Time Value of Money and its importance
Time value of money is one of the most important concepts in finance. It means that the value of a rupee received one year from now is not the same as the value of a rupee received today. The concept of time value of money deals with the fact that can amount of money as seen in the future is not valuable as the same amount of money received at present.
Importance of Time Value of Money
- Valuation of loans and other assets
- Capital budgeting (criteria of investment)
- Lease analysis
- Working capital
Nominal and effective interest rates
- The basic annual rate of interest is the nominal interest rate, r
- The quoted interest rate which is used to compute the interest paid per period is effective interest rate, i.
The relation between nominal and effective interest rates
i = (1+r/m)^m – 1
where i = effective IR, r = nominal IR and m = no of compounding periods per year ie m = 2 (semiannual), 12 (monthly)