Elearnmarkets - Financial Market Learning
  • Categories
    • Basic Finance
    • Derivatives
    • Financial Planning
    • Fundamental Analysis
    • Technical Analysis
    • Marketshala
    • Miscellaneous
  • Language
    • English
    • Hindi
    • Bengali
No Result
View All Result
  • Courses
  • Webinars
  • Learn On Elearnmarkets
Elearnmarkets - Learn Stock Market, trading, investing for Free
  • Categories
    • Basic Finance
    • Derivatives
    • Financial Planning
    • Fundamental Analysis
    • Technical Analysis
    • Marketshala
    • Miscellaneous
  • Language
    • English
    • Hindi
    • Bengali
No Result
View All Result
  • Courses
  • Webinars
  • Learn On Elearnmarkets
Elearnmarkets - Learn Stock Market, trading, investing for Free
No Result
View All Result
Home Basic Finance
Understanding the Time Value of Money 1

Understanding the Time Value of Money

Elearnmarkets by Elearnmarkets
September 27, 2022
in Basic Finance
Reading Time: 10 mins read
4
31.3k
VIEWS
Share on FacebookShare on TwitterShare on WhatsApp

The concept of the time value of money is an essential one for anybody who is involved in the decision-making processes for some critical aspects of finance like capital budgeting and valuation.

On the other hand, it is important for a loan-taker to understand the implications of the time value of money as well.

Simply put, the concept of the time value of money states that a sum of money that is received at this current time, has a higher value than that exact sum of money received down the track in the future.

Table of Contents
What is Time Value of Money?
Components of TVM
Time Value of Money Formula
Applications of Time Value of Money
Key Takeaways

What is Time Value of Money?

Suppose I offer you the choice of taking Rs. 1,00,000 from me today, or taking this same sum from me after a year.

What decision will you make?

Join TMP Join TMP Join TMP

If you chose to take the sum today, you’ve made the right choice.

There are 2 reasons why taking up the first option is better –

High purchasing power – Because of inflation, it’s safe to consider that an amount of money can get us more services and goods than it can in the future.

You have chosen the first option in the previous example because you understand that Rs. 1,00,000 can get you more things today than it will get you a year later.

Risks involved– What if, in the previous example, you chose to receive the money a year later, but when you approach me then, I don’t have any money to give to you?

This could also happen to you if you lend money to someone, but they go bankrupt before they can repay you. This shows that there is a certain level of risk involved if you choose to get your money at a later date.

With these two reasons, we can justify the existence of the concept of the time value of money. Now, let us discuss some components that we’ll need to be able to calculate the time value of money.

Components of TVM

The key components are as mentioned below –

1. Interest/Discount Rate (i)– It’s the rate of discounting or compounding that we apply to an amount of money to calculate its present or future value.

2. Time Periods (n) – It refers to the whole number of time periods for which we want to calculate the present or future value of a sum. These time periods can be annually, semi-annually, quarterly, monthly, weekly, etc.

3. Present value (PV)– The amount of money that we obtain by applying a discounting rate on the future value of any cash flow.

4. Future value (FV)– The amount of money that we obtain by applying a compounding rate on the present value of any cash flow.

5. Installments (PMT)– Installments represent payments to be paid periodically or received during each period. The value is positive when payments have been received and become negative when payments are made.

Time Value of Money Formula

What if you bought a bike and the dealer gives an option to pay Rs 3,00,000, its total cost, now, or 3 installments of Rs 1,00,000 for the next three years at the end of each year.

It’d be wrong if you add the installments and provide a comparison with the current amount that you’ll have to pay.

Why? Let’s find out by learning about the two main calculations that we encounter in situations of time value.

1. Present Value (PV)

The present value is known as the current value of a sum of money that we will receive in the future.

We have mentioned that the purchasing power of money reduces over time. The formula of PV accounts for this reduction by applying a discounting rate to the sum that we will receive in the future.

