WHAT IS THE MEANING OF “TIME VALUE OF MONEY”, “SIMPLE INTEREST” AND “COMPOUND INTEREST”?
In construction industry, it is very important to have enough
knowledge of money and time because construction is field where large amount of
money is invested to earn large amount of profit. Yet there are many conditions
that matters in construction but importance of money and time is also very
important.
TIME VALUE OF MONEY
The time value of money is important when one is interested
either in investing or borrowing the money. If a person invests his money today
in bank savings, by next year he will definitely accumulate more money than his
investment. This accumulation of money over a specified time period is called
as TIME VALUE OF MONEY.
Similarly if a person
borrows some money today, by tomorrow he has to pay more money than the
original loan. This is also explained by time value of money.
The time value of money is generally expressed by interest
amount. The original investment or the borrowed amount (i.e. loan) is known as
the
PRINCIPAL.
The amount of
interest indicates the increase between principal amount invested or borrowed
and the final amount received or owed.
In case of an investment made in the past, the total amount
of interest accumulated till now is given by;
Amount of interest =
Total amount to be received – original investment (i.e. principal amount)
Similarly in case of a loan taken in past, the total amount
of interest is given by;
Amount of interest = Present amount owed – original loan
(i.e. principal amount)
In both the cases there is a net increase over the amount of
money that was originally invested or borrowed. When the interest amount is
expressed as the percentage of the original amount per unit time, the resulting
parameter is known as the rate of interest and is generally designated as „i‟.
The time period over which the interest rate is expressed is
known as the interest period. The interest rate is generally expressed per unit
year. However in some cases the interest rate may also be expressed per unit
month.
SIMPLE INTEREST:
The interest is said to simple, when the interest is charged
only on the principal amount
For the interest period. No interest is charged on the
interest amount accrued during the
Preceding interest periods. In case of simple interest, the
total amount of interest
Accumulated for a given interest period is simply a product
of the principal amount, the
Rate of interest and the number of interest periods. It is
given by the following expression.
IT = P X n X i
Where
IT = total amount of interest
P = Principal amount
n = number of interest periods
i = rate of interest
Simple interest reflects the effect of time value of money
only on the principal amount.
COMPOUND INTEREST:
The interest is said to be compound, when the interest for
any interest period is charged
on principal amount plus the interest amount accrued in all
the previous interest periods.
Compound interest takes into account the effect of time
value of money on both principal
as well as on the accrued interest also.
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