Time Value of Money (TVM)
What Is the Time Value of Money (TVM)?
The time value of money (TVM) is the concept that a sum of money is worth more now than a similar sum will be sometime not too far off due to its earnings potential in the interim.
This is a core principle of finance. A sum of money in the hand has greater value than a similar sum to be paid from here on out.
The time value of money is additionally alluded to as present discounted value.
Understanding the Time Value of Money (TVM)
Investors like to receive money today as opposed to a similar amount of money in the future on the grounds that a sum of money, once invested, develops after some time. For instance, money kept into a savings account earns interest. After some time, the interest is added to the principal, earning more interest. That is the power of compounding interest.
On the off chance that it isn't invested, the value of the money disintegrates over the long haul. Assuming you stow away $1,000 in a sleeping cushion for a long time, you will lose the extra money it might have earned throughout that time whenever invested. It will have even less buying power when you recover it since inflation has diminished its value.
As another model, say you have the choice of getting $10,000 now or $10,000 a long time from now. In spite of the equivalent face value, $10,000 today has more value and utility than it will a long time from this point due to the opportunity costs associated with the postponement.
All in all, a payment delayed is an opportunity missed.
Formula for Time Value of Money
Depending on the specific situation, the formula for the time value of money might change somewhat. For instance, on account of annuity or perpetuity payments, the generalized formula has extra or less factors. However, as a general rule, the most fundamental TVM formula considers the accompanying factors:
- FV = Future value of money
- PV = Present value of money
- I = interest rate
- n = number of compounding periods each year
- t = number of years
In light of these factors, the formula for TVM is:
FV = PV x [ 1 + (I/n) ] (n x t)
Time Value of Money Examples
Assume a sum of $10,000 is invested for one year at 10% interest accumulated yearly. The future value of that money is:
FV = $10,000 x [1 + (10%/1)] ^ (1 x 1) = $11,000
The formula can likewise be modified to track down the value representing things to come sum in present day dollars. For instance, the current day dollar amount accumulated yearly at 7% interest that would be worth $5,000 one year from today is:
PV = $5,000/[1 + (7%/1)] ^ (1 x 1) = $4,673
Effect of Compounding Periods on Future Value
The number of compounding periods emphatically affects the TVM estimations. Taking the $10,000 model above, on the off chance that the number of compounding periods is increased to quarterly, month to month, or daily, the ending future value computations are:
- Quarterly Compounding: FV = $10,000 x [1 + (10%/4)] ^ (4 x 1) = $11,038
- Month to month Compounding: FV = $10,000 x [1 + (10%/12)] ^ (12 x 1) = $11,047
- Daily Compounding: FV = $10,000 x [1 + (10%/365)] ^ (365 x 1) = $11,052
This shows TVM depends not just on the interest rate and time horizon yet additionally on how frequently the compounding computations are processed every year.
How Does the Time Value of Money Relate to Opportunity Cost?
Opportunity cost is key to the concept of the time value of money. Money can become provided that it is invested after some time and earns a positive return.
Money that isn't invested loses value over the long run. In this manner, a sum of money that is expected to be paid from here on out, regardless of how without hesitation it is expected, is losing value meanwhile.
Why Is the Time Value of Money Important?
The concept of the time value of money can assist with directing investment choices.
For example, assume an investor can pick between two projects: Project An and Project B. They are indistinguishable with the exception of that Project A commitments a $1 million cash payout in year one, though Project B offers a $1 million cash payout in year five.
The payouts are not equivalent. The $1 million payout received following one year has a higher present value than the $1 million payout following five years.
How Is the Time Value of Money Used in Finance?
It would be elusive a single area of finance where the time value of money doesn't influence the dynamic interaction.
The time value of money is the central concept in discounted cash flow (DCF) analysis, which is one of the most famous and compelling methods for esteeming investment opportunities.
It is additionally a fundamental part of financial planning and risk management activities. Pension fund managers, for example, consider the time value of money to guarantee that their account holders will receive adequate funds in retirement.
Features
- For savings accounts, the number of compounding periods is an important determinant too.
- Time value of money means that a sum of money is worth more now than a similar sum of money later on.
- This is on the grounds that money can develop just through investing. An investment delayed is an opportunity lost.
- The formula for computing the time value of money considers the amount of money, its future value, the amount it can earn, and the time period.
