Definition of Time Value of Money
- It is the concept that money you have now is worth more than the identical sum in the future due to its potential earning capacity.
- It refers to the present discounted value.
- The rationale behind this is that investors would prefer to receive money today rather than the same amount of money in the future because of money's potential to grow in value over a given period of time.
- The time value is greater at present rates due to higher risks in the future, possibility of inflation and greater reinvestment opportunity at present.
- The entire premise of this concept is based on opportunity.
The considerations for tie value of money are – - Amount of payment currently, - The future value of the sum (estimated), - Interest rate, - Time frame, - Number of compounding periods.
Calculation of Time Value of Money
The time value formula is as follows – FV = PV x [ 1 + (i / n) ] (n x t) Where, FV = Future value of money PV = Present value of money i = interest rate n = number of compounding periods per year t = number of years
Use of Time Value of Money Concept
- It is used in discounted cash flow analysis to calculate investment opportunities.
- It is used to understand the depreciation in the value of the currency by virtue of inflation.
- It is essential to make financial decisions involving acquisition of assets or procurement of funds.
- It is also important when decisions concerning loans have to be taken.
- Financial managers will take a decision about where to invest based on the time value of money and the goal involved i.e. value maximization or wealth maximization.
Techniques for Estimating Time Value of Money
- Discounting Technique or the Present Value Method - In this method, the future value is converted into the present value using discounting.
- Compounding Technique or the Future Value Method – it is the process of converting Present Value into Future Value through compounding. It must be calculated at a specific compound rate of interest.
Timeline and Time Value of Money
- A timeline is an important tool of time value of money that provides one an insight into the amount of each cash flow and the cash flow stream.
- The cash flows in consideration can be in the form of perpetuity, annuity due, growing perpetuity and growing annuity.
