The Time Value of Money Explained!
Time value of money is one of the most powerful and most important concepts in finance.
The time value of money is a basic financial concept also known as the present discounted value that holds that money in the present is worth more than the same sum of money to be received in the future. This is true because the money that you have right now can be invested and earn a return, thus creating a larger amount of money in the future. So money available now is worth more than the same amount in the future, because of its ability to grow.
In other words ‘time is money’, in the sense of the money itself, rather than one’s own time that is invested. As long as money can earn interest (which it can), it is worth more the sooner you get it. The time value of money is a wider concept and can also be related to the concepts of purchasing power and inflation. Both the factors will need to be taken into account along with whatever the rate of return that may be realized by investing the amount of money.
Why is this factor being so much important? Well, the reason being inflation constantly erodes the value of the money, and henceforth the purchasing power of the money. This can be best exemplified by the value or the prices of commodities such as food or gas.
The basic TVM formula takes into account the following variables:
FV = Future value of money
PV = Present value of money
i = interest rate
n = number of compounding periods per year
t = number of years
Based on these variables, the formula for TVM is:
FV = PV x [ 1 + (i / n) ] (n x t)
Time Value of Money Examples
Assume a sum of $10,000 is invested for one year at 10% interest. The future value of that money is:
FV = $10,000 x [1 + (10% / 1)] ^ (1 x 1) = $11,000
The formula can also be rearranged to find the value of the future sum in present-day dollars. For example, the value of $5,000 one year from today, compounded at 7% interest, is:
PV = $5,000 / [1 + (7% / 1)] ^ (1 x 1) = $4,673
Whenever calculating TVM there three basic parameters must be taken into account: inflation, opportunity cost, and uncertainty.
Inflation is reducing the purchasing power of money because it increases the prices of goods and services. Therefore, over time the same amount of money can purchase fewer goods and services.
Opportunity cost refers to the loss of investment opportunities and the benefit associated with them due to the commitment of money to another investment for a specific period of time.
Uncertainty relates to the investment risk that investors undertake when putting their money into investment assets.
So the bottom line is that one-dollar today is worth more than one-dollar tomorrow because of interest and inflation.