Time Value Of Money: What Does It Entail?

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TEAM STARTUPED 12 Jan 2022 . 3 min read
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    What would you do if you were given a choice between receiving $100 today or after one year? What if the choice was between $ 100 now and $125 after one year? The first choice is easy- you would choose to take the money today but what about the second choice? How do you compare those two?

    • Why money has time value?
    Time value of money is an important concept in the field of finance. This concept is as easy to understand as important it is. The concept states that the value of a dollar received today is more than the value of a dollar received in the future. Intuitively you would choose to have a dollar today because tomorrow is not certain?! The main argument for this is opportunity cost. Opportunity cost is the cost of the best alternative foregone. A dollar received today can be invested and we can get a return on that at a particular rate – this return is the opportunity cost of not choosing to take a dollar today. Secondly, the money received today will have higher purchasing power as compared to money received in the future. This is due to inflation(price rise)-as you may notice that a hundred rupee note could have bought a lot of things a decade ago as compared to what it can buy today.
    • How to calculate the time value of money?
    Certain terms you need to know before going on to calculations-
        • Future value- The value of a certain amount of money you have today at a particular time in future
        • Present value- The value of a certain sum of money today
        • Interest Rate-The per period interest rate (generally given yearly)
        • Time Period- Total number of time period units for ex: 6 months or 2 years
    Suppose you have $100 today and want to know its value 3 years later. Then the formulae for the same is Future value = Present value * (1+ rate) ^ no of time periods So here, Value of $100 after 3 years at the rate of 10% per annum will be 100*(1+10) ^ 3= $133.10 This can also be understood as follows- After year 1, the value of money will be 100*(1+10) =$110. After year 2 this money will be 110*(1+10) =$121 and again after year 3, 121*(1+10) = $133.10. This is the technique of compounding. If you want to calculate the present value of an amount in the future then we use the discounting technique. Suppose a sum of money when invested for four years at a 5% rate of interest amounts to $ 121.55. What is that sum of money? To find out the answer we need to substitute the values in the equation, let present value be denoted by PV. Future value = Present value *[(1+ rate) ^ no of time periods] 121.55=PV*[(1+0.05) ^ 4] On solving the equation we get PV= $100. So if $100 invested for four years at a rate of 5% pa will yield an amount of $121.55. When discounting, the interest rate is called the discount rate. You deposit $1000 at the end of each year for 5 years at the rate of 6% pa. What amount will you receive at the end of 6 years?  Instead of a single amount, if you receive a certain amount at regular intervals then, to find future value, add up all the individual future value amounts or simply use the formulae- Present value*[({(1+rate)^ no of periods} – 1)/ rate]. So here the answer is 1000*((((1+0.06) ^5)-1)/0.06) = $5637.09
    • Things to keep in mind while doing time value of money calculations
        • Cash inflow (receiving money) is denoted by a +ve sign while cash outflow (giving away money) is denoted by a –ve sign.
        • The time period and rate of interest must be expressed in similar units i.e. if the rate of interest is given in per year terms and time period is given in month terms either rate or time period must be converted in accordance with the other for the correct result.
    • Practical Application
    One of the important applications of the time value of money is in capital budgeting decisions. When a business chooses to invest in a project, it must be able to assess whether the investment is worth the future cash flows (which may come early or later in the life of the project) i.e. whether the cash flows received in future will make the project profitable to invest in.

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