The time value of money is an important core financial concept that states that sum of money is worth more now than in the future. This may sound strange, but this is true, and this is owing to the below 3 reasons:
1. Opportunity cost: Money which we have today can be invested and accrue interest, increasing its value.
2. Inflation: Our money may buy less in the future than it does today.
3. Uncertainty: There is always a little bit of uncertainty involved and there may be a scenario that something could happen to the money before we are scheduled to receive it. So, until we have it, it’s not given.
This concept is integral to personal, corporate, and government finance, influencing budgeting, investing, and financial decision making. TVM relies on several key components, namely, interest rates (both simple and compound), the number of periods over which money is invested or borrowed, payments (cash inflows and outflows), present value (the current worth of future cash flows), and future value (the amount to which an investment will grow over time).
For individuals, understanding TVM can aid in developing investment strategies, like modern portfolio theory, which emphasizes diversification to optimize returns while managing risk. For businesses, accurately assessing corporate value is crucial; it involves analyzing assets, liabilities, and equity to make well informed decisions regarding growth, mergers and acquisitions. Overall, TVM serves as a critical tool in evaluating investment opportunities, comparing alternatives, and ensuring sound financial management across various sectors.
Time Value of Money Formula:
How can you calculate TVM depends on which value you have and which you want to solve for.
FV = PV * [ 1 + (i/n) ]^ (n * t)
In the above formula,
FV = Cash’s future value
PV= Cash’s present value
i = interest rate (when calculating future value) or discount rate (when calculating present value)
n = number of compounding periods per year
t = number of years
Alternatively, if we know the money’s future value (for instance, a sum that’s expected three years from now) , we can use the below version of the formula to solve for its present value:
PV = FV/[1 + (i/n)]^ (n* t)
Why is TVM important?
Understanding the concept of TVM in one’s daily work can help guide decisions about which investments or initiatives to pursue. Investors can leverage TVM to assess businesses’ present values based on projected future returns, which helps them decide which investment opportunities need to be prioritized. If we dream of becoming an entrepreneur and want to seek venture capital funding, we definitely need to understand that the quicker we provide returns to the investors, the higher cash’s present value , and the higher is the likelihood that we will be chosen by the venture capitalists to invest in our company over others.
