CORPORATE FINANCE

TIME VALUE OF MONEY

PREPARED BY:

ZUBAIR ARSHAD
Phd Scholar, MS/MPHIL (COMMERCE), M.COM, DIP.FM, ACFA
http://www.facebook.com/zubair.arshad6
0321-9405067

PU
 TIME VALUE OF MONEY

TIME VALUE OF MONEY

In simple terms TVM can be defined as Money loses its value with the passage of time. i.e. the
money we have today will not have the same value after some time.
Discounted cash flow (DCF) techniques take into account this time value of money when
appraising the new project.
TVM exists primarily due to following factors (may also be called components of TVM):
1. Inflation
2. Opportunity to invest/ Potential for earning interest
3. Uncertainty/ Risk

TIME LINE
A horizontal line on which time zero appears at the leftmost end and future periods are marked
from left to right can be used to depict investment cash flow.

CASH FLOW
Cash flow is the movement of money into or out of a business, project, or financial product. It is
usually measured during a specified, limited period of time. Measurement of cash flow can be
used for calculating other parameters that give information on a company's value and situation.
Cash flow can be used, for example, for calculating parameters: it discloses cash movements
over the period

DCF ASSUMPTIONS
Having learnt the basic calculation of NPV and IRR and their decision rules, now we will
learn how to extract data from a descriptive case study and summarize it in period-wise net
cash flows, which were made available to us in our project A and B.
First thing to learn is DCF assumptions, which are following:
1. Initial investment is taken at zero (immediate or today) unless told otherwise

2. Cash flows which arise during any year are assumed to have arisen at the end of that
year. Thus if we are told that we will receive $ 20,000 during 3rd year, on a time line
(table) it shall be placed in front of 3, which mean after 3 year from today and so on.

3. Cash flows which arise at the start of any year are assumed to have arisen at the end
of previous year. Thus if we are told that we will receive $ 30,000 at the start of 5th
year, then the cash flow shall be placed in front of 4th year and so on.

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BASIC PATTERNS OF CASH FLOW

Both inflow and outflow of a firm can be described by its general pattern. It can be defined as a
single amount, a mixed stream, or an annuity.

SINGLE AMOUNT A lump-sum amount either currently held or expected at some future
date.

MIXED AMOUNT More than one amount of cash flows for different time scale.

ANNUITY AMOUNT Annuity is fixed amount of money paid/received regular interval for
define period.

SINGLE AMOUNT
A lump-sum amount either currently held or expected at some future date.
Example: $10,000 to day investment, $ 23,000 received after 5 year.

INTEREST
Simple interest
Compound interest

SIMPLE INTEREST
Simple interest is calculated based on the original sum invested. Any interest earned in earlier
periods is not included. Simple interest is often used for a single investment period that is less
than a year.
To calculate the future value of an amount invested under simple interest situation the following
formula can be used:
FV = PV + (PV x r x n ) number of periods

Future Value Principle Amount interest Rate

COMPOUND INTEREST
Compounding calculates the future value of a given sum invested today for a number of years.
To compound a sum, the figure is increased by the amount of interest it would earn over the
period. Interest is earned on interest gained in earlier periods.
Future value can be calculated by using the following formula:
FV = PV (1 + r)n number of periods

Future Value Present Value interest rate

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EXAMPLE: 1
$5,000 is invested in an account for five years. The interest rate 10% per annum. Calculate the
value of the account after five years.
EXAMPLE: 2
$650 is invested now at the rate of 6.25% per annum. Calculate the value after 12 years.

EXAMPLE: 3
How much money we receive in 5 years time if we invest $10,000 today in a bank at 10% p.a.?

EXAMPLE: 4
Calculate the value of $ 38,000 invested for 7 years at 5% per annum?

Personal Finance Example 5.2

MIXED AMOUNT
More than one amount of cash flows for different time scales.

EXAMPLE: 5
Year Project A Project B If Company want 10% interest
$ $ Calculate accumulate return at
1 5,500 3,500 the end of project.
2 4,700 3,200 If
3 (2000) 2,900 1. Cash flow received at
4 4,000 1,500 end of year
5 4,000 2. Cash flow received at
start of year.

EXAMPLE: 6
Year Cash flow
$ If Company want 8% interest
1 11,500 Calculate accumulate return after 5 year.
2 14,000 If
3 12,900 1. Cash flow received at end of year
4 16,000 2. Cash flow received at start of year.
5 18,000

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ANNUITY
Annuity is a series of cash flow, having all the following 3 characteristics:
i. Even (equal) cash flows
ii. Occurring at regular intervals AND
iii. for definite (defined) period of time
For example we are told that we will $ 1,000, every year for three years, then this series of cash
flow is an annuity, whose value is $ 1,000 (annual cash flow) and period is 3.

