Time Value of Money - Introduction to Financial Management, Accountancy and Financial Management | Accountancy and Financial Management - B Com PDF Download

Time Value of Money (TVM)
Time value of money is the concept that the value of a dollar to be received in future is less than the value of a dollar on hand today. One reason is that money received today can be invested thus generating more money. Another reason is that when a person opts to receive a sum of money in future rather than today, he is effectively lending the money and there are risks involved in lending such as default risk and inflation. Default risk arises when the borrower does not pay the money back to the lender. Inflation is the rise in general level of prices.
Time value of money principle also applies when comparing the worth of money to be received in future and the worth of money to be received in further future. In other words, TVM principle says that the value of given sum of money to be received on a particular date is more than same sum of money to be received on a later date.
Few of the basic terms used in time value of money calculations are:

Present Value
When a future payment or series of payments are discounted at the given rate of interest up to the present date to reflect the time value of money, the resulting value is called present value. 

Future Value
Future value is amount that is obtained by enhancing the value of a present payment or a series of payments at the given rate of interest to reflect the time value of money.

Interest
Interest is charge against use of money paid by the borrower to the lender in addition to the actual money lent. 

Application of Time Value of Money Principle
There are many applications of time value of money principle. For example, we can use it to compare the worth of cash flows occurring at different times in future, to find the present worth of a series of payments to be received periodically in future, to find the required amount of current investment that must be made at a given interest rate to generate a required future cash flow, etc.

Basic TVM Formula
Based on your financial circumstances at the time, the TVM formula can vary to some extent. Example, in the case of annuity (income) or perpetuity (until death) pension payments, the general formula can have more components. But as a whole, the basic TVM formula is as shown in the image.

FV = PV x [ 1 + (I/ N) ] (N*T)
Where,
FV is Future value of money,
PV is Present value of money,
I is the interest rate,
N is the number of compounding periods annually and
T is the number of years in the tenure.
For instance, if you invest Rs. 1 lakh for 5 years at 10% interest, the future value of this one lakh will be Rs. 161,051 as per the formula. This formula can help you to analyze different investments over different time periods, enabling you to make optimal and informed financial decisions.

TVM with an example
The relevance of TVM depends on how much returns you can generate from the capital available. Money has immense growth potential and the more you delay employing this potential, the more you lose the chance to earn on it. For instance, if a friend or lender gives you two options – to take Rs. 10,000 today or to take Rs, 10,500 next year.
Now, even if this promise is from someone or an entity you trust implicitly, chances are more that the second option is a raw deal. With more and more schemes ranging from low-risk to high-risk – tax-saving FDs, ELSS et. – there is a high chance that you can make at least 7% on this sum, which is Rs. 10,700. But if the interest rate offered is less than 5%, then you may consider taking the money next year. So, it depends on the possible returns as per the RBI guidelines or the market.