Time Value of Money

1. There is time value attached to money which means that with the
passage of time, the value of money decreases. It also means that a
rupee today is worth less a year hence. The rate at which the value
of money decreases is the discount rate.
2. We have learnt in school, the various concepts like simple interest,
compound interest, principal, amount etc.
3. Simple interest means that the interest is calculated only on the
principal amount whereas compound interest means the interest is
calculated on both the principal and interest amounts.
4. Everyone is familiar with the formula for calculating amount when a
sum of money is invested at a certain rate of interest, r for n period
with interest compounded annually.
A = P (1+r)n
In financial language, we denote P= Present value; r = rate of
interest ; n = number of years and A= future value
5. Using the above equation we can re write the equation as:
FV = PV (1+r)n
6. Therefore, given the present value of a sum of money, the rate of
interest and the number of periods, we can find the future value
using the above formula. In order to make the calculations easier,
the value of the term (1+r) n can be founding using the PVIF (r%, n)
table . So, in order to find out the future value of a single sum of
money, one can use the formula,
FV = PV X FVIF (r%,n)

7. From equation 5, we can also find the present value of a given

future sum at a discount rate r, for n period.
PV = FV /(1+r)n
In order to make calculations easier, one can find the value of the
term (1/(1+r)n) using the PVIF (r%, n) tables. So, in order to find out
the present value of a single sum of money, one can use the
formula,
PV = FV X PVIF (r%, n)
8. When we invest or receive equal sums of amount at equidistant
periods of time, it is known as an annuity. There are two types of
annuities:
a. Ordinary Annuity: When the amounts are received /paid at the end
of the period.

b. Annuity due: When the amounts are received/paid at the

beginning of the period.
9. When equal sums of amounts are deposited at equidistant periods
of time, the amount accumulated at the end of the period is called
Future Value of An Annuity (FVA). This can be found out using the
formula,
FVA = Annuity X FVIFA (r%, n)
10. When equal sums of amounts are to be received/paid at
equidistant periods of time in the future, in order to find the present
value of such amounts, we use the formula,
PVA = Annuity X PVIFA (r%,n)
11. We use time value of money in various applications like financial
planning, capital budgeting etc.
12. While solving a Time Value for money problem, it is important to
follow the following steps:
i)
Read the problem carefully in order to identify and list
all the given values
ii)
Identify whether you have to calculate the Present Value
of a sum of money, Future Value of a sum of money,
Present Value of an Annuity or Future Value of an
annuity.
iii)
Having identified the above, proceed to the calculations.
iv)
Remember, it is always advisable to use a time line in
order to know the position of the cash flows.
Please find below some solved problems.

Practice Problems

1. If you deposit Rs.3,000 today at 8 percent rate of interest in how

many years (roughly) will this amount grow to Rs.1,92,000 ? Work this
problem using the rule of 72do not use tables. ( 54 years)
2. You can save Rs.5,000 a year for 3 years, and Rs.7,000 a year for 7
years thereafter. What will these savings cumulate to at the end of 10
years, if the rate of interest is 8 percent? (Rs. 90, 281)
3. Krishna saves Rs.24,000 a year for 5 years, and Rs.30,000 a year for
15 years thereafter. If the rate of interest is 9 percent compounded
annually, what will be the value of his savings at the end of 20 years?
(Rs. 14,04,010)
4. You plan to go abroad for higher studies after working for the next five
years and understand that an amount of Rs.2,000,000 will be needed
for this purpose at that time. You have decided to accumulate this
amount by investing a fixed amount at the end of each year in a safe
scheme offering a rate of interest at 10 percent. What amount should
you invest every year to achieve the target amount? ( Rs. 3,27,600)
5. A finance company advertises that it will pay a lump sum of
Rs.100,000 at the end of 5 years to investors who deposit annually
Rs.12,000. What interest rate is implicit in this offer? (26%)
6. Someone promises to give you Rs.5,000,000 after 6 years in
exchange for Rs.2,000,000 today. What interest rate is implicit in this
offer? (16.49%)
7. At the time of his retirement, Rahul is given a choice between two
alternatives: (a) an annual pension of Rs120,000 as long as he lives,
and (b) a lump sum amount of Rs.1,000,000. If Rahul expects to live
for 20 years and the interest rate is expected to be 10 percent
throughout , which option appears more attractive?