Time Value of Money (TVM) is a financial principle. The value of money held today is worth more than the same amount of money in the future. In simple terms, the value of INR 1,000 was worth more yesterday than today. With time, factors like inflation affect the value of money. This article explains the Time Value of Money concept in detail and its importance.
What is Time Value of Money (TVM)?
Time Value of Money (TVM) is an important concept that validates that money’s worth is higher now than in the future. Idle cash held is worth less today than yesterday or last month.
Holding money today can be put to use. For instance, it can be used for business expansion, investments, or other expenses. On the other hand, the money you ought to get in the future is only on paper. Hence doesn’t add any value in the present.
The concept of TVM revolves around the following three parameters:
- Inflation: Inflation has an impact on purchasing power. In other words, the value of goods and services increases in the future. As a result, you will be able to acquire lesser goods for the same amount in the future in comparison to the present.
- Opportunity Cost: Opportunity cost is the potential benefit you may miss while choosing an alternate investment option over another.
- Risk: It is the risk you undertake while investing in an asset.
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Time Value of Money Formula
FV = PV * [1 + (i/n)] ^ (n*t)
FV = Future Value
PV = Present Value
i = Growth Rate
n = No. of compounding periods yearly
t = No. of years
What is Present Value?
Present value is the value of the money you hold today. Also, it is the present value of the sum of all future cash flows from an investment. The future cash flows are discounted at a discount rate. A lower discount rate implies a higher present value of the future cash flows and vice versa.
What is Future Value?
Future value is the value of an investment at the end of the investment duration. You can determine the future value for lump sum investments as well as recurring investments such as SIPs.
How Does TVM Work?
The Time Value of Money concept revolves around the Future Value concept. You can determine the future value of an investment opportunity. Considering the investment amount, investment duration, and growth rate, you can determine the future value of an investment.
Therefore, utilizing this concept, you can compare multiple investment options or business proposals to determine which is a better prospect.
Let’s understand the concept with an example. Ms Vidhi wishes to invest INR 5,00,000 for a tenure of 5 years at a 10% rate.
The future value of her investment at the above rate is INR 8,05,225.
Similarly, if her investment duration is ten years, then the value of her investment at the end of the tenure would be INR 12,96,871.
Using the TVM formula, you can determine the future value of an investment over different time periods. As a result, you can make better financial decisions.
TVM and Compounding Periods
The compounding period of investment has a significant impact on its future value. The higher the compounding period, the higher the investment’s future value. This is where you can see the effect of the power of compounding. For the above example, the following are the future values for different compounding periods:
- Monthly: INR 8,22,654
- Quarterly: INR 8,19,308
- Semi-Annually: INR 8,14,447
- Annually: INR 8,05,225
From the above figures, you can see the impact of compounding periods. The more the number of compounding periods, the higher the investment’s value.
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Importance of Time Value of Money
- Having money right now is more valuable than getting the same amount in the future. From a business perspective, the money can be used for the expansion of the business, which can generate more money.
- You can assess the debt position of a business with the help of the time value of money.
- The future is always uncertain. Therefore, better financial decisions can be taken with the time value of money.
- The time value of money also helps in comparing two projects that are similar in nature. For instance, Project A offers INR 10,00,000 payout after one year. While a similar Project B offers the same payout of INR 10,00,000 after three years. Here the present value of Project A is higher than Project B. Thus, choosing Project A and getting an early payout will help put money to better use.