Time Value of Money Notes for the UGC-NET Commerce Examination (2024)

The time value of money means that a sum of money's value is more now than what it is expected to be soon, which is because of its earnings potential in the interim. The time value of money mainly acts on the principle of finance. Money today is worth more than what the worth of the money will be in the future. This is because money today can be invested to earn interest and grow in value. The concept that a dollar today is worth more than a dollar tomorrow is the time value of money. The time value of money states that a dollar today is worth more than a dollar tomorrow due to option costs and inflation. This principle is used to accurately compare and evaluate cash flows that occur at different times. Present worth and future value calculations help apply the time value of money in finance.

Besides being an exciting topic, the time value of money is also repeatedly asked in the UGC-NET Commerce examination, so learners are advised to know this topic well.

In this article, the learners will be able to understand this topic well to spot the correct answers in the examination.

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Time Value of Money Meaning

The Time Value of Money (TVM) is a financial concept that describes the idea that money available today is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that money can be used to earn more money: it can be invested in interest-bearing financial instruments, such as stocks, bonds, or a savings account, which can provide returns over time.

What is the Time Value of Money?

The time value of money could be understood from the points said below.

• Money today is better than money tomorrow.
• Money today can earn interest and grow.
• Money tomorrow lost time to earn interest.
• Inflation makes money lose value over time.
• So $1 today is worth more than $1 tomorrow.
• We compare money at different times using the following
  • Present value: Value now of money in future
  • Future value: Value in the future of money now

Time Value of Money Calculator

The time value of money is widely public online. To quickly calculate the value, the following is needed.

• Present value: Value now of a future cash flow
  • Enter the future amount, interest rate, and period
• Future value: Value in the future of an initial amount
  • Enter a present amount, interest rate, and period

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Time Value of Money Formula

The present Value Formula is as follows.

PV = Future Value / (1 + Interest Rate)^Number of Periods

Enter the following.

• Future value = amount you'll receive in future
• Interest Rate = Rate of return or discount rate
• Number of Periods = Years until you get the future cash flow

The Future Value Formula is as follows.

FV = Present Value * (1 + Interest Rate)^Number of Periods

Enter the following.

• Present value = amount you have now
• Interest Rate = rate of return you'll earn
• Number of Periods = Years until the future date

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Time Value of Money Example

$100 now at 10% for 2 years

FV = $100 * (1 + 0.1)^2

FV = $100 * 1.21

FV = $121

So the future value is $121

Need of Time Value of Money

The needs of the time value of money have been stated below.

• Compare investments: You must compare income/costs at different times to choose the best investment.
• Choose between loans: You must compare loans with different interest rates and terms to pick the best deal.
• Calculate loan payments: We must determine the correct loan amount to repay with interest over time.
• Evaluate projects: We must determine if a project's future cash flows justify the initial investment when discounted to present value.
• Assess profits: We need to decide if a firm's future profits will exceed the costs incurred today.

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• Value bonds: We need to decide the correct price to pay today for the bond that pays income in the future.
• Set prices: Firms need to factor in the time value of money when setting prices for products or services.
• Calculate depreciation/amortization: We need to decide how much a depreciating or amortizing asset is worth over time.
• Evaluate leases: We need to compare costs of buying vs leasing by determining the present value of lease payments.

Methods of Time Value of Money

The methods of the time value of money have been stated below.

• Present Value
  • Find the value as on today of a future cash flow
  • Subtracts for the time delay
  • Uses the time value of money principle
• Future Value
  • Finds the value in the future of a cash flow today
  • Adds for the time delay
  • Uses the interest that could be earned
• Net Present Value
  • Calculates the present value of all cash inflows and outflows in a project
  • Subtracts outflows from inflows
  • Projects with positive NPV should be accepted
• Internal Rate of Return
  • Determines the rate of return a project is expected to earn
  • The rate where the present value of cash flows equals zero
  • Compare IRR to the required rate of return
• Annuity
  • A series of constant cash flows that occur at regular intervals - Calculates the future or present value of the annuity
  • Uses compounding to decide the value
• Perpetuity
  • An infinite series of constant cash flows
  • Calculates present value of perpetuity
  • Uses a capitalization rate instead of interest rate

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Significance of Time Value of Money

The significance of the time value of money has been stated below.

