What Is Present Value Of Money?

In the earlier articles, we have understood the time value of money, compounding interest to get the future value of money, we now need to understand what is the present value of money.

Simply, the present value is the amount that must be invested NOW to reach a given sum at a given point of time in the future, using the compounding interest rate.

In this case, the present value is actually the opposite of future value. Hence, to get the present value, we can then use the compound interest to be the factor to discount the future value back to the present value.

Earlier illustrated in the article on the future value of money, the $12,100 is receivable in Year 2 using the compound rate of 10%. By using the 10% as the discount rate, we can then discount this future value of $12,100 at 10% back to the present value of $10,000 which is amount that must be invested Now.

Time Value, Future Value & Present Value Concepts

By understanding the time value of money and the future value concept, we can then be able to appraise investment project that has characteristics of up-front cash outflow and future cash inflows which takes a few years to recoup. [refer to earlier articles on time value and future value]

What do we mean by Future Value Of Money?

The future value is merely the amount an investment would grow to if it accumulates interest at a certain interest rate COMPOUNDED over the terms of the investment.

To understand the future value of money, we need to understand compound interest.

For example, if we have cash, $10,000 and if we were to put this $10,000 into a yearly time deposit which attracts a yearly interest rate of 10%. This present deposit of $10,000 will be growing at a COMPOUNDING INTEREST rate of 10% namely in Year 1 grow by $10,000 x 1.10=$11,100 which again in Year 2 grow by $11,100x 1.10 = $12,100

Therefore, for Now, we can see that our $10,000 has a future value of $11,100 in Year 1 and $12,100 in Year 2

What do we mean by Time Value Of Money?

In simple terms, a dollar in hand TODAY is worth more than when you supposed to received say ONE YEAR from today.

Is it important to understand this Time Value Of Money concept?

It is definitely important to understand especially when an entity start investing in projects that involves paying cash outflow up-front and only receiving cash inflows after a certain period of years. Those cash inflows supposed to receive after a few years later are not the same as being received upfront.

By understanding this concept, we can then later on learn to use a certain discount factor to relate these inflows supposed to receive in future years back to the up-front capital outflow.

Time Value Of Money concept generally applied to :

Capital Investment Appraisals

Risk Versus Return Scenario as risk is associated with the time

Concept is used in Insurance and time related products