Background
Scenario (I)
If you have Two option.
(I) To receive $1,000 today, and
(Ii) To receive $1,000 on 31/December/2020.
then, which option you prefer ? Usually you prefer to receive today.
Scenario (II)
If you have Two option.
(I) To pay $1,000 today, and
(Ii) To pay $1,000 on 31/December/2020.
then, which option you prefer ? Usually you prefer to pay on 31/December/2020 .
In both the cases, reason is same, if you have $1,000 today, you can invest $1,000 today and earn extra income upto 31/December/2020.
The extra income which you can earn is the Time Value of Money.
Reason
Risk :- There is uncertainty about the receipt of money in future.
Inflation :- In an Inflationary period, a 1$ represents a greater real power than of a 1$ after a year.
Preference :- Most of the person's in general, prefer current consumption over future consumption.
Time Value of Money
Time Value of Money means worth of a money received today is different from the worth of a money received in future.
Time Value of Money = Future Value of Money - Present Value of Money.
Future Value
This is also known as terminal value. The accrued amount FV(n) on a principal P(0) after 'n' payment periods at the rate of 'r' is the Future Value.
FV(n)=P(0)X(1+r/k)^n
(1+r/k)^n is known as Future Value factor {FVF(n)}
=> FV(n)=P(0)X{FVF(n)}
Present Value
' Present Value' is the current value of a 'Future amount'. It can also be defined as the amount to be invested today (Present Value) at a given rate over specified period to equals the 'Future amount'.
If we reverse the flow by saying that we expect a fixed amount after 'n' number of years, and we also know the current prevailing interest rate, then by discounting the future amount, at the given interest rate, we will get the present value of the investment to be made.
Discounting future amount converts it into present value and compounding converts present value into future value.
Therefore, we can say that the present value of a sum of money to be received at a future date is determined by discounting the future value at the internet rate that the money could earn over the period. This process is known as discounting.
PV(0)=FV(n)*{(1+r/k)^-n}
Thank you for reading.