TYPES OF ANNUITY
There are three types of annuity and their PV is calculated by applying the definitions of Annuity
Factor as described above
Normal annuity: Delayed annuity: Advance annuity:
(ordinary) (annuity due)
Definition Series of cash flows Series of cash flows Series of cash flows
having all the three having all the three having all the three
characteristics and characteristics and characteristics and
starting after 1 year starting beyond 1 year starting immediately.
from today. (i.e. 2, 3, or onwards)
from today.
For Example
Year $ $ $
0 0 0 1000
1 1000 0 1000
2 1000 1000 1000
3 1000 1000 1000
4 1000 1000 1000
5 1000 1000
6 1000

FUTURE VALUE OF ANNUITY CASH FLOW

NORMAL ANNUITY: (ORDINARY)

Formula to calculate future value of ordinary annuity cash flow is as follows;

EXAMPLE: 7
Calculate the future value of an annuity of $ 8,000 per annum for 5 years starting 1 year from
now the cost of capital in 17% per annum.

EXAMPLE: 8
Calculate the FV of an annuity of $ 15,000 per annum for 8 years starting 1 year from now the
cost of capital in 8% per annum.

Personal Finance Example 5.7

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ADVANCE ANNUITY: (ANNUITY DUE)

Formula to calculate future value is as follows;

EXAMPLE: 9
Calculate the FV of an annuity of $ 11,000 per annum for 5 starting immediately the cost of
capital in 10% per annum.

EXAMPLE: 10
Calculate the FV of an annuity of $ 16,000 per annum for 7 years starting immediately the cost
of capital in 16% per annum.

Personal Finance Example 5.7

COMPOUNDING & DISCOUNTING

Compounding calculates the future sum (Future Value-FV) that we will get if we invest some
money in present (Present Value-PV) at given investment rate, for certain period of time.

Compounding

Present Future
Time Line

Discounting

Discounting is the technique which shall solve our problem and enable us to apply DCF for
investment appraisal. Discounting is opposite to compounding.

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SINGLE AMOUNT

As mentioned earlier, DISCOUNTING estimates that how much a cash to be received in future
is worth now? and it can be calculated by simply rearranging the compounding formula
introduced above:

PV = FV x OR PV = FV x (1 + r)-n
(+ )

EXAMPLE: 11
What should be invested NOW to receive $10,000 in 4 years time if r = 8% per annum?

EXAMPLE: 12
What is the PRESENT VALUE of $ 115,000 receivable in 9 years time if r = 6% p.a.?

EXAMPLE: 13
What is the today value of $ 15,000 receivable in 19 years time if r = 16.5% p.a.?

EXAMPLE: 14
What should be invested NOW to receive $13,000 in 3years time if r = 18.25% per annum?

Personal Finance Example 5.4

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MIXED AMOUNT
More than one amount of cash flows for different time scales.

EXAMPLE: 15
Year Project A Project B
$ $ If Company want 10% interest
1 5,500 3,500 Calculate present value of cash
2 4,700 3,200 flow. If
3 (2000) 2,900 1. Cash flow received at end
4 4,000 1,500 of year
5 4,000 2. Cash flow received at
start of year.

EXAMPLE: 16
Year Cash flow If firm required earning 8% on
$ its investment, what is the present
1 11,500 value at the end of year 5. If
2 14,000 1. Cash flow received at end
3 12,900 of year
4 16,000 2. Cash flow received at start
5 18,000 of year.

PRESENT VALUE OF ANNUITY CASH FLOW

NORMAL ANNUITY: (ORDINARY)

Formula to calculate present value (PV) of ordinary annuity cash flow is as follows;

EXAMPLE: 17
Calculate the PV of an annuity of $ 8,000 per annum for 5 years starting 1 year from now the
cost of capital in 17% per annum.

EXAMPLE: 18
Calculate the PV of an annuity of $ 15,000 per annum for 8 years starting 1 year from now the
cost of capital in 8% per annum.

Example5.8

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ADVANCE ANNUITY: (ANNUITY DUE)

Formula to calculate present value is as follows;

EXAMPLE: 19
Calculate the PV of an annuity of $ 11,000 per annum for 5 starting immediately the cost of
capital in 10% per annum.

EXAMPLE: 20
Calculate the PV of an annuity of $ 16,000 per annum for 7 years starting immediately the cost
of capital in 16% per annum.

Example5.8

COMPOUNDING INTEREST MORE FREQUENTLY THAN ANNUALLY

Interest is often compounded more frequently than one a year. Savings institutions compounding
interest semiannually, quarterly, monthly, weekly, daily, or even continuously.
There are two methods to calculate of frequently compound interest.
1. With the help of table
Beginning principle Total amount at
Period Interest amount
amount end of period

2. With the use of formula

Hence
FV Future Value
PV Present Value
.r Interest rate
.m Number of times per year interest is compound
.n Number of year

SEMIANNUAL COMPOUNDING
Of interest involves two compounding periods within the year. Instead of the stated interest rate
being paid once a year, one-half of the stated interest rate is paid twice a year.
EXAMPLE: 21
Fred Moreno has decided to invest $100 in a savings account paying 10% interest compounded
semiannually. (If he leaves his money in the account for 24 months (2 years), he will be paid
5% interest compounded over four periods, each of which is 6 months long.)

