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Understanding The Time Value of Money (TVM)


What is Time Value of Money (TVM)?
  • The concept of Time value of money is the baseline of major finance decisions. The  value of money is different at different points of time as the money can be put to productive use. The time value of money often signifies that money available at the present time is worth more than the same amount to be received in the future due to its potential earning capacity. This concept of TVM is important from decision point of view for different investors.

  • For example: $500 today is more valuable than $500 for tomorrow.
  • Therefore, concept TVM always influences our decision about what we intend to do with our money.

Time Value of Money (TVM)
Significance of Time Value of Money (TVM) in financial decision making
  • A rupee today is more valuable than rupee after a year due to several reasons:

  1. Risk:  there is uncertainty about the receipt of money in future.
  2. Investment opportunities: People often have a preference for present money because of availabilities of opportunities for investment for earning additional cash flow
  3. Inflation: In an inflationary period a rupee today represents a greater real purchasing power than a rupee a year hence.
  4. Preference for present consumption: People often prefer current consumption over future consumption.

  • Some people put their money in a bank account, some invest in stocks, bonds etc. different people follow different strategies to utilize their ideal money because are aware of the fact that time is the biggest enemy of idle money.
  • When time value of money concept comes in Finance, we are dealing with two types of time value:
  1. Future Value
  2. Present Value
Present Value And its formula
  • Present value techniques allow you to adjust cash flows backward along a timeline. You might want to compute how much you would need set aside today in order to meet your retirement expectations in the future.
  • The present value of an amount of money that has to be received at a future date is calculated by discounting the future value at the interest rate that the money could earn over the period. This process is known as Discounting.
  • The formula for the present value is:

               PV = FV/ (1+r)

              Here,
             FV = Future Value
             PV = Present Value
             r = rate of return is uniform for the period
             t = number of periods
Future value and its formula
  • Future value calculations shows much a sum deposited today will grow in the future and compound interest affects future values differently.
  • The future value of a sum of money to be received at a present date is determined by compounding the present value at the interest rate that the money could earn over the period. This process is known as Compounding.
  • The future value formula is: 

              FV= PV (1+r) t

              Here,
              FV = Future Value
              PV = Present Value
              r = rate of return is uniform for the period
              t = number of periods




What are different financial applications for the time value of money?

  • Equipment purchase or new product decision,
  • Determination of return on an investment
  • Regular payment necessary to provide a future sum, investment,
  • Present value of a contract providing future payments,
  • Future worth of an investment,
  • Regular payment necessary to amortize a loan,
  • Determination of the value of a bond, etc.


Also read Beginner's Guide for trading in equities




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