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Time Value of Money

Time Value of Money (TVM) means it cannot determine the value of present rupee in tomorrow’s value and it can support generating cash flows
in the form of interest (or ) investment appreciation in the future. Present discounted value is also known as

Time Value of Money

Future Value of a Single Amount

The calculation of the future value of a single investment can understand with consideration of the following formula. For example, one invests
$1,000 for 3 years in a Savings account which pays 10% interest per year. If one allows the interest income to be reinvested, the investment
shall grow as follows:

Future Value at the End of First Year

Future Value at the End of Second Year

● Principal at the beginning of the year Rs.1,100

● Interest for the year ($Rs.1,100 * 0.10) Rs.110

● Principal at the end Rs.1,210

The process of investing money and reinvesting the interest earned is called Compounding. The future value of an investment after “n” year
when the interest rate is “r” % is:

FV = PV (1+r)n

As per the above equation, (1+r)n is called the future value factor. There are pre- defined tables that specify the rate of interest and its value
after ‘n’ number of years. It can be utilized with the help of a calculator or an excel spreadsheet as well. The below snapshot is an instance of
how the rate is calculated for different interest rates and at different time intervals.

Hence, taking the above instance, the FV of $Rs.1,000 can be used as: FV = 1000 (1.210) = $Rs.1210

Time Value of Money: Doubling Period

The initial action of the time value of money (TVM) concept is the doubling period. Investors are generally keen to know by when their
investment can double up at a given Interest. Though a little crude, an established rule is the “Rule of 72” which states that the doubling period
can be obtained by dividing 72 by the interest rate.

E.g. if the interest is 8%, the doubling period is 9 years [72/8=9 years]

Present Value of a Single Amount

The process of discounting used for computation of the present value is simply the inverse of compounding. The PV formula is ;

PV = FV [1 / (1+r)n] 
For instance, if a client is expected to receive Rs.1,000 after 3 years @ 8% ROI its value at present can be calculated as:
PV = 1000 [1/1.08]3

PV = 1000*0.794 = $Rs.794

4 – Future Value of an Annuity

An annuity is a stream of cash flows that will occur at regular time intervals. When the cash flows will occur at the beginning of each period, it is
called Annuity. The formula

of an annuity is (1+r) times. For example, one deposit generate Rs.1, 000 annually in a bank for 5 years and the deposit is earning compound
interest at 10% ROI, the present value of the series of deposits at the end of 5 years:
Future Value = 1,000(1+1.10)4 + 1,000(1+1.10)3 + 1,000(1+1.10)2 +

1,000(1.10) + 1,000

= 6,105

In other words, the future value of the annuity is also calculating with the following formula:

FVA = A [(1+r)n – 1] / r

Where,

FVA = Future value of the annuity

N = number of periods

A = constant periodic cash flow

r = required rate of return

While calculating the future value factor the following formula will be useful. [(1+r)n – 1] / r

Example on Future Value of Annuity

X has decided to save certain amount, thereby depositing Rs 1000 into an account per year for 5 years. The effective annual rate on the account
is 2%. Calculate Future Value of Annuity to determine the balance after 5 years.

Solution:-

FV of Annuity = P [(1+ r) n – 1/r]

● P = Periodic Payment

● r = rate per period

● n = number of periods

Therefore FV of Annuity = 1000[(1+.02) ^5 – 1/.02] Therefore the balance after 5 years would be Rs 5204.04

5 – Present Value of Annuity

The present value of the annuity is a reversal of the future value of the annuity. Example: A investor is expecting to receive Rs1, 000 annually for
3 years with each receipt occurring at the end of the year and the discount rate of 10%. Calculate the present value of an annuity. The present
value of the annuity is as follows.

Rs1,000[1/1.10] + 1,000 [1/1.10]2 + 1,000 [1/1.10]3 = Rs.2,486.80

In general terms, the present value of an annuity can also be expressed as follows: A = [{1 – (1/1 + r)n} / r]

6 – Present Value of Perpetuity

The time value of money (TVM) is used to calculate the present value of a perpetuity. Further, the Present Value of the perpetuity is the
aggregate value of the discounted value of each periodic payment of the perpetuity. The following formula is used to compute the present value
of the perpetuity is:
The present value of the perpetuity =

Fixed periodic payment

ROI or the discount rate per compounding period

For instance on Jan 1, 2015, of a perpetuity paying Rs.1,000 at the end of each month starting from January 2015 with a monthly discount rate
of 8%. calculate the PV.:

● PV = Rs.1,000 / 0.8% = Rs.125,000

Techniques for evaluation of Capital Expenditure Proposals

Various techniques are available for evaluation of capital expenditure proposals. They can be broadly categorised under two heads.

● Techsniques not considering time value of money.

● Technsiques considering time value of money.

A. Techniques not considering time value of money

● Pay Back Period: Pay back period indicates the period within which the cost of the project will be completely recovered. In other words it
indicates the product within which the total cash inflows equal to the total cash outflows. Thus,

Pay Back Period= Cash outlay/Annual cash inflow

Illustration 1

A project requires an outlay of Rs. 5,00,000 and earns, an equal inflow of Rs.

1,00,000 for 8 years. Calculate pay back period.

Solution:

Pay back period for the period is Rs 5,00,000/Rs. 1,00,000= 5 years.

