Importance of time-value of money in investment decisions:
Time value of money is very obliging for taking various type of investment decisions that we can show in following ways:
1. It is helpful for computing the future value of cash inflows:
With the aid of time value of money, investor can recognize future value of money when he invests his principle amount nowadays. We can compute this amount with the following formula:
Amount = Principle (1+ r/100) and its power no. years or FV = PV (1+i)n
Assume that Ram invests Rs. 100 annually for 6 years; he will obtain 10% compound interest on it from bank. What he receives today after 5 years.
{*} We can recognize future value of money.
A = p(1+r/100) power tA = 100 X (1+10/100) power 5 years
Future value of money (A) = 100 X (1.1) power 5 years Future value of money = Rs. 161.051
Not only cash inflow's future value, we can as well compute future value of annuity with the given formula:FV (A) = A. [(1+i)n - 1]/i2. It is helpful for making least reserve:
Computation of present value and computation of net present value is completely based on time value of money. When we know cut off rate or minimum discount rate which we have to reimburse or receive, then we can recognize minimum amount of reserve for achieving particular amount after some time, it is based on the idea that when we invest small amount, interest will automatically comprise in it and after sometime, this small amount will equivalent to our target amount. Assume, you require Car after 10 years, you are capable to save Rs. 2000 per month, when you invest it in that scheme which offer you high interest, you can know whenever your small saving will become as equivalent to the amount of Car. Its formula is simply opposite the formula of Future value of cash inflows.
Present Value of Money or Principle = Future Value X [1/(1+(r/100))t]
Assume that a man will receive Rs. 161.051 after 5 years, when cut off rate is 10%, and then what is the present value of that money? After computation with above formula it will be Rs. 100.
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