Time value of money is very helpful technique for taking investment decisions. We accept that proposal first which will return our money fasty than any other project. We can also calculate value of today earned money if we invest it in specific period on the basis of interest rate.
Example which shows the time value of money:
Today we receive Rs. 100 and invest it in saving account of bank and After one year we will receive Rs. 103.50. Rs. 3.50 is the time value of money and in other word it is interest which we will earn on our investment.
Importance of time value of money in investment decisions
Time value of money is very helpful for taking different type of investment decisions which we can show following ways:
1. It is helpful for calculating the future value of cash inflows
With the help of time value of money, investor can know future value of money if he invest his principle amount today. We can calculate this amount with following formula
Amount = Principle ( 1+ r/100 ) and its power no. years
or
Suppose, Ram invests Rs. 100 annually for six years , he will receive 10% compound interest on it from bank. Please tell me today what he receive after 5 years.
{*} We can know future value of money.
A = p(1+r/100) power t
A = 100 X ( 1+10/100) power 5 years
Future value of money ( A ) = 100 X (1.1) power 5 years
Future value of money = Rs. 161.051
Not only cash inflow's future value, we can also calculate future value of annuity with following formula.
2. It is helpful for making minimum reserve
calculation of present value and calculation of net present value is totally based on time value of money. If we know cut off rate or minimum discount rate which we have to pay or receive, then we can know minimum amount of reserve for achieving specific amount after some time, it is based on the idea that if we invest small amount, interest will automatically include in it and after sometime, this small amount will equal to our target amount. Suppose, you need Car after 10 years, you are capable to save Rs. 2000 per month, if you invest it in that scheme which give you high interest, you can know when your small saving will become as equal to the amount of Car. Its formula is just opposite the formula of Future value of cash inflows.
Present Value of Money or Principle =
Suppose a man will receive Rs. 161.051 after 5 years, if cut off rate is 10%, then what is the present value of that money. After calculation with above formula it will be Rs. 100.
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