-Time Value of money is concept that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.
-Money the bank will earn interest. Because of this universal fact, we would prefer to receive money today rather than the same amount in the future.
Theory:
The time value of money received today is more than the value of same amount of money received after a certain period.
Time preference for money:
Options of time period for receivables.
(i)Immediate
(ii)Later
Reasons for time preference for money
(i)Uncertainty and loss
(ii)To satisfy present needs
(iii)Investment opportunities.
RATIONALE OF TIME PREFERENCE FOR MONEY
UNCERTAINTY– FUTURE IS UNCERTAIN AND IT INVOLES RISK. HENCE HE/SHE WOULD LIKE TO PREFER TO RECEIVE CASH TODAY INSTEAD IN THE FUTURE.
EXAMPLE- MACHINE X $ 1,000,000 WITH 10YEAR LIFEAND MACHINE Y IS $ 1,100,000 WITH 14 YEAR LIFE
WHICH ONE DO YOUR PREFER?
MOST OF THE PEOPLE GENERALLY PREFER TO USE THE PRESENT MONEY FOR SATISFYING THE PRESENT NEEDS.
POSSIBILITY OF INVESTMENT OPPORTUNITY
ANOTHER REASON WHY INDIVIDUALS PREFER PRESENT MONEY IS DUE TO THE POSSIBILITY OF INVESTMENT OPPORTUNITY THROUGH WHICH THEY CAN EARN ADDITIONAL CASH
Technique of time value of money
The interest earned on the principal amount becomes a part of principal at the end of the compounding period.
To determine the future value of money.
Formula Method Future Value (FV)= P(1+i)n
Lumpsum Method
P=Principal, i = interest, n = number of years
Table Value – used when period of maturity is long.
Multiple compounding periods – interest calculated half-yearly, quarterly or every month. FV=P(1 + i/m)mxn
Discounting or present value technique
Money to be received in future date will be less because we have lost the opportunity cost in the form of interest.
Computation of present value:
ØLump sum
PV = Fv/ (1+i)n
ØDiscount factor Tables
ØSeries of payment
PV= F1 / (1+i) + F2 / (1+i)2 + ….. Fn / (1+i)n
ØAnnuity
At the end
PV= A / (1+i) + A / (1+i)2 + ….. A / (1+i)n
At the beginning
PV= A+ A / (1+i) + A / (1+i)2 + ….. A/ (1+i)n
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