• Necessary to evaluate investments.
  • Compare present value of costs and future cash flows
  • Calculate returns like IRR and payback period
• Needed to value financial contracts
  • Loans: Calculate correct interest and repayment amounts
  • Bonds: Define fair value based on future coupon payments
• Important for pricing products and services
  • Factor in the cost of capital over time
  • Charge higher prices for delayed payments
• Crucial for budgeting and forecasting
  • Adjust future income and expenses to present value
  • Ensure cash flows are compared accurately
• Required for business valuation
  • Discount future cash flows to decide firm value
  • Cannot ignore the time value in valuations
• Essential to make financially sound decisions
  • Compare alternatives based on risk-adjusted present value
  • Opt for options with higher present values
• Drives economic activity
  • Incentivizes saving, investing, and capital building
  • Directs capital to its most productive uses

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Fundamentals of Time Value of Money

The basic fundamentals of the time value of money have been stated below.

• Money has value over time - Money today is worth more than the same amount in the future.
• Opportunity cost - Money now can be invested or used to earn interest. Money in the future has lost that time for investing and earning interest.
• Inflation - The purchasing power of money decreases over time due to inflation. So $1 today is worth more in real terms than $1 in the future.
• Interest - Interest rates represent the cost of borrowing money or the return available on investments. They reflect the time value of money.
• Compounding - Interest that is earned on previous interest is called compound interest. It allows money to grow over time.
• Present value - The current worth of a future sum of money or stream of cash flows after accounting for the time value of money.
• Future value - The worth of a current sum of money or stream of cash flows at some point in the future when accounting for the time value of money.
• Net present value - The present value of all cash inflows minus the present value of all cash outflows from an investment project.
• Discounting cash flows - Removing for the time value of money by discounting future cash flows to determine their present value.

Objectives of Time Value of Money

Objectives of the time value of money have been stated below.

• Compare cash flows: Compare income and costs that happen at different times accurately.
• Evaluate investments: Determine if investments are worthwhile based on future cash flows.
• Decide fair value: Calculate the present worth of future payments to find a fair value.
• Choose between financial options: Compare loans, leases, and contract terms by discounting to present value.
• Allocate capital efficiently: Fund projects with the highest present value returns.
• Set appropriate prices: Factor in the time value of money when pricing products or services.
• Accurately forecast budgets: Adjust future income/costs to present value to compare in budgets.
• Fairly value businesses: Discount future cash flows to determine a company's worth today.
• Make financially optimal decisions: Choose options that maximize total present value.
• Drive economic growth: Incentivize effective investment of capital over time.

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Features of Time Value of Money

The features of the time value of money have been stated below.

• Money has value over time - Money today is worth more than money at a later date.
• Opportunity cost - Money now can be invested to earn interest. Money later loses out on that opportunity.
• Inflation - The purchasing power of money declines over time due to inflation. So money today is worth more in real terms.
• Compounding - Interest that is earned on previous interest is called compound interest. It allows money to grow over time.
• Discounting - Subtracting for the time value of money by discounting future cash flows to determine their present value.

Key Components of Time Value of Money

The parts of the time value of money have been stated below.

• Present value - The current worth of a future sum of cash or payments after accounting for the time value of money.
• Future value - The future worth of an initial cash amount or payments after accounting for interest over time.
• Interest rate is used to decide how much interest is earned or paid on an investment over a while.
• Time - The number of periods between the current and future dates a cash flow occurs.
• Net present value - The present value of all cash inflows minus all cash outflows from an investment project.
• Internal rate of return - The interest rate at which the net present value of all cash flows from an investment equals zero.

Conclusion

The time value of money states money today is worth more than money in the future. We use present value, future value, interest, and time to apply this concept. It helps compare cash flows accurately and make optimal financial decisions. So alliances and people must consider the time value of money when evaluating investments, loans, projects, contracts, and prices.

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