The Time Value of

Money
Dr. K. B. Kiran
• Money has time value. A rupee today is more
valuable than a rupee a year hence. Why ?

Individuals, in general, prefer current consumption to future

consumption.
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
investment).
In an inflationary period a rupee today represents a greater
real purchasing power than a rupee a year hence.
• Most financial problems involve cash flows occurring
at different points of time.
• These cash flows have to be brought to the same
point of time for purposes of comparison and
aggregation.
• Understanding the tools of compounding and
discounting which underlie most of what we do in
finance – from valuing securities to analyzing
projects, from determining lease rentals to choosing
the right financing instruments, from setting up the
loan amortization schedules to valuing companies…
• Is Re 1 to be received one year from today worth less than Re
1 in hand today? If so, why is it worth less? How much less is
it worth?

• The answers to these questions depend on the alternative

uses available for the rupee between today and one year from
today.
• Suppose the rupee can be invested in a guaranteed savings
account paying a 6 per cent annual rate of return (interest
rate). The Re1 invested today will return Re 1(1.06) = Re 1.06
one year from today.
• To receive exactly Re 1 one year from today, only Re 1/ (1/06)
= Re .943 would have to be invested in the account today.
• At a 6 per cent rate of return, we see that Re 1 to be received
one year from today is indeed worth less than Re 1 in hand
today, it’s worth being only Re .943.
• Existence of opportunities to invest the dollar at
positive rates of return makes Re 1 to be received at
any future point in time worth less than Re 1 in hand
today.
• This is what is meant by the time value of money.
The investor’s required rate of return is called the
discount rate.
• The term capital refers to wealth in the form of
money or property that can be used to produce
more wealth. The majority of engineering economy
studies involve commitment of capital for extended
periods of time, so the effect of time must be
considered.
• It is recognized that a rupee today is worth more than rupee one or
more years from now because of the interest (or profit) it can earn.
Therefore, money has a time value.
• Capital - people, machines, materials, energy, and
other things needed in the operation of an
organization
1. Equity capital is that owned by individuals who
have invested their money or property in a
business project or venture in the hope of receiving
a profit.
2. Debt capital, often called borrowed capital, is
obtained from lenders (e.g., through the sale of
bonds) for investment. In return the lenders
receive interest from the borrowers.
LENDERS
• do not receive any other benefits that may accrue from the
investment of borrowed capital.
• not owners of the organization and do not participate as fully as the
owners in the risks of the project or venture.
• lenders’ fixed return on the capital loaned, in the form of interest,
is more assured (has less risk) than the receipt of profit by the
owners of equity capital.
• If the project or venture is successful, the return (profit) to the
owners of equity capital can be substantially more than the interest
received by lenders of capital.

• However, the owners could lose some or all of their money

invested, whereas the lenders still could receive all the interest
owed plus repayment of the money borrowed by the firm.
• There are fundamental reasons why return to
capital in the form of interest and profit is an
essential ingredient of engineering economy
studies.
1. interest and profit pay the providers of capital for
forgoing its use during the time the capital is being
used.
• The fact that the supplier can realize a return on capital acts
as an incentive to accumulate capital by savings, thus
postponing immediate consumption in favor of creating
wealth in the future.
2. Interest and profit are payments for the risk the
investor takes in permitting another person, or an
organization, to use his or her capital.
• In typical situations investors must decide whether
the expected return on their capital is sufficient to
justify buying into a proposed project or venture.
• If capital is invested in a project, investors would
expect, as a minimum, to receive a return at least
equal to the amount they have sacrificed by not
using it in some other available opportunity of
comparable risk.
• This interest or profit available from an alternative
investment is the opportunity cost of using capital in
the proposed undertaking.
Thus, whether borrowed capital or equity
capital is involved, there is a cost for the
capital employed in the sense that the project
and venture must provide a return sufficient
to be financially attractive to suppliers of
money or property.
INTEREST
• manifestation of the time value of money
• the increase between an original sum of money
borrowed and the final amount owed, or the
original amount owned (or invested) and the
final amount accrued .
• Interest for past investments:
Interest = total amount now – original principal
• If the result is negative, you have lost money and there is
no interest.
• Interest for borrowed money in past:
Interest = amount owed now – original principal

• When interest is expressed as a percentage of the original amount

per time unit, the result is an interest rate.

