Time Value of Money 1.

2
1.2.1 Rationale

M
ost financial decisions, personal as well as business, involve time value of money considerations. Money
of the financial problems involves cash flows occurring at different points of the time. For evaluating
such cash flows an explicit consideration of the time value of money is required.
Money has time value. A rupee today is more valuable than a rupee a year hence.
So, the time value of money is an individual’s preference for possession of a given amount of money now, rather
than the same amount at some future date.
Mainly there are three reasons may be attributed to the individual’s time preference for money.
(i) Risk: We are not certain about future cash receipts. In an inflationary period, a rupee today represents a
greater real Purchasing Power than a rupee a year hence. So, an individual prefers receiving cash now.
(ii) Preference for consumption: Individuals, in general, prefer current consumption to future consumption.
(iii) Investment opportunities: Capital can be employed productively to generate positive returns. An investment
of one rupee today would grow to (1+r) a year hence (r is the rate of return earned on the investments).

1.2.2 Techniques
There are two methods of estimating time value of money which are shown below figure.

Time Value of Money

Compounding (Future Value) Discounting (Present Value)

● Single Flow ● Single Flow
● Multiple Flows ● Uneven Multiple Flows
● Annuity ● Annuity
● Perpetuity

Figure 1.3: Techniques of Time Value of Money

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Discounting

Future Value Present Value

Compounding

Future Value Present Value

Figure 1.4: Comparison between Compounding and Discounting

A. Compounding Technique:
Compounding is the process of finding future values of cash flows by applying the concept of compound interest.
We can calculate the future values (FV) of all the cash flows at the end of the time period at a given rate of interest.
Future value = Present value + Interest
Compounding technique can be used to the following cases:
(a) Single Flow
(b) Multiple Flows
(c) Annuity
B. Discounting Technique
Discounting is the process of determining present values of a series of future cash flows. The compound interest
rate used for discounting cash flows is also called the discount rate.
We determine the time value of money at time “O” by comparing the initial outflow with the sum of the present
values (PV) of the future inflows at a given rate of interest.
Discounting technique can be used to the following circumstances.
(a) Single Flow
(b) Un-even Multiple Flows
(c) Annuity
(d) Perpetuity

1.2.3 Future Value and Present Value of a Single Cash Flow

(i) Future Value of a Single Flow
Suppose an investor have ` 1,000 today and he deposits it with a financial institution, this pays 10 % interest
compounded annually, for a period of 3 years. The deposit would grow as follows:
(`)
Principal at the beginning 1,000
First year Interest for the year (1,000 × 0.10) 100
Principal at the end 1,100

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Principal at the beginning 1,100

Second year Interest for the year (1,100×0.10) 110
Principal at the end 1,210
Principal at the beginning 1,210
Third year Interest for the year 1,210×0.10) 121
Principal at the end 1,331
The general formula for the future value of single flow:
FV = PV (1+r)n
Where FV = Future value n years hence
PV = Amount invested today
r = Interest rate per period
n = Number of periods of investments

To find out the future value (FV) of a single cash flow, we can use the MS Excel’s built-in function.
The FV is given below:
FV (RATE, NPER, PMT, PV, TYPE)
RATE is the discount or the interest rate for a period.
NPER is the number of periods.
PMT is the equal payment (annuity) each period
PV is the present value
TYPE indicates the timing of cash flow, occurring either at the beginning or at the end of the period.

Illustration 1
If a person invests ` 1,50,000 in an investment which pays 12% rate of interest, what will be the future value of the
invested amount at the end of 10 years?
Solution:
The future value (FV) of the invested amount at the end of 10 years will be
FV = PV (1+r)n
FV = ` 1,50,000 (1 + 0.12)10
FV = ` 1,50,000 × 3.106
FV = ` 4,65,900
Doubling Period
Investor wants to know how long would take to double the investment amount at a given rate of interest. If we look
at the future value interest factor table, we find that when the interest rate is 12% it takes about 6 years to double
the amount. When the interest rate is 6%, it takes about 12 years to double the amount, so on and so forth.

