Financial

Management -
An Overview
UNIT 2 TIME VALUE OF MONEY

Objectives:

The objectives of this unit are to:

• Explain and illustrate the concepts of future value, time value of money.
• Illustrate the computation of future value and the present value of
money.
• Application of time value of money in financial decisions.

Structure:
2.1 Introduction
2.2 Future Value
2.3 Calculation of Future Value
2.4 Present Value vs. Future Value
2.5 Time Value of Money and its Significance
2.6 Calculation of Time Value of Money
2.7 Financial Decisions - Time Value of Money
2.8 Summary
2.9 Key Words
2.10 Self-Assessment Questions.
2.11 Further Readings

2.1 INTRODUCTION
You must have heard that a rupee today is worth more than a rupee
tomorrow. Do you know why is it so? Now, let us take an example. Sriram's
grandfather decided to give a gift of Rs. One lakh at the end of the fifth year;
and gave him a choice of having Rs. 75,000 today. Had you been in Sriram's
place what choice would you have made?
Do you accepted Rs. 1,00,000 after five years or Rs. 75,000 today? What do
you say? Rs. 75,000 today is much more attractive than Rs. 1,00,000 after
five years because the present is more certain than the future. You could
invest Rs. 75,000 in the market and earn a return on this amount. Rs.
1,00,000 at the end of five years would have less purchasing power due to
inflation.
We hope you got the message that a rupee today is worth more than a rupee
tomorrow. But the matters of money are not so simple. The time value of
money concept will unravel the mystery of such choices that all of us face in
our daily life.
In our day-to-day life, several investment decisions involve cash flow
occurring at different points in time. Therefore, recognition of the time value
24 of money is very important.
In this unit, you will learn about the time value of money and how it is Time Value of
Money
calculated.

2.2 FUTURE VALUE

Future value (FV) is the value of a current asset at a future date based on an
assumed rate of growth. The future value is important to investors and
financial planners, as they use it to estimate how much an investment made
today will be worth in the future. Knowing the future value enables investors
to make sound investment decisions based on their anticipated needs.
However, external economic factors, such as inflation, can adversely affect
the future value of the asset by eroding its value.
Determining the FV of an asset can become complicated, depending on the
type of asset. Also, the FV calculation is based on the assumption of a stable
growth rate. If money is placed in a savings account with a guaranteed
interest rate, then the FV is easy to determine accurately.
To understand the core concept, however, simple and compound interest
rates are the most straightforward examples of the FV calculation.Future
value is what a sum of money invested today will become over time, at a
given rate of interest.

2.3 CALCULATION OF FUTURE VALUE

There are two types of future value calculations:
• The “future value of a lump sum” is the value of a single deposit, like a
bank fixed deposit over time.
• The “future value of an annuity” is the value of a series of payments, like
payment of insurance premium at regular intervals, over time. The term
"annuity" refers to a series of payments of constant amounts.
The easiest way to calculate future value is to use one of the many free
calculators on the internet, or a financial calculator app such as the HP 12C
Financial Calculator available on Google Play and in the Apple App Store.
Most spreadsheet programs have future value functions as well, but for the
purpose of this course we are going to refer to present value, future value and
annuity tables which are provided in this course.
The FV formula assumes a constant rate of growth and a single up-front
payment left untouched for the duration of the investment. The FV
calculation can be done one of two ways, depending on the type of interest
being earned.

i) Using Simple Annual Interest

If an investment earns simple interest, then the FV formula is:
�� = � × (1 + � × �)
Where,
FV= Future Value
25
Financial
Management - P = Principal amount or Investment Amount
An Overview R = Interest rate
T = Number of years
FV= Future value or final amount
For example, assume a Rs.1,000 investment is held for five years in a
savings account with 10% simple interest paid annually.
In this case, the FV of the Rs.1,000 initial investment is Rs1,000 × [1 +
(0.10 x 5)], or Rs.1,500.

ii) Compounded Annual Interest

With simple interest, it is assumed that the interest rate is earned only on
the initial investment. With compounded interest, the rate is applied to
each period’s cumulative account balance.
In the example above, the first year of investment earns 10% ×
Rs.1,000, or Rs.100, in interest. The following year, however, the
account total is Rs.1,100 rather than Rs.1,000; so, to calculate
compounded interest, the 10% interest rate is applied to the full balance
for second-year interest earnings of 10% × Rs.1,100, or Rs.110.
The formula for the FV of an investment earning compounding interest
is:
�� = � × (1 + �)�
Where,
P = Principal amount or Investment amount
R = Interest rate
t = Number of years
Using the above example, the same Rs.1,000 invested for five years in a
savings account with a 10% compounding interest rate would have an FV of
Rs.1,000 × [(1 + 0.10)5], or Rs.1,610.51.

