Every business operating in the economy is trying to earn maximum profits through its operations over a given period. Businesses making short-term gains from the sale of products/services are considered crucial since they can be invested in a manner in which the return on investment would keep increasing with the passage of a particular timeframe. Here, the Time value of money comes into action. To make it simpler, time is the major factor that will decide the value of money in future and to what extent the initial investment you had made in the past would get appreciated in the future through the help of the time value of money. Now let’s get ahead and learn about the meaning of the time value of money meaning.
Did you know? The time value of money is commonly denoted as TVM by finance and corporate professionals, and it is also termed as present discounted value.
Time value of money meaning and Definition
Questions may start to arise in your mind like “ What do you mean by the time value of money?”. To answer this, TVM is an absolute fundamental financial concept that states that the present value of money is higher than the future value of money, given it has the potential to appreciate in the years to come in the future. TVM is the potential earning capacity of money that is the deciding factor behind money's current and future value.
TVM is also considered as a present discounted value based on its ability to provide a higher amount of returns based on its future value. A person or a business having additional money in their hands can invest it for the future for higher returns and if the same amount is received after it had been invested long back leads to a loss of value of money. Some key takeaways regarding TVM definition are as follows:
- TVM is a financial concept that states the current value of money is higher than the future value of money, given it can appreciate in the future.
- The potential earning capacity decides the current and future value of money.
- TVM allows investors to make decisions based on what kind of investment to make and for what period, and the number of returns they can expect when they invest a certain amount.
Time Value of Money Formula and Basic Concepts
Before going towards the formula, we have to ascertain what factors or components contribute to the Time value of the money formula. The following is the list of components that make the formula to ascertain time the present and future value according to the time value of money:
- FV- Future value of money
- PV – Present value of money
- i- Interest rate
- n- number of compounding periods per year
- t- number of years
With these components, we get the formula of the Time value of money, which is:
FV= PV x [ 1 (i/n) ] ( nxt)
To clarify concepts based on calculating the future value of investments based on the formula of the time value of money, let’s take a look at an example.
Assume that a sum of ₹10,000 is invested for a period of one year at 10% interest, which is compounded annually. What will be the future value of money?
- According to the Time value of money formula,
FV= PV x [ 1 (i/n) ] ( nxt)
Hence , FV= 10,000 x[ 1 (10/1)] ^( 1x1) = 11,000
TVM is mainly based on financial concepts and primarily focuses on ascertaining the approximate value of estimated cash flows that a firm or company expects to receive in the upcoming years. TVM also plays a major role in ascertaining purchasing power, due to which is an important concept for inflation. During Hyper or Running inflation, which generally states an excess of 20% inflation in a given year, TVM is highly affected as the real value of money falls very low due to a major increase in prices of essential and luxurious commodities, which eventually leads to a decrease in the purchasing power of a common individual.
Inflation can adversely affect the future value of money. If you are receiving ₹13,310 for ₹10,000 invested at a fixed interest rate of 10% per annum for 3 years, it is not always necessary that the amount received will be higher related to real value. There might be severe inflation due to which the real value of money might not be as par with the real value of money three years back.
Importance of Time Value of Money
TVM is an important tool for corporates to take financial decisions related to short and long-term investments. Let’s take a look at the importance of the time value of money related to financial management perspective:
- Cash in hand with the corporates will lead to diversification of investments in different sectors of the economy as a whole, which will eventually lead to the growth of the business. But corporates need to have money in hand to make investments and grow the business.
- TVM will help business personnel to assess the amount of short and long-term debt they are currently facing or will face shortly.
- Since there is a saying that the future is largely uncertain and anything can happen in the future which will be beyond our control despite our efforts, which is why time value of money in financial management plays an important role in managing finances and earning a substantial amount in terms of profits to help the business sustainable.
Time Value of Money in Financial Management
The time value of money in financial management has a major role as most of the concepts under financial management base their formulas or theories related on the concepts of the TVM. TVM concepts are used when calculating simple interest for a certain sum of money invested for a particular period at a given interest rate. The formula of simple interest is :
Calculation of Simple Interest: F= P + Pi = P (1+i)
- F= Future Value
- P= Present value and,
- i= Interest rate
For example,the future value of an investment of 8,000 at 10% rate of interest will amount to:
F = 8,000( 1+ 10/100)= 8,800 , Hence an investment of 8,000 at 10% rate of interest will amount to 8,800 at the end of one year.
Just like simple interest, TVM also plays a major role in finding out the compounding value of a certain sum of money invested for a period of time. The compounding values of an investment made can be estimated with the help of the following formula:
F = P (1+i)^n where,
- F= future value
- P= Present value and
- i= interest rate
For Example, if a sum of 10,000 is invested for aperiod of 3 years at a rate of interest of 10% compounded quarterly, the equation will look like:
F= 10,000(1+10/4)^12= 13,342
Just like while ascertaining future value using the formula of the time value of money, one can also find out about the present value from the future value mentioned. The formula for ascertaining the present value of money is :
P= F/ (1+i) where ,
- P= Present value
- F= Future Value
- i= interest rate
For example, if the future value of an investment made amount to 13,310at 10% rate of interest after 2 years then the present value will amount to:
P= 13,310/ (1+10/100)^2= 11,000. Hence, The present value ascertained of a future value of 13,310 at 10% rate of interest after 2 years, amount to 11,000
Banks also use the concept of the Time value of money to estimate the amount of EMI a loan borrower needs to pay in regular intervals an amount of money borrowed as a loan on a given rate of interest, and The EMI amount varies according to the repayment time limit undertaken by the borrower. The higher the Repayment schedule, the Lower will be the EMI amount to be paid.
So, that was everything related to the time value of money, the concept of the time value of money, the time value of money formula and the importance and application of the time value of money in financial management. We hope that through this blog, you will have got a basic idea of what the time value of money is all about and its application in the financial world.
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