If the project involves unequal cash inflows, the pay back period can be computed by adding up the cash inflow till the total is equal to cash
outlay.

Illustration 2

A project requires an outlay of Rs. 1,00,000 and earns the annual cash inflow of

Rs. 25,000, Rs. 30,000, Rs. 20,000 and Rs. 50,000. Calculate pay back period.

Solution

If we add up cash inflows, we find that in the first 3 years, an amount of Rs. 75,000 of the cash outlay is recovered. Fourth years generates the
cash inflow of Rs. 50,000 whereas the amount of Rs. 25,000 only remains to be recovered.

Pay Back Period = Years before Full Recovery + ( Amount to be recovered/ Cash

Inflow of the upcoming year)

= 3 + 25000/50000

= 3 + 0.5 or

= 3 + ( 0.5*12 months)

= 3 years 6 Months

Thus, the pay back period is 3 years and 6 months.

● Accounting/Average Rate of Return: Accounting rate of return computes the average annual yield on the net investment in the project.
Accounting Rate of Return is computed by dividing the average profits after depreciation and taxes by net investment in the project. Thus
Accounting rate of return can be computed as:

= Average Annual Net Income/ Average Investment * 100

Illustration

A project involves the investment of Rs. 5,00,000 which yield profit after depreciation and tax as stated below:

At the end of five years the machineries in the project can be sold for Rs. 40,000. Find the Accounting Rate of Return.

Solution-

The total profits after depreciation and taxes are Rs. 2,30,000. Average Profits = 230000/5 = 46,000

The net investment in the project will be original cost less salvage value i.e. Rs. 5,00,000-Rs 40,000 = Rs. 4,60,000.

Average Investment = 460000/2 = 230000

Accounting Rate of Return will be

= 46000/230000 * 100

= 0.2 * 100

= 20%

Acceptable rate

As pay back period method, Accounting Rate of Return also can be used as accept or reject criteria or as a method for ranking the projects. As
accept or reject criteria, the projects having the Accounting Rate of Return more than minimum rate prescribed by the management will be
accepted and vice versa. As a ranking method, the projects having maximum Accounting Rate of Return will be ranked highest.

B. Techniques considering time value of money.

● Net Present Value: Net Present Value (NPV) is a method of calculating present value of cash inflows and outflows in an investment project, by
using cost of capital as the discounting rate, and finding out net present value by subtracting present value of cash outflows from present value
of cash inflows. Thus,

Net Present Value=∑Discounted cash inflows - ∑Discounted cash outflows

Illustration

Calculate net present value of a project involving initial cash outflow Rs. 1,00,000 and generating annual cash inflows of Rs. 35,000, Rs. 40,000,
Rs. 30,000 and Rs.

50,000, discounting rate is 15%.

Solution :

Net Present Value= ∑Discounted cash inflows - ∑Discounted cash outflows

=1,09,030-1,00,000

= 9,030
C. Internal Rate of Return

Internal Rate of Return is that rate at which the discounted cash inflows math with discounted cash outflows. The indication given by Internal
Rate of Return is that this is the maximum rate at which the company will be able to pay towards the interest on amounts borrowed for
investing in the projects, without losing anything. Thus, Internal Rate of Return may be called as the ‘Break Even Rate’ of borrowing for the
company.

In simple words, Internal Rate of Return indicates that discounting rate at which Net Present Value is zero. If by applying 10% as the discounting
rate, the resultant Net Present Value is positive, while by applying 12% discounting rate the resultant Net Present Value is negative, it means
that Internal Rate of Return, e.g. the discounting rate at which Net Present Value is zero, falls between 10% and 12%. Thus, by applying the trial
and error method, one can find out the discounting rate at which Net Present Value is zero. The process is to compute Internal Rate of Return
will be selected any discounting rate and compute Net Present Value. If Net Present Value is negative, a lower discounting rate should be tried
and the process should be repeated till the Net Present Value becomes zero. Following illustration explains the process to calculate Internal
Rate of Return.

Illustration

A project costs Rs. 1,00,000 and generates annual cash flows of Rs. 35,000, Rs.

40,000, Rs.30,000, and Rs. 50,000 over its life of 4 years. Calculate the Internal Rate of

Return.

Solution-

Using 15% as discounting rate, the present value of cash inflows can be calculated as below:

The Total Present Value Rs. 1,02,435

Using 20% as discounting rate, the present value of cash inflows can be calculated as below:

Internal Rate of Return.

Thus Internal Rate of Return will be = A + C/D (B-A) Where A = Lower Discounting Rate

B = Higher Discounting Rate

C = NPV at lower discounted rate

D = Difference between the NPV Value at higher discounted rate & Lower Discounted rate

= 18 + 2435/ 4050 * 2

= 18 + 1.202

= 19.2% (approx.)

Acceptable rule

The computed Internal Rate of Return will be compared with the cost of capital.

● If the Internal Rate of Return is more than or, atleast equal to the cost of capital the project may be accepted (Internal Rate of Return > Cost of
Capital= Accept).
● If the Internal Rate of Return is less than to the cost of capital the project may be rejected (Internal Rate of Return < Cost of Capital= Reject).

Last modified: Monday, 3 July 2023, 12:34 PM

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