Time Value of Money - Explained
What is the Time Value of Money?
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What is the Time Value of Money?
Time Value of Money is the potential earning capacity of money available in the present which is greater than its value in the future for the same amount. It is a core financial concept that emphasises on the value of money in hand due to its potential to make more money and the sooner you own it, the more its worth. Its also known as Present Discounted Value of Money.
Back to:ECONOMIC ANALYSIS & MONETARY POLICY
Why is the Time Value of Money Important?
Rational investors preference for receiving money sooner rather than later in order to maximize its earning potential by way of interest in a saving account or profits on a stock purchase is the idea behind the concept of Time Value of Money. A 100 bucks in hand today have a much greater value than a 100 bucks in hand next month, as this sum can be put to good use and increase in value to 120 bucks by next month. 120 > 100. So, receiving this money now is better value than receiving it in the future. TVM factors in the opportunity costs of having the money and believes that the potential to earn more with the sum in hand is what makes it imperative that you have it now rather than in the distant future. Given the option to get $24000 in one shot now, vs. getting it in installments of $2000 for the next two years, a rational person would choose option one. Investing $24000 wisely could turn this sum into $30,000 by the end of two years. If you were to choose option two, you would be losing out on the additional $6000 as opportunity costs.
Formula for Calculating Time Value of Money
FV = PV * (1+r)^n This basic TVM formula accounts for the following variables:
- PV - Present Value of Money
- FV - Future Value of Money
- r - interest rate
- n - total number of years under consideration
The formula varies slightly for different situations like annuity payments. Lets calculate the value of $1000 in two years time at 9% interest rate using the TVM formula above. FV = $1000*(1+.09)^2 = $1000*1.188 = $1188.1 So, according the principle of TVM, the potential earning value of a $1000 today is $1188, as opposed to getting the same $1000 after two years when their comparative value is less by $188. The value of r in this formula could greatly influence the amount of FV depending upon whether these interest periods are accounted for in terms of months, quarters, or annual percentages.
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