The time value of money or TVM is one of the core principles of finance. For an investor, it is almost as fundamental as 3 golden rules of accounts are for accountants. If you want to learn more about it you can check out Khatabook. It is used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities.
Assume that you have Rs. 1000 today or Rs. 1000 after 1 year. Which option will you choose? Obviously, you will choose Rs. 1000 now rather than waiting for 1 year to get Rs. 1000 because you can use this money for investment or for meeting your current needs. This preference for the present over the future is known as the time preference of money which leads to the time value of money concept.
The importance of the time value of money is that a dollar today is worth more than a dollar in the future because the dollar received today can earn interest up till the time the future dollar is received.
The time value of money is based on two concepts:
- Money has a greater value now than in the future. This is because the money that you have now can be invested and earn a return, thus creating a larger amount of money in the future.
- Inflation causes a loss in the value of money over time. As inflation rises, each unit of currency buys fewer goods and services.
How is TVM determined?
The time value of money depends on four variables:
- The principal amount, which is the initial amount of money
- The interest rate, which is the percentage of interest generated per period
- The number of periods, such as years or months
- The number of compounding periods per year
Why is it essential?
- The basic principle behind TVM helps investors determine the value of cash flows at different points in time. With this information, investors can make better choices about whether to invest in stocks and bonds or simply hold cash instead.
- The time value of money concept holds true even if interest rates are at 0% thanks to inflation. Inflation means that the purchasing power of a dollar declines over time. The value of a dollar today will not be equal to the value of that same dollar in the future due to inflation. Even if you were able to borrow money at 0% interest, you would still be losing money because inflation is negative interest.
What forms the TVM?
Time value of money in financial management can be broadly divided into two sub components, namely:
- Present value: PV stands for present value. You can think of it as what you could pay now to get a guaranteed return on your investment, or what you can expect your investment to grow into in the future, in current dollars.
- Future value: Future Value is a formula that tells you what a current cash flow would be worth in the future. This can help you compare various options even if they don’t all have the same time periods between them. For example, if you would receive $80 three years from now and $120 four years from now under two different scenarios, which option is better?