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What is Time Value of Money? : Formula & Examples

  


Introduction 

TVM, or the time value of money, is a financial concept that discusses the value of money. According to this theory, the current value of money is always greater than the future value of the same amount of money.

As a result, this concept favours the idea that the money you have right now is more valuable than the same money in the future. For example, suppose you can have INR 10,000 right now or the same amount after two years. Which one would you select?

It is always preferable to choose the former. Because there is a high likelihood that the value of INR 10,000 will fall in two years. For example, Inflation could be one of several factors responsible for this. Aside from that, what if the person goes bankrupt after two years or if there is some unforeseen circumstance that prevents you from receiving the value in the future?

As a result, it is always preferable to obtain a sum of money now and invest it in a place where you can earn sufficient interest on it so that you have the same sum but with interest after two years.

The time value of money assists you in converting the value of future cash into its present value. You can use this concept to compare money's worth and make more informed financial decisions. Keep reading.

Understand the Concept of the Time Value of Money

The time value of money is a well-known financial concept. It assists investors in determining the true value of future cash flows. Furthermore, it helps individuals and businesses make investment decisions based on the future and the present value of money.

This concept is commonly used by investors who wish to invest a sum of money in the present to earn a significant return on that investment in the future. For example, suppose you have INR 1000 right now, but instead of investing it, you keep it under your bed.

If you do not invest that money, the value of that sum will depreciate over time, as will your purchasing power. Inflation increases daily, making the same sum's face value low even after a year.

If you invest that money in a savings account or a security market, you can earn interest on it and interest on the interest sum. That is how you can make compound interest while also beating inflation to some extent.

The time value of money allows you to beat inflation and make better financial decisions. Remember that inflation continues to rise over time, causing the value of your money to fall. In this case, the concept of the time value of money assists you in making an informed investment decision.

 

What Is the Importance of the Time Value of Money?

You're probably wondering how you can apply the concept of TVM to your investment.

The vast majority of investors rely on TVM to make critical financial decisions. Although this concept may not be instrumental in your daily life, it is always a good idea to learn it to assess the worth of a business or a specific project.

There is a formula to calculate the time value of money, which we discuss ahead. This formula can help you forecast the current return on several projects. Then, this current return can be compared to others and used to determine which project is more beneficial to invest in.

Aside from this, the time value of money also assists investors in projecting future returns so that they can find and pursue the right opportunity rather than wasting time on misfit opportunities.

This concept is also beneficial if you are an entrepreneur looking for funding. The better the returns you can provide to the investor, the more likely you will receive funding for your venture. The concept of the time value of money can be applied in various investment and daily work situations.

The best part is that it always assists you in making informed decisions to prioritize the right opportunities and invest your money in the right places. Using this method, you can project cash flow to determine the true value of a company or a specific project.

 How to calculate the Time Value of Money?

You are now familiar with the concept of the time value of money—this concept's definition, how it works, and how you can apply it. However, in this section, we will look at how to calculate the time value of money and make the most of this concept.

There are two methods for calculating future and present value. First, we'll go over how to calculate future value.

 Calculation of Future value:

To calculate the future value of an investment, you must first know its present value, interest rate, and the number of years you intend to hold your investment. You can easily calculate the future value of that investment using these three factors. Using these terms, the TVM formula is as follows:

FV = PV * [1 + (I / n)] (n*t)

Where,

FV stands for future value.

PV stands for present value.

I represent the interest rate

N is the number of compounding periods per annum.

T stands for the number of years.

It is the formula you can use to calculate the future value, but remember that it is not flawless. For example, TVM does not consider any capital losses or negative interest rates you may incur due to your investment. In this case, you can use a negative growth rate to calculate the time value of money.

 Calculation of present value:

You can calculate the present value of your investment in the same way that you can calculate future value. This formula will assist you in calculating the present value of future returns. For example, if you receive INR 1000 in cash, the value of the sum at present will be INR 1000. However, if you receive this money, assume that after a year, the value will not remain INR 1000 because it will depreciate. You can use the time value of money formula to determine the future value of money in the present.

PV = FV / [1 + (I / n)] (n*t)

Where,

FV represents the future value

PV represents the present value

I represent an interest rate

N represents the number of compounding periods per year

T represents the number of years

Even though we have already discussed the numerous advantages of the time value of money, we will now look at how this concept can help you in considerable detail.

  • Financial Administration

The time value of money aids in financial management by estimating future cash flows. If you know whether or not an investment will depreciate in the future, you can make better decisions and find more opportunities.

In addition, the time value of money is an essential factor in accounting. If you know that the cash flows are more valuable in the present than in the future, you can invest in the present and earn a reasonable return.

  • Capital Budgeting

The time value of money plays a vital role in capital budgeting. It aids in determining whether a fixed asset company's investment will generate a good return in the future. For example, if a company is considering purchasing machinery or expanding, it can calculate the return on investment.

Capital budgeting allows a company to determine the future cash flow on investment, and if the results are unsatisfactory, you can also avoid that investment.

  • Decision on Financing

The time value of money can give you a good idea of whether the financial decisions you make now will be fruitful in the future or will cause you to suffer from a financial crunch. TVM allows you to assess the long-term consequences of your financial decisions.

This concept teaches you that the money you invest now will not be worth the same amount in the future. As a result, always ensure that the capital you invest in now will be worth more in the future to beat inflation and keep your wealth safe from losing value over time.

How does the time value of money affect inflation?

Inflation has an inverse relationship with the time value of money. The concept of TVM can beat inflation, which has the greatest impact on the value of money. The basic fact is that inflation rises over time, causing the value of your money to fall and your purchasing power to decrease. 

In this case, you can apply the time value of money concept to forecast future values and invest in opportunities that can outperform inflation while providing an adequate return on your capital.

The time value of money is a useful concept for assessing an investment's worth by understanding the future and present value of money. This method can be used to calculate the value of an investment and make an informed decision based on it. It is preferable for evaluating investment opportunities, loan transactions, and mortgage payments. Applying this method to your investment allows you to identify better opportunities.

What are your thoughts on the time value of money? Share your thoughts on the concept in the comments section.



Frequently Asked Questions

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The time value of money concept helps in determining the value of an amount of money in both the present and the future. The concept is about the fund you have at present is always greater in value than the same fund in future.

 

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The time value of money aids investors in choosing the optimal investment opportunity based on the money's present and potential future value.

 

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Most definitely. The time value of money is greatly impacted by inflation. It decreases the value of money over time.

 



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