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Time Value of Money - Khatabook

What is Time Value of Money? Concept, Definition and Examples

by Khatabook

It is a well-known fact that time is precious. Every business has started to make a profit. A small amount available today is crucial than the lump sum due in the future. This indicates that time decides the value of money. 

What is the Time Value of Money? Here’s an example!

For example, You purchase a 1-kilogram silver bar for 60 INR per gram 2 years ago. Today the market rate of silver is 40 INR. This means that the silver bar you purchased has lost value. It can be otherwise too, but in general, in business, it is always advisable to focus on the current market value than to wait for the future.

Therefore, the time value of money is defined as the money that is present with any individual currently. The money that is available at the moment will allow businesses to invest it for expansion, to pay salaries for its employees, to purchase raw materials, etc. The money which is due for the future is only on papers and does not add any value in the present. 

Time value of money is commonly identified as TVM by finance professionals. It is called a present discounted value as well.

3 Parameters of TVM 

  1. Inflation – It reduces the purchasing power of money as it raises the cost of goods or services. The same amount of money can purchase lesser goods in the future. 
  2. Opportunity cost – It is the loss associated with the investment and the profit linked with them because of the obligation of money in another investment within the fixed time duration.
  3. Risk – It relates to the risk involved in investment to be undertaken by each investor while investing. 

Importance of Time Value of Money

Understand the time value of money importance from the following section from a financial management perspective.  

  1. Money in hand will help businesses to invest and grow the business. According to the saying “Make hay while the sun shines.” One needs to have money in hand when there is a need and an opportunity.
  2. The time value of money will help you assess the debt carried by the business.  
  3. The future is uncertain and hence time value of money in financial management plays a crucial role to manage finances and generate profit from the business. 

Time Value of Money Formula:

The basic formula of TVM is given below –

Future Value (FV) = Present value (PV) + T

 

FV = PV (1 + (I/N)) NT

 

  • N is the number of compounding periods yearly
  • T is the number of years
  • I –Growth Rate
  1. PV – The amount that is currently available 
  2. FV – It is the value that you get in the future. It may be from the business profit you expect. The return on investment or simply the debt amount which is in due.  
  3. N – How many years you invest the money for or the number of years you have to wait for getting your money from the lender, etc.
  4. I – The growth rate of the money for a lifetime investment.

Time Value of Money Concepts

The two concepts of the time value of money are explained below:

#1. Time Value of Money for a One-Time Payment 

You invest INR 10000 for 5 years in a bank that offers 10% annual interest. You allow it to grow cumulatively.

In this case, the future value after five years can be quickly calculated using the basic simple interest formula PNR/100. Add the interest rate every rate to find the simple interest for the next consecutive interest and that is how cumulative interest is calculated.

Doing so you will get a total value of INR 14641 at the end of 5 years. 

Now the question is: Is INR 10000 worth or INR 14641? This depends on the inflation rate, interest rate, and risk associated with it. If the inflation increases then it is a loss. If the interest rate goes down, then again it is a loss. Thus there is no certainty of getting INR 14641 after waiting for 5 years. Thus using INR 10000 in hand today for business is a wise decision than waiting without being sure about the market. 

#2. Doubling The Period – Time Value of Money 

Let us take another example to explain when the time value of money will double. This is done by using RULE OF 72.  For instance, from the above example of investing INR 10000 for 5 years with an interest of 8%, it will take 9 years to double the present value of money.

Time Value of Money Example 

  • Dividend Discount Model (DDM)

The future expected value of the company cash flow is taken and the net present value is calculated. In this model, the company’s stock price is calculated based on the current market rate. Therefore if the DDM value obtained is greater than the present trade value then company stocks are undervalued. Thus current value to money is important. 

  • Loan EMI Calculator 

This is another common example of the time value of money. Here, one will borrow an amount for a particular interest rate. It could be floating or fixed, irrespective of the interest the business pays for the loan the current amount it obtains will help it to expand the business. 

Key Pointers To Takeaway

  • It is purely based on the concept that the business would prefer to think about the money they will have in hand today than that will come in the future. Whether the money in hand is less than what it will be in the future does not matter as the present value of money is the key to business expansion. 
  • The money will certainly earn compound interest and hence it adds more value today than years down the line. 
  • TVM formula takes into consideration the current payment, future value, time, and interest percentage. 
  • The total number of compounding periods for every time slot is very vital in determining the time value of money.

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