What Is Time Value of Money?

FT Contributor  | 

The value of money seems easy to calculate since it’s just a number. However, the time value of money is also a factor to take into account when analyzing your money and holdings. The time value of money (TVM) refers to the consideration that money’s current value is higher than the exact same sum would be in the future due to its ability to earn and grow over time.

The TVM principle assumes that money has the ability to earn interest and therefore, the sooner it’s received, the more earning potential it has and the higher its value. Whether you want to save for retirement or simply want to build up your savings accounts, the concept of TVM is important since it’s a way to ensure the money you have now is working for you and making itself even more valuable in the future.

How Does Time Value of Money Work?

Investors follow the time value of money principle closely because time is one of the most important assets related to growing money. With the TVM concept, investors that have money now can grow that money over time and therefore, the value of that money is considered higher in the present moment due to its earning potential.

Receiving money immediately so the time value of money principle can be applied is also important for investors because there’s always risk associated with future funds. If you don’t receive money right away, anything can happen that prevents you from receiving it in the future. A deal could fall through or an item you were planning to sell could lose its value or demand. Money in hand now is more valuable than a promise that you’ll receive money in the future.

Examples of the Time Value of Money

With the TVM concept in mind, consider this example: you receive $10,000 as a bonus from your employer and immediately invest it in the stock market. You hit on some hot stocks and other successful short-term investments and your $10,000 grows into $20,000 over the course of two years. The money was worth more to you on the day you received it than if your employer had held onto it and given it to you two years from that date.

Using the same example, say your employer offered to pay you the $10,000 bonus now or a $12,000 bonus next year. If you think you can invest that $10,000 and get a return greater than $2,000 by the end of the year, you’d choose to receive the money now. If you think waiting is a better idea, you’re risking a smaller return. You’re also making the risky assumption that you’ll still work for the same employer in a year, that the deal will still stand. What’s more, there are other factors that can change throughout the year.

Inflation

In addition to analyzing your rate of return, you also need to understand inflation and how it relates to the value of your money. Inflation refers to the rising prices of commodities, such as food or gas. Ten years ago, $2 could have bought you a gallon of milk but now, a gallon costs about $4. That’s an example of inflation at work.

When calculating the TVM of your investments, consider how that value will be affected due to inflation. For example, you may assume you’re going to make a $10,000 profit from investments over five years. While your money really does grow by $10,000 over this time period, it may only be truly worth about $8,000 since the cost of goods increased while your money was growing.

Time Value of Money Formula

There’s a specific time value of money formula you can use to estimate how much your money is worth over time. However, you must have a few factors in mind to accurately calculate your money’s future value, including how much you have, how you’re investing it, and the rate of return you expect to get. The time value of money formula is as follows:

FV = PV x [ 1 + (i / n) ] ^ (n x t)

In this formula, the following variables are:

  • FV: The future value of your money.
  • PV: The present value of your money.
  • i: The interest rate you expect.
  • n: The number of compounding periods per year.
  • t: The number of years your money will be invested.

To use this formula, you must already have an investment plan for your money. If you plan to invest in mutual funds or buy investment bonds, know the details on your expected return and how many years your money will be invested. You’re also responsible for understanding the present value of your money to utilize this formula successfully.

Present Value of Future Money Formula

To calculate the present value of your future money, you must know the future value and rearrange the time value of money formula as it relates to the present value. To calculate the present value of your money, use the following formula:

PV = FV / (1 + (i / n) ^ (n x t)

In this formula, the following variables are:

  • PV: The present value of your money.
  • FV: The future value of your money.
  • i: The interest rate you expect.
  • n: The number of compounding periods per year.
  • t: The number of years your money will be invested.

This formula allows you to calculate the future sum of your money in present-day value. Whether you’re an investor or just trying to figure out how shopping affects your financial future, the TVM concept and formula can help you to better understand the value of your money and predict its value.


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