Compiled by Shweta Kadtan
A Dollar is more valuable today than tomorrow
The time value of money (TVM) is the concept that a sum of money is worth more now than the same sum will be at a future date due to its earning potential in the interim. This is a core principle of finance. The time value of money is also referred to as present discounted value.
Investors prefer to receive money today rather than the same amount of money in the future because a sum of money, once invested, grows over time. For example, money deposited into a savings account earns interest. Over time, the interest is added to the principal, earning more interest. That’s the power of compounding interest. If it is not invested, the value of the money erodes over time. If you hide $1,000 in a mattress for three years, you will lose the additional money it could have earned over that time if invested. It will have even less buying power when you retrieve it because inflation has reduced its value. In other words, a payment delayed is an opportunity missed.
Formula for Time Value of Money
where, PV= Present Value
FV= Future Value
i= Discount rate
n= Number of periods
Time Value of Money Examples
Assume a sum of ₹10,000 is invested for one year at 10% interest compounded annually. The future value of that money is:
FV = ₹10,000 x [1 + (10% / 1)] ^ (1 x 1) = ₹11,000
Difference between Present Value Vs Future Value
| Basis Of Comparison | Present Value | Future Value |
| Meaning | It is the current value of future cash flow or future value. | It is the amount of money which will grow over a period of time with simple or compounded interest. |
| Rate | Involves both discounted as well as the interest rates. | Involves only interest rate. |
| Decision | Investors can make the decision whether to accept/invest or reject the proposal with help of the PV method. | FV shows the only future gain of total investment so the importance for investment decision making is less. |
| Process/ Method | Discounting | Capitalization |
| Formula | PV = FV/(1+r)n | FV = PV (1 + r)n |
| Concept | Amount to be invested now to get the expected amount in future | Amount expected at a future date by investing a specific amount now |
How Is the Time Value of Money Used in Finance?
- Assess the debt position of a business with the help of time value of money.
- For valuing investment opportunities using Discounted cash flow (DCF) analysis.
- For financial planning and risk management activities.
- Pension fund managers, for instance, consider the time value of money to ensure that their account holders will receive adequate funds in retirement.
Conclusion
Time Value of Money is perhaps the foremost concept when it comes to financial planning. If you can’t appreciate the damage inflation can inflict on purchasing power of your assets, it is difficult to plan your finances well. You can invest today, earn return and end up with a higher amount.
Alternatively, the purchasing power of money goes down due to inflation, i.e., you can buy more today with same amount than you can after a few years. Those who understand this concept can make it work to their advantage and make prudent investment choices.
