The Time Value of Money states that Money in the present is worth more than the same sum of money to be received in the future because you can invest it and earn interest.
We’ve often heard our parents say that when they were young, they could buy things for much less money than what those same things cost today. This shows that over time, the value of money decreases. That’s why money we have now is more valuable than money we might have in the future. This is called Time value of money.
Time value of Money (TVM)
This concept states that money in the present is worth more than the same sum of money to be received in the future because you can invest it and earn interest. This is used to calculate present worth of future money (more information later in the article). The other reason for receiving money at present worth more because of risk of not receiving that money in future.
Formula
FV = PV * (1 + r)ⁿ or PV = FV / (1 + r)ⁿ
Where:
- FV is the future value of the money
- PV is the present value or initial amount of money
- r is the interest rate (in decimal form)
- n is the number of periods
Examples
Let’s start with the Future Value (FV) calculation.
→ Future Value (FV) Calculation:
Suppose you invest $1000 (PV) in a savings account that offers a 5% annual interest rate (r = 0.05). You want to know how much money you’ll have after 3 years (n = 3).
Using the formula: FV=PV∗(1+r)ⁿ
We substitute the values: FV=$1000∗(1+0.05)³
So, the future value of your investment after 3 years would be $1157.63.
→ Present Value (PV) Calculation:
Suppose you want to have $2000 (FV) in your savings account after 3 years (n = 3), and the annual interest rate offered by your bank is 5% (r = 0.05). You want to know how much money you need to deposit today.
Using the formula: PV=FV/(1+r)ⁿ
We substitute the values: PV=$2000/(1+0.05)³
So, the present value or the amount of money you need to deposit today would be $1727.67.
Frequently Asked Questions (FAQ)
What is Time Value Of Money (TVM)
Money in the present is worth more than the same sum of money to be received in the future because you can invest it and earn interest
Why Time Value of money is important?
It’s mainly used to calculate how much your current money will be worth in the future, taking into account things like interest and inflation. This helps you see if your investment today will be worth more than just keeping the money.
Other applications of the time value of money include:
- Comparing loan options to see which has the lowest cost over time.
- Planning for retirement by estimating how much you need to save now.
- Deciding between taking a lump sum payment now or annuity payments over time.
- Evaluating business projects to see if they are worth investing in.
- Setting up a savings goal for big future purchases like a house or education.