Future Value of an Annuity Example

A common use of future value is planning for a financial goal, such as
funding a retirement savings plan. Future value is used to calculate what you
need to save and invest each year at a given rate of interest to achieve that
goal.
In general terms the future value of an Annuity is given has the following
formula:

���� = �[(1 + �)� − 1]/�

Where,
���� = Future Value of annuity
�= Constant Periodic flows
�= Interest rate period
�= duration of annuity
26
Example 1 Time Value of
Money
If you contribute Rs. 2,400 every year to a retirement account and want to
calculate what that account will be worth in 30 years; you could use the
future value of an annuity formula. For this example, you assume a 7%
annual rate of return:

�� = ��. 2,400 × [(1 + 0.07)�� − 1]/0.7

��. 2,400 × [7.612 − 1]/0.7
��. 2,400 × 94.461
��. 226,706
Over 30 years, you would contribute a total of Rs. 72,000, but because of the
time value of money and the power of compounding interest, your account
would be worth Rs. 226,706 (with an annual 7% rate of return), or more than
three times the amount you invested.
Future value is also useful to decide the mix of stocks, bonds, and other
investments in your portfolio. The higher the rate of interest, or return, the
less money you need to invest to reach a financial goal. Higher returns,
however, usually mean a higher risk of losing money.
The term [(1 + �)� − 1]/� is referred to as the future value interest factor for
an annuity(������,� ) and the value of this factor for several combinations of
r and n can be found out from the annuity table.

Activity-2.1
1) What do you mean by Future value?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
2) You have deposited Rs. 10,000 in a fixed deposit in a bank at a 6% rate
of interest. How much will you get after 5 years?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

2.4 PRESENT VALUE Vs. FUTURE VALUE

We can also measure the present value of money which is going to be
received in future. Using it, you can calculate the worth of something today
when you know its value in the future. This process is also referred to as
"discounting" because, for any positive rate of return, the present value will
be less than what it is worth in the future. 27
Financial
Management - The interest rate used to calculate the present value of a future return cash
An Overview flow is called the "discount rate." To illustrate present value, let’s look at a
example. The future value of Rs. 1,000 deposited for one year into an account
earning an annual 2% interest rate is Rs. 1,020:
FV = 1000 × (1+.02)1 = Rs. 1,020
We also know that the present value of that Rs. 1,020 is Rs. 1,000 because
it’s what we started with. Present value is the mirror image of future value.
The relationship between Present Value and Future Value
� �
�� = ��� �(���)��. The factor (���)�
is called the discounting factor or the
present value interest factor (�����,� ).

Some common uses for present value include:

• Calculating the value of pension annuity payments versus taking a lump

sum
• Determining whether a business owner’s investment will meet profit
expectations.
• Valuing a business

2.5 TIME VALUE OF MONEY AND ITS

SIGNIFICANCE
The time value of money is very important to all for financial planning, from
the decision you make to buy or lease an asset to a financial decision to invest
in new equipment. The future value determines the effect of time on money.
Using future value and other measures can help you make sound financial
decisions.
From the standpoint of financial management, the importance of time value
of money can be seen as follows:
i) For expansion and growth companies deploy a mix internal funds (equity
and retained earnings) and external funds (debt). The time value of
money will assist us in determining the impact and effect of debt owed
by businesses on earning and profits.
ii) Because the future is unknown, the time value of money is essential for
managing funds and generating profits from a corporation.

The time value of money is significant because it can aid in financial

decision-making. An investor, for example, has the option of choosing
between two projects: Project ‘A’ and Project ‘B’.The only difference
between the two initiatives is that Project ‘A' promises Rs.1 million cash
reward in year one, while Project ‘B' promises Rs.1 million cash payout in
year five. If the investor does not grasp the time value of money, both
projects may appear to be equally appealing.In reality, because Project ‘A'
has a higher present value than Project ‘B,' the time value of money mandates
that Project ‘A' is more appealing.
28
 Time Value of
2.6 CALCULATION OF TIME VALUE OF MONEY Money

The Time Value of Money can be calculated in two ways. The following
formula can be used to calculate the present value (PV) of future cash flows:

�� = �� × (1 + �)�� or FV= PV × (1+r)n

Where:
PV — Present Value.
FV — Future Value.
r — interest rate.
n — number of periods.

Notice the negative sign of the power n which allows us to remove the
fractions from the equation.The following formula allows us to calculate the
future value FV) of cash flow from its present value.

