Time Value of Money

Time Value of Money

General Concept:

“1 dollar at present worth more than 1 dollar in future”.  That means if you borrow 1 dollar from someone today and return it after 1 year, you are returning comparatively lower value. The value of money well always becomes lower in future.  

Suppose you have won a lottery of $2000 and you have two payment options –

1.      You can take the cash($2000) now
2.   You can take the cash ($2000) after 1 year later.  

What will you do?? Will you go for option one or option two ???

Lets make it easier for you to choose:

The value of $2000 will change after 2 years and surely it will be lower. But why?? There are two main factors that change the value-

1. Inflation
2. Interest

Inflation reduces the value of money over time. For example if inflation rate is 10% over a year than the value of $2000 will become 1800 at the end of the year. Inflation =10% means the value of money has decreased by 10%. If you have $100 at the beginning of a year it will worth $90 at the end of the year. So it is better to have the money now rather than in future

Time Value of Money

Interest rate (Market Interest Rate) has significant impact on value of money. If interest rate is 12% that means value of $2000 will become $1760 after one year.

If we consider these two facts we can easily understand the “Time Value of Money”. In “Time Value of Money” 2 terms are important.

•   Present Value (PV)
•   Future Value (FV)

Suppose you have chosen option one. You have got $2000 right now. So the "Present Value" (PV) = $2000.

Now consider the interest rate of 5% so after 1 year the value will be

= (95*2000)/100

= $1900

This value is the “Future Value” (FV) of $2000. 

For more detail visit following link- 

http://www.investopedia.com/terms/t/timevalueofmoney.asp