Time Value of Money
If I give you two options, Rs.100 right now or Rs.100 after a year what would you choose? Most of you will choose Rs.100 right now and only a few will choose the other. After reading this they will also change their answer to option 1.
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Understanding Time Value of Money concept:
Time value of money is basically a concept which states that the same amount of money is worth more right now than in the future. This is because of its potential earning capacity that is the money’s capacity to earn more money. For example, the money you have now can be invested in different types of assets which can give returns such as interests and dividends. Whereas the money you will receive in the future cannot be invested right now and therefore is a fixed amount for the future. The simplest example is investors preferring receiving money right now so that they can deposit it in a savings account which will earn a high amount of interest. So the time value of money indicates the potential earning capacity of money given that it can be used to earn compound interest.
Computation and Formula:
The time value of money is an important factor not only for individuals but also for the decision-making of companies. Companies take into consideration the time value of money when making decisions on investment in the production of various products, purchasing new business machinery or infrastructure, and setting credit terms for the selling of their products or services. The below formula is used in order to equate the future value of money for comparing with the present value.
FV = PV x [ 1 + (i / n) ] (n x t)
FV= Future value of money
PV= Present Value of money
i= interest rate
n= number of compounding periods per year
t= total number of years
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Let us take a simple example and understand the above formula.
You invest Rs.10000 @10% p.a. After a year, the value of that money is:
We can also use the formula to find the present value of money. For example, the PV of Rs.5000 after a year compounded at 7% p.a is
So, in conclusion, the same amount of money is worth in the present than in the future because it can be used to earn more money. This is called its potential earning capacity so investors prefer receiving money in the present than in the future. The concept of Time Value of Money is essential in the computation of the intrinsic value of shares and investment prospects in businesses and projects.
Author: Raj Mehta