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The Time Value of Money – Understand the Meaning and How It Works

Time Value of Money

Did you ever come across the term time value of money? If yes do you know about its basic concepts and formula? If not then do not worry we are here to answer all your questions. We know money management is hard and different and that is why we are here to guide you. This article is a complete package about the time value of money.

Let us first check your knowledge about it. suppose you won a contest and this is the message that you receive: Very Very congratulations!! You're our lucky contestant and you have won a cash prize of $20,000. You have two options to receive the cash prize:

A. Receive $20,000 now

OR

B. Receive $20,000 in three years.

Which option will you choose or I choose? That depends on you and your knowledge about the time value of money.

What Is the Time Value of Money?

So basically time value of money is a concept that is mostly used in the financial sector. According to this concept, the value of money is different at different points in time. The principle is that having a certain amount of money today is more than having the same amount in the future.

Sounds weird right? but it is true because the money that you have now can be invested and this invested money can earn the interest over time. Various factors influence the time value of money and they also affect the purchasing power of money like inflation, interest rates, and the return on investment.

The concept of the time value of money is used in comparing different investment options, evaluating investment opportunities, and most importantly determining loan payments.

When you truly understand this concept you will be able to make good financial decisions by assessing the risks and return on the investment that you will be making shortly. Let us look at the concept that is involved in the time value of money.

The Formula for Time Value of Money

There are various formulas for the time value of money depending on different factors and scenarios, But the most commonly used formula is

FV = PV * (1 + r)^n

where, 

PV= Present Value, FV= Future Value, n= Number of periods, r= Interest rate per period

One thing that you have to keep in mind is that this formula can change depending on the factors for example when we calculate annuity then there will be different factors that are going to be added to the formula. Hence this generalized formula is not applicable in the case of annuity or perpetuity payments.

Before moving further let us look at a calculative example that help you to understand the time value of money more thoroughly.

Calculative Example

Let us look at a calculative example that will help you to understand the basics of the time value of money. Suppose in a hypothetical situation you invest $8,000 at 6% for five years then the future value will be

  • FV = PV * (1 + r)^n
  • FV = 8000 * (1 + 0.06)^5
  • FV = $10705.8

Basics of Future Value

The future value represents the value of money or any kind of investment at a particular time in the near or far future. This value represents the amount up to which an invested amount of money will grow by the effect of returns or interest rates over time.

The amount in future value is dependent on factors like time of investment period, compounding frequency, and interest rates. The empirical formula that is used to calculate the future value of the annuity is given as :

FV = P * [(1 + r)^n - 1] / r

where, 

PV= Present Value, FV= Future Value, n= Number of periods, r= Interest rate per period

This empirical formula is not fixed. It depends on two factors whether the payment was made on an ordinary annuity which means the payments are made at the end of each period or the payment was made on an annuity due which means the payments are made at the beginning of each period.

Calculations

Let us look at a calculative example that will help you to understand the basics of future value. Suppose in a hypothetical situation you invest $5,000 at 10% for two years then the future value will be

FV = P * [(1 + r)^n - 1] / r

FV = 5000 * [(1 + 10)^2 - 1] / 10

FV = $55,000

So that's how you can easily calculate the future value. Let us move to another section where we will discuss the present value of money.

Basics of Present Value

The present value of money is a term used in financial calculations to represent the current value of money about a future amount of money or an investment. In simple words, the present value of money is used to calculate a specific amount of money in the future keeping in mind the time value of money.

The amount in present value is dependent on factors like time of investment period, compounding frequency, and interest rates. The empirical formula that is used to calculate the present value of the annuity is given as :

PV = P * [1 - (1 + r)^(-n)] / r

where, 

PV= Present Value, n= Number of periods, r= Interest rate per period

This empirical formula is not fixed. It depends on two factors whether the payment was made on an ordinary annuity which means the payments are made at the end of each period or the payment was made on an annuity due which means the payments are made at the beginning of each period.

Calculations

Let us look at a calculative example that will help you to understand the basics of present value. Suppose in a hypothetical situation you invest $5,000 at 10% for two years then the present value will be

PV = P * [1 - (1 + r)^(-n)] / r

PV = 5000 * [1 - (1 + 10)^(-2)] / 10

PV = $8677.68

Now you know about the two major terms related to the time value of money. For a quick view let us the difference between these two terms.

Difference Between Present Value and Future Value

The common difference between present value and future value depends on two factors. These factors are cash flow direction and perspective of time. Present value looks at the current value of cash while the future value looks at the future value of cash after investment and interest rates.

These concepts are essential for performing financial calculations. These calculations are necessary to make good financial decisions like investments. This also helps in risk management.

Effect of Compounding Period on Future Value

The power of compounding is so powerful that it has a great impact on future value. Compounding also plays a crucial role in the determination of accumulation as well as the growth of various investments over time. But before starting do you know what is compounding?

Compounding is a financial process in which a person gets interest on the initially invested amount as well as on the amount earned after interest over time. The basic principle behind investing is that it reinvests the invested amount after getting interest so that the reinvested amount can get more interest.

There are a lot of effects that happened due to compounding on future value but the most common are more frequent compounding intervals, exponential growth, higher interest rates, and time horizon.

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Why Time Value of Money Is Important in Finance?

Now you know almost everything about the time value of money but there is still an important question left, why it is important in finance?