Learn to Earn Time Value Safely in just 2 hours by Market Experts

Due to the use of the discounting rate, the process of calculating the present value of a sum of money is also known as discounting a sum of money.

The PV of a sum of money can be used to determine the current value of projected cash flow from a bond, an annuity, a loan, or any such instance where you are supposed to receive money from a third party in the future and you want to know exactly how much that money will be worth today.

It is given by the following formula –

PV = FV / (1 + i)^n

Here, we require three things to calculate the present value –

  1. What is the value of the sum we will receive in the future? (FV);
  2. What is the rate of discounting at which the purchasing power of the money will fall? (i); and
  3. After how many years will we receive the concerned sum of money? (n).

2. Future Value (FV)

As the name goes, the FV denotes the value of a sum of money at some date in the future.

This calculation is useful for investors and businesses who want to know the future value of their potential investments to make a good investment decision.

The formula for FV is given by –

FV = PV (1+i)n

This formula requires only three things to give us a future value –

  1. What amount of money do we have right now? (PV);
  2. What is the assumed interest rate at which it will grow? (i); and
  3. After how many years will we need the money? (n)
Time value of money

Applications of the time value of money

The concept of the time value of money will be relevant in any situation where a party will be receiving or paying a sum of money to a third party.

That being said, let us discuss two everyday situations where we might have to apply the concepts of the time value of money.

Loan EMIs

EMIs, short for Equated Monthly Installments, constitute the prime method of repaying back a loan.

The need for the concept of time value arises when it comes to calculating the value of the EMIs. Let us return to the example we had talked about before.

As per the example, you went to purchase a bike worth Rs. 3,00,000 and the dealer gives you a choice.

  1. You either pay Rs 3,00,000 now, or
  2. Opt for installments of Rs 1,00,000 at the end of each year for the next three years.

Let’s evaluate each choice one by one.

The first one is pretty simple, right? You can just pay off Rs. 3,00,000 this instant, but this amount can cause a huge dent in your savings, depending on your income and financial status.

Now, for the second one, if you pay Rs. 1,00,000 at the end of each year for three years, it might cause you a bigger dent in your savings because as we’ve learned, the value of money keeps increasing over time.

Therefore, it is clear that even if we are paying three installments of Rs. 1,00,000 each, the effective value of these installments can be much higher in the future.

It’s because the installments are not the present values, whereas the Rs. 3,00,000 is the present value of your purchase.

One should always make sure that they are either comparing two future values or two current values to come to a correct investment decision.

Therefore, to make the correct decision, you should evaluate the present value of all the installments, add up their value, and then compare that value to the current price of the product to see how much interest you’re paying on the product.

This technique is relevant for any loan – from a home loan to a simple EMI-system purchase of home appliances. You can read about calculating EMIs in an easy way.

Value of Investments in Bonds

The PV formula plays a pivotal role when it comes to calculating the yield to maturity (YTM) of a bond.

What is the Yield to Maturity?

In simple terms, the YTM is the rate of return that shows the total anticipated return to an investor if they hold the bond till maturity.

Consider this – suppose an investor wants to invest in a security that will yield them an interest rate of at least 10%.

How will the investor be able to decide if the bonds they want to purchase will give them as many returns?

Simple! Calculating the YTM requires the calculation of the PV of every cash flow from the bond to the investor.

Therefore, the investor can compare the YTM rate with their desired rate of interest to decide if the bonds are a suitable purchase for them.

In this way, the concept of time value is essential for an investor looking to buy bonds in the future.

You can also read more about YTM and bond yields here.

You can also use Kredent Money App to know the future value of your mutual funds.

