Money in the present is worth more than the same sum of money to be received in the future

INTRODUCTION.

Time Value of Money.

THE CONCEPTS OF TIME VALUE OF MONEY

The time value of money is a basic financial concept that holds that money in the present is
worth more than the same sum of money to be received in the future. This is true because money
that you have right now can be invested and earn a return, thus creating a larger amount of
money in the future. (Also, with future money, there is the additional risk that the money may
never actually be received, for one reason or another.) The time value of money is sometimes
referred to as the net present value (NPV) of money.

Reasons For Time Value Of Money:

Money has time value because of the following reasons:
Risk and Uncertainty.
Future is always uncertain and risky. Outflow of cash is in our control as payments to parties are
made by us. There is no certainty for future cash inflows. Cash inflows is dependent out on our
creditors, bank etc. As an individual or firm is not certain about future cash receipts, it prefers
receiving cash now.
Inflation.
In an inflationary economy, the money received today, has more purchasing power than the
money to be received in future. In other words, a money today represents a greater real
purchasing power than a money a year hence.
Consumption.
Individuals generally prefer current consumption to future consumption.
Investment opportunities.
An investor can profitably employ a money received today, to give him a higher value to be
received tomorrow or after a certain period of time.
How the Time Value of Money Works
A simple example can be used to show the time value of money. Assume that someone offers to
pay you one of two ways for some work you are doing for them: They will either pay you $1,000
now or $1,100 one year from now.
Which pay option should you take? It depends on what kind of investment return you can earn
on the money at the present time. Since $1,100 is 110% of $1,000, then if you believe you can
make more than a 10% return on the money by investing it over the next year, you should opt to
take the $1,000 now. On the other hand, if you don’t think you could earn more than 9% in the
next year by investing the money, then you should take the future payment of $1,100 – as long as
you trust the person to pay you then.

 Time Value and Purchasing Power

The time value of money is also related to the concepts of inflation and purchasing power. Both
factors need to be taken into consideration along with whatever rate of return may be realized by
investing the money.

Why is this important? Because inflation constantly erodes the value, and therefore the
purchasing power, of money. It is best exemplified by the prices of commodities such as gas or
food. If, for example, you were given a certificate for $100 of free gasoline in 1990, you could
have bought a lot more gallons of gas than you could have if you were given $100 of free gas a
decade later.

 Inflation and purchasing power must be factored in when you invest money because to calculate
your real return on an investment, you must subtract the rate of inflation from whatever
percentage return you earn on your money. If the rate of inflation is actually higher than the rate
of your investment return, then even though your investment shows a nominal positive return,
you are actually losing money in terms of purchasing power. For example, if you earn a 10% on
investments, but the rate of inflation is 15%, you’re actually losing 5% in purchasing power each
year (10% – 15% = -5%).

 Time Value of Money Formula

The time value of money is an important concept not just for individuals, but also for making
business decisions. Companies consider the time value of money in making decisions about
investing in new product development, acquiring new business equipment or facilities, and
establishing credit terms for the sale of their products or services.

A specific formula can be used for calculating the future value of money so that it can be
compared to the present value:

 
Where:

FV=Future value of money

PV= present value of money

I= interest rate

T=times of periods

n = the number of compounding periods of interest per year

Using the formula above, let’s look at an example where you have $5,000 and can expect to earn
5% interest on that sum each year for the next two years. Assuming the interest is only
compounded annually, the future value of your $5,000 today can be calculated as follows:

FV = $5,000 x (1 + (5% / 1) ^ (1 x 2) = $5,512.50 

Present Value of Future Money Formula

The formula can also be used to calculate the present value of money to be received in the
future. You simply divide the future value rather than multiplying the present value. This can be
helpful in considering two varying present and future amounts. In our original example, we
considered the options of someone paying your $1,000 today versus $1,100 a year from now. If
you could earn 5% on investing the money now, and wanted to know what present value would
equal the future value of $1,100 – or how much money you would need in hand now in order to
have $1,100 a year from now – the formula would be as follows:

PV = $1,100 / (1 + (5% / 1) ^ (1 x 1) = $1,047

 The calculation above shows that, with an available return of 5% annually, would need to
receive $1,047 in the present to equal the future value of $1,100 to be received a year from now.

To make things easy for you, there are a number of online calculators to figure the future value
or present value of money.
 Techniques for Estimating Time Value of Money – Discounting and  Compounding Technique
(With Differences and Methods for Calculating Future Value and Comparison)

There are two techniques of estimating time value of money which are shown in figure 2.2
and explained as follows:
1. Discounting Technique or the Present Value Method

2. Compounding Technique or the Future Value Method

Discounting or Present Value Method:

The current value of an expected amount of money to be received at a future date is known as
Present Value. If we expect a certain sum of money after some years at a specific interest rate,
then by discounting the Future Value we can calculate the amount to be invested today, i.e., the
current or Present Value.

Hence, Discounting Technique is the method that converts Future Value into Present Value. The
amount calculated by Discounting Technique is the Present Value and the rate of interest is the
discount rate. Discounting can be done a number of times and based on this, methods for
calculating Present Values are listed as follows in Table 2.2 –

Compounding or Future Value Method:

Compounding is just the opposite of discounting. The process of converting Present Value into
Future Value is known as compounding.

Future Value of a sum of money is the expected value of that sum of money invested after n
number of years at a specific compound rate of interest.

Difference between Compounding and Discounting Methods:

The points of differences between compounding and discounting are as follows:

Compounding.
The process of converting the Present Value into Future Value is known as compounding.
ii. Interest rate is used to calculate the Future Value or the compounded value.

iii. Higher the interest rate greater will be the future or the compounded value.

iv. Future Value is always greater than the Present Value provided the interest rate is positive –

FV = PV (1 + r)n

Discounting:
i. The process of converting Future Value in Present Value terms is known as discounting.

ii. Discount rate is used to calculate the Present Value.

iii. Higher the discount rate lower will be the Present Value.

iv. Present Value is always less than the Future Value

Conclusion, finance manager has to take three important Financial Management decisions such
as – the Investment Decision, Financing decision and the Dividend decision. Finance manager
has to take all these decisions keeping in mind the value maximization or the wealth
maximization objective of Financial Management.
REFERENCE

Elliott, B. and Elliott, J. (2009) Financial Accounting and Reporting (13th edn), Harlow, Essex,
Pearson Education Limited.

Amigoni, F. (1978) Planning management control systems, Journal of

Business Finance and Accounting, 5, (3), 279-92

Brigham, Eugene F.(1989). Fundamentals of Financial Management. 5th ed. Dryden

Press, 1989.