The money available at the present time is worth more than the same amount in the future since it has the potential to earn returns
The value of money does not remain the same at all points of time. The money available at the present time is worth more than the same amount in the future. Itt has the potential to earn returns (or interest as the case may be).
Consider the following options, assuming there is no uncertainty associated with the cash flow: Receiving Rs.100 now. Receiving Rs.100 after one month. All investors would prefer to receive the cash flow now. Rather than wait for a month, though the amount to be received has the same value. This preference is attributed to the following reasons:
Instinctive preference for current consumption over future consumption.
The Ability to invest the Rs.100 for a month like a bank account or deposit. It earn a return so that it grows in value to more than Rs. 100 after one month. Clearly, Rs.100 available now is not equivalent to Rs.100 received after a month. The value associated with the same sum of money received at various points on the timeline is called the time value of money (popularly known as TVM). The time value of money received in earlier periods as compared to that received in later time periods will be higher. Since most decisions in finance involve cash flows spread over more than one period (monthly, quarterly, yearly etc.). The time value of money is a key principle in financial decision-making.
Present value
Present value is the amount that you would pay today for a cash flow that comes in the future. It brings the future value down to today’s price. It is based on the basic principle of time value of money that value of money keeps reducing as time passes. There are two ways in which the present value can be calculated. If there is a future value that has been given then this can be brought to the present by discounting it by the rate of return. This will give an idea of what the value of the future amount is worth today.
PV = FV/(1+r)^n Where FV= Future Value
PV= Present Value
r = rate of return for each compounding period
n = number of compounding periods For a one time receipt,
PV is calculated as per the following formulae:
PV = C/(1+r)^n
In case of a regular cash flow the present value can be calculated by the following formula
PV = C * ((1-(1/(1+r)^n))/r) Where C is the regular cash flow
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