Skip to main content

Understanding The Time Value of Money (TVM)


What is Time Value of Money (TVM)?
  • The concept of Time value of money is the baseline of major finance decisions. The  value of money is different at different points of time as the money can be put to productive use. The time value of money often signifies that money available at the present time is worth more than the same amount to be received in the future due to its potential earning capacity. This concept of TVM is important from decision point of view for different investors.

  • For example: $500 today is more valuable than $500 for tomorrow.
  • Therefore, concept TVM always influences our decision about what we intend to do with our money.

Time Value of Money (TVM)
Significance of Time Value of Money (TVM) in financial decision making
  • A rupee today is more valuable than rupee after a year due to several reasons:

  1. Risk:  there is uncertainty about the receipt of money in future.
  2. Investment opportunities: People often have a preference for present money because of availabilities of opportunities for investment for earning additional cash flow
  3. Inflation: In an inflationary period a rupee today represents a greater real purchasing power than a rupee a year hence.
  4. Preference for present consumption: People often prefer current consumption over future consumption.

  • Some people put their money in a bank account, some invest in stocks, bonds etc. different people follow different strategies to utilize their ideal money because are aware of the fact that time is the biggest enemy of idle money.
  • When time value of money concept comes in Finance, we are dealing with two types of time value:
  1. Future Value
  2. Present Value
Present Value And its formula
  • Present value techniques allow you to adjust cash flows backward along a timeline. You might want to compute how much you would need set aside today in order to meet your retirement expectations in the future.
  • The present value of an amount of money that has to be received at a future date is calculated by discounting the future value at the interest rate that the money could earn over the period. This process is known as Discounting.
  • The formula for the present value is:

               PV = FV/ (1+r)

              Here,
             FV = Future Value
             PV = Present Value
             r = rate of return is uniform for the period
             t = number of periods
Future value and its formula
  • Future value calculations shows much a sum deposited today will grow in the future and compound interest affects future values differently.
  • The future value of a sum of money to be received at a present date is determined by compounding the present value at the interest rate that the money could earn over the period. This process is known as Compounding.
  • The future value formula is: 

              FV= PV (1+r) t

              Here,
              FV = Future Value
              PV = Present Value
              r = rate of return is uniform for the period
              t = number of periods




What are different financial applications for the time value of money?

  • Equipment purchase or new product decision,
  • Determination of return on an investment
  • Regular payment necessary to provide a future sum, investment,
  • Present value of a contract providing future payments,
  • Future worth of an investment,
  • Regular payment necessary to amortize a loan,
  • Determination of the value of a bond, etc.


Also read Beginner's Guide for trading in equities




Labels:
Location: United States

Comments

Post a Comment

Popular posts from this blog

Fundamental Analysis of Stocks

Q1. What is fundamental analysis? Answer: Fundamental analysis is the detail evaluation and analysis of the entity’s financial statement. It provides the information regarding the entity’s operation. With the help of financial analysis tools, one can easily forecast the company’s future. It gives the bird’s eye view of the performance and growth of an organization. Q2. What is a fundamental analysis of the stock? Answer: Apart from the technical analysis as we have discussed earlier, fundamental analysis is the detailed study of both macroeconomic and microeconomic factors that affect the company’s share price in the secondary market (i.e. stock exchanges).  In order to determine the fair value of the shares, we have to calculate the intrinsic value of the shares. Various fundamental analytical tools help an investor to determine the intrinsic value of the stocks. Q3. What are the major components of the fundamental analysis? Answer: Fundam...
Post a Comment
Read more

Stock Market Bubble And Crashes

Stock market bubbles and crashes have evolved from a phenomenon known as the tulipmania of the 1630s and are two of the earliest recorded financial bubbles. A stock market bubble happens when a company’s stock is overvalued and investors wrongly believe they will get high returns on their investments. This leads investors to buy more of the overvalued stocks, resulting in a rapid increase in the stock prices. A stock market crash then occurs when the market significantly falls resulting in a large amount of investors losing money. This is usually caused by the overvalued stock prices dropping back to more realistic levels. This can be caused by a sudden decrease in investor confidence due to a major external event such as a recession or a war, or can be caused by the market overheating; when rising stock prices cause investors to think the market is invincible and to buy overvalued stocks, creating a bubble. When investing in stocks, investors need to consider the risks involved with t...
Post a Comment
Read more

Things You Need To Know Before Getting A Mortgage

Buying a house is one of the biggest financial decisions a person can make. It’s hard to understand where you should begin or what the most important things are to consider when it comes to taking out a mortgage Whether you want to purchase your first home, an investment home, or a vacation home, it’s important to know what you need to know before getting a mortgage. First and foremost, know your credit score and be prepared to explain your credit history. Your credit score is one of the most important factors when it comes to a lender making a decision whether to grant you a mortgage. While it can take time to improve your credit score, it’s important to address any red flags that lenders may see during their review. Pay close attention to your score and start improving it as soon as possible if you find any discrepancies. Next, know your overall financial situation and determine how much you can afford. You’ll need a financial buffer and it’s advisable to have access to funds for mai...
Post a Comment
Read more