�� = �� × (1 + �)�
Where:
FV — Future Value.
PV — Present Value.
r — interest rate.
n — number of periods.

Effect of Compounding Periods on Future Value

The number of compounding periods used in time value of money estimates
can have a significant impact. If the number of compounding periods is raised
to quarterly, monthly, or daily in the Rs.10,000 example above, the
concluding future value calculations are:
• Quarterly Compounding: FV = Rs. 10,0000 × [1 + (10%/4)]�×� =
Rs. 11,038
• Monthly Compounding: FV = Rs. 10,0000 × [1 + (10%/12)]��×� =
Rs. 11,047
• Daily Compounding: FV = Rs. 10,0000 × [1 + (10%/365)]���×� =
Rs. 11,052
This demonstrates that the time value of money is determined not just by the
interest rate and time horizon, but also by the number of times the
compounding computations are performed each year.
In cases where we have more than one compounding period of interest per
year, we can tweak the formula, to make sure we are using the appropriate
portion of annual interest:
� ��
�� = �� × �1 + �
�
Where:
29
Financial
Management - FV — Future Value.
An Overview
PV — Present Value.
r— interest rate (annual).
n— no. of periods (years).
t— no. of compounding periods of interest per year. If it is quarterly
t=4, for half yearly t=2 and for monthly t=12.
The time worth of money is a key concept in determining Net Present Value
(NPV), Compound Annual Growth Rate (CAGR), Internal Rate of Return
(IRR), and other financial calculations.

The general formulas of the concept can be applied to any series of cash
flows. One can use financial calculators or a spreadsheet program like Excel
to calculate the metrics surrounding the time value of money. One can learn
more about business functions or look for the following specific ones in the
office Excel - PV, FV, IRR, NPV.

Selecting the appropriate rate of return is one of the most important aspects of
the time value of money assessments (discount rate). Apart from interest on
the debt, the Weighted Average Cost of Capital is a popular rate option
(WACC). It is critical to understand that making the wrong rate decision will
almost certainly ruin the entire procedure rendering it meaningless and can
have a severely adverse impact on our decision-making process.
In practice, there are two sorts of the time value of money notions, which are
described below:
i) Time Value of Money for a One-Time Payment
You invest INR 10000 for 5 years in a bank that offers 10% annual interest.
You allow it to grow cumulatively.
After 5 years, you will have accumulated a total value of Rs.16,110.
The question now is whether Rs.10,000 is worth more than Rs.16,110. This is
dependent on the rate of inflation, interest rate, and risk involved. It is a loss
if the inflation rate rises. If the interest rate falls, then it is a gain.

ii) Time Value of Money -Doubling the Period

To calculate when the amount of money will double, consider another
scenario. The rule of 72 is used to estimate the doubling period. Doubling
period can be estimated by dividing 72 by interest rate. This is also known as
rate of 72. For example, if you invest Rs. 10,000 for 5 years at an interest rate
of 8%, it will take 9 years to double the present value of your money.
Example-1: Assume a sum of Rs.10,000 is invested for one year at 10%
interest. The future value of that money is:

�� = ��. 10,0000 × [1 + (10%/1)�×� = ��. 11,000

The formula can also be altered to get the present-day value of the future
total. For instance, the value of Rs.5,000 to be received after year's time,
compounded at 7% interest, is:
30
 ��. 5,0000 Time Value of
�� = = ��. 4,673 Money
[1 + (7%/1)�� ]
Example-2:
We will use the following example to demonstrate the notion of the time value
of money. We intend to invest in a machine that will provide us with annual
cash flow of Rs. 38,500 for the next ten years. The device will cost Rs.
2,50,000 to purchase, and after its useful life has expired, we will be able to
sell it for Rs. 1,40,000.

Time Value of Money – NPV Calculation (in Rs)

Investment Opportunity
Initial CAPEX 2,50,000
Annual Benefit 38,500
Resale value of an asset after 10 years 1,40,000

We can build a simple schedule to represent our cash flows per period. To
keep the example, compact we will assume inflation is at 0% over the period.
We start with the initial CAPEX and list the cash benefit per annum.

Year 0 1 2 3 4
31.12.2019 31.12.2020 31.12.2021 31.12.2022 31.12.2023
Cash out-flows (250,000)
(investment)
Cash in-flows (incl. 38,500 38,500 38,500 38,500
release value)
Net cash flow (2,50,000) 38,500 38,500 38,500 38,500

5 6 7 8 9 10
31.12.2024 31.12.2025 31.12.2026 31.12.2027 31.12.2028 31.12.2029 Total
(2,50,000)
38,500 38,500 38,500 38,500 38,500 38,500+1,40,000 3,80,500
38,500 38,500 38,500 38,500 38,500 1,78,500 5,25,500

At the end of our table, cash inflow at the end of 10th year is Rs. 1,78,500
which includes Rs. 1,40,000 of resale of assets.

