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What is Time Value of Money Concept?
Think, I will give you $100 Dollars today or 1 $100 Dollars the next year. Which one will you take?
Of course, you’ll want to take $100 Dollars today. Because you don’t want to wait for the next 1 year. Why wait if you get $100 Dollars today?
Here, you love the present that we all do. But what if you were given an extra price or reward for waiting for the next 1 year?
For example, If I would give you $100 Dollars today or give you $120 Dollars after 1 year, which would you accept?
Here, you would want to accept the second option, that is, take $120 Dollars. Because for your waiting 1 year, you can get more $20 Dollars
This extra $20 Dollars is time value of money. This is universally known as Interest.
Khan & Jain- “Time value of money means that a sum of money received today is more than its value received after some time.”
Current or time preference for money
In the sense of time value in money, we like the present more. Why do we like the present more? There are some reasons. For example:
- Uncertainty of the future
- Currently, the opportunity to enjoy
- Investment opportunities
- Avoid the risks
- Inflation: The value of money may decrease in the future
Factors Considered in Time Value of Money
The present value of a certain amount of money is called future value. For example, after 3 years how much will the amount you deposited today be adding interest? Suppose $1050. This is the future value of $ 1000 today.
Interest rates have a direct or indirect effect on the time value of money. Without interest rates or discounted rates, the present or future value of money cannot be determined.
Type of Interest
If simple interest is used, the present value varies. Again, if the compound interest is used then the present value will change to another variation.
Number of Compounding / Multiplication
If compound interest is applied once a year, the value of time varies. Again if it is applied multiple times, the time value varies relatively high. Example: Yearly compounding, Half-yearly compounding, Monthly Compounding, etc.
Risk Free Rate of Return
In each country, the interest rate paid on banks, government bonds, bonds, and various deposits and investments of insurance is called the risk-free reimbursement rate.
Please ask any questions you may have about the value of money over time, in the comment box below.
At next lesson, I’ll share Time Value of Money Formula with Example. Till then, good bye. Have a nice day.