Key Takeaways –

  • Time value of money is an important concept which one should understand if they are associated with the fields of finance.
  • Time value of money works on the principle that money today is worth more than the same amount of money received in the future.
  • There are 5 major components of time value – rates, time periods, present value, future value, and payments.
  • The Present Value (PV) is known as the current value of a sum of money that we will receive in the future.
  • The Future Value (FV) denotes the value of a sum of money at some date in the future.
  • The concepts of present and future value are essential for many day-to-day situations involving the exchange of money.
Tags: coupon bondEMIenglishFuture valueHome loanTime Value of Moneyyield to maturity
ShareTweetSend
Previous Post

Did you know that Behavioural Finance affects your Stock Price?

Next Post

Corporate Tax in India

Elearnmarkets

Elearnmarkets

Elearnmarkets (ELM) is a complete financial market portal where the market experts have taken the onus to spread financial education. ELM constantly experiments with new education methodologies and technologies to make financial education effective, affordable and accessible to all. You can connect with us on Twitter @elearnmarkets.

Related Posts

5 Best Practices in Your First Year of Stock Market Trading 2
Basic Finance

5 Best Practices in Your First Year of Stock Market Trading

May 15, 2023
1.5k
Understand the MSCI Index and its Rebalancing Impact on the Indian Stock Market 3
Basic Finance

Understand the MSCI Index and its Rebalancing Impact on the Indian Stock Market

May 12, 2023
2.2k
Tax Planning - 7 Changes in the Indian Financial Environment that you need to know this Financial Year! 4
Basic Finance

Tax Planning – 7 Changes in the Indian Financial Environment that you need to know this Financial Year!

April 18, 2023
1.3k
Last-Minute Tax Planning- 5 Common Mistakes that Taxpayers Make 5
Basic Finance

Last-Minute Tax Planning- 5 Common Mistakes that Taxpayers Make

April 12, 2023
1k

Comments 4

  1. Jessie Hookie says:
    3 years ago

    I found your article very informative and you had great use of facts throughout the article.

    Thanks for sharing this valuable information with us, it is a really helpful article!

    Reply
    • Sakshi Agarwal says:
      3 years ago

      Hi Jessie,

      Thank you for Reading!

      Keep Reading!

      Reply
  2. Sadam Hussain says:
    1 year ago

    Your article is very informative and very helpful about this topic thanks for share this informative article.

    Reply
    • Sakshi Agarwal says:
      1 year ago

      Hi,

      We really appreciated that you liked our blog! However, there is no option to download the same.

      Thank you for Reading!

      Keep Reading!

      Reply

Leave a Reply Cancel reply

Your email address will not be published. Required fields are marked *

Follow Us

Facebook-f Twitter Instagram Linkedin-in Youtube Telegram

Register on Elearnmarkets

Continue your financial learning by creating your own account on Elearnmarkets.com

Register Free Account

Download App

Categories

  • Basic Finance
  • Derivatives
  • Financial Planning
  • Fundamental Analysis
  • Technical Analysis
  • Marketshala
  • Miscellaneous

