Time value of Money

Introduction

Money is the most important element in the whole world. Both at the macro and micro levels, money plays the most important role in business, finance, and economics. Therefore, a better study of the value and nature of money is very crucial. The time value of money is therefore a concept that explores the nature of the value of money.

What is the time value of money?

The time value of money indicates that a certain amount of money will hold a greater value in the current time rather than the value it will have in the future. It happens due to the reduction of money earning potential over time. This concept is a primary and core principle of business which states that a sum of money has greater value now than it may have in the future.

More about the time value of money

As the time value of money indicates that the value of money will decrease in the future, investors always want to receive money on the current date rather than in the future. They do so because once they invest a certain sum of money, it will grow gradually over time. A good example will be a savings account. A certain amount of money when deposited in a savings account earns interest. Eventually, the interest which is earned adds up to the principal and thus earns even more interest. That is how compound interest works.

When a sum of money is not invested, the value of the money declines over time. If a person keeps a thousand rupees note in his locker, the money will lose its value significantly after three years. The sum of money will lose its purchasing power because of inflation. However, if the same money was invested, a certain amount of interest could have been earned.

The formula for Time Value of Money

The formula of calculating the time value of money may experience minor changes according to the situation. For instance, in some cases of perpetuity or annuity payments, the generally used formula has more or lesser factors. However, generally, the time value of the money calculator considers the following variables.

FV = Future value of money

PV = Present value of money

I = interest rate

N = number of compounding periods per year

T = number of years

Based on these variables, the formula for TVM is:

FV = PV x [ 1 + (I / n)] ^{(n x t)}

Relationship between opportunity cost and time value of money

Opportunity cost refers to the next best alternative of the highest value of a particular activity when one activity is eliminated. Therefore, it is the key to the whole point of the time value of money. The value of money will not grow in the future however, money can grow but only when it is invested. As for investment, the money earns a positive return. On the contrary, money, if not invested, loses value gradually. This means that if the sum of money is supposed to be paid in the future, the value of that sum of money will diminish with time.

Importance of time value

Time value of money is an important concept concerning financing and therefore proper understanding of this concept can help investors by guiding them in making good decisions regarding investments. Time value of money can also help creditors in estimating the value of a given sum of money in the future and therefore help them in charging a suitable rate of interest.

Use of time value of money in finance 

Time value of money is such an important concept in finance, that it is difficult to find even one single topic in finance where the time value of money does not play a role. It plays a crucial role in almost every decision-making process. In the analysis of discounted cash flow (DCF), the time value of money plays as the primary and the most important concept. DCF is also the most influential and most popularly used procedure for evaluating investment opportunities. Similarly, DCF also plays a very important role in various financial activities, like financial planning and risk management.

Conclusion

Time value of money is an important concept and thus investors, businesses, and any other individuals who deal with finances must possess proper knowledge regarding the concept of the time value of money. Application for the time value of money helps creditors and investors a lot. Therefore, without this concept smooth working of finances is not possible.