Interest accrued per time unit

Percent interest rate = ------------------------------- x100%
Original amount
• Interest – Normally per year
• Interest rates may be expressed over periods of time shorter than 1
year, for example, 1% per month, the time unit used in expressing
an interest rate must also be identified. This period is called the
interest period.
EQUIVALENCE
• Different sums of money at different times are equal in
economic value
• E.g., if the interest rate is 6% per year, Rs 100 today (present
time) would be equivalent to Rs 106 one year from today.

Amount accrued = 100 +100(0.06) = 100(1+ 0.06) = Rs 106

• In addition to future equivalence, we can apply the same logic to
determine equivalence for previous years.
• If you have Rs 100 now, it is equivalent to Rs 100/1.06 = Rs 94.34
one year ago at an interest rate of 6% per year. From these
illustrations, we can state the following: Rs 94.34 last year, Rs 100
now, and Rs 106 one year from now are equivalent at an interest
rate at 6% per year.
Nominal interest is the annual interest rate without considering the effect of any
compounding.

Effective interest is the annual interest rate taking into account the effect of any
compounding during the year.

A bank may pay 1½% interest on the amount in a savings account every three
months. The nominal interest rate in this situation is 6%(4 x 1½% = 6%).
• Effective interest rate =(l + i)m – 1
where
i = Interest rate per interest period;
m = Number of compounding per year.

Example:
• A bank charges 1½% per month on the unpaid balance for
purchases made on its credit card. What nominal interest rate is it
charging? What effective interest rate?
• Solution:
The nominal interest rate is simply the annual interest ignoring
compounding,
Or 12(1½%) = 18%.
Effective interest rate = (1+0.015)12 – 1 = 0.1956 = 19.56%.
• The general relationship between the effective rate of interest and
the nominal rate of interest is as follows:

m
 k
 1 rateof interest
Where r =reffective 1
 rate
k = nominal mof interest
m = frequency of compounding per year
 Example
A bank offers 8 per cent nominal rate of interest with quarterly
compounding. What is the effective rate of interest?
The effective rate of interest is:

per cent.

4
 0.08 
1    1  0.0824  8.24
 4 
Future Value of a Single Amount
• The future value or compounded value of an investment after n
years when the interest rate is r per cent is

Fv  Pv1  r 
• Suppose you deposit Rs.1000/- today nin a bank that pays 10
per cent interestncompounded annually how much will the
deposit grow to after 8 years?

• = Rs.2,144/- 8
Fv8  10001  0.10 

Fv8  10002.144 
How long would it take to double
the amount at a given interest
rate?
•rule of thumb and it is called the rule of 72
• doubling period is obtained by dividing 72 by the interest rate
• if the interest rate is 8 per cent, the doubling period is about 9
years (72/8)
• more accurate rule of thumb is the rule of 69
• doubling period :
69
0.35 + ----------------
Interest Rate

• @10%, doubling period =

69
0.35 + ---- = 7.25 years
• 10
Finding the Growth Rate
• Suppose your company currently has 5,000
employees and this number is expected to grow
by 5 per cent per year. How many employees
will your company have in 10 years?

• The number of employees 10 years hence will be

5000 x (1+0.5)10 = 5000 X 1.629 = 8145.
XYZ limited had revenues of Rs.100 million in 1990
which increased to Rs.1000 million in 2000. What
was the compound growth rate in revenues? The
compound growth rate may be calculated as

100(1+g)10 = 1000

1000
(l + g)10 = ------- = 10
100

(1 + g) = 101/10

g = 101/10 – 1

g = 1.26 – 1 = 0.26 or 26%

Present value of a simple
amount
• The process of discounting is used for calculating the present
value, is simply the inverse of compounding.

