Time value of money (TVM) is a financial concept concept widely used in businesses and investing and it is used to estimate the value of money over time. This concept states that the value of money changes over time.
What does this mean? It is simple, the value of money is not static, it changes and this it does over time. It can increase or decrease depending on various economic factors. Take, for example, the money you have at hand right now. Say you have $100. This money can buy you more petrol today then few months or years down the line because of surging fuel prices. Same goes for your housing. Housing was pretty cheap a few decades back but is it cheap today? That’s the effect of Time value of money.
To put it simply, economic factors like inflation can affect your purchasing power now and in the future. This is because the value of your money will have likely decreased over the one-year period, in the case of inflation. Time value of money is not always negative.
Let’s say you buy land for $50,000 that might be worth $55,000 in the next year. In this case, TVM will have had a positive effect on your investments because its appreciated its value by 20%.
Understanding the time value of money requires that you also understand the two elements that are intrinsic to TVM; the present value of money and future value
The present value of money vs the Future value of Money
It refers to how much worth money is today while the future value is the worth of money at a later time. This is quite straightforward, simply think about it regarding purchasing power.
In our example above, for instance, the present value of $50, 000 can buy you land today, but it won’t buy you the same piece of land in a year or two to come. Why? Because in a year’s time your purchasing value would have diminished based on the future value of $55,000.
So basically, the money you have or are to get today is more valuable than if received in the future. Therefore, you can invest whatever money you have today and enjoy more of it in the future. Otherwise, you can also choose to spend it right away, if you opt to spend it and you don’t have the money needed for this, you can borrow and pay back in future with accumulated interest.
Moreover, while investing money can gain you more money at a later time, the chances are that that money might not gain in value; this happens when factors such inflation creep and decrease the value of money in the future. In an inflated economy, the further into the future you invest your money, the less valuable it is.
This correlation between the present and future value is the reason most financial experts advise that investors should regard the timing of receipts from their investments with great importance, at least more valuable than the sum received. That is, because of TVM, given a chance to gather money in a shorter time could be shrewder that collecting a bigger entirety of cash in the future.
Ideally, discount rates tend to determine the amount by which the value of money diminishes over time. This is proportionate to an interest rate. If the rate is high, then the present value of money in the future is low and vice versa. In other words, discount rates vary from time to time and from one person to the other. If alternative investment opportunities are great, the rate will be high.
In case the individual giving a loan has no quick prerequisite for the money, the rate will be lower. Risk likewise increases the rate. In case the possibility of repayment is uncertain, then the lender will demand a higher interest rate.
Compound interest significantly impacts investment returns as it increases investment returns in most cases. Compounding in this regard implies that additional interest is paid on the accrued interest and left on deposit. So when interest is accrued and then plowed back, it tends to multiply together with the original principal amount. In actuality, the interest earned in this case thus becomes the principal.
Understanding time value of money, along these lines, is vital for investors and those seeking financial success. You need to understand all the tenets of TVM, and that implies to it. It is this knowledge that attempts to explain why we endeavor so earnestly to quantify and comprehend for those progressions with so many components as internal rate of return (IRR) and net present value (NPV). When attempting to measure an investor’s rate of return, you ought to do so with the concept of TVM in mind.
To further explain the time value of money and why it is better to receive money now than in the future, consider the accompanying case.
Example of Time value of Money
Example; If you own a parcel of land now, you should take note of its present value today; let’s say the present value is $50,000. You can opt to sell the property today and spend the money on things that need immediate cash. On the other hand, you can choose to invest in the property to increase its value in future. You can, for instance, develop rental properties on the land or whatever venture you see fit. You can also cash out now and loan that money to someone else who will pay back with interest in the future.
These investments will put you in a position of enjoying greater returns in the future. Unfortunately, not everyone acknowledges the value of money in consideration for time. Most people will want to cash out money today rather than wait for it to appreciate in value or invest the money for profit. They find cashing out a more viable option as it saves them the heartaches of having to deal with late payments or no payments at all.
Calculation for Time Value of Money
Here is how to calculate the change in the value of money over time. We will use our present value of $50,000, a period of 1 year and a return rate of 10%.
FV= future value
PV = present value
r = return rate
n = period of investment
FV = PV (1 + r) ^n
FV = (50,000) x (1 + 10%) ^ 1
FV = (50,000) x (1.1) ^1
FV = $55,000
Summarily, understanding the time value of money can significantly help you to make better assessments on the value of money presently compared to in the future. This way you can make wise investments decisions thus being able to achieve your much desired financial success.