What is Time Value of Money and Its Impact?

What is Time Value of Money and Its Impact?

5 mins readComment
Jaya
Jaya Sharma
Assistant Manager - Content
Updated on Apr 18, 2024 17:58 IST

The time value of money (TVM) is a financial concept. As per this concept, the value of money is dependent on the time when it is received. The money available now is worth more than the same amount in the future due to its potential earning capacity. As per this core principle of finance, the money that you have can earn you interest. Any amount of money is worth more the sooner it is received.

time value of money

 

Table of Contents

What is Time Value of Money: Understanding the Concept With An Example

Let us understand the concept of time value of money (TVM) through an example. Say, you can either receive ₹1,000 today or ₹1,000 one year from now. Additionally, assume there is an opportunity to invest money at a 5% annual interest rate.

1. If You Choose ₹1,000 In the Present:

If you choose to take the ₹1,000 today and invest it at a 5% annual interest rate, after one year, this amount would grow to:

 ₹1,000 × (1+0.05) = ₹1,050

Therefore, in one year, you'll have ₹1,050.

2. If You Choose ₹1,000 in One Year:

If you opt to receive ₹1,000 in a year's time, you will miss out on the interest you could have earned by investing the ₹1,000 immediately. So, you just receive ₹1,000 at the end of the year, with no additional growth.

Analysis (Now vs One Year Later):

  • Receiving ₹1,000 now is more beneficial since it allows you to earn an extra ₹50 as interest by the end of the year.
  • This example proves the TVM principle. This means that the money available at present is worth more than the same amount in the future due to its potential earning capacity.

Explore online investing courses

Reasons Behind the Concept of Time Value of Money

The concept of time value of money is true for the following reasons:

  1. Interest and Earnings: Money can earn interest over time, which means that receiving money now gives it more time to grow through investments.
  2. Inflation: Inflation generally causes the value of money to decrease over time. This means that a dollar in the present time will buy more than a dollar in the future when the purchasing power of money decreases.
  3. Risk and Uncertainty: There is a risk factor associated with the timing of money received in the future. The assurance of having money now is preferred over receiving the same amount later.
  4. Opportunity Costs: Having money now presents opportunities to use it for investments or other financial ventures that might not be possible if one has to wait for the money.

How to Calculate Time Value of Money?

It is important to calculate the time value of money to understand how your investments will work for you in the future. Through these online courses on time value of money, you will learn why the value of money changes over time. You will also identify the best investment proofs for financially securing your future. 

How to Calculate Time Value of Money?
How to Calculate Time Value of Money?
Time value of money is an important concept for those who want to realize the future value of the money that they currently have. This is an extremely useful concept...read more

Impact of Time Value of Money

The following points highlight the importance of time value of money concept:

  • Investment Decisions: Time value of money helps people decide where to put their money. It compares what money is worth now to what it will be worth later after earning more money from an investment.
  • Loan Evaluation: This concept helps in determing the total cost of taking out a loan. This includes all the interest you will pay over time. It helps people understand how much more they will pay back than they borrowed.
  • Retirement Planning: Time value of money helps in planning how much money you need to save now to have enough when you retire. It considers how prices rise over time and how your savings can grow.
  • Business Projects: Companies use time value of money to decide if long-term projects are worth doing. They look at what money spent now will bring back in the future and pick projects that bring the most return.
  • Pricing Financial Instruments: In financial markets, time value of money helps set prices for financial instruments like bonds and stocks. It calculates how much future money from these investments is worth right now.
  • Insurance Policies: Insurance companies use time value of money to set premiums and decide on payout amounts. They need to ensure the premiums they collect now will cover the costs of future claims.
  • Inflation Impact: Time value of money is important for dealing with inflation, which makes money worth less over time. It helps in choosing investments that will grow and not lose value despite rising prices.

Key Takeaways from TVM

In summary, the concept of time value of money teaches us the following:

  1. It teaches the importance of investing early to maximize returns over time.
  2. TVM helps in making better decisions about borrowing and lending, highlighting the costs of loans over time.
  3. Businesses apply TVM to assess project viability to maximize future returns.
  4. It helps in planning ahead for impact of inflation on savings and investments. This ensures that the purchasing power of money does not diminish significantly over time.

FAQs

How is the time value of money calculated?

The time value of money can be calculated using formulas for present value (PV) and future value (FV). These calculations involve discounting future cash flows to the present or compounding present cash to a future date, taking into account the rate of interest or return and the number of time periods involved.

What are present value and future value?

Present value (PV) represents the present worth of the future sum of money or cash flows at a specified rate of return. Future value (FV) is the value of a current asset specified at a future date based on assumed rate of growth over time.

How do interest rates affect the time value of money?

Interest rates directly impact TVM by determining the rate at which money grows over time. Higher interest rates increase the future value of money if invested, and also increase the present value needed to achieve a certain future sum.

What are the practical applications of time value of money?

Practical applications include evaluating investment opportunities, making decisions on loans and mortgages, planning for retirement, determining lease or annuity payments, and assessing the financial health of projects.

Can time value of money principles apply to personal finance?

Absolutely. Individuals use the time value of money to make personal financial decisions such as saving for retirement, financing a home, investing in stocks or bonds, or planning significant purchases.

About the Author
author-image
Jaya Sharma
Assistant Manager - Content

Jaya is a writer with an experience of over 5 years in content creation and marketing. Her writing style is versatile since she likes to write as per the requirement of the domain. She has worked on Technology, Fina... Read Full Bio