Time Value Of Money [ Compounding Method ] class is for the HSC candidates or for the students of class 11 and 12. This class is a part of HSC (11-12) [ এইচএসসি (১১-১২) ], Finance 1st Paper. You can find it in the Finance 1st Paper, chapter 3, the topic name is “Time Value Of Money”. This class will help you in your upcoming HSC examination.
Time Value Of Money [ Compounding Method ]
f I offered to give you $100, you would probably say yes. Then, if I asked you if you wanted the $100 today or one year from today, you would probably say today. This is a rational decision because you could spend the money now and get the satisfaction from your purchase now rather than waiting a year. Even if you decided to save the money, you would rather receive it today because you could deposit the money in a bank and earn interest on it over the coming year. So there is a time value to money.
Next, let’s discuss the size of the time value of money. If I offered you $100 today or $105 dollars a year from now, which would you take? What if I offered you $110, $115, or $120 a year from today? Which would you take? The time value of money is the value at which you are indifferent to receiving the money today or one year from today. If the amount is $115, then the time value of money over the coming year is $15. If the amount is $110, then the time value is $10.
In other words, if you will receive an additional $10 a year from today, you are indifferent to receiving the money today or a year from today. When discussing the time value of money, it is important to understand the concept of a time line. Time lines are used to identify when cash inflows and outflows will occur so that an accurate financial assessment can be made. A time line is shown in the next column with five time periods.
The time periods may represent years, months, days, or any length of time so long as each time period is the same length of time. Let’s assume they represent years. The zero tick mark represents today. The one tick mark represents a year from today. Any time during the next 365 days is represented on the time line from the zero tick mark to the one tick mark.
At the one tick mark, a full year has been completed. When the second tick mark is reached, two full years have been completed, and it represents two years from today. Move on to the five tick mark, which represents five years from today.
Because money has a time value, it gives rise to the concept of interest. Interest can be thought of as rent for the use of money. If you want to use my money for a year, I will require that you pay me a fee for the use of the money. The size of the rental rate or user fee is the interest rate. If the interest rate is 10%, then the rental rate for using $100 for the year is $10.
Compounding
Compounding is the impact of the time value of money (e.g., interest rate) over multiple periods into the future, where the interest is added to the original amount. For example, if you have $1,000 and invest it at 10% per year for 20 years, its value after 20 years is $6,727. This assumes that you leave the interest amount earned each year with the investment rather than withdrawing it. If you remove the interest amount every year, at the end of 20 years the $1,000 will still be worth only $1,000.
But if you leave it with the investment, the size of the investment will grow exponentially. This is because you are earning interest on your interest. This process is called compounding. And, as the amount grows, the size of the interest amount will also grow. As shown in Table 1, during the first year of a $1,000 investment, you will earn $100 of interest if the interest rate is 10%.
When the $100 interest is added to the $1,000 investment it becomes $1,100 and 10% of $1,100 in year two is $110. This process continues until year 20, when the amount of interest is 10% of $6,116 or $611.60. The amount of the investment is $6,727 at the end of 20 years.