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There is a thumb rule of 72 that helps to find out the doubling period. According to this rule of thumb, the doubling
period is obtained by dividing 72 by the interest rate.
However, an accurate way of calculating the doubling period is the Rule of “69”.
69
Under this Rule, doubling period = 0.35 +
Interest Rate

Illustration 2
How long it will take for ` 20,000 to double at a compound rate of 8% per annum (approximately)?
Solution:
The rule of 72 is
The rule of 72 is

r = 72 Where,
n r = rate of interest or return
n = number of investment years

72
No. of years =
Annual rate of Interest

72
No. of years (n) =
8
No. of years (n) = 9 years
Future value of single and multiple cash flows can be calculated by using the following formulae:
Table 1.1 Future Value of Single and Multiple Cash Flows

Annually single cash flow FV= PV(1+r)n PV = Present value

FV = Future value
Or, FV= PV (FVIFr,n) r = Interest rate
n = Number of years
FVIFr,n = Future Value Interest Factor
Multiple times say m no. PV = Present value
of times compounding FV = Future value
done
r = Interest rate
n = Number of years
m = Number of times
compounding done say
quarterly then m = 4, half-yearly
m = 6 and so on.

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Cash flows of different FV = PV1 × (1+r)1+ PV2 × (1+r)2 PV = Present value

amounts over years i.e. a FV = Future value
series of payments +….+PVn × (1+r)n i.e.
r = Interest rate
n = Number of years
t = 1, 2, 3, 4….
At = Cash flow occuring at time t

(ii) Present Value of a Single Flow

Present Value can be calculated by using the following formulas:

1. Annually single PV = Present value

cash flow FV = future value
r = discount
n = no of years
or, PV = FV(1+r)-n
PVIFr,n = Present Value Interest Factor
or, PV = FV(PVIFr,n)

2. Multiple PV = Present value

times, say m FV = future value
no of times r = discount rate
discounting done n = no of years
m =
no of times discounting done say
quarterly then
m = 4, half-yearly m = 6 and so on.
3. Cash flows PV = Present value
of different PV= FV = future value
amounts over r = discount rate
years n = duration of the cash flow stream
t = indicates years of extending from one
year to n years
A = cash flow occuring at time t
The process of discounting, used for finding present value, is simply the reverse of compounding. The present
value formula can be readily obtained by manipulating the compounding formula:
FV = PV(1+r)n
Dividing both sides of above Eq. by (1+r)n we get

 1 
 n  in above equation called the discounting factor or the present value interest (PVIFi,n), the value of
 1 + r) 
(PVIFi,n) for several combinations of i and n.

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To find out the present value (FV) of a single cash flow, we can use the MS Excel’s built-in function.
The PV is given below:
PV (RATE, NPER, PMT, FV, TYPE)
RATE is the discount or the interest rate for a period.
NPER is the number of periods.
PMT is the equal payment (annuity) each period
FV is the Future value
TYPE indicates the timing of cash flow, occurring either at the beginning or at the end of the period.
Illustration 3
Suppose someone promise to give you ` 1,000 three years hence. What is the present value of this amount if the
interest rate is 10%?
Solution:
The present value can be calculated by discounting ` 1,000, to the present point of time, as follows:
Value of three years hence = ` 1,000
1
Value two years hence = ` 1,000 × Value one year hence = ` 1,000 ×
(1 + 0.10)
1
Value one year hence = ` 1,000 ×
(1 + 0.10) 2

1
Value now (present value) = ` 1,000 × = ` 1,000 × 0.751 = ` 751
(1 + 0.10)3
1.2.4 Annuity and Perpetuity
(A) Annuity
An annuity is a series of equal payments or receipts occurring over a specified number of periods. The time period
between two successive payments is called payment period or rent period. The word annuity in broader sense
includes payments which can be annual, semi-annual, quarterly or any other length of time. For example, when a
company set aside a fixed sum each year to meet a future obligation, it is using annuity.
Future Value of Ordinary Annuity
In an ordinary annuity, payments or receipts occur at the end of each period. In a ten-year ordinary annuity, the last
payment is made at the end of the tenth year.

