Chapter 2: Time Value of Money - Comprehensive Notes
1. The Core Concept of Time Value of Money (TVM)
The fundamental principle of TVM is that
money available at the present time is worth more than the same amount in the
future. 1This preference is due to the money's potential to earn returns or interest, and
an instinctive preference for current consumption over future consumption. 2 TVM
provides a way to compare the value of money received at different points in time.
2. Future Value and Compounding
• Future Value (FV): This is the value of a current asset at a future date based on
an assumed rate of growth. It is calculated through the process of
compounding.
• Compounding: This is the process where earnings from an asset (like interest or
capital gains) are reinvested to generate additional earnings over time. It is
"interest on interest" and is a powerful tool for wealth creation.
• Formula for Future Value:
FV=PV(1+r)n
Where:
o PV = Present Value (the initial amount)
o r = Interest rate per period
o n = Number of compounding periods
• Example from the PDF: If you invest ₹1,00,0e00 at an interest rate of 8% per
annum for 5 years, the future value would be:
FV=1,00,000(1+0.08)5=₹1,46,933
• Impact of Compounding Frequency: The more frequently interest is
compounded (e.g., semi-annually or quarterly instead of annually), the higher
the future value will be, because interest starts earning interest sooner.
3. Present Value and Discounting
• Present Value (PV): This is the current value of a future sum of money, given a
specified rate of return. It is calculated through the process of discounting.
• Discounting: This is the reverse of compounding. It determines how much a
future cash flow is worth today. The interest rate used in this calculation is called
the discount rate.
• Formula for Present Value:
PV=FV/(1+r)n
• Example from the PDF: If you need ₹1,50,000 in two years and the discount rate
is 8%, the amount you need to invest today (the present value) is:
PV=1,50,000/(1+0.08)2=₹1,28,600
4. Net Present Value (NPV)
• Concept: NPV is a method used to evaluate the profitability of an investment by
comparing the present value of its future cash inflows with the present value of
its cash outflows.
• Decision Rule:
o If NPV > 0: The investment is considered profitable and should be
accepted.
o If NPV < 0: The investment is not profitable and should be rejected.
• Example from the PDF: An investment requires an initial outflow of ₹10,00,000
and is expected to generate an inflow of ₹12,00,000 after one year. The discount
rate is 10%.
o Present Value of Inflow = ₹12,00,000 / (1 + 0.10) = ₹10,90,909
o NPV = Present Value of Inflow - Initial Outflow
o NPV = ₹10,90,909 - ₹10,00,000 = ₹90,909. Since the NPV is positive, the
project is acceptable.
5. Concept of Annuity
An annuity is a series of fixed payments made at equal intervals over a specified period
of time.
• Ordinary Annuity: Payments are made at the end of each period (e.g., a loan
EMI).
• Annuity Due: Payments are made at the beginning of each period (e.g., an
insurance premium or a SIP investment).
• Future Value of an Annuity: Calculates what a series of regular payments will be
worth at a point in the future.
o Example from the PDF: If a person invests ₹50,000 at the end of each
year for 3 years at an 8% interest rate, the future value of this annuity is
₹1,62,320.
• Present Value of an Annuity: Calculates the current value of a series of future
payments.
o Example from the PDF: The present value of receiving ₹20,000 at the end
of each year for the next 4 years at a discount rate of 10% is ₹63,400.
6. Concept of Perpetuity
A perpetuity is a type of annuity where the stream of cash flows continues
forever. 3
• Formula for Present Value of a Perpetuity:
PV=C/r
Where:
o C = Cash flow per period
o r = Discount rate
• Example from the PDF: A perpetual bond pays ₹10,000 in interest annually. If the
discount rate is 8%, the value (present value) of this perpetuity is:
PV=10,000/0.08=₹1,25,000 4
