The time value of money is a basic financial concept that holds that money in the present is worth more than the same sum of money to be received in the future. This is mainly because there is there are risks associated with receiving future value, but current cash in your hand doesn’t have those risks.
Understanding the time value of money can help you in making decisions ranging from which job has better salary terms, what’s a good rate for a loan, or if the investment you’re considering has good growth potential. It is the potential earning capacity of the money that decides its current and future value.
There are two main reasons backing the TVM theory:
- Opportunity Cost: If you have capital on hand currently, the funds could be used to invest into other projects to achieve a higher return — i.e. the “opportunity cost” of the money.
- Inflation: There are risks to consider such as inflation or the probability that the company in question might go bankrupt in the future — i.e. future uncertainty should be costlier than the lower risks identified on the present date.
TMV is a fundamental concept that provides the foundation for virtually every financial and investing decision. From taking out a loan to negotiating a salary, or making a purchase decision, use the time value of money to evaluate the best financial course of action.
How to calculate Time Value of money
How you calculate TVM depends on which value you have and which you want to solve for. If you know the money’s present value (for instance, the amount you deposited into your savings account today), you can use the following formula to find its future value after accruing interest:
- FV = cash’s future value
- PV = cash’s present value
- i = interest rate (when calculating future value) or discount rate (when calculating present value)
- n = number of compounding periods per year
- t = number of years
Calculating TVM is important as it helps financial sectors make suitable investment decisions. Using the concept, the key investors compare the available investment options and choose the best alternatives to invest in. Then, given the expected loss in the value of money, the rate of interest and tenure of repayment for loan and mortgage schemes are determined. In addition, determining TVM also helps fix the wages of workers and prices of consumer goods.
Factors that Influence the Time Value of Money
- Compounding is when you earn interest on any investment you make.
- As time passes, you make more money because of the interest you earn.
- Compound interest is the earnings that you make based on the initial amount of investment and accumulated interest.
- On the other hand, simple interest is the interest you earn on the initial investment.
- Therefore when you add both the compound interest and the simple interest up, you get the total interest.
The financial firms use this idea of TVM for the following purposes:
- It helps in comparing the investment alternatives available in the market. Investors assess the returns and other conditions to make a final decision on what option to choose.
- Investors choose the best investment proposals based on the evaluation, considering the TVM.
- Lenders decide the interest rates for loans, mortgages, etc., based on the present and future value of an amount.
- The value of money, when known, helps in fixing appropriate wages and prices of products.
To determine the present value of the $8,000 in two years, you could use the same interest rate as before. Your calculation would look like this:
PV = $8,000 / [1 + (0.06 / 1)] ^ (1 x 2)
PV = $7,119.97
You find that the present value would be $7,119.97 and that receiving $8,000 in the future is the same as if you took $7,119.97 today and invested it for two years. Again, you can see that accepting the $8,000 today will give you more value than waiting.
The time value of money is an important concept to understand for personal finance. It can help you decide how much to budget, evaluate a job offer, figure out if a loan is a good deal and help you save for the future.