Description
Understand what gives money its time value., Explain the methods of calculating present and future values
TIME VALUE OF MONEY
? Understand what gives money its time value.
? Explain the methods of calculating present
and future values.
? Highlight the use of present value technique
(discounting) in financial decisions.
? Introduce the concept of internal rate of
return.
? Time preference for money or Time value of
money is an individual’s preference for
possession of a given amount of money now,
rather than the same amount at some future
time.
? Three reasons may be attributed to the
individual’s time preference for money:
? risk
? preference for consumption
? investment opportunities
3
? The time preference for money is generally
expressed by an interest rate. This rate will be
positive even in the absence of any risk. It may
be therefore called the risk-free rate.
? An investor requires compensation for
assuming risk, which is called risk premium.
? The investor’s required rate of return is:
Risk-free rate + Risk premium.
4
? Would an investor want Rs. 100 today or after one year?
? Cash flows occurring in different time periods are not
comparable.
? It is necessary to adjust cash flows for their differences in
timing and risk.
? Example : If preference rate =10 percent
? An investor can invest if Rs. 100 if he is offered Rs 110
after one year.
? Rs 110 is the future value of Rs 100 today at 10% interest
rate.
? Also, Rs 100 today is the present value of Rs 110 after a
year at 10% interest rate.
? If the investor gets less than Rs. 110 then he will not
invest. Anything above Rs. 110 is favourable.
5
? Two most common methods of adjusting
cash flows for time value of money:
? Compounding—the process of calculating future
values of cash flows and
? Discounting—the process of calculating present
values of cash flows.
6
? Compounding is the process of finding the future
values of cash flows by applying the concept of
compound interest.
? Compound interest is the interest that is received on
the original amount (principal) as well as on any
interest earned but not withdrawn during earlier
periods.
? Simple interest is the interest that is calculated only
on the original amount (principal), and thus, no
compounding of interest takes place.
7
8
9
10
11
12
? Present value of a future cash flow (inflow or
outflow) is the amount of current cash that is
of equivalent value to the decision-maker.
? Discounting is the process of determining
present value of a series of future cash flows.
? The interest rate used for discounting cash
flows is also called the discount rate.
14
15
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20
End Payment Interest Principal Outstanding
of Year Repayment Balance
0 10, 000
1 3, 951 900 3, 051 6, 949
2 3, 951 625 3, 326 3, 623
3 3, 951 326 3, 625* 0
? In most instances the firm receives a stream
of uneven cash flows. Thus the present value
factors for an annuity cannot be used.
? The procedure is to calculate the present
value of each cash flow and aggregate all
present values.
21
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27
28
29
? The present value of Re 1 paid at the
beginning of each year for 4 years is
1 × 3.170 × 1.10 = Rs 3.487
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34
? A bond that pays some specified amount in future
(without periodic interest) in exchange for the
current price today is called a zero-interest bond
or zero-coupon bond.
? In such situations, one would be interested to
know what rate of interest the advertiser is
offering. One can use the concept of present value
to find out the rate of return or yield of these
offers.
? The rate of return of an investment is called
internal rate of return since it depends exclusively
on the cash flows of the investment.
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37
doc_269735459.pptx
Understand what gives money its time value., Explain the methods of calculating present and future values
TIME VALUE OF MONEY
? Understand what gives money its time value.
? Explain the methods of calculating present
and future values.
? Highlight the use of present value technique
(discounting) in financial decisions.
? Introduce the concept of internal rate of
return.
? Time preference for money or Time value of
money is an individual’s preference for
possession of a given amount of money now,
rather than the same amount at some future
time.
? Three reasons may be attributed to the
individual’s time preference for money:
? risk
? preference for consumption
? investment opportunities
3
? The time preference for money is generally
expressed by an interest rate. This rate will be
positive even in the absence of any risk. It may
be therefore called the risk-free rate.
? An investor requires compensation for
assuming risk, which is called risk premium.
? The investor’s required rate of return is:
Risk-free rate + Risk premium.
4
? Would an investor want Rs. 100 today or after one year?
? Cash flows occurring in different time periods are not
comparable.
? It is necessary to adjust cash flows for their differences in
timing and risk.
? Example : If preference rate =10 percent
? An investor can invest if Rs. 100 if he is offered Rs 110
after one year.
? Rs 110 is the future value of Rs 100 today at 10% interest
rate.
? Also, Rs 100 today is the present value of Rs 110 after a
year at 10% interest rate.
? If the investor gets less than Rs. 110 then he will not
invest. Anything above Rs. 110 is favourable.
5
? Two most common methods of adjusting
cash flows for time value of money:
? Compounding—the process of calculating future
values of cash flows and
? Discounting—the process of calculating present
values of cash flows.
6
? Compounding is the process of finding the future
values of cash flows by applying the concept of
compound interest.
? Compound interest is the interest that is received on
the original amount (principal) as well as on any
interest earned but not withdrawn during earlier
periods.
? Simple interest is the interest that is calculated only
on the original amount (principal), and thus, no
compounding of interest takes place.
7
8
9
10
11
12
? Present value of a future cash flow (inflow or
outflow) is the amount of current cash that is
of equivalent value to the decision-maker.
? Discounting is the process of determining
present value of a series of future cash flows.
? The interest rate used for discounting cash
flows is also called the discount rate.
14
15
16
17
18
19
20
End Payment Interest Principal Outstanding
of Year Repayment Balance
0 10, 000
1 3, 951 900 3, 051 6, 949
2 3, 951 625 3, 326 3, 623
3 3, 951 326 3, 625* 0
? In most instances the firm receives a stream
of uneven cash flows. Thus the present value
factors for an annuity cannot be used.
? The procedure is to calculate the present
value of each cash flow and aggregate all
present values.
21
22
23
24
25
26
27
28
29
? The present value of Re 1 paid at the
beginning of each year for 4 years is
1 × 3.170 × 1.10 = Rs 3.487
30
31
32
33
34
? A bond that pays some specified amount in future
(without periodic interest) in exchange for the
current price today is called a zero-interest bond
or zero-coupon bond.
? In such situations, one would be interested to
know what rate of interest the advertiser is
offering. One can use the concept of present value
to find out the rate of return or yield of these
offers.
? The rate of return of an investment is called
internal rate of return since it depends exclusively
on the cash flows of the investment.
35
36
37
doc_269735459.pptx