Concept of Time Value of Money: Present Value and Future Value

Time value of money

Time Value of Money – Introduction:

We have already seen in our earlier post on Money laundering regarding change of value/purchasing power of currency. So this change of value of money with respect to time brings the concept of time value of money.How many of you heard your grandma saying rice was so cheap; we bought many things using Re.1 in our younger age?.

Lets take an example:

Your dad wants to gift you money but he gives two option. Option 1- Cash gift of Rs.10,000/- now. Option 2 – A new Samsung Mobile worth Rs.10,000/- going to be released within six months.  Which option do you would choose?. If you are like most people then you would choose Cash Gift of Rs.10,000/- now. Why would a rational person choose that option because though the value are same it is better to have the money now than later.

But why is this?

If I keep the money I received as gift in a savings account/fixed account i will earn interest for six months. Lets say it is Rs.200/-; So when purchasing the new mobile I can also buy a SD card/ a scratch card/ or I can recharge etc. So the value of Rs.10000/- has become Rs.10200/- within six months due to the earning capacity of the money.  The potential earning capacity of the money makes it worth more at present than the future.

What is Time Value of Money?

The idea of money available at present is worth more than the same amount in future is called Time Value of Money. Here the present value is compounded (increased) to arrive the future value .

The converse is also true money required in future is worth less than the same amount at present. Here the future value is discounted (reduced) to arrive the present value. So to measure the time of money the concept of Present value and Future value of money comes into action.

Factors affecting Time Value of Money:

Mathematics – Rate of interest, Time period and frequency of compounding/discounting

Economics – Inflation rate and Risk associated with the cash flow (Investment Risk).

Future Value of Money

The Formula for calculating the future value of the money is

 F.V =P.V x [1+(i/n)] ^ n*t

  1.  F.V = Future Value of the money,
  2. P.V = Present Value of the money,
  3. i = rate of interest after divided by 100
  4. n = number of compounding (monthly,quarterly,half-yearly, annually)
  5. t = time period of investment.

Present Value of Money

The Formula for calculating the Present value of the money is

 P.V = (F.V ) / [1+(i/n)] ^ n*t

  1.  F.V = Future Value of the money,
  2. P.V = Present Value of the money,
  3. i = rate of interest after divided by 100
  4. n = number of compounding (monthly,quarterly,half-yearly, annually)
  5. t = time period of investment,

Conclusion

The concept of time value and calculating the present & future value is very important for bankers. We use it while doing project finance,  for arriving  OTS amount after grace period, for personal finance and investments. The time value of money is also helpful for individuals for their investment planning.Please understand the concept of time value of money. Instead of keeping the money idle at home bureau or safety lockers, use its potential earning capacity by investing them properly in financial assets. By investing we are not only helping our-self but also for productive growth of our economy.

 

 

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