Time Value Of Money

1.0 Introduction

Time value of money is middle or main to the concept of finance. It recognizes the value of money is different at different points of time. Since money can be put to productive use, its values is different depending upon when it is received or paid. In simpler terms, the value of a certain amount of money today is more valuable than its value tomorrow. It is not because of uncertainty involved with time but purely an account of timing. The difference in the value of money today and tomorrow is referred as time value of money. The value of money is different at different points of time due to several reasons. There are presence of inflation, preference of individuals for current consumption and investment opportunities that

Like any other commodity, money too is scarce. The surplus money with one person / business entity can be utilized by another who requires finance. The latter can put it to some productive use and derive some benefit. For passing the benefit to another party, some reward must accrue to the lending party. While accepting deposit from individuals, banks are willing to pay some interest on deposit from individuals, bank are willing to pay some interest on deposit because they would lend to someone who needs money and thus receive a greater reward. Therefore, even the idle money has value because of the lost opportunity to invest and earn an income on it.

The reasons forwarded above apply equally to firms. The time value of money for firms is primarily governed by the available investment opportunities for investment and less by the factors of inflation and preference of current consumption over future consumption. Financial managers and investors are always faces with opportunities to earn positive rates of return their investment or fund. Therefore, the concept of time value which is value today is worth than value will received in

Park Ji Hyung places RM 800 in saving account paying 6% interest compounded annually. He wants to know how much money will be in the account at the end of 5 years. Therefore :-

0 1 2 3 4 5

PV = RM 900 FV= ?

PV = RM 900 i = 0.06 n = 5 years

FV5 = RM 900 X (1+0.06)5 = RM 900 X (1.338) = RM 1,204.20

Present value is the amount that should invest today at rate over specified period time to equal the future amount. Concept of present value is referred to as discounting cash flows. It is actually behind of compounding interest.

Equation of Present Value: PV= FVn (1 + i)n

FV = Future Value i = Interest rate PV = Present value n = number of period

An example of using present value in single amount. Wan Jalal wishes to find the present value of RM 2,900 that will be received 8 years from now. Jalal’s opportunity cost is 8%. Therefore:-

0 1 2 3 4 5 6 7 8

PV = ? FV8 = RM 2,900

FV = RM 2,900 i = 0.08 n = 8 years

PV8 = RM 2,900 (1 + 0.08)8 = RM 2,900 1.851 = RM