TIME VALUE OF MONEY: FACTORS, IMPORTANCE, EXAMPLES - ECONOMY - 2025

The time value of money is the concept that indicates that the money available at the present moment is worth more than the same amount in the future, due to its potential earning capacity.

This basic principle of finance holds that as long as money can earn interest, any amount of money is worth more the sooner it is received. The time value of money is also known as the net present value.

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This concept is based on the idea that investors prefer to receive money today, rather than receive the same amount of money in the future, due to the possibility that the money will grow in value over a certain period of time.

Explain why interest is paid or earned: Interest, whether on a bank deposit or debt, compensates the depositor or lender for the time value of money.

Factors that affect

The time value of money is related to the concepts of inflation and purchasing power. Both factors must be taken into consideration along with the rate of return that can be obtained from investing the money.

Inflation and purchasing power

This is important because inflation constantly erodes the value, and therefore the purchasing power, of money. It is best exemplified by the prices of basic products, such as gasoline or food.

For example, if a certificate was issued for $ 100 of free gasoline in 1990, many more gallons of gasoline could have been purchased than if you had received $ 100 of free gasoline a decade later.

Inflation and purchasing power must be taken into account when investing money because, to calculate the real return on an investment, the inflation rate must be subtracted from the percentage of return obtained from money.

If the rate of inflation is actually higher than the rate of return on the investment, then even though the investment shows a positive nominal return, it is actually losing money in terms of purchasing power.

For example, if you earn 10% on investments, but the inflation rate is 15%, you are actually losing 5% in purchasing power each year (10% - 15% = -5%).

Importance

Companies consider the time value of money when making investment decisions in the development of new products, the acquisition of new equipment or business facilities, and the establishment of credit terms for the sale of their products or services.

The dollar available today can be used to invest and earn interest or capital gains. Due to inflation, a dollar that is promised for the future is actually worth less than a dollar today.

As long as money can earn interest, this basic principle of finance holds that any amount of money is worth more the sooner it is received. At the most basic level, the time value of money shows that, other things being equal, it is better to have money now than later.

Present and future value

The present value determines the value of the cash flow that will be received in the future, in today's dollars. Discounts future cash flow to date, using the number of periods and the average rate of return.

Regardless of the present value, if that value is invested in the present value at the rate of return and the number of specified periods, the investment will grow to the amount of future cash flow.

Future value determines the value of the cash flow received today in the future, based on interest rates or capital gains. Calculates the value of current cash flow in the future, if invested at a specified rate of return and number of periods.

Both present and future value take compound interest or capital gains into account. This is another important aspect that investors should consider when looking for good investments.

How is it calculated?

Depending on the situation in question, the formula for the time value of money may change slightly.

For example, in the case of annual or perpetual payments, the generalized formula has fewer or more factors. However, in general, the most fundamental formula for the time value of money takes into account the following variables:

FV = future value of money.

VP = 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 the time value of money would be the following:

VF = VP x ^ (N xt).

Formula of the present value of future money

The formula can also be used to calculate the present value of money that will be received in the future. You simply divide the future value instead of multiplying the present value. The formula would then be:

VP = VF / ^ (N xt).

Examples

Suppose someone offers to pay for work being done in one of two ways: pay $ 1,000 now or $ 1,100 a year from now.

What payment option should be taken? It depends on what kind of return on investment can be earned with the money at the present time.

Since $ 1,100 is 110% of $ 1,000, then if you think you can get more than 10% return on your money by investing it over the next year, you should choose to take the $ 1,000 now.

On the other hand, if you think that you could not earn more than 9% in the next year by investing the money, you should accept the future payment of $ 1,100, as long as you trust the person who will pay.

Future value and present value

Suppose a sum of $ 10,000 is invested for one year, at an interest of 10% per year. The future value of that money would then be:

FV = $ 10,000 x (1 + (10% / 1) ^ (1 x 1) = $ 11,000.

The formula can also be rearranged to find the value of the future amount at its present value.

For example, the value to invest today to obtain $ 5,000 in a year, at 7% annual interest, would be:

PV = $ 5,000 / (1 + (7% / 1) ^ (1 x 1) = $ 4,673.

References

1. Investopedia (2018). Time Value of Money - TVM. Taken from: investopedia.com.
2. Wikipedia, the free encyclopedia (2018). Time value of money. Taken from: en.wikipedia.org.
3. The Pennsylvania State University (2018). What is time value of money? Taken from: psu.instructure.com.
4. CFI (2018). Time Value of Money. Taken from: corporatefinanceinstitute.com.
5. James Wilkinson (2013). Time value of money. The Strategic CFO. Taken from: strategiccfo.com.
6. Brian Beers (2018). Why the Time Value of Money (TVM) Matters to Investors. Taken from: investopedia.com.