• What in the present value of Rs.1000 receivable 6 years

PV  Fv(.0.565)
= Rs.1000 
hence if the rate of discount is 10 per cent.
n 1 / 1= r
n
Rs.565. 

PV  Rs1000 1 / 1  0.10
6

The present value of a cash flow stream – uneven or even – may be calculated
with the help of the following formula:

A A A n
At
Where PV
PVn  n = present
1
 value
2 of a cash
 ...  flow
n

stream
1  r  1  r 2
1  r  t 1 1  r 
n
At= cash flow occurring at the end of year t
t

r = discount rate
n = duration of the cash flow stream
• An annuity is a stream of constant cash flow
(payment or receipt) occurring at regular intervals of
time.
• The premium payments of a life insurance policy, for
example, are an annuity.
• When the cash flows occur at the end of each period,
the annuity is called an ordinary annuity or a deferred
annuity.
• When the cash flows occur at the beginning of each
period, the annuity is called an annuity due.
• Our discussion here will focus on a regular annuity –
the formulae of course can be applied, with some
modification, to an annuity due.
• the future value of an annuity is given by the following formula

 1ofan
Where FVAn = future value
r 1
annuity
n
 which has a duration of

FVA n  An periods 
r 

A = constant periodic flow 
r = interest rate per period
n = duration of the annuity
How Much Should You Save
Annually ?
• You want to buy a house after 5 years when it is
expected to cost Rs.2 million. How much should
you save annually if your savings earn a
compound return of 12 per cent?
• The future value interest factor for a 5 year annuity, given an
interest rate of 12 per cent, is:

FVIFA n  5, r 12% 
1  0.12   1
5
 6.353
0.12
The annual savings should be:
Rs.20000,000 = Rs.314,812
6.353

Present Value of an Annuity

 1  k n  1
PVA n  A n 
 k 1  k  

Where PVAn= present value of annuity which has a duration of n

periods
A = constant periodic flow
k = discount rate
Example
• A 10-payment annuity of Rs.5,000 will begin 7 years hence.
(The first payment occurs at the end of 7 years). What is the
value of this annuity now if the discount rate is 12 per cent?

This problem may be solved in two steps.

Step 1 Determine the value of this annuity a year before
the first payment begins,i.e. 6 years from now. This is equal
to

Rs.5,000 PVIFA12%,=10 Rs.5,000

 (5.650) = Rs.28,250

Step 2 Compute the present value of the amount obtained

in Step 1.

Rs.28,250 PVIFA12%,=6 Rs.28,250 (0.507) = Rs.14,323.

 Capital Budgeting
Long-Term Investment Decisions
and
Risk Management
 Long-Term Investment Decisions and Risk
Management
ECONOMIC, POLITICAL, AND SOCIAL
ECONOMIC ANALYSIS AND
ENVIRONMENT
DECISIONS
1. Business Conditions (Trends, Cycles and
1. Demand Analysis and
Seasonal Effects
Forecasting
2. Factor Market Conditions (Capital,
2. Production and Cost Analysis
Labour, Land and Raw Materials)
3. Pricing Analysis
3. Competitors’ Response
4. Capital Expenditure Analysis
4. External, Legal and Regulatory Constraints
5. Organizational (Internal) Constraints

Cash Flows Risk

Firm Value
(Shareholders’ Wealth)
• Investment analysis (capital budgeting) is the
process of planning for the purchases of assets
whose returns (cash flows) are expected to continue
beyond one year.
• When making capital budgeting decisions, the
managers of a firm are committing the firm’s
resources to the expansion of its productive capacity,
an improvement in its cost efficiency, are a
diversification in its asset base.
• Each of these decisions has important implications
for the future cash flows the firm can be expected to
generate and the risk of those cash flows.
• Capital Expenditures are a bridge between the short-term price
and output determination decision facing managers daily and the
long-term strategic decisions that wealth maximizing managers
must make to remain competitive.
• Public sector managers use the techniques of cost-benefit analysis
and cost-effectiveness analysis when analyzing many long-term
resource-allocation decisions.