Time Value of Money (TVM) is a financial concept wherein the value of money is much higher now, at present than the same sum of money will be in the future. This is because money at present can only grow if it is invested and can help you earn returns. However, the same amount of money can lose value to inflation over time. Thus, while the cash at present enables you to accumulate higher value, the same sum would have lesser buying power in the future. Moreover, the money not invested now loses value over time; even when it might look promising.
Let us see an example to understand this better. Imagine you have Rs. 5000 today. This money can get you an interest of 5% when invested or help you buy 100 bottles of mineral water. However, after two years, each bottle of water may cost up to Rs. 20 while the value of the money remains the same. In such a scenario,its utility and purchasing power both have dropped. Instead of 100 bottles, your purchasing power is down to half.
Time Value of Money (TVM) is an underlying concept for all financial decisions, from taking a loan to salary and purchase decisions. It is one concept that comes in handy in all situations to evaluate decision-making and taking a calculated risk.
The Time Value of Money (TVM) is also referred to as Net Present Value (NPV) of money or Present Discounted Value.
The following formula can be used to calculate:
Future Value of Money (FV)
FV = PV x [1+ (i/n)] (nxt)
Present Value of Money (PV)
PV = FV / [1+ (i/n)] (nxt)
Here, FV is Future Value
PV is Present Value
i stands for the interest rate or return that can be earned on money
t stands for the number of years under consideration
n stands for the number of compounding periods of interest per year
Not just interest rates and time period, but the Time Value of Money (TVM) also depends upon how many times the compounding calculations are computed per year. Each compounding period increase- daily, quarterly, monthly directly impacts the Future Value of Money.
Let us take an example to understand it better. Assume you have Rs. 20,000 and there is an interest rate of 10% on it, which is calculated quarterly, monthly and daily for a year. In such a case, the Future Value (FV) of money would be different.
|Compounding Period||Formula||Future Value (FV)|
|Quarterly||FV = Rs. 20,000 x [1+10%/4] (4*1)||Rs. 21,038|
|Monthly||FV = Rs. 20,000 x [1+10%/12] (12*1)||Rs. 21,047|
|Daily||FV = Rs. 20,000 x [1+10%/365] (365*1)||Rs. 21,052|
Let us take our earlier example to calculate the Future Value (FV) of money. We assume that the interest is compounded annually for a two-year period.
FV = Rs. 5000 x [1+(5%/1)] (1×2)
FV = Rs. 5,512.50
Let us take another example to better understand how to calculate Present Value (PV). You are offered Rs. 1000 today as against Rs. 1,100 after one year. Now, if you get 5% interest on it, we need to calculate how much money is required now to get the Future Value (FV) of the money which is Rs. 1,100. How do we calculate this?
PV = Rs. 1,100/ [1+(5%/1] (1×1)
PV = Rs. 1,047
The Time Value of Money (TVM) is directly related to the following parameters, and you need to calculate the returns of money invested by keeping the following factors in mind.
Inflation – It reduces the purchasing power of money and raises the cost of goods and services. Thus, your purchasing capacity with the same amount of money reduces. Therefore, if the inflation rate is higher than the investment return rate, one will lose out on money value even with positive returns due to purchasing power fluctuations.
Opportunity Cost – It is the loss related to an investment and the profit linked to it due to the commitment of money in another investment for a stipulated time period. There could be times when a particular financial decision prevents you from investing and taking advantage of Time Value of Money (TVM).
Risk – It is the risk that investors take while investing their money in investment assets.
Let us take an example to understand this further. Suppose you have invested Rs. 1,000 at an annual interest rate of 8.5% for 5 years. The inflation rate was 2.5% at the start of the investment period.
In the first year, you receive Rs. 1,000 x (1+8.5%) = Rs. 1,085
In the second year, you will receive Rs. 1,085 x(1+8.5%) = Rs. 1,177.23
Third year, you will receive Rs. Rs. 1,177.23 x (1+8.5%) = Rs. 1, 277.29
Fourth year, you will receive Rs. 1,277.29 x (1+8.5%) = Rs. 1, 385.86
In the fifth year, you will receive Rs. 1, 385.86 x (1+8.5%) = Rs. 1, 503.66
In this case, Time Value of Money (TVM) is what you receive as compensation for investing Rs. 1000 for five years at an 8.5% annual interest rate. Now, in this case, inflation is considered to be static.
However, if the inflation rate is not static, and there is a rise or drop, it impacts the value of money related to an individual’s purchasing capacity. In such a case, the investment made will hold no value and can even lead to a loss.
Since inflation triggers a rise in the prices of goods and services, it affects consumers’ purchasing capacity and businesses’ profitability. Since higher inflation directly impacts cash in hand for purchases, this kind of scenario witnesses lower revenues and profits for companies and consumer spending reduces, pulling down the country’s economy.
The Time Value of Money (TVM) is an important indicator to help investors make the right investment decisions. It can help them preempt the future value of money and invest wisely with fewer risks involved.
For example, if there are two investment portfolios, wherein one gives you Rs. 2000 back in one year and the other payback Rs. 2,000 in five years, with the help of Time Value of Money (TVM) calculation, you can derive the future value of money as against the present value.
In this case, it helps in identifying that Rs. 2,000 payback in one year’s time is better than after five years. It is a key aspect of financial management and can help businesses and individuals manage finances better and generate higher profits.
There are two concepts of Time Value of Money (TVM).
1) One-Time Payment: In this, one can calculate the Future Value of the money based on the cumulative period of investment. For instance, it could pertain to the annual interest rate provided by the bank on a particular amount. In this case, the value of money depends on the inflation during the period, interest rates provided and the risk attached
.2)Doubling The Period: Here, one can calculate when the Time Value of Money (TVM) will double by using the Rule method of 72. In this method, the interest rate for the mentioned period (in years) is divided by 72 to derive an approximate number of periods required for money to double.
We need to understand that the utility factor of money is crucial and Time Value of Money (TVM) tells us how. While inflation, opportunity cost and risks play a key role in estimating the value of money and its purchasing power, knowing the worth of money now and in the future enables you to plan investments better.
Time Value of Money (TVM) principle is a fundamental concept for almost all financial decisions. It enables you to track how money doubles or grows, and how you can invest money more wisely with all risks and opportunities taken into account.
The Time Value of Money (TVM) formula is led by five parameters, Future Value (FV), PV is Present Value, i stands for the interest rate or return that can be earned on money, t stands for the number of years under consideration and n stands for the number of compounding periods of interest per year. In the formula to derive Time Value of Money (TVM) – present as well as future – one needs to take into consideration interest rates, amount of money and time frame.
The number of compounding periods each year is crucial to determining Time Value of Money (TVM). In addition to this, the higher inflation rate during the investment period can dampen the value of money over time instead of building it, despite strong fundamentals of investment and regularity.
Lastly, one needs to remember that money not invested erodes over time due to inflation and means lesser in value. Therefore, one must plan one’s money well and make most of it with the Time Value of Money (TVM) concept.