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Time Value of Money (TVM) Definition
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. It’s also known as ‘Present Discounted Value of Money’.
A Little More on What is the Time Value of Money
Rational investors’ preference for receiving money sooner rather than later in order to maximise 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.
Let’s calculate the value of $1000 in two year’s 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.
References for Time Value of Money
Academic Research on Time Value of Money
Interest in Disguise: Taxing the Time Value of Money, Halperin, D. I. (1985). Yale LJ, 95, 506. This paper deals with the taxation of TVM.
Effects of inflation and time–value of money on an inventory model with linear time-dependent demand rate and shortages, Datta, T. K., & Pal, A. K. (1991). European Journal of Operational Research, 52(3), 326-333. This paper examines the concept of TVM on a linear time-dependent demand rate of an inventory model under the effects of inflation.
Replenishment and pricing policy for deteriorating items taking into account the time–value of money, Wee, H. M., & Law, S. T. (2001). International Journal of Production Economics, 71(1-3), 213-220. This paper studies the impact of TVM on a deteriorating inventory model with the application of discounted cash flows (DCM) approach and analysis.
Economic production lot size for deteriorating items taking account of the time–value of money, Wee, H. M., & Law, S. T. (1999). Computers & Operations Research, 26(6), 545-558. This paper studies the TVM of a inventory model deteriorating at a varying rate over time with a DCM approach.
The effects of inflation and the time value of money on some inventory systems, Chandra, M. J., & Bahner, M. L. (1985). International Journal of Production Research, 23(4), 723-730. This paper studies the effect of inflation and TVM on different inventory model systems.
Effects of inflation and the time value of money on order quantity and allowable shortage, Sarker, B. R., & Pan, H. (1994). International Journal of Production Economics, 34(1), 65-72. This paper studies the impact of TVM and inflation on inventories with finite replenishment order quantities and limits on order shortages.
Two storage inventory problem with dynamic demand and interval valued lead-time over finite time horizon under inflation and time–value of money, Dey, J. K., Mondal, S. K., & Maiti, M. (2008). European Journal of Operational Research, 185(1), 170-194. This paper studies the influence of inflation and TVM on a two storage inventory problem with dynamic demands.
The effects of inflation and time–value of money on an economic order quantity model with a random product life cycle, Moon, I., & Lee, S. (2000). European Journal of Operational Research, 125(3), 588-601. This paper examines the effect of TVM and inflation on an economic inventory ordering model with random product life cycles.
Effects of inflation and time–value of money on an inventory model with time-dependent demand rate and shortages, Hariga, M. A. (1995). European Journal of Operational Research, 81(3), 512-520. This paper explores the impact of TVM and inflation on an inventory model that has time dependant shortages and demand rates.
An imperfect production process for time varying demand with inflation and time value of money–an EMQ model, Sarkar, B., Sana, S. S., & Chaudhuri, K. (2011). Expert Systems with Applications, 38(11), 13543-13548. This paper studies an Economic Manufacturing Quantity (EMQ) model and its time varying demand dependant production process under the influence of TVM and inflation.
Time value of money and discounting in Islamic perspective, Khan, M. F. (1991). Review of Islamic Economics, 1(2), 35-45. This paper sheds light on the Islamic perspective on TVM and discounting.