Sunday, October 4, 2009

What is Time Value of money?

The Time Value of Money (abbreviated as TVM) is a concept in which both the present value of cash inflows and that of cash outflows is taken into consideration. Time Value of Money (TVM) is an important concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities. TVM is based on the concept that a rupee that you have today is worth more than the promise or expectation that you will receive a rupee in the future. Money that you hold today is worth more because you can invest it and earn interest. After all, you should receive some compensation for foregoing spending. Let us take an example to understand the concept better:-
Receive $10,000 now OR receive $10,000 in three years. Which option would you choose?
If you are choosing Option A, your future value will be $10,000 plus any interest acquired over the three years. The future value for Option B, on the other hand, would only be $10,000. So how can you calculate exactly how much more Option A is worth, compared to Option B? If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the future value of your investment at the end of the first year is $10,450, which of course is calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% :-
Future value of investment at end of first year: =($10,000x0.045)+$10,000 = $10,450
If the $10,450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have?
Future value of investment at end of second year: =$10,450x(1+0.045) =$ 10,920.25
Or we can say:-
So, the equation for calculating the three-year future value of the investment would be:
This calculation shows us that we don't need to calculate the future value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value can be calculated by the following:
Let's walk backwards for Option B. Remember; the $10,000 to be received in three years is really the same as the future value of an investment. If today we were at the two-year mark, we would discount the payment back one year. At the two-year mark, the present value of the $10,000 to be received in one year is represented as the following:
Present value of future payment of $10,000 at end of year two:
Continuing on, at the end of the first year we would be expecting to receive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a $10,000 payment expected in two years would be the following:
Present value of $10,000 in one year:
Of course, because of the rule of exponents, we don't have to calculate the future value of the investment every year counting back from the $10,000 investment at the third year. We could put the equation more concisely and use the $10,000 as FV. So, here is how you can calculate today's present value of the $10,000 expected from a three-year investment earning 4.5%:
So the present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are 4.5% per year. In other words, choosing Option B is like taking $8,762.97 now and then investing it for three years. The equations above illustrate that Option A is better not only because it offers you money right now but because it offers you $1,237.03 ($10,000 - $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from Option A, your choice gives you a future value that is $1,411.66 ($11,411.66 - $10,000) greater than the future value of Option B.
So, Time value of money is an important aspect of wealth maximization. As it is one of the objectives of wealth maximization. From this concept we have learnt that money received today is more valuable than money received tomorrow.

No comments:

Post a Comment