Saturday Brain Storming Thought (179) 08/07/2023
TIME VALUE OF MONEY (TMV)
Time value of money is the concept that Money today is worth more than Money tomorrow
That is because money today can be used, invested or grown
Money earned today can generate interest, unrealized gains or unrealized losses
Types of time value of money
1) future value of a lump sum
2) future value of an annuity
3) present value of lump sum
4) present value of an annuity
Factors of time value of money
1) Opportunity cost
2) Interest rates
Elements of time value of money
1) PV = cashs present value
2) i = interest rate (when calculating future value) or discount rate (when calculating present value)
3) n = number of compounding periods per year
Applications of time value of money
1) loan valuation
2) bonds valuation
3) capital budgeting decisions
4) investment analysis
5) personal finance analysis
Methods of time value of money
Compounding and discounting is a process used to compare rupees on our pocket today versus rupees we have to wait to receive at some time in the future
Components of time value of money
1) rates
2) time periods
3) present value
4) future value
5) payments
Ket Takeaways of time value of money
1) TVM is the basic financial concept that advocates how the current value of money is higher than its value in future
2) it is the potential earning capacity of the money that decides it’s current and future value
3) TVM helps investors make the best investment decisions, knowing the future returns they should expect from what they invest
4) Money loses its value over time, which causes inflation affecting the buying power of the public
Time value of money formula
FV = PV X (1 + i/n) nxt
FV = Future value of money
PV = Present value of money
i= Rate of interest or current yield on similar investment
t = number of years
n = number of compounding periods of interest each year
Purposes of time value of money
1) it helps in comparing the investment alternatives available in the market, investors assess the returns and other conditions to make a final decision on what option to choose
2) investors choose the best investment proposals based on the evaluation, considering the TVM
3) lenders decide the interest rates for loans, mortgages etc based on the present and future value of an amount
4) the value of money, when known, helps in fixing appropriate wages and prices of products
5) changing value of an amount also plays a considerable role in determining when a particular investment matures or when to repay a loan amount etc
Important concepts of time value of money
1) Inflation
Inflation is the loss of purchasing power caused by the deteriorating future value of money
2) Risk or uncertainty
Risk or uncertainty is the difference between what is received asan outcome and expected when the investment or expenditure was made
3) Liquidity
Liquidity makes it easy for owners to sell their assets for cash as illiquid assets are difficult to sell
Functions of Money
1) a medium of exchange
2) a standard of deferred payment
3) a store of wealth
4) a measure of value
Compounding of time value of money
Compounding is the impact of time value of money (eg interest rate) over multiple periods into the future, where the interest is added to the original amount
Time Value of Money Calculation example
Assuming interest rate 10%
Today Rs 100
After 1 year – Rs 110
After 2 years – Rs 121
After 3 years – Rs 133.10
After 4 years – Rs 146.41
Reversionary value of Rs 4 year – Rs 100
After 3 years – Rs 90.90
After 2 years – Rs 82.60
After 1 year – Rs 75.10
Today – Rs 68.30
Techniques of time value of money
1) Compounding techniques/Future value techniques
The process of calculating future values of cash flows
In this concept, the interest earned on the initial principal amount becomes a part of the principal at the end of the compounding period
2) Discounting/Present value techniques
The process of calculating present value of cash flows
Reasons for time value of money
1) individuals prefer current consumption to future consumption
2) capital can be employed productively to generate positive returns
3) in an inflationary period a rupee today represents a greater deal of purchasing power than a rupee a year hence
Time preference rate and required rate for time value of money
1) TVM is generally expressed by an interest rate, it is normally risk free rate
2) if risk is involved, risk premium is added to the interest rate
3) Required rate = Risk free rate + Risk premium
4) the required rare of return may also be comparable with the opportunity cost of capital
Value of an annuity due
An annuity whose payment is to be made immediately, rather than at the end of period
An annuity due requires payments to be made at the beginning of the period
Compiled by
Compiled by:
Er. Avinash Kulkarni
9822011051
Chartered Engineer, Govt Regd Valuer, IBBI Regd Valuer
