o Ordinary Annuity: Payments are made at the end of each period.
o Annuity Due: Payments are made at the beginning of each period.
o Deferred Annuity: Payments begin after a certain period.

Future Value of an Ordinary Annuity

Where:
• CF(A) = Cash flow per period
FV annuity = CF×[(1+r)n−1]/r • r = Interest rate
• n = Number of periods

• Example: If you deposit Rs. 30,000 at the end of each year for 10 years in an account
earning 15% per annum, the future value is:

FV = 30,000×((1+0.15)10−1)/(0.15)= Rs. 609,120

Present Value of an Ordinary Annuity

PV annuity= CF × [1−(1+r)-n]/r
• Example: If you will receive Rs. 40,000 at the end of each year for 20 years, and the
discount rate is 10%, the present value is:

PV=40,000×(1−(1+0.10)−20)/0.10)=340,542.55

9. Perpetuities
• An infinite series of equal payments.
PV = CF/r
• Example: If you receive Rs. 25,000 at the end of each year indefinitely,
and the discount rate is 10%, the present value is:
PV=25,0000.10=250,000
10. Loan Amortization
• The process of paying off a loan over time through regular payments
that cover both principal and interest.
Where:
o P = Principal amount
Loan Payment = PV × r/(1−(1+r) )
-t
o r = Interest rate per period
o t = Number of periods

• Example: If you borrow Rs. 600,000 to be repaid in 4 equal annual

installments at 12% interest, the annual payment is:
Payment=600,000×0.121−(1+0.12)−4=197,000

11. Solving for Unknown Variables

• Interest Rate (rr): If you know the present value, future value, and time
period, you can solve for the interest rate.
o Example: If you invest Rs. 200,000 and it grows to Rs. 304,175 in
3 years, the interest rate is:
r=(304,175200,000)1/3−1=15%
• Number of Periods (tt): If you know the present value, future value, and
interest rate, you can solve for the number of periods.
o Example: If you invest Rs. 150,000 at 16% interest compounded
quarterly, and it grows to Rs. 328,668.40, the number of quarters
is:
t=ln⁡(328,668.40/150,000)ln⁡(1+0.04)=20 quarterst=ln(1+0.04)ln(328,668.
40/150,000)=20 quarters

12. Effect of Compounding Frequency

• Nominal Rate (APR): The stated annual interest rate without
considering compounding.
 • Effective Rate (APY): The actual interest rate earned or paid,
considering compounding.
• Formula:
APY=(1+rm)m−1APY=(1+mr)m−1
Where:
o rr = Nominal interest rate
o mm = Number of compounding periods per year
• Example: If the nominal rate is 12% compounded quarterly, the
effective rate is:
APY=(1+0.124)4−1=12.55%APY=(1+40.12)4−1=12.55%

13. Conclusion
• The Time Value of Money is a fundamental concept in finance that
helps in making informed decisions about investments, loans, and
savings.
• Understanding compounding, discounting, annuities,
and perpetuities is essential for evaluating the value of cash flows over
time.
• By mastering these concepts, you can make better financial decisions,
such as choosing between investment options, planning for retirement,
or managing debt.

Example
I. A used car sells for Rs.9,000,000. The buyer of this car wishes to pay for
it in 60 monthly instalments, the first is due on the day of purchase. If
the interest rate charged is 24% p.a. compounded monthly, find the size
of the monthly payment.

II. John wishes to collect Rs.10 million to purchase a land. To collect that
money, he wishes to deposit Rs.10,000 each at the end of each month
 in a bank account that pays 12% p.a. compounded monthly so that
after making the last deposit he would have the desired sum of money
in the account. Determine the number of deposits he will have to make.

III. You are offered a special set of annuities by your pension fund in which
you will receive Rs.200,000 a year for the next 10 years and Rs.300,000
a year for the following 10 years. How much would you be willing to pay
for these annuities, if the discount rate is 9% p.a. and the annuities paid
are at the beginning of the year?

IV. You just received an offer in the mail to transfer your Rs.100,000
balance from your current credit card charging annual interest rate of
18% compounded monthly to a new credit card charging an annual
interest rate of 9% compounded monthly. How faster could you pay off
the balance by making planned monthly payments of Rs.2,000 with the
new card if there is a 2% fee charged on any balances transferred?

V. Assume that you are saving for university education of your two
children. They are two years apart in age; one will begin university in 15
years from today and the other will begin 17 years from today. You
estimate your children’s university expenses to be Rs.230,000 per year
per child, payable at the beginning of each university year. The annual
interest rate is 12%. How much money you must deposit in an account
each year to fund your children’s education? Assume, your deposits
begin one year from today, you will make your last deposit when your
oldest child enters university, and four years of university.