Week 3 - Introduction To Time Value of Money

Introduction to Time Value of Money
An important principle in financial management is that the value of money depends on

when the cash flow occurs – £100 now is worth more than £100 at some future time.
There are a number of reasons for this:
1 Risk. One hundred pounds now is certain, whereas £100 receivable next year is less
certain. This ‘bird-in-the-hand’ principle affects many aspects of financial management
that will be covered in later chapters.
2 Inflation. Under inflationary conditions, the value of money, in terms of its purchasing
power over goods and services, declines.
3 Personal consumption preference. Most of us have a strong preference for immediate

rather than delayed consumption.
More fundamental than any of the above, however, is the time-value of money. Money –
like any other desirable commodity – has a price. If you own money, you can ‘rent’ it to
someone else, say a banker, and earn interest. A business which carries unnecessarily
high cash balances incurs an opportunity cost – the lost opportunity to earn money by
investing it to earn a higher return. The investor’s overall return, which reflects the time-
value of money, therefore comprises:
(a) the risk-free rate of return rewarding investors for forgoing immediate consumption,
plus
(b) compensation for risk and loss of purchasing power.
The future value (FV) of a sum of money invested at a given annual rate of interest will
depend on whether the :
- interest is paid only on the original investment (simple interest),

- or whether it is calculated on the original investment plus accrued interest
(compound interest).
Suppose you win £1,000 on the National Lottery and decide to invest it at 10 per cent
for five years’ simple interest. The future value will be the original £1,000 capital plus
five years’ interest of £100 a year, giving a total future value of £1,500.
With compound interest, the interest is paid on the original capital plus accrued interest,
as shown in Table 3.1. The process of compounding provides a convenient way of
adjusting for the time-value of money. An investment made now in the capital
Formula for Future Value
Present Value
An alternative way of assessing the worth of an investment is to invert the compounding

process to give the present value of the future cash flows. This process is called
discounting.
The time-value of money principle argues that, given the choice of £100 now or the
same amount in one year’s time, it is always preferable to take the £100 now because it
could be invested over the next year at, say, a 10 per cent interest rate to produce £110
at the end of one year. If 10 per cent is the best available annual rate of interest, then
one would be indifferent to (i.e. attach equal value to) receiving £100 now or £110 in
one year’s time. Expressed another way, the present value of £110 received one year
hence is £100.
We obtained the present value (PV) simply by dividing the future cash flow by 1 plus the
rate of interest, i, i.e.
Discounting is the process of adjusting future cash flows to their present values. It is, in
effect, compounding in reverse.
Effect of discounting
Shows how the discounting process affects present values at different rates of interest
between 0 and 20 per cent. The value of £1 decreases very significantly as the rate and
period increase. Indeed, after 10 years, for an interest rate of 20 per cent, the present
value of a cash flow is only a small fraction of its nominal value.
Annuity and Perpetuity

Perpetuity
Frequently, an investment pays a fixed sum each year for a specified number of years.
A series of annual receipts or payments is termed an annuity. The simplest form of
Annuity is the infinite series or perpetuity. For example, certain government stocks
offer a fixed annual income, but there is no obligation to repay the capital. The present
value of such stocks (called irredeemables) is found by dividing the annual sum
received by the annual rate of interest:
PV perpetuity = Annual Sum / Annual rate of interest
Example
Uncle George wishes to leave you in his will an annual sum of £10,000, starting next
year. Assuming an interest rate of 10 per cent, how much of his estate must be set
aside for this purpose? The answer is:
PV perpetuity = £10,000 / 0.10 = £100,000
Annual Percentage Rate
Unless otherwise stated, it is assumed that compounding or discounting is an annual

process; cash payments of benefits arise either at the start or the end of the year.
Frequently, however, the contractual payment period is less than one year. Building
societies and government bonds pay interest semi-annually or quarterly. Interest
charged on credit cards is applied monthly. To compare the true costs or benefits of
such financial contracts, it is necessary to determine the annual percentage rate
(APR), or effective annual interest rate, taking into account any costs such as one-off
fees. .

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Introduction to Time Value of Money

An important principle in financial management is that the value of money depends on

There are a number of reasons for this:

3 Personal consumption preference. Most of us have a strong preference for immediate

(b) compensation for risk and loss of purchasing power.

- interest is paid only on the original investment (simple interest),

An alternative way of assessing the worth of an investment is to invert the compounding

Annuity and Perpetuity

PV perpetuity = Annual Sum / Annual rate of interest

PV perpetuity = £10,000 / 0.10 = £100,000

Annual Percentage Rate

Unless otherwise stated, it is assumed that compounding or discounting is an annual

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