See there are various reasons for which the time value of money is important and it is not possible to mention all of them so our team of experts did research and listed some of the most important aspects that make the time value of money so important.

1. Investment Evaluation

By knowing the time value of money one can evaluate and compare the investment decisions. When we know the time value of money, we can easily check the profitability of any investment, which will help us make informed decisions.

By calculating the time value of money we can determine various factors such as evaluating the viability of ventures, and assessing the return on investment and expected cash flow.

2. Risk Management

When we perform risk management by doing the calculation using the time value of money formula, it helps us to locate risk as well as uncertainty in the financial decisions that we are going to make. One thing that you have to keep in your mind is that the timing of cash outflows and inflows is uncertain.

The time value of money helps us to adjust the cash flow based on two parameters which are the timing of occurrence as well as the probability of occurrence. It helps us to get a more realistic approach to risk management and helps us to make better financial decisions.

3. Financial Planning

Not only in corporate financing but also in personal finance planning time value of money plays a very essential role. It helps various businesses and individuals to make better financial decisions about investing, retirement planning, savings as well as debt management.

When a person truly understands the concept of the time value of money he can easily determine the amount which is required to invest today. So he can get his dream amount after investing and getting the interest rates in the future.

4. Debt Repayment

One of the best use of the time value of money formula is that you can easily calculate the amount that you have to pay to settle your debt even before applying for a loan. Not only this we can also calculate interest costs and loan payments.

The time value of money allows lenders as well as borrowers to understand the cost of lending money along with the cost of borrowing money. They can also structure loans and assess their affordability.

5. Capital Budgeting

This one is my favorite application of the time value of money. By applying the formula when can easily calculate the effectiveness of an investment that we are going to make, or before we buy some equipment or expand our project.

With the help of the time value of money formula, we can easily calculate the internal rate of return as well as the net present value which helps us to determine the profitability and the value of an investment.

With this, I'm pretty sure that you are now able to understand the why time value of money is important in finance. Let us now look at how inflation affects the time value of money because inflation is seriously harmful in the financial sector.

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Impact of Inflation on the Time Value of Money

If I say inflation has the biggest impact on the time value of money then I'm not wrong. This is because inflation directly affects the purchasing power of money which eventually affects the time value of money. Let us see how inflation affects the time value of money:

1. Reduced Purchasing Power

Inflation degrades the value of money from time to time.  As the price of basic services starts rising it starts decreasing the purchasing power of money. In simpler words, you can buy more items in the same amount but you will be able to get a few items in the same amount in the future because of inflation.

2. Real Interest Rate

Basically, in simple words, the real interest is those nominal interest rates that are adjusted to make into account inflation. Real interest rates show the actual gain or loss which is achieved due to inflation on an investment.

One thing that you have to keep in mind while performing the time value of money calculation is that it is important to take the factor of inflation. This becomes more important when we compare different investments to choose a better one.

3. Inflation's Effect on Returns

Inflation not only affects Borrowing costs but also affects the returns on investments. If the returns on investment fail to outpace the inflation rate then the actual returns will be less than the returns that we calculated or were expecting. It is also valid in the case of borrowers which results in increased costs because of inflation.

4. Long-Term Planning

This is a must-applied rule in financial planning that you take account of inflation while planning for long-term financial goals like setting future financial goals or doing retirement planning. If you ignore the effect due to inflation then you will most probably underestimate the amount that you need for your future savings.

5. Adjusting for Inflation

It is very important to make an account for inflation so that one can easily adjust the cash inflow or outflows, investment returns, or interest rates while doing time value for money calculations.

You can use various techniques to make account for inflation like considering inflation in the growth rate, inflation-adjusted cash flow, or as said above you can use real interest too so that you can make more precise future estimations for future values.

Frequently Asked Questions (FAQs)

Here are some frequently asked questions that our readers ask us often.

Q1. Why Is the Time Value of Money Important?

A1. As we said earlier time value of money is very important in financial calculations because it helps in various aspects of financial planning such as capital budgeting, debt repayment, investment evaluation, and Risk Management.

Q2. How Does the Time Value of Money Affect Financial Decision-Making?

A2. The time value of money has a great impact on financial decision-making because it helps us to calculate various aspects of financial planning such as the impact due to inflation, real interest rates, and many more such things.

Q3. What Is the Time Value of Money?

A3. The time value of money is a concept that is mostly used in the financial sector. According to this concept, the value of money is different at different points in time. The principle is that having a certain amount of money today is more than having the same amount in the future.

Conclusion

We are glad to see you at the end. You're here which means you read our article and I'm pretty sure that you like it too. We tried our best to provide you with all the information which is available on the internet regarding the time value of money in one place.

In conclusion, the time value of money is a concept that is mostly used in the financial sector. According to this concept, the value of money is different at different points in time. The principle is that having a certain amount of money today is more than having the same amount in the future.

When we perform risk management by doing the calculation using the time value of money formula, it helps us to locate risk as well as uncertainty in the financial decisions that we are going to make. One thing that you have to keep in your mind is that the timing of cash outflows and inflows is uncertain.

The concept of the time value of money is used in various concepts in financial calculations. This includes comparing different investment options, evaluating investment opportunities, and most importantly determining loan payments.

If you still have any more doubts regarding the time value of money then you can contact us in the comments and there we will try to reach you as soon as possible. Also, if you like this article kindly share it with your family and friends.