The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Also referred to as "present discounted value".
Everyone knows that money deposited in a savings account will earn interest. Because of this universal fact, we would prefer to receive money today rather than the same amount in the future.
For example, assuming a 5% interest rate, 100 invested today will be worth 105 in one year (100 multiplied by 1.05). Conversely, 100 received one year from now is only worth 95.24 today (100 divided by 1.05), assuming a 5% interest rate.
I give you 100 rupees. You take it to the bank. They will give you 10% interest per year for 2 year.
- The Present Value = 100
- Future Value = 121.
Time Value of Money is an important concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities.
Time Value of Money is based on the concept that a rupee that you have today is worth more than the promise or expectation that you will receive a rupee in the future. Money that you hold today is worth more because you can invest it and earn interest. After all, you should receive some compensation for foregoing spending. For instance, you can invest your rupee for one year at a 6% annual interest rate and accumulate 1.06 at the end of the year. You can say that the future value of the rupee is 1.06 given a 6% interest rate and a one-year period. It follows that the present value of the 1.06 you expect to receive in one year is only 1.
A key concept of Time Value of Money is that a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today. Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date.
You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods, Payments, Present Value, and Future Value.
| FV= PV (1 + i )N |
- FV = Future Value
- PV = Present Value
- i = the interest rate per period
- n= the number of compounding periods
Determine Future Value Compounded Annually
What is the future value of 34 in 5 years if the interest rate is 5%? (i=.05)
- FV= PV ( 1 + i ) N
- FV= 34 ( 1+ .05 ) 5
- FV= 34 (1.2762815)
- FV= 43.39.
Determine Future Value Compounded Monthly
What is the future value of 34 in 5 years if the interest rate is 5%? (i equals .05 divided by 12, because there are 12 months per year. So 0.05/12=.004166, so i=.004166)
- FV= PV ( 1 + i ) N
- FV= 34 ( 1+ .004166 ) 60
- FV= 34 (1.283307)
- FV= 43.63.
Determine Present Value Compounded Annually
You can go backwards too. I will give you 1000 in 5 years. How much money should you give me now to make it fair to me. You think a good interest rate would be 6% ( You just made that number up). (i=.06)
- FV= PV ( 1 + i ) N
- 1000 = PV ( 1 + .06) 5
- 1000 = PV (1.338)
- 1000 / 1.338 = PV
- 747.38 = PV
O.K. so you give me 747.38 today and in 5 years I'll give you 1000. Sound fair?? You will get 6% interest on your money.
Determine Present Value Compounded Monthly
Here's that last one again, but with monthly compounding instead of annual compounding. (i equals .06 divided by 12, because there are 12 months per year so 0.06/12=.005 so i=.005)
- FV= PV ( 1 + i ) N
- 1000 = PV ( 1 + .005) 60
- 1000 = PV (1.348)
- 1000 / 1.348= PV
- 741.37 = PV
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