What is the Time Value of Money
The principle of the time value of money (TVM) states that the money you have today is worth more than the same amount in the future due to its possible earning power. This fundamental financial theory states that since money will collect interest, every sum of money is worth more the faster it is earned.
Money has a time value, which is one of the most basic principles of economics. In simplistic words, a dollar was worth more yesterday than it is today, and a dollar today is worth more than a dollar tomorrow. TVM is also known as present discounted value at times.
Time Value of Money Formula
The time value of the money formula can vary slightly depending on the specific situation at hand. For example, In the case of annuity or perpetuity payments, the generalized formula can include more or fewer variables. However, in general, the most basic TVM formula considers the following variables:
- FV = Future value of money
- PV = Present value of money
- i = interest rate
- n = number of compounding periods per year
- t = number of years
The TVM formula is based on these variables:
FV = PV x [ 1 + (i / n) ] (n x t)
Examples of Time Value of Money
Assume a $10,000 investment is made for a year at a 10% interest rate. The money’s future worth is:
FV = $10,000 x [1 + (10% / 1)] ^ (1 x 1) = $11,000
The formula can also be rearranged to calculate the present-day value of the future sum. For instance, the value of $5,000 one year from now, compounded at 7% interest, is:
PV = $5,000 / [1 + (7% / 1)] ^ (1 x 1) = $4,673
Why Time Value of Money is Important?
Since inflation continually erodes the value of the currency, and therefore its buying power. When investing money, you must consider inflation and purchasing power because to calculate the actual return on investment, you must deduct the rate of inflation from the percentage return you make on your money. If the rate of inflation is higher than the rate of return on your investment, even if the nominal return is positive, you are potentially losing money in terms of purchasing power.
So the time value of money is important because it will help direct investment decisions. For Example, An investor has a choice between two projects: Project X and Project Y. Both ventures have similar outlines, with the exception that Project X promises a $2 million cash payout in year one, while Project Y promises a $2 million cash payout in year five.
If the investor does not understand the time value of money, he or she will conclude that both projects are equally attractive. However, due to the higher current valuation of Project X’s $2 million payoff, the period of money determines that Project X is more appealing than Project Y.
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