What Is Time Value of Money? was originally published here.
Definition Of Time Value Of Money (TVM)
- Time value of money describes how the sum of money that you hold currently is worth more than the equivalent sum in the future.
- This is mainly because there is there are risks associated with receiving future value, but current cash in your hand doesn’t have those risks.
- Inflation, a rise in the general price level of goods and services, is one of those risks.
- Inflation erodes value. A meal at a restaurant today is likely to cost more in the future.
- A meal at a restaurant today is likely to cost more in the future.
- For example, $100 could buy you more now or could earn more interest than it can in say five years.
- Present value is your calculation of what a sum of future money is worth today.
What Are The Factors That Influence The Time Value Of Money?
- Compounding is when you earn interest on any investment you make.
- As time passes, you make more money because of the interest you earn.
- Compound interest is the earnings that you make based on the initial amount of investment and accumulated interest.
- On the other hand, simple interest is the interest you earn on the initial investment.
- Therefore when you add both the compound interest and the simple interest up, you get the total interest.
What Are The Effects of Compounding Periods on Future Value (FV)?
- The number of compounding periods can severely impact the calculations.
- The higher your frequency of compounding, the more interest you earn.
- For example, if you were earning interest every day, then you would have more money compared to if you were earning interest every month.
- Interest rates, therefore, aren’t the only important factor, compounding periods are just as important.
Time Value Of Money Formula
- Four variables are used in TVM calculation: Present value, future value, time, and an interest rate
FV = PV * (1 + (i/n)) ^ (n * t)
PV = FV / (1 + (i/n)) ^ (n * t)
What is Present Value (PV)?
- When finding the present value, we discount the money from the future to the present to see how much it is worth today using an appropriate interest rate.
- We generally refer to the calculating of future cash flows as “discounting” because we are reducing those cash flows.
Time Value of Money in Practice
- Say you had a spare $100,000 lying around and you invested it at an interest rate of 10%.
- Now, using the future value formula, you would see that the $100,000 would turn into $110,000 in a year.
- The $110,000 is calculated through the formula mentioned above -> $100,000 (1 + 10%/1) ^ (1*1) = $110,000
- However, if you wanted $110,000 next year, but you could only earn an interest of 8% on the investment at this moment, then how much would you need right now to have $110,000 next year?
- 110,000 / (1+ (8%/1) ^ (1 x 1) = $101,851.85
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DISCLAIMER: This content is for information purposes only. It is not intended to be investment advice. Readers should not consider statements made by the author(s) as formal recommendations and should consult their financial advisor before making any investment decisions. While the information provided is believed to be accurate, it may include errors or inaccuracies. The author(s) cannot be held liable for any actions taken as a result of reading this article.
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