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Time value of Money is time preference i.e. it considers receiving of a good at an earlier date rather than receiving it later. Before focusing on Time Value of Money (TVM), one first needs to understand the concept of time preference. Time preference is based on how large premium a person can pay for enjoyment in nearer time over more remote enjoyment in future when the value of present money will be lost. Time preference is solely a personal preference. It’s dependent on an individual what he or she prefers high or low time preference. High time preference people focus on their immediate future well-being and possess an average life standard at present while low time preference people concentrates more than an average on their well-being in the further future. A person is considered to be under high time preference if he or she wants to save money but cannot save it in present time. Sometimes age factors are also considered like an old age person will likely to choose short time preference or will spend money for short period of time to collect more returns and enjoy more commodities within time limit & of life as well. Thus time value of money is related with the receiving of money now or at earlier date rather than receiving it later; related with greater benefits on earlier receiving. Time preference, in economics, is called discounting and the time value of money is called as present discounted value.
The principle of valuation i.e. time value of money explains why interest is paid or earned for instance the payment of interest to a holder for the time value of money on a bank deposit. It also remarks with the investments. Investors investing in present time are likely to get favorable return of their investments in the future.Time value of money prefers any amount of money is worth at present time and the investors are likely to receive same amount of money today rather than the same amount receiving in future because the value of money increases with time. For example, a person invests $50 at an interest rate of 10% for a period of one year and he gets $55 after one year. Since the value of money increases with time, the value of $55 will be same as that of $50 before one year. And from this one can assume inflation rate would be nothing or zero.
FORMULA FOR TIME VALUE OF MONEY
Calculation for time value of money, it set equivalent to the future value or one can say that the present amount is discounted to a amount equivalent to time value of money. Consider FV is the future value to be received in one year at an interest rate of r provides Present Value (PV) as
PV = FV/(1+r)
Or, PV+PV*r = FV
PV = FV – PV*r
The factor (1+r) in denominator is known as the discounting factor in the time value of money.
There are certain terms that come with the standard calculations based on the time value of money or TVM and these terms are:
- PRESENT VALUE: present value is also known as present discounted value that has its value less or mostly equivalent to the future value. Present Value is considered to be ‘more worth’ or valuable than the future value because the sum of future value is included with the interest rate or amount and can possess the same value as that of present value. Higher the discount rate, lower is the present value and vice versa.
- PRESENT VALUE OF AN ANNUITY: an annuity is a series of payment given at an equal interval of time, for example premium paid for insurance half yearly or yearly, monthly, quarterly or the way the depositor wants (following the regular intervals or evenly spaced criteria). For an ordinary annuity,the payments or receipt formation can occur at the end the period (or interval) whereas for an annuity due it occurs at the beginning of each period or an interval.
- FUTURE VALUE: future value is the sum of the amount to be given in future at a specified date after specified interval of time. For example, after receiving a particular amount of premium for a period of time, a calculated sum of amount is provided which becomes the future value for the ‘present value’ provided over the period of time and which further doesn’t consider the point of inflation.
- FUTURE VALUE OF AN ANNUITY: It assumes that the amount is provided at a specified rate and further considers that the rate and payment at regular interval of time remains unchanged.