Time value of Money

Concept of Time Value of Money 

Finance is an art and science of money management. The time value of money is one of the best concept in fiance. Money has time value. For example, if you're invested Rs. 100 today for a next five years @ 10% p.a. the future value will not be same as today. 

Time Value of Money

The time value of the money is a concept that present worth of money is more than same amount in the future. In short, receiving money Today is preferable than receiving same money in the future. It has happened due to following three reasons:

  1. Reinvestment opportunity: Money received today can be reinvested to get further return.

  2. Inflation: Inflation brings upward change in the price level with the passes of time. 

  3. Sacrifice of Present Consumption: For making an investment a person must have saving habit by sacrificing his/her present consumption pattern so that they can easily invest to get better and further return.

Components of Time Value of Money

In this topic we have to understand about four major component time value of money

  1. Present value: Present value means today's value of your money.

  2. No of years: For making any change in the today's value of your money it must be available any number of years

  3. Rate of return: It is a kind of growth rate which helps to grow the money continuously at specific period of time .

  4. Future value: It is a final result or outcome of your today's value in a specified period of time.

Time Value Money Formula

The formula of time value of money considers as present value or future value, and it can be calculated as: 

PV = FV/(1+r)^n

FV = PV * (1+r)^n

Where,

PV = Present Value

FV = Future Value

r = annual rate of return

n = number of years 

Note-1: The value of PV or FV is affected by rate of return (r), type of rate, holding time period and compounding approach. The compounding approach could be annually, semi-annually, quarterly, monthly, weekly, daily and continuously.

Note-2: Do the following adjustment in annual rate of return and time period if anything mentions in compounding approach:

  • Compounding- Annually = r/1 and n*1
  • Compounding- Semi-annually = r/2 and n*2 
  • Compounding- Quarterly = r/4 and n*4 
  • Compounding- Monthly = r/12 and n*12 
  • Compounding- Weekly = r/52 and n*52 
  • Compounding- Daily = r/365 and n*365 
  • Compounding Continuously =  e^rn

Note-3:  No changes if compounding is annually and you can use 360 total number of days in a year. It depends on practices.

Note-4: The type of rate also affects the PV and FV. Basically there are two types of rate used in practice. One in Reducing Rate and another is Flat Rate. Under flat rate,interest is calculated on the initial principal amount throughout the loan tenure. While under reducing rate, interest is calculated on the remaining principal amount at any time. 

Conclusion

The time value of money is one of the best concept in finance. It has happened due to three reasons include reinvestment opportunity, inflation and sacrifices of present consumption. Time value of money considers mainly four components includes present value, number of years, rate of return and future value. The value of PV or FV is affected by rate of return (r), type of rate, holding time period and compounding approach. The compounding approach could be annually, semi-annually, quarterly, monthly, weekly, daily and continuously.

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