When we look at it in absolute terms, we can see that we will get back twice
as much as we put in throughout the years. However, we must include the
Time Value of Money to get a clearer understanding.

The company's Weighted Average Cost of Capital (WACC) can be used as a

discount rate because it best represents the enterprise's real cost of capital. We
can now compute the Net Present Value of the cash flows using Excel's more
advanced NPV calculation.

Discount Factor (WACC) 10 %

Net Present Value (NPV) 40,622.5

31
Financial
Management - The cash flows of Rs.38,500 here can be considered as an annuity of 10 years
An Overview of Rs.38,500 and the resale value of Rs.1,40,000 is to be discounted to the
present value.
Here we have to find the present value of an annuity of Rs.38,500 of 10 years
tenure value occurring after 10 years. Here the discount factor is going to be
the weighted average cost of capital (WACC) which is 10%.
Now putting the values in the formula
� �/�
Present value of annuity = � �1 − ����� �

� �/�
Where �1 − ����� � is the present value interest factor from annuity
(������,� ). This value can be found from the present value interest factor for
annuity for 10% discount rate and 10 years, and is 6.145. Therefore, present
value of annuity of Rs.38,500 would be 6.145 × 38,500 = 2,36,582.50.
Now let us find the present value of Rs.1,40,000 going to be received ten
years hence from now.
The present value in first factor for discount rate of 10% for 10 years is 0.386,
therefore present value of Rs.1,400,000 is going to be:

1,40,000 × .386 = 54,040

The present value of cash flows would be Rs. 2,36,582.50 + Rs. 54,040= Rs.
2,90,622.50
The net present value would be:
2,90,622.5 – 2,50,000 = 40,622.5
Since NPV is positive investment can be accepted.

Example-3: Present Value of Uneven Cash Flows:

You may often get uneven cash flow streams. An example is a dividend on
equityshares. Aman invests in a mutual fund that promises followingcash
flows for five years. The discount rate is 10%. Find the present value.
Year Cash flow (Rs.)
1 1,000
2 2,000
3 2,000
4 3,000
5 3,000

First, see the present value table to the present value factor.

Year Cash flows (Rs.) P.V. factor P.V. of each cash flow (Rs.)
1 1,000 0.9091 909.1
2 2,000 0.8264 1652.8
32
 Time Value of
3 2,000 0.7513 1502.6 Money
4 3,000 0.6830 2049.0
5 3,000 0.6209 1862.7
Total P.V. Rs. 7,976.2

Example-4: Perpetuities:
When the cash flow is for an indefinite period, it is called perpetuity or
CONSOLS. It is a special type of annuity. Its present value can be found by
dividing cash flow by discount rate (Cash flow1 Discount rate). For example,
if you get an offer of a perpetual cash flow of Rs 1000 every year and the
return required is 16%.

The value of the perpetuity will be (1000/0.16) = Rs. 6250

It means if Rs, 6250 is invested at a 16% rate of interest, it would provide a

yearly income of Rs. 1,000 every year.

Activity-2.2:
At the end of one, two, three, four and five years, an investor can expect to
receive Rs.1,000, Rs.1,500, Rs.800, Rs.1,100, and Rs.400, respectively. If the
investor's interest rate is 8%, what is the present value of this stream of
irregular cash flows?
............................................................................................................................
............................................................................................................................
............................................................................................................................
............................................................................................................................

2.7 FINANCIAL DECISIONS - TIME VALUE OF

MONEY
The discounted cash flow analysis (DCF), which is one of the most common
and prominent approaches for appraising investment proposals, is based on
the time value of money. It is also a necessary component of financial
planning and risk management. It would be quite difficult to find a single
key sector of finance that is not touched by the time value of money in some
way.

