Table of Contents
Time Value of Money
Definition of Time Value of Money:-
Time value money means that the value of a unit of money is different in different time periods. Time vale of money can also be referred to as time preference for money (or) present discounted value.
Value of money = Value of money receivable at present + Time value of money Receivable at Future.
Techniques
There are two techniques for doing this:
- Compounding / Future Value
- Discounting / Present Value
Compounding:- is determining the future value of present amount.
Discounting:- is determining the present value of future amount.
How value of Money related to Time?
With passage of time value of money decreasing.
Why this Happens?
- Earning capacity increases money supply increases
- Inflation Price increases
- Sacrifice the present consumption
- Risk Compensation
The main reason of decrease in money value is inflation. However the lenders of money need to be compensated the sacrifice of their present compensation and risks undertaken by them.
The amount by which the money is increased to compensate for inflation, sacrifice present consumption and risk is called as interest.
Interest
Interest may be defined as the charge for using the borrowed money. It is an expense for the person who borrows money and income for the person who lends money. This term is commonly used in banks, loans, installments and investments.
Methods of Interest
- Simple interest method
- Compound interest method
Simple Interest Method:
Under this method, the interest is charged only on the amount originally lent (principal borrowed) to the borrower. Simple interest is usually charged on short-term borrowings.
Compound Interest Method
Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. In this way amount i.e. interest plus principal will become the principal for the next year or period and this process continue till the maturity date.
- The Compound interest method is generally used in long-term borrowing.
- If there is only one conversion period, compound interest is the same as simple interest.
Annuity:-
A fixed amount of money that is paid or received at regular intervals or a set of equal a payments made at equal intervals of time such as annually, semi-annually, quarterly or monthly, is called annuity.
Basics Terms used in Time Value of Money
Principal (P):- Capital originally invested
Amount (A):- Sum of principal + interest
Interest (I):- Consideration (or fee) for the use of invested or loaned capital
Rate of interest (r):- It is the amount charged for the use of principal for a given length of time, usually on a yearly or per annum basis. Usually rate of interest expressed in percentages i.e. 5% p.a.
Time (t):- It is the number of years or fraction of year for which the principal is borrowed or loaned.