Basic concepts of time value of money

1. TIME VALUE OF MONEY
 The change in value of money with respect to time brings the concept of time value of money.
 Money available in present time is worth more than the same amount in the future due to its potential earning capacity .
 Time value helps in knowing the money invested .
 This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received
 TVM is also sometimes referred to as present discounted value.

2.  Present value of time value of money is calculated by using the above formula .
Factors that Affect time value of money -
 Principal (P) – amount of the investment
- Lump Sum : Single quantity of money
- Annuity : Stream of equal instalments at equal time intervals
 Number of Periods (n)
- From the beginning of the investment until termination
 Interest Rate
i. Annual percentage earned in investment
- Simple Interest
- Compound Interest

3. Reasons for Time Value of Money
Following are the reasons for time value of Money –
1. Risk and Uncertainity – As we grow future is not certain and we can’t determine the risk involved in future because outflow of cash is in our
hands as payment where as there is no certainity for future cash inflows .
2. Inflation – In an inflationary economy , the money received today , has no purchasing power than the money to be received in future.
3. Consumption – Individuals generally prefer current consumption to future consumption .
4. Investment Opportunities – An investor can profitably use the received money today to get higher return tomorrow or after a certain period
of time . Eg – If an individual is given an alternative either to receive rs 10,000 now . This is because , today , he may be in a position to purchase
more goods with this money then what he is going to get for the same amount after one year .

4. Importance of Time Value of Money
• In Investment Decisions – Small businesses often have limited resources to invest in business operations , activities and expansion . Investment
is a major factor and one needs to know how to invest.
• In Capital Budgeting Decisions – When a business chooses to invest money in a project – such as expansion , a strategic acquisition or
purchase of new piece of equipment – it must be years before that project begins producing a positive cash flow . Business needs to know if these
cash flows are worth the upfront investment .
Techniques of Time Value of Money
There are two techniques of adjusting time value of money . They are –
 Compounding Techniques / Future Value Techniques – The process of calculating future values of cash flow . Under it, the interest earned
on the initial principal amount becomes a part of the principal at the end of the compounding period .
 Discounting/Present Value Techniques – It involves the process of calculating present values of cash flows .

5. Case Study Of Time Value Of Money
CASE- BHARAT ENGINEERING WORK
• CASE OBJECTIVE:
The case study aims at showing the computation of Equated Quarterly Installments and splitting the same into the principal and interest components.
DISCUSSION POINTS:
• Concept of annuity and its application in the case study
• What will be the cash outflows for the firm during the moratorium period of first two years
• The model for finding of value of annuity; value of principal; and value of interest(Reference may be made to PMT, PPMT, and IPMT formulae built-
in excel)
• Relationship between the rate of interest and period of compounding/discounting. (The rate of interest given in the case is 12% p.a. but since it
is the case of quarterly installments the equivalent quarterly rate needs to be taken for the purpose of computations. The effective rate in the case
shall be taken as 12/4 = 3 %
• SUGGESTED APPROACH TO THE DISCUSSION QUESTIONS:
The value of EQI is given in Column D of tables 4-1 and 4-2.

6. Contd..
Table 4-1: Computation of Interest during the Moratorium period
Year Quarter Beginning
Balance
EQI Principal Interest Closing
Balance
Annual
Interest
(A) (B) (C) (D) (E) (F) (G) (H)
(Rs. In
Lakh )
1 1 30.00 0.00 0.00 -0.90 30.00
2 30.00 -0.90 30.00
3 30.00 -0.90 30.00
4 30.00 -0.90 30.00 -3.60
2 1 50.00 0.00 0.00 -1.44 50.00

8. Time Value of Money Discounted Cash Flow Analysis
• The time value of money concept is the basis of discounted cash flow analysis in finance. It is one of the core principles of small business financing
operations. It has to do with interest rates, compound interest, and the concepts of time and risk with regard to money and cash flows.
• The underlying principle is that the value of $1 that you have in your hand today is greater than a dollar you will receive in the future. Conversely, the
time value of money (TVM) also includes the concepts of future value (compounding) and present value (discounting).
• For example, if you have money in your hand today, you can save it and earn interest on it, or you can spend it now. If you don't get it until some
point in the future, you lose the interest you could earn, and you can't spend it now.
• Time value of money formulas are used to calculate the future value of a sum of money, such as money in a savings account, money market fund, or
certificate of deposit. It is used to calculate the present value of both a lump-sum of money or a stream of cash flows that you'll receive over time.
Types of TVM Calculations
• Future Value of a Lump Sum - The calculation for future value of a lump sum is used when a business wants to calculate how much money it will
have at some point in the future if it makes one deposit with no future deposits or withdrawals, given an interest rate and a certain period of time.
• Future Value of an Annuity - The calculation for the future value of an annuity is used when a business wants to calculate how much money it
will have at some point in the future if it makes equal, consecutive deposits over a period of time, given an interest rate and a certain period of time.

9. Present Value of a Lump Sum - The calculation for the present value of a lump sum is used when a business wants to calculate how much money it
should pay for an investment today if it will generate a certain lump sum cash flow in the future, given an interest rate and a certain period of time.
Calculating the present value is also called discounting .
Present Value of an Annuity - The calculation for the present value of an annuity is used when a business wants to calculate how much money it should
pay for an investment today if it will generate a stream of equal, consecutive payments for a certain time period in the future, given an interest rate and a
certain period of time.

10.  CONCLUSION
 Time Value of Money (TVM) is a concept which recognizes the relevant worth of future cash flows arising as a result of financial decisions by considering
the opportunity cost of the funds.
 Since money tends to lose value over time, there is inflation which reduces the buying power of money. However, the cost of receiving money in the
future rather than now shall be greater than just the loss in its real value on account of inflation.
 The opportunity cost of not having the money right now also includes the loss of additional income which could be earned by simply having possession of
cash earlier.
 Moreover, receiving money in the future rather than now may involve some risk and uncertainty regarding its recovery. For these reasons, future cash
flows are worth less than the present cash flows.
 Time Value of Money concept attempts to incorporate the above considerations into financial decisions by facilitating an objective evaluation of cash
flows from different time periods by converting them into present value or future value equivalents.
 This will only attempt to neutralize the present and future value of money and arrive at smooth financial decisions.