Time Value of Money
One of the most fundamental concepts in Finance Theory is Time Value of Money. This concept is so crucial that without understanding and applying it correctly, none of the financial models be able to produce reliable outcome.
So, what is time value of money (TVM)?
This concept describes that money at two different time points is not same since money earns interest over that time period (money earns money). Let's say 1 year interest rate on fixed deposits on US Dollar is 10%. So, it's same as having $100 today vs $110 a year from now.
The reason why this concept is so important to us as an investor is we need to make an investment decision. Should we invest today or should we wait a year from now when we have 10% more money in hand? It's not that easy to answer but using some assumptions, a decision can be made.
Example: you have $100,000 today and you want to buy a house. The house costs $200,000. You have a choice of putting 100K down today and finance 50% or buy the house in a year from now with 55% down payment assuming nothing else has changed which usually doesn't happen. (House price can go up or down, inflation can skyrocket or etc... etc...)
In finance, value of money today is known as "Present Value" and value of money in future is called "Future Value". The interest income is called "Carrying Benefits" or plain "Interest Income" or "Time Value of Money"
Another one of the most important terms that is used in TVM is called "Discount Factor".
In above example as you might notice, that you give $100 today to receive $110 in a year can also be expressed as you give $90.91 today to receive $100 in a year from now. (They are same things)
Discount factor is calculated as PV/FV
In above example, 100/110 = 0.9091. In finance, we say it as 1 Year Discount factor at 10% is 0.9091.
To better use this information, the question can be asked as how much money do I need to deposit today in the bank to receive $525 in a year from now. You simply multiply your future value with the discount factor to get the answer. So, in this case you multiply 525 * 0.9091 = $477.27. In other words, you deposit $477.27 today and the bank will give you $525 in a year from now.
-Nitin
One of the most fundamental concepts in Finance Theory is Time Value of Money. This concept is so crucial that without understanding and applying it correctly, none of the financial models be able to produce reliable outcome.
So, what is time value of money (TVM)?
This concept describes that money at two different time points is not same since money earns interest over that time period (money earns money). Let's say 1 year interest rate on fixed deposits on US Dollar is 10%. So, it's same as having $100 today vs $110 a year from now.
The reason why this concept is so important to us as an investor is we need to make an investment decision. Should we invest today or should we wait a year from now when we have 10% more money in hand? It's not that easy to answer but using some assumptions, a decision can be made.
Example: you have $100,000 today and you want to buy a house. The house costs $200,000. You have a choice of putting 100K down today and finance 50% or buy the house in a year from now with 55% down payment assuming nothing else has changed which usually doesn't happen. (House price can go up or down, inflation can skyrocket or etc... etc...)
In finance, value of money today is known as "Present Value" and value of money in future is called "Future Value". The interest income is called "Carrying Benefits" or plain "Interest Income" or "Time Value of Money"
Another one of the most important terms that is used in TVM is called "Discount Factor".
In above example as you might notice, that you give $100 today to receive $110 in a year can also be expressed as you give $90.91 today to receive $100 in a year from now. (They are same things)
Discount factor is calculated as PV/FV
In above example, 100/110 = 0.9091. In finance, we say it as 1 Year Discount factor at 10% is 0.9091.
To better use this information, the question can be asked as how much money do I need to deposit today in the bank to receive $525 in a year from now. You simply multiply your future value with the discount factor to get the answer. So, in this case you multiply 525 * 0.9091 = $477.27. In other words, you deposit $477.27 today and the bank will give you $525 in a year from now.
-Nitin
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