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1. With the help of table

Beginning principle Total amount at
Period Interest amount
amount end of period
6 month
12 month
18 month
24 month
2. With the use of formula

EXAMPLE: 22
Fred Moreno has decided to invest $100 in a savings account paying 8% interest compounded
semiannually. Calculate the future value for semiannually and at the end of two year.

QUARTERLY COMPOUNDING
Quarterly compounding of interest involves four compounding periods within the year. One-
fourth of the stated interest rate is paid four times a year.

EXAMPLE: 23
Fred Moreno has found an institution that will pay him 10% interest compounded quarterly. (If
he leaves his money in this account for 24 months (2years), he will be paid 2.5% interest
compounded over eight periods, each of which is 3 months long.)
1. With the help of table
Beginning principle Total amount at
Period Interest amount
amount end of period
3 month
6 month
9 month
12 month
15 month
18 month
21 month
24 month
2. With the use of formula

EXAMPLE: 24
Fred Moreno has found an institution that will pay him 8% interest compounded quarterly.
Calculate the future value for each of 3 month and at the end of two year.

Note: if the interest are compound monthly m=12, weekly m=52, or daily m=365.

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NOMINAL INTEREST RATE

Nominal interest rate is the interest rate expressed as per annum figure, e.g. 12% pa nominal
even though interest may be compounded over periods of less than one year.

EFFECTIVE INTEREST RATE

The annual interest is the rate per day or per month that is adjusted to give an annual rate. The
following formula can be used to convert the nominal interest rate into effective annual interest
rate.

EXAMPLE: 25
A bank adds interest monthly to investors account even though interest rates are expressed in
annual terms. The current rate of interest is 12%. Fred deposits $2,000 on 1 July. How much
interest will have been earned by 31 December (to the nearest $)?

EXAMPLE: 26
A company has $500,000 to invest for 2 years.
The choices available are;
A deposit account offering interest at 10% per year, with interest calculated quarterly.
A deposit account offering interest at 10.25% per year, with interest calculated annually.
Which deposit account gives the best return?
Personal Finance Example 5.19

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SPECIAL APPLICATIONS OF TIME VALUE

Future value and present value techniques have a number of important applications in finance.
Well study four of them in this section: (1) deposits needed to accumulate a future sum, (2) loan
amortization, (3) interest or growth rates, and (4) finding an unknown number of periods.

DEPOSITS NEEDED TO ACCUMULATE A FUTURE SUM

Following formula use to find out amount deposits needs to accumulate a future value.

EXAMPLE: 28
A person wants to buy a house 5 years from now, and estimate that an initial down payment of
$20,000 will be required at that time. To accumulate the $20,000, person will wish to make equal
annual end-of-year deposits into an account paying annual interest of 6 percent.
Calculate the size of annuity will result in a single amount equal to $20,000 at the end of year 5.

EXAMPLE: 29
ABC company wants to by a plant 7 years from now, and company estimate that an initial down
payment of $3.5 million will be required at that time. To accumulate the $3.5 million, company
will wish to make equal annual end-of-year deposits into an account paying annual interest of 8.5
percent.
Calculate the size of annuity will result in a single amount equal to $3.5 million at the end of
year 7.

LOAN AMORTIZATION
The determination of the equal periodic loan payments necessary to provide a lender with a
specified interest return and to repay the loan principal over a specified period.
Following formula used to find out equal periodic loan payments.

EXAMPLE: 30
Person borrow $5,000 at 10 percent and agree to make equal annual end-of-year payments over
5years. Calculate the size of the payments.

EXAMPLE: 31
Person borrow $15,000 at 6.5 percent and agree to make equal annual end-of-year payments over
7 years. Calculate the size of the payments.

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LOAN AMORTIZATION SCHEDULE

Lenders use a loan amortization schedule to determine these payment amounts and the allocation
of each payment to interest and principal.

Principle
End of Amount Loan Interest Principle Principle
year (Beginning of Payment Payments Payments (End of year)
year)
1
2

EXAMPLE: 32
Person borrow $5,000 at 10 percent and agree to make equal annual end-of-year payments over
5years. Developed loan amortization schedule?

Principle
End of Amount Loan Interest Principle Principle
year (Beginning of Payment Payments Payments (End of year)
year)
1
2
3
4
5

EXAMPLE: 33
Person borrow $15,000 at 6.5 percent and agree to make equal annual end-of-year payments over
7 years. Developed loan amortization schedule?

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