The time value of money principle must first be grasped in order to have a solid foundation in finance. Time value of money can be calculated as:
- Present value – Current worth of a future sum of cash given a specified rate of return.
Present Value = Future value x [1 / (1 + interest)]^time
- Future value – Future value is the value of an asset or cash at a specified date in the future.
Future Value = Present value x (1 + interest)^time
Assuming that a bank pays an interest of 10%, if I deposit P100 now, how much will it be next year? Answer is: P110 [P 100 x (1 + .10)].
P110 is the future value of your 100 pesos deposited now in the bank that pays 10% interest.
Assuming that current interest to borrow cash is 10%, if Jose approached you and offered you P110 after 1 year, how much will you give him today for a future value of P110?
Answer is: P100 [P110 x (1/1.10)]
P100 is the present value of 110 pesos to be received in the future.
To further illustrate:
The Present value simply discounts the future interest income to be earned hence the term ‘discounted’ in Discounted Cash Flow (DCF) Method of valuation.
There are only three approaches to valuation: Relative valuation, Contingent claim valuation and DCF valuation.