Financial literacy As per the concept of the time value of money (TVM), the amount available at present is worth more than the same amount in the future because of its potential earning capacity. In simple words, the future value of money is used to be more than its present value. This is because of the money that we have currently with us can be invested to earn returns and thus adding the amount of money in the future. Time value of money also referred to as Net Present Value (NPV) or present discounted value.
For example, if someone asks you to select between receiving Rs 100000 now versus Rs 100000 in two years, so you would choose the option Rs. 100000 now. Its rationale because of the equal value at the time of disbursement, receiving the Rs 100000 today has more value due to the opportunity costs associated with it.
Financial literacy with Time value of money is an important concept for both individuals as well as for business investment decisions. By determining the TVM with the help present value or future value, one can get the worth of investments that offer returns at different times and then can choose the best option.
The basic formula to determine the time value of money is
FV = PV x [ 1 + (i / n) ] (n x t)
FV = the future value of money
PV = the present value of money
i = the interest rate or other return that can be earned on the money
t = the number of years
n = the number of compounding periods of interest per year
Now let’s try to rationalize the above example with the details for better understanding.
Option A i.e. Rs 100000 now
PV=FV as we are going to receive the amount now, so PV is Rs 100000.
Options B i.e. Rs 10000 after 2 years
In this case, we calculate the PV with the help of the above formula. As we already know we are going to receive Rs 100000 after 2 years, the FV will be Rs 100000.
Present Value (PV)=?
Future Value (FV)= 100000
Interest Rate (i)= 5% (Suppose the risk-free rate of interest is 5% and the same is taken for calculation purpose)
Years (t)=2 (as the amount we are going to receive after 2 years)
n = 1 (Assume that the compounding is annual)
So 100000 = PV*[1+(5%/1)](1*2)
So, option A is having more present value as compared to option B because of the concept of the time value of money and it’s a logical decision to select options A.
Time value of money is the base of the below mention concepts of finance:
- Net Present Value (NPV)
Net Present Value is one of the most prominent concepts of Capital Budgeting to analyze the profitability of a projected investment or project. NPV in capital budgeting is the difference between the present value of cash inflows and outflows over the period (calculated with the help of time value of money). NPV is the criteria to select the more profitable investment project among the available options.
- Internal Rate of Return (IRR)
Internal rate of return (IRR) ) from a project is the interest rate at which the net present value of all the cash inflows and cash outflows equals zero. IRR is an important concept for companies to accept or reject the project. If the IRR of a new proposed project exceeds the required rate of return, then the project is acceptable else the project should be rejected.
- Compound Annual Growth (CAGR)
CAGR used to measure the growth over multiple periods. CAGR shows the growth rate that gets the initial investment value to the ending investment value if the investment has been compounding over the period.
The above-mentioned finance concepts are based on Financial literacy with the Time Value of Money and thus prove the importance of TVM in the field of finance