Time Value of Money

The concept of time value of money lays down that money received today has a greater value than money received at a future certain time. It holds that it’s better to receive money today than at a later date. This concept is based on the English proverb that “a bird in a hand is better than two in a bush”. A person will always prefer to receive a certain sum of money right now rather than at a later date. Such a preference may arise due to the following reason:

  1. Future Uncertainty: Future is uncertain and is full of risk. Because of this risk, the individual prefers to have a current sum of money.
  2. Present consumption: An individual may have some need right now. So, he would not want to delay the acquisition of money for the future. He may prefer a sum of money now. So that he could consume it as per present need. Also, the purchasing power of money decreases with the time.
  3. Reinvestment opportunity available today: A consumer always has an opportunity to re-invest money somewhere else and earn some interest on it.

The concept of time value of money is based on two principle

Principal of Compounding

Compounding technique helps in finding the future value of a present sum of money.

FV = PV (1 + r)*n

Where,

 FV = Future Value, PV = Present Value,  r = Rate of interest,  n = Number of years

 

Principle of Discounting

Compounding technique helps in finding the present value of a future sum of money.

PV = FV / (1 +r)*n

Where,

FV = Future Value, PV = Present Value, r = Rate of interest, n = Number of years

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