The value of money is time-dependent, and is a fundamental principle in

finance. The value of money received today is not the same as the worth of
money received at a later date. The principle is based on the reality that we
can invest and earn a return on what we receive today. For example, if you
choose between Rs 100 now and Rs 100 in a year, Rs 100 now has more
temporal value because it can be invested at a 10% rate of interest and
receive a return of Rs 10. After a year, Rs 100 becomes Rs 110.

a) Investment Decision: Investment decision involves current cash outlay

for an expected stream of cash inflows in the future. 33
Financial
Management -
Time to t1 t2 ……......... tn
An Overview
cash Current cash cash cash
flows Cash outlay (Co) inflow inflow inflow

The cash flows (outflows and inflows) take place at various times. As a
result, they are not comparable. The present value of all cash inflows is
calculated by discounting the cash inflows to get the time value of
money. The PV of cash inflows is then compared to the current cash
outlay or project cost.
For Example, A project costs Rs.1,00,000. It is expected to provide cash
inflows as follows for 3 years. The company’s cost of capital or required
rate of return is 15%. Whether the project is acceptable?
Year 1 2 3
Cash Inflows Rs. 40,000 Rs. 50,000 Rs.30,000

Solution:
PV of Cash inflows = PV of Rs 40,000 + PV of Rs 50,000 + PV of Rs 30,000
= [40,000 × 0.870] + [50,000 × 0.756] + [30,000 × 0.658]
= Rs 34,800 + Rs 37,800 + Rs. 19,740
= Rs. 92,340
The present value of cash inflows in this example is Rs 92,340, whereas
the project cost is Rs 1 lakh. The project is not acceptable since the
benefits are smaller than the costs.

b) Financing Decision: When a business issues a debenture, it receives

immediate cash flow. At the end of each year, interest payments (cash
outflows) are due. The debenture amount is redeemed after the period.
As a result, cash inflows come first, followed by cash outflows in the
financing choice.
Time to t1 t2 . . . . . . . . . . . . tn

These cash flows cannot be compared because they occur at separate times.
Finding the discounted value (present value) of interest payments and the
redemption value is used to calculate the time value of the payment. The
present value of cash outflows is compared to the debenture selling value,
and a decision is made on whether to issue debentures.

2.8 SUMMARY
In estimating the intrinsic value of shares and investment opportunities in
companies and projects, the Time Value of Money idea is critical. Almost
every piece of advice ever made, even if the person making it is not aware of
it, is based on the time value of money notion. As a result of this principle, we
understand that the earlier we begin investing, the better.Investing works
because of the benefit of receiving money now rather than later, which is
34
based on temporal preference. Finally, the concept of money's time value has Time Value of
Money
been articulated.

2.9 KEY-WORDS
Future Value: The value at some future time of a present amount of money,
or a series of payments, evaluated at a given interest rate.
Net Present Value: The Present Value of an investment project’s net cash
flows minus the project’s initial cash outflow.
Present Value: The current value of a future amount of money, or a series of
payments, evaluated at a given interest rate.
Price/Earnings Ratio (P/E): The market price per share of a firm’s common
stock dividend by the most recent 12 months of earnings per share.
Compound Interest: Interest paid on any previous interest earned, as well as
on the principal borrowed.

2.10 SELF-ASSESSMENT QUESTIONS

1 What do you mean by the Time Value of Money?
2 Explain the relevance of the Time Value of Money in financial decision-
making.
3 Suppose you invest Rs.1,000. This first year the investment returns 12%,
the second year it returns 6%, and the third year in returns 8%. How
much would this investment be worth, assuming no withdrawals are
made?
4 Mr. Harry has just bought a lottery ticket and won Rs. 10,000. He wants
to finance the future study of his newly born daughter and invests this
money in a fund with a maturity of 18 years offering a promising yearly
return of 6%. What is the amount available on the 18th birthday of his
daughter?
5 Given the uneven streams of cash flows shown in the following table,
answer parts (a) and (b):

Cash Flow Stream (in Rs.)

End of Year A B
1 50,000 10,000
2 40,000 20,000
3 30,000 30,000
4 20,000 40,000
5 10,000 50,000
Total 1,50,000 1,50,000

a) Find the present value of each stream, using a 15 percent discount rate.
35
Financial
Management - b) Compare the calculated present values, and discuss them because the
An Overview undiscounted total cash flows amount to Rs.150,000 in each case.

2.11 FURTHER READINGS

1. Chandra, Prasanna. 2019, Financial Management, Theory and Practice,
Mc Graw-Hill, New Delhi
2. Pandey. I.M., 2021, Financial Management, Pearson Education India,
New Delhi
3. Sheridan Titman, Arthur J. Keown, and John D. Martin, 2019, Financial
Management: Principles and Applications, Pearson Education India,
New Delhi.
4. M.Y. Khan. M. Y and Jain. P.K., 2018, Financial Management,
McGraw Hill Education, New Delhi
5. Eugene F. Brigham, Joel F. Huston, 2018, Fundamental of Financial
Management, Cengage Learning India, New Delhi.
6. Richard Brealey, Stewart Myres & Franklin Allen, 2019, Principles of
Corporate Finance, Mc Graw Hill, New Delhi .

36