Future Value of Ordinary Annuity can be calculated by using the following formula:

 (1 + r) n − 1 
FVAn= A  
 r 
Or

FVAn= A[{(1+r)n-1}/r]

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Where,
FVAn = Future value of an annuity which is the sum of the compound amounts of all payments and a
duration of n periods
A = Amount of each instalment or constant periodic flow
r = Interest rate per period
n = Number of periods

is known as the future value interest factor of an annuity (FVIFAr,n)

Illustration 4
Apex Ltd. has an obligation to redeem ` 50 crore bonds 6 years hence. How much should the company deposit
annually in a sinking fund account wherein it earns 12% interest, to accumulate ` 50 crore in 6 years’ time?
Solution:
The future value interest factor for a 6-year annuity, given an interest rate 12% is:
(1+0.126)-1
FVIFAn=6, r=12% = = 8.115
0.12
The annul sinking fund deposit should be:
` 5, 00, 00, 000
=
8.115

= ` 61,61,429.00

Present Value of Ordinary Annuity

Present Value of Ordinary Annuity can be calculated by using the following formula:
PVAn= A [{1 – (1/1+ r) n}/r]
where,
PVAn = Present value of an annuity which is the sum of the compound amounts of all payments and a duration
of n periods
A = Amount of each instalment or constant periodic flow
r = Discount rate
n = Number of periods
[{1- (1/1+r)n}/r] is called present value interest factor.

(B) Perpetuity:
Perpetuity is an annuity that occurs indefinitely. The stream of cash flows continues for an infinite amount of
time. Fixed coupon payments on permanently invested (irredeemable) sums of money are prime examples of
perpetuities. Scholarships paid perpetually from an endowment fund. The value of the perpetuity is finite because
receipts that are anticipated far in the future have extremely low present value.

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By definition, in a perpetuity, time period, n, is so large (i.e., mathematically n approaches infinity) that tends to
become zero and the formula for a perpetuity simply becomes
Present value of a perpetuity may be written as follows:

P∞ = A × PVIF Ar,∞
Where,

P∞ = Present value of a perpetuity

A = Constant annual payment

PVIF Ar,∞ = Present value interest factor of perpetuity

Here, the present value interest factor of perpetuity is simply 1 divided by the interest rate expressed in decimal
form. So, the present value of a perpetuity is simply equal to the constant annual payment divided by the
interest rate.

So, P∞ = 1
r
Or,
Perpetuity
Present value of perpetuity =
Interest rate

1.2.5 Compound Annual Growth Rate (CAGR)

Compound Annual Growth Rate (CAGR) is the annual growth of investments over a specific period of time.
In other words, it is a measure of how much an investor earned from the investments every year during a given
interval.
This is one of the most accurate methods of calculating the rise or fall of your investment returns over time.
Steps involved in calculating the CAGR of an investment:
Step 1: Divide the value of an investment at the end of the period by its value at the beginning of that period.
Step 2: Raise the result to an exponent of one divided by the number of years.
Step 3: Subtract one from the subsequent result.
Step 4: Multiply by 100 to convert the answer into a percentage.
The Compound Annual Growth Rate (CAGR) formula is:

 EV 1/n 
CAGR=   − 1 × 100
 BV  
Where, EV= Ending balance is the value of the investment at the end of the investment period.
BV= Beginning balance is the value of the investment at the beginning of the investment period.
N = Number of years amount invested.
CAGR may be used in the following cases:
(i) Calculating and communicating the average returns of investment funds.

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(ii) Demonstrating and comparing the performance of investment advisors.

(iii) Comparing the historical returns of stocks with bonds or with a savings account.
(iv) Forecasting future values based on the CAGR of a data series.
(v) Analyzing and communicating the behavior, over a series of years, of different business measures such as
sales, market share, costs, customer satisfaction, and performance.
For example, X Ltd. had revenues of ` 100 crore in 2010 which increased to ` 1,000 crore in 2020. What was the
compounded annual growth rate?
Solution:
The Compounded Annual Growth Rate (CGAR) can be calculated as follows:

CAGR

1.2.6 Practical Applications

An important use of present value concepts is in determining the payments required for an instalment-type loan.
The distinguishing feature of this loan is that it is repaid in equal periodic payments that include both interest and
principal. These payments can be made monthly, quarterly, semi-annually, or annually. Instalment payments are
prevalent in mortgage loans, auto loans, consumer loans, and certain business loans.
The future value of an annuity can be applied in different scenarios by different organisations and individuals such
as:
(i) One may able to know the accumulated fund at the certain period (i.e., Deposit in Public Provident Fund)
(ii) How much should one person save annually if his or her savings earn a compound return (i.e., annual savings
to buy a house after certain period, deposit in sinking fund).
(iii) The present value of an annuity can be applied in case of loan amortisation by a borrower.