Popular On Elearnmarkets

  • Market Superheroes:
  • Vivek Bajaj
  • Chetan Panchamia
  • Ashish Kyal
  • Premal Parekh
  • Abhijit Paul
  • Jegan
  • Sivakumar Jayachadran
  • Vishal Malkan
  • Jyoti Budhia
  • Vivek Gadodia
  • Vishal Mehta
  • Piyush Chaudhry
  • Santosh Pasi
  • Gomathi Shankar
  • Market Superheroes:
  • Vivek Bajaj
  • Chetan Panchamia
  • Ashish Kyal
  • Premal Parekh
  • Abhijit Paul
  • Jegan
  • Sivakumar Jayachadran
  • Vishal Malkan
  • Jyoti Budhia
  • Vivek Gadodia
  • Vishal Mehta
  • Piyush Chaudhry
  • Santosh Pasi
  • Gomathi Shankar
  • Courses:​
  • Options Trading
  • Dow Theory
  • Momentum Trading
  • Stock Investing
  • Stock Market for Beginners
  • Harmonic Chart Patterns
  • Algo Trading
  • Elliot Wave Theory
  • Advanced Excel
  • Cryptocurrency
  • NSE Certification Course
  • Courses:​
  • Options Trading
  • Dow Theory
  • Momentum Trading
  • Stock Investing
  • Stock Market for Beginners
  • Harmonic Chart Patterns
  • Algo Trading
  • Elliot Wave Theory
  • Advanced Excel
  • Cryptocurrency
  • NSE Certification Course
  • Webinars:
  • Bank Nifty Scalping
  • Intraday Trading Strategies
  • Options Trading Strategies
  • Options selling
  • Price Action
  • Relative Strength
  • Tax Planning
  • Options Buying
  • Growth Stocks
  • Portfolio Management
  • Relative Strength Index
  • Risk Management
  • Renko Charts
  • Crude Oil
  • Traders Psychology
  • Moving Average
  • Multibagger Stocks
  • Webinars:
  • Bank Nifty Scalping
  • Intraday Trading Strategies
  • Options Trading Strategies
  • Options selling
  • Price Action
  • Relative Strength
  • Tax Planning
  • Options Buying
  • Growth Stocks
  • Portfolio Management
  • Relative Strength Index
  • Risk Management
  • Renko Charts
  • Crude Oil
  • Traders Psychology
  • Moving Average
  • Multibagger Stocks
  • Free Learning Modules:
  • Intraday Trading
  • Options Scalping
  • Swing Trading
  • Financial Modelling
  • RSI Indicator
  • Bollinger Bands
  • Pricing of Futures
  • Personal Finance
  • Initial Public Offerings (IPO)
  • Value Investing
  • Technical Indicators
  • Candlesticks
  • Chart Patterns
  • Option Greeks
  • ELSS Funds
  • Banking and Insurance
  • Real Estate
  • Gold
  • Free Learning Modules:
  • Intraday Trading
  • Options Scalping
  • Swing Trading
  • Financial Modelling
  • RSI Indicator
  • Bollinger Bands
  • Pricing of Futures
  • Personal Finance
  • Initial Public Offerings (IPO)
  • Value Investing
  • Technical Indicators
  • Candlesticks
  • Chart Patterns
  • Option Greeks
  • ELSS Funds
  • Banking and Insurance
  • Real Estate
  • Gold
  • Book Summaries:
  • Rich Dad Poor Dad
  • Psychology of Money
  • The Intelligent Investor
  • The Richest Man in Babylon
  • Think and Trade Like a Champion
  • Value Investing and Behavioural Finance
  • Trading in the Zone
  • Learn to Earn
  • Book Summaries:
  • Rich Dad Poor Dad
  • Psychology of Money
  • The Intelligent Investor
  • The Richest Man in Babylon
  • Think and Trade Like a Champion
  • Value Investing and Behavioural Finance
  • Trading in the Zone
  • Learn to Earn
  • Tools:
  • CAGR Calculator
  • SIP Calculator
  • eLearnOptions
  • Future Value Calculator
  • Present Value Calculator
  • Atal Pension Yojana
  • Cost of Delay Calculator
  • Become a Crorepati
  • Tools:
  • CAGR Calculator
  • SIP Calculator
  • eLearnOptions
  • Future Value Calculator
  • Present Value Calculator
  • Atal Pension Yojana
  • Cost of Delay Calculator
  • Become a Crorepati

© 2023 Elearnmarkets. All Rights Reserved

  • Visit Elearnmarkets
  • Courses
  • Webinars
  • Financial Guides
  • Get Free Counselling
  • Visit Elearnmarkets
  • Courses
  • Webinars
  • Financial Guides
  • Get Free Counselling

Get Elearnmarkets App

No Result
View All Result
  • Article Categories
    • Basic Finance
    • Derivatives
    • Financial Planning
    • Fundamental Analysis
    • Technical Analysis
    • Marketshala
    • Miscellaneous
  • Language
    • Hindi
    • Bengali
    • English
  • Courses
  • Webinars

© 2020 Elearnmarkets All Rights Reserved