Question

Explain what is meant by the time value of money. Why is it important? Why is the present value of $100 that you expect to receive one year from today worth less than $100 received today?

Answer 1

Meaning of Time Value of Money (TVM) : TVM is based on the priciple that money has a potential earning capacity and it provides that the money available at the present time is more valuable than the identical sum on a future date.If the amount of money is used today it can be utilised to invest and earn interest on it .TVM is the amount of difference between the amount of interest, that can be earned on a particular value of money invested today and the same amount of money invested on a later date at the same rate of ineterest. The amount of interest earned during the time gap is refered to as incremental gain, further defined as time value of money.

For Eg :

FV = PV x [ 1 + (i / n) ] ^{(n x t)}

^where

^{FV = Future Value of Money}

^{PV = Present value of money}

i = interest rate

n = no. of compounding periods per year

t = number of years

Supposse you invest $100 @ 10 % at annual interest rate fo one year

Future value of money is as follows :

FV= $100 x (1 + (10% / 1) ^ (1 x 1) = $100 x (1.1) = $ 110

Reasons why present value of $100 you expect to receive one year from today is worth less than $ 100 received today is as follows :

1 Preference for Present Consumption : Individuals prefer present consumption over future consumption. It is required to offer them more in future to prefer future consumption instead of present consumption.

2 Inflation : Due to inflation value of currency decreases over time. The greater the inflation , the greater is the gap between the value of money today to the value of money in future.

3 Risk : Risk here is refered to as uncertainity associated with the cash flows in future. The higher the risk , the lower is the value of money of such cashflows.