The value of money changes over a certain time period. In the simpler term, the money received today is more valuable than money received at some point in the future. For example, your friend has to repay you $10,000 and gives two options –to take $10,000 today or to take $10,050 next year. Although in absolute terms, the second option offers a higher amount the first option gives you the choice to earn more than $50 over the next year by investing your money elsewhere. So your preference would be the first option because receiving money today has its potential earning capacity and is more valuable than in the future. This concept is also known as the concept of Time Value of Money (TVM). Time Value of Money (TVM) is defined as the money available at the present being more valuable than the same amount in the future. Sometimes, the time value of money is referred to as the Net Present Value (NPV) of money.
When people give preference for current money as against future money, it is known as time preference. Why do Individuals always have a preference to receive money at present and give higher value to the current money? Let’s understand this by the reasons for it.
Inflation and Investment, how does it affect your money?
Reasons for the preference of present money:
There are several reasons for the preference of current money:
- Future Uncertainties: An Investor gives preference to current money as it has certainty, but future money has uncertainty because the other party may become insolvent or fail to pay the amount to the investor.
- Inflation: The Economy never stables over a period of time as it fluctuates. In the Inflationary situation, the money received today has more purchasing power instead of in the future.
- Reinvestment Opportunities: People have reinvestment opportunities available to them. If they got the money today, they can invest to get better returns in the future. The existence of reinvestment opportunities and the urge to earn a return by investing current money seems to be an obvious reason for the preference for present money.
These reasons help in investment opportunities. Now let’s understand what the present value and future value of money are.
Future Value (FV) and Present Value (PV):
Present value and future value is the monetary concept used by the investors. These terms are used in the financial world to calculate the future and current net worth of money.
- Future Value (FV): It defines as the value of the future cash flow after a certain time period. It derives the value of an investment that will grow over a period of time at a specific rate of interest. It helps Investors on a savings plan for a specific amount in the future and on determining how much taxes will cost them.
- Present Value (PV): It represents the current value of the future value or future cash flow. The present value concept describes what amount should we invest today to get a specific return in the future. Investors can make decisions based on the present value whether they should accept or reject the project.
Investors can estimate the future value and present value by the techniques of the time value of money.
Techniques of the Time Value of Money:
There are majorly two techniques of the time value of money(TVM):
- Compounding Technique:
The compounding technique is the method that determines the future value of the present investment after a certain period of time at a specified rate. The compounding technique converts the present value into future value. It is the same concept as compound interest. The future value of the investment can be computed by the formula:
FV= PV (1+R)N
Where,
FV : Future Value
PV : Present Value
R : % of Rate of return, and
N : Number of years
2. Discounting Technique:
The discounting technique is the method that determines the present value of the future sums of money for a certain period of time at a specified rate. The discounting technique converts the future value into present value or it is a reverse of the compounding technique. The present value of the specified future amount can be computed by the following formula:
PV =FV/(1+R)N
Where,
PV : Present Value
FV : Future Value
R : % of Rate of return, and
N : Number of years
Conclusion:
The time value of money specifies the value of money changes from time to time. The value of the present money will not be the same in the future and vice-versa. Whenever investors make an investment, they need to measure the present value and future value because both are important for taking crucial decisions regarding investment decisions. So, Investors calculate present value and future value by compounding and discounting techniques. The compounding technique helps to ascertain the future value of the present investment after a certain time period at a specified rate of return. Whereas the discounting technique helps to ascertain the present value of future returns or cash flows at a discount rate. So, compounding is the easiest way to grow investment, and discounting is a vital factor in making the decision on whether to invest or not. The Compounding and Discounting techniques both rely on the time factor and the rate of return. Firms and investors assumed the present value and future value can be changed due to risk factors involved in the time value of money.
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Author: Pooja S. – Jr. Analyst
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