What is time value of money?
The value of money does not remain the same at all points in time. The money available at the present time has more worth in the future for the same amount since it has the potential to earn returns in terms of interest. The value associated with the same sum of money received at various points on the timeline is called the time value of money.
Receiving Rs 1,000 now and receiving the same amount after a year, makes a huge difference. Any person would prefer to receive the cash now, rather than wait for a year, though the amount to be received has the same value; still, Rs 1,000 available now is not equivalent to Rs 1,000 received after a year.
Time value of money is one of the most important concepts in finance as most of the financial decisions involve cash flows spread over more than one period (monthly, quarterly, yearly, etc.) thereby, playing a significant role in decision-making.
The important parameters involved are:
Present value (PV): It is the amount that one would pay today for a cash flow that comes in the future. It brings the future value down to today’s price. It is based on the basic principle of the time value of money that the value of money keeps reducing as time passes.
Future value (FV): It represents what something is worth at some point in the future. There can be various amounts such as future value might need to be calculated and this will give an idea of the erosion in value from the current period.
Rate of Interest (r): It is the percentage rate that is earned on a particular investment.
The number of periods (n): This is the timeline, which is usually measured in years, but it could be in other terms too like quarterly, monthly, etc.
The calculation can be done as follows:
FV = PV (1+r)^n
Where, FV= future value, PV= present value, r = rate of return for each compounding period while n = number of compounding periods.
For example: If one invests Rs 10,000 now for the next 10 years at 8 per cent interest, then value of Rs 10,000 will be:
FV = 10,000 (1+8%)^10 = Rs 21,589.25.