With the passing of time, the value of a product decreases. This is referred to as depreciation. There are many methods to calculate the value of depreciation. And the two important aspects of it are present value and future value.
But many of these methods do not take into account the time value of money. As time goes by, the value of the product depreciates and along with this the value of money might also increase or decrease. Also, attached to this principle is the time. The duration during which the value of a product depreciates.
Depreciation and Time Value of Money
The time value of money is generally a principle within a financial theory which states that the people if given a preference, would like to receive the money as sooner as possible. It lays the foundation for many of the theories which mainly determines the discount rate that one should expect during the future cash flows.
This principle does not calculate the market value of that asset, instead, it calculates the intrinsic value. Intrinsic value is nothing but the total value that is required to own the asset for the entirety of its lifetime. For better understanding, let’s consider an example. Every business to operate requires machinery for its operations.
The machinery is the necessity for every business and thus whenever the machine or in business terms, assets reaches its life, it needs to replace. Now, the machine that we used to replace the current one reaches its life, also requires to be replaced at the end of that asset’s life. And so the process goes on and on till the business is being run.
This replacement of machines results into the outflow of the cash and thus the whole amount can be added to get a depreciation amount. This is called the depreciation value. There are many methods to calculate this depreciation of any machinery. These methods include the write-down value method, the straight-line method, etc.
Browse more Topics under Time Value Of Money
- Simple and Compound Interest
- Effective Rate of Interest
- Present and Net Present Value
- Future Value and Perpetuity
- Annuities and Sinking Funds
- Valuation of Bonds and Calculating EMI
- Calculations of Returns
While talking about the time value of money principle, there are many assumptions that you need to make so that the depreciation can be demonstrated in a simple manner. Some of these assumptions include:
- Each machinery that will be replaced will have the same cost
- The productivity of all the assets remains the same during its lifetime
- The asset and its replacement have the same total lifetime
- There will be no residual value of the asset at the end of its lifetime
- The asset that is used for replacement will have the same productivity
- The assets that are used does not require any repairs or maintenance during its lifetime
- No taxation is involved in the transaction
- The payment done for the asset which is replaced will be upfront
- The replacement of the asset will be immediately done
Present Value and Future Value
While compounding value for the depreciation of the assets, you need to keep in mind two important values: present value and future value. Future value is the value of the asset after a certain time period. While the present value is the value of the asset that we calculate after deducting the residual value.
FV = PV(1 + r)n
where FV= future value,PV = present value, r = rate of interest, n = equal number of periods.
PV = FV / (1 + r)n
Practice Questions for You
Q. A car is depreciating at the rate of 20% when you deduct the balance. The ultimate scrap value of the car is Rs. 30,000 while the original amount was Rs. 1,00,000. What will be effective life value of the car?
- 5 years
- 4.5 years
- 5.4 years
- None of the above
Answer. C. 5.4 years
Q. The asset has a useful life of 10 years and its cost is Rs. 10,000. The rate at which asset is depreciating is 10% per annum. At the end of its life, what will be the scrap value of the asset?
- Rs. 3490
- Rs. 4380
- Rs. 3400
- Rs. 4400
Answer. A. Rs. 3490
Q. Find the number of years that we can use the machine for. It depreciates 10% every year. The scrap value of that machine is Rs. 9000 while the cost was Rs. 23,240.
- 9 years
- 10 years
- 8 years
- 7 years
Answer. A. 9 years