Illustration 5
Find the present value of ` 1,000 receivable 6 years hence if the rate of discount is 10%.
Solution:
` 1,000 × PVIF10%, 6 = ` 1,000 × 0.5645 = ` 564.5
Illustration 6
Find the present value of ` 1,000 receivable 20 years hence if the discount rate is 8%.

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Solution:
We obtain the answer as follows:

Illustration 7
An individual deposited ` 1,00,000 in a bank @ 12% compound interest per annum. How much he would receive
after 20 years ?
Given, FVIF12, 20 = 9.646
Solution:
FV= PV (1+r) n
Or, FV= PV (FVIFr, n),
Where,
PV = Present value or sum invested ` 100,000
FV = Future value
r = Interest rate i.e 12% or 0.12
n = Number of years i.e., 20
FV = PV (FVIFr, n)
FV = `100,000 × 9.646

FV = ` 9,64,600
Illustration 8
Mr. X is depositing ` 20,000 in a recurring bank deposit which pays 9% p.a. compounded interest. How much
amount Mr. A will get at the end of 5th Year.
Solution:
Formula for calculating future value of annuity
FVAn= A[{(1+r)n-1}/r]
where,
FVAn = Future value of an annuity which is the sum of the compound amounts of all payments and a duration
of n periods

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A = Amount of each instalment or constant periodic flow

r = Interest rate per period
n = Number of periods
= ` 20,000 ×1 [{(1+0.09)5-1}/0.09]
= ` 1,19,694
Illustration 9
A Person is required to pay annual payments of ` 8,000 in his Deposit Account that pays 10% interest per year.
Find out the future value of annuity at the end of 5 years.
Solution:

Amount Deposited Term of the deposit

At the end of Future Value (` )
(` ) (Years)
1st year 8,000 4 8,000 × 1.464 = 11,713
2nd year 8,000 3 8,000 × 1.331 = 10,648
3rd year 8,000 2 8,000 × 1.210 = 9,680
4th year 8,000 1 8,000 × 1.110 = 8,800
5th year 8,000 - 8,000 × 1.000 = 8,000
Future Value of annuity at the end of 5 years 48,841
Alternatively, the future of annuity can be obtained by using the following formula:
Formula for calculating future value of annuity
FVAn = A[{(1+r)n-1}/r]
where,
FVAn = Future value of an annuity which is the sum of the compound amounts of all payments and a duration
of n periods
A= Amount of each instalment or constant periodic flow
r= Interest rate per period
n= Number of periods
= ` 8,000 × 6.1051 = ` 48,841
Future Value of Annuity at the end of 5 years = ` 48,841.

Illustration 10
Ascertain the future value and compound interest of an amount of ` 75,000 at 8% compounded semi-annually for
5 years.
Solution:
Amount Invested = ` 75,000
Rate of Interest = 8%

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No. of Compounds = 2 × 5 = 10 times

Rate of Interest for half year = 8%/2 = 4%
Compound Value or Future Value = P (1+i)n
Where,
P = Principal Amount
i = Rate of Interest (in the given case half year interest)
n = No. of years (no. of compounds)
= ` 75,000 (1+4%)10
= ` 75,000 × 1.4802
= ` 1,11,018
Compound Value = ` 1,11,018
Compound Interest = Compound Value – Principal Amount

= ` 1,11,018 – ` 75,000 = ` 36, 018.

Illustration 11
An investor expects a perpetual sum of ` 5,000 annually from his investment. What is the present value of the
perpetuity if interest rate is 10%?
Solution:
Perpetuity
Present value of a perpetuity =
Interest Rate
A
PV = = ` 50,000
i

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