Understanding Time Value of Money

This is a guest post by Elearnmarkets.com.

Time value of money

Time value of money is a fundamental building block on which the entire finance is built upon. It is a very important concept especially if you are dealing with loans, investment analysis, capital budgeting and other finance related decisions. Let’s understand what exactly time value of money is.

Time value of money simply says that a dollar received today has a greater value than a dollar received in the future. Let’s illustrate this with the help of an example. Say if you have to choose between taking $10,00,000 today or after say 30 years. You will obviously opt for the first option.

Some of the reasons which justify this include the risk factor involved and obviously the high purchasing power. High purchasing power implies that a sum of money can be exchanged for more goods and services today than after 40-50 years.

Time is Money

You must have heard people saying that “Time is money” and truly speaking, they are right. Since money has time value, the present value of future cash flows will be worth less the longer you wait to receive it. This is why we expect the future value to be greater than present value due to time value of money. However, the difference between the future and present value depends upon the interest rate and the compounding period. Moreover, receiving the money quickly also reduces the chances of default.

Compounding and discounting

Time value of money is based on two important aspects: compounding and discounting, which helps us in computing future and present value respectively. It’s important to have an understanding of these terms before getting into details of time value of money.

            Formula: FVn  = PV(1+i)n

Compounding

It’s a process of computing the future value of an investment made today or series of investments made over a period of time. In simple words, it’s about moving your sum of money forward in time.

Say your investment of $1,000,000 at an interest of 10% p.a. will turn into $ 1,210,000 in a period of 2 years.

Discounting

It helps in determining the present value of a sum of money or a series of payments to be received in future. It’s about moving your money back in time.

Say you’ll receive a $1,210,000 after 2 years from now, so the present value of it stands at $1,000,000. 

Key components of time value of money

Let’s understand some of the key elements of time value of money. These are the 5 main points which are very important in solving the time value of money problems.

  1. Payment (PMT) – It represents equal periodic payments to be paid or received each period. It’s a positive value when you receive the payments while it’s negative in case you make the payments.
  2. Present value (PV) – It represents a sum total of future cash flows at a present date. It is done by discounting the future cash flows.
  3. Periods (n)– It is a total number of periods in the overall time frame which can be weekly, monthly, quarterly, semi-annually, annually and so on.
  4. Future value (FV) – It implies a sum of money to be received at a future date which is obtained by compounding the present cash flow.
  5. Rate It is a discount rate or an interest rate which is used in compounding or discounting a sum of money.

Interest rates

Whether we use the compound interest rate for compounding or the discount rate for discounting, one single rate is used constantly for all the cash flows of the different years, not taking inflation into account. Taking a constant rate simplifies calculation but distorts the accuracy because it does not reflect changes in the economy or the governmental policies likely to affect the interest rate. Since the future changes are unknown, there is no adjustment factor which can be incorporated into the interest rate as the direction of the change is unknown i.e. whether it will increase or decrease the respective rate.

Annuity

Both Present Value and Future Value may be calculated for a single amount or a series of equally-spaced cash flows i.e. at equal intervals. Annuity is this stream of cash flows of the same frequency which may vary across daily, monthly, quarterly or annually.

Caveat : In addition to the same frequency cash flows, they must also be identical for them to be considered as an annuity.

There are two types of annuity, namely, Regular Annuity and Annuity Due based on the timing of the first cash flow. When the first cash flow is made immediately at n=0, it is Annuity Due and when it is made one period in future, it is Regular Annuity.

TVM example

Let’s take a simple time value of money problem to understand more clearly. Say you went to purchase a Scooty and the shopkeeper gives you a choice to pay either $40,000 now or to opt for five installments of $10,000 at the end of each year for the next five years.

It would be very wrong if you simply add the five installments (i.e. $50,000) and compare it with the alternative ($40,000 today). You should rather use time value of money to determine the present value of the installments and then make a comparison.

Present value computation

n=5, I/Y= 10%, PMT= $10,000, PV= Unknown?

Feed the data in the calculator or spreadsheet and the value comes at $37,908. As you can see that going with the installment option is a better choice. This is the reason time value of money is so important.

TVM application in the financial world

The concept of TVM can be applied in Bond value calculation, determining housing loan, EMI calculations, credit card calculations, mortgages etc.

Bottomline

Time is your greatest asset if you can wisely use it. The importance of money is that it buys us time and opportunity. So if you’re smart enough, you should use your money to create more of it.

2 Comments

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    I can write unique and interesting posts for you. Let me know if you
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