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Unit 5 Time Value of Money BBS Notes eduNEPAL - Info - PDF

The document discusses the time value of money concept. It explains that a rupee received today is worth more than a rupee received in the future due to factors like inflation, risk, time preference, and opportunity cost of other investments. It also discusses why the time value of money is an important concept in financial analysis for capital budgeting, calculating the cost of capital, working capital management, lease payments, and balancing risk and return. The document provides short notes defining future value and compounding, present value and discounting, and the different types of annuities.

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2K views

Unit 5 Time Value of Money BBS Notes eduNEPAL - Info - PDF

The document discusses the time value of money concept. It explains that a rupee received today is worth more than a rupee received in the future due to factors like inflation, risk, time preference, and opportunity cost of other investments. It also discusses why the time value of money is an important concept in financial analysis for capital budgeting, calculating the cost of capital, working capital management, lease payments, and balancing risk and return. The document provides short notes defining future value and compounding, present value and discounting, and the different types of annuities.

Uploaded by

Torreus Adhikari
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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BBS Notes - 2nd Year Finance | www.edunepal.

info

Unit-5 Time Value of Money


QN1Explain what is meant by the following statement? “A rupee in hand today is worth
more than a rupee to be received next year.” Or why most of us would prefer to receive
cash sooner than later?

Time value of money means that the value of rupee received one year from now is not the same
as the value of a rupee received today. In other words most of us would prefer to receive cash
sooner rather than later, and to spend cash later rather than sooner, because intuitively we know
that money has a time value.

There are various reasons that bring changes in the value of money with the passage of time. The
major factors which affect the value of money are as follows:

Inflation: Inflation brings upward change in the price level with the passes of time. One cannot
buy same quantity of goods and services in future with the passes of time This means the
purchasing power of money diminishes with the passing of time.
Involvement of risk: Present is certain as compared to future. The degree of uncertainty (risk
element) increases as the time line increases to longer period.
Time preference: It is human behavior that every one prefers to receive money as earlier as
possible. Therefore on one will not prepare to lengthen the credit period, if satisfactory return is
not given.
Risk free opportunity: Financial market has made risk-free opportunity for investment. One can
earn certain rate at zero risk. Earlier money can earn interest on principal and previously earned
interest.
Sacrifice of present consumption: For making investment one must save his earning. Saving
from current earning is not possible without sacrificing present consumption and people do not
like to scarify their present consumption if they do not get reward for it.
Liquidity preference: Liquidity means ability to convert the assets into spendable cash without
significant loss in the value of assets. Thus cash is the liquid form of assets. When one makes
investment he changes his most liquid assets into some less liquid asset.

QN2 Why is the time value of money concept so important in financial analysis?
Time value of money is one of the most important concepts in finance. It means that the value of
rupee received one year from now is not the same as the value of a rupee received today. Time
value of money concept is important for these reasons:

1. Capital budgeting (The analysis of investment projects): Capital budgeting is the process of
evaluating as selecting the investment project. For the investment decision, time value of
money is very important to convert the future cash flows in the present.

Provided by: Everest International College, Soalteemode, Kalimati, Kathmandu. 1


BBS Notes - 2nd Year Finance | www.edunepal.info

2. The cost of capital: Company needs the capital for long term investments. For this purpose it
is necessary to calculate the cost of capital of long-term investments. Cost of capital is
calculated based on time value of money concept.
3. Working Capital (Short-term asset and liability) management: Holding of inventory,
receivable, payable etc are evaluated on its opportunity cost basis.
4. Lease payment: Analysis and purchase of lease is done on the time value of money basis.
5. Trade off between risk and return: A firm invests in the project for the positive return. But
this return should be balanced with risk. One cannot maintain balance between risk and return
without using the concept of time value of money.
QN3 Write short notes on:
Future value and compounding: The concept of future value deals with the accumulation of
funds to some date in the future. The amount of money that will increase/grow within a certain
time period at a given interest rate in an investment is called future value. The future value is the
sum of beginning amount and interest earned. To find future value following formulae are used.
Cash Flows Numerical Solution Tabular Solution
Single FV n =PV(1+K)n FV n =PV(FVIF k,n )
Ordinary Annuity (1+𝐾)𝑛 −1 FVA n = PMT(FVIFA k,n )
FVA n =PMT ×
𝐾
Annuity Due (1+𝐾)𝑛 −1 FVA n Due = PMT(FVIFA k,n ) ×
FVA n Due = PMT× × (1+K)
𝐾 (1+K)
Where, FV n = Future value at year n; PV= Present Value; K=Interest Rate; n=no of cash flows
year; PMT=Yearly Payment.

The present value and discounting: The value today of a future cash flow or series of cash
flows. The actual present value of a rupee depends on the earnings opportunities of the recipient
and the point in time when the money is to be received.
Cash Flows Numerical Solution Tabular Solution
Single PV = FV n /(1+K)n PV = FV n ×(PVIF k,n )
1
Ordinary 1−(1+𝐾)𝑛 PV = PMT ×(PVIF k,n )
Annuity PV = PMT × � �
𝐾
1
Annuity Due 1−(1+𝐾)𝑛 PV = PMT ×(PVIF k,n ) × (1+K)n
PV = PMT × � � × (1+K)n
𝐾

Where, FV n = Future value at year n; PV= Present Value; K=Interest Rate; n=no of cash flows
year; PMT=Yearly Payment.
Annuity: An annuity is a special cash flow pattern in which, a constant annual amount is to be
paid or received over a defined number of periods. Annuity is of two types: ordinary annuity and
annuity due.

Provided by: Everest International College, Soalteemode, Kalimati, Kathmandu. 2


BBS Notes - 2nd Year Finance | www.edunepal.info

In ordinary annuity, it is assumed that the cash flows occur at the end of the period. Ordinary
annuity is also known as deferred annuity. In contrast an annuity due is one in which cash flows
occur at the beginning of each period.

Provided by: Everest International College, Soalteemode, Kalimati, Kathmandu. 3

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