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Explain the concept Time value of money in finance.
Time value of money tells, what would be the worth of value of your present money in future. In other words, it tells about the worth of today’s money in future. Money potential increases with time.
If you invest your today’s money, for which you will get interest, it will automatically increase the value of money. Factors like inflation and purchasing power are to be considered, while investing the money because both can erode the value.
Time value of money helps investors to take decisions about where to invest, when to invest. It also helps us to understand about interest, inflation, risk and return.
Components of time value of money are as follows −
Number of discounting/compounding periods.
Rate of interest.
Present value.
Future value.
Periodic payments.
Formula
Fv = Pv * [1 + (i/n)] ^ (n*t)
Where,
Fv = future value
Pv = present value
i = interest rate
t = number of years
n = compounding periods
Present value: It’s the present value of money you have in your pocket.
Future value: It’s the value of money that you have invested earlier and additional amount you have acquired by interest.
Techniques in time of value of money are mentioned below −
Compounding − It is the technique that represents the conversion of today’s money into future money by compounding factor/interest.
Vn=Vo*(1+k) ^n
Where, Vo= todays money, n = time of interval, Vn= future money, (1+k)= compounding factor, k = profitability rate
Discounting − It is the technique which is used to calculate the present value of future money.
Vo=Vn* (1/(1+k)^n)
Factors used to determine time value of money are as follows −
Inflation rate.
Interest rates.
Risk premium.
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