Question

Explain how the Valuation Principle applied when using present value and future value calculations?

Answer 1

Valuation principles: Time Value of Money

If I offered you $500 now or $500 in a year, which option would you take? You might be thinking it’s a trick question and you probably will pick the correct answer intuitively (hint: it’s to take the money now!), but a proper canalization of the options can help better understand a crucial principle in financial valuation: Time Value of Money.

So, let’s examine what the concept is all about and the theoretical reason for going with Option A.

THE CORE CONCEPT OF TIME VALUE OF MONEY:

The concept of Time Value Money (TVM) is a useful concept for everyone to understand. Aside from being known as TVM, the theory is sometimes referred to the present discount value. The concept is one of the many theories of financial management and it can help you understand the value of things more comprehensively.

Instead of just knowing what the value of something is at the current moment, you should also be aware of the value in the future or indeed in the past. So, what does TVM imply? The core principle of TVM states that money at the present value is worth more than the same amount of money in the future. The statement sounds simple, but that is the beauty of TVM: the core concept shouldn’t be that difficult to grasp. If you get $500 now, the value of it will be higher than if you get $500 in a year.

The explanation is also simple. If you are scratching your head thinking how the same amounts of money can be more valuable now than in six months, the answer is: it has more earning potential. You are essentially able to increase the value of your $500 from the present more than the value of the $500 you get in a year. The money you receive sooner will have more time to increase in value, through interest, than the money you receive later – even when the actual amount is the same in value.

This idea is one of the core principles of finance and if you think about it, it’s rather obvious, isn’t it? Your money can earn more interest the quicker you get it. If you want to look at what you have in a year, the $500 you get today will have more time to gain interest than the $500 you get in next year.

The reason the first option is more valuable is down to a few reasons, which you need to understand about the TVM. Your today’s $500 is more valuable because:

· The risk associated with the value is non-existent.

· The purchasing power of the money you receive now will be higher.

· By taking the money later, you would face an opportunity cost.

What does the example here tell us about TVM? It highlights the two fundamental principles of the concept: more is better than less and sooner is better than later.

Let’s put the above information down into a graph format, as it can help understand the example of TVM even better. So, you’ll have two options:

OPTION A: Take $500 now

$500                                                                                                                  $500+interest

Now.......              .....2 months....                .....4 months....... ......6 months

OPTION B: Take $500 in six months

$500-interest                                                                                                               $500

TVM essentially helps you to understand:

1. Investments.

2. Cash flow.

3. Savings.

4. Earnings.

TVM formula can help you calculate:

1. The present value of something: The calculation could be about the present value of things like annuities and perpetuities. This can help you evaluate whether a specific cash flow is currently an earning or an obligation to the organization, for example.

2. The future value of something: Again, this might be in regards of the future value of an annuity. If you are taking out a retirement annuity, you can use the formula to count how much more you could make by starting it right now, against starting in five years, for example.

THE TVM FORMULA:

So, how can you calculate the time value of money? The formula requires you to examine the following variables:

· A balance – In the example, the balance would be $500.

· A periodic rate of interest – The interest you gain during a specific period. For example, it could be 2% each month.

· The number of periods – The number of periods of interests you’ll have. In the example, if you gain 2% each month, the number of periods would be 12 months.

· A series of cash flow/monetary intake–Refers to any additional money intake that might take place during the time. This is especially important when dealing with savings accounts or cash flow predictions.

The formula looks like this:

FV = PV X (1+ (i/n)) ^ (n x t)

Where,

FV= Future value of money

PV= Present value of money

i= interest rate

n= number of compounding periods

t= number of years

If we take the above information and calculate our little thought experiment, the calculation would look like this:

FV= $500 X (1+(2%/12)) ^ (1 X 1)

= $500 X (1+ 0.16666)^1

= $ 583.3 ^1

FV= $583.3