Module 1

Time Value of Money and
Related Concepts
Concept of Time Value of Money
• • Definition: The principle that a specific amount of
money has a different value today than in the future
due to its earning potential.
• • Key Assumptions:
• - Money can earn interest.
• - Individuals prefer to receive money now rather
than later (due to risk, inflation, or opportunity
costs).
• • Applications: Investment analysis, financial
planning, loan management.
Factors Responsible for the Change in the Value of Money
1.Inflation:
1. Inflation reduces the purchasing power of money, meaning that over time, the
same amount of money buys fewer goods and services.
2. Higher inflation rates decrease the real value of money, eroding savings and
necessitating higher wages or returns to maintain purchasing power.
2.Interest Rates:
1. Interest rates, determined by central banks, influence the opportunity cost of
holding money.
2. Higher interest rates encourage saving, as money can earn a return, whereas
lower rates encourage borrowing and spending.
3.Supply and Demand of Money:
1. The money supply, controlled by monetary policies, directly impacts its value.
For example, excessive money printing leads to devaluation (hyperinflation).
2. Demand for money depends on economic activities; higher demand can
stabilize or increase its value.
4. Economic Growth:
1. Robust economic growth often increases the demand for money as businesses
expand and transactions increase, potentially stabilizing or enhancing its value.
2. Conversely, recession or economic slowdown can lead to a decrease in money’s
perceived value.
5. Global Exchange Rates:

3. Currency values fluctuate based on international trade, investment flows, and
geopolitical stability.
4. A currency with strong demand in global markets appreciates, while weak
demand or oversupply leads to depreciation.
6. Risk and Uncertainty:

5. In uncertain times, people prefer liquidity, opting to hold cash rather than invest
in volatile markets.
6. This behavior affects the velocity and perceived value of money in circulation.
Need for Time Value of Money
• • Importance:
• - Reflects the opportunity cost of money.
• - Essential for making informed financial decisions.
• • Practical Applications:
• - Investment decision-making: Evaluating project
feasibility.
• - Loan management: Structuring repayment
schedules.
• - Retirement planning: Determining savings goals.
Difference Between Present Value and
Future Value
• • Present Value (PV):
• - Definition: The current value of a future sum of money, discounted at a
specific rate.
• - Focus: Determines how much a future amount is worth today.
• • Future Value (FV):
• - Definition: The amount a present sum of money will grow to, using a
specific rate over time.
• - Focus: Projects how much a current investment will grow in the future.
• • Key Differences:
• - PV involves discounting, while FV involves compounding.
• - PV helps in determining the worth of future cash flows today, while FV
helps in forecasting future growth.
Difference Between Simple Interest and
Compound Interest
•Definition:
•Simple Interest: Interest is calculated only on the original principal
throughout the loan or investment period.
It does not account for the effect of previously earned interest.
•Compound Interest: Interest is calculated on both the initial principal

and the interest that accumulates over previous periods.
• It represents "interest on interest."

•Growth Pattern:
•Simple Interest grows in a linear fashion. For example, if you invest

Rs.1,000 at 5% annual interest, you earn Rs.50 every year, regardless of
the accumulated amount.
•Compound Interest grows exponentially. Using the same Rs.1,000 at

5% compounded annually, the interest in the second year includes the
interest earned in the first year, increasing total returns.
•Applications:
•Simple Interest: Common in short-term loans, bonds, or fixed-term

deposits.
•Compound Interest: Preferred in investments like savings accounts,

retirement funds, or reinvested dividends.
Process of Compounding and Discounting
• • Compounding:
• - Definition: Calculating future value of an investment
by applying interest over multiple periods.
• - Formula: FV = PV × (1 + r)^n
• - Example Use: Saving for retirement.
• • Discounting:
• - Definition: Determining the present value of a future
sum of money.
• - Formula: PV = FV / (1 + r)^n
• - Example Use: Valuation of bonds or projects.
Future Value of a Single Amount
• • Definition: The amount a single investment will
grow to after earning interest over a given period.
• • Formula: FV = PV × (1 + r)^n
• • Key Factors:
• - Principal amount (PV)
• - Interest rate (r)
• - Time period (n)
• • Applications: Long-term savings, calculating growth
of a fixed deposit.
Future Value of an Annuity
• • Definition: The total future value of a series of
equal payments made at regular intervals,
compounded at a specific interest rate.
• • Formula (Ordinary Annuity): FV = P × [(1 + r)^n -
1] / r
• • Key Points:
• - Applies to recurring investments like retirement
funds or savings plans.
• - Can vary for ordinary annuity (payments at end of
periods) or annuity due (payments at the start).
Present Value of a Single Amount
• • Definition: The current value of a single sum
of money to be received in the future,
discounted at a specific interest rate.
• • Formula: PV = FV / (1 + r)^n
• • Key Considerations:
• - Higher interest rate or longer time period
results in lower present value.
• • Applications: Calculating the price of zero-
coupon bonds, comparing project valuations.
Present Value of an Annuity
• • Definition: The current value of a series of
equal payments to be received in the future,
discounted at a specific interest rate.
• • Formula (Ordinary Annuity): PV = P × [1 - (1 /
(1 + r)^n)] / r
• • Applications: Valuing mortgages, pension
plans, or loan repayments.
• • Insights: Reflects the time-sensitive value of
consistent cash flows.
Difference between Annuity and Perpetuity
Summary and Applications
• • Key Takeaways:
• - The time value of money forms the foundation of
financial decision-making.
• - Compounding and discounting are essential tools
for valuing investments and liabilities.
• - Future and present value calculations guide
savings, investment, and loan strategies.
• • Applications in Real Life:
• - Corporate finance, personal finance, and
macroeconomic planning.

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Time Value of Money and

5. Global Exchange Rates:

6. Risk and Uncertainty:

It does not account for the effect of previously earned interest.

•Compound Interest: Interest is calculated on both the initial principal

• It represents "interest on interest."

•Simple Interest grows in a linear fashion. For example, if you invest

•Compound Interest grows exponentially. Using the same Rs.1,000 at

•Simple Interest: Common in short-term loans, bonds, or fixed-term

•Compound Interest: Preferred in investments like savings accounts,

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