Definition of Time Value of Money (TVM)
- Time value of money describes how the sum of money that you hold currently is worth more than the equivalent sum in the future.
- This is mainly because there is there are risks associated with receiving future value, but current cash in your hand doesn’t have those risks.
- Inflation, a rise in the general price level of goods and services, is one of those risks.
- Inflation erodes value. A meal at a restaurant today is likely to cost more in the future.
- A meal at a restaurant today is likely to cost more in the future.
- For example, $100 could buy you more now or could earn more interest than it can in say five years.
- Present value is your calculation of what a sum of future money is worth today.
What are the Factors that Influence the Time Value of Money?
- Compounding is when you earn interest on any investment you make.
- As time passes, you make more money because of the interest you earn.
- Compound interest is the earnings that you make based on the initial amount of investment and accumulated interest.
- On the other hand, simple interest is the interest you earn on the initial investment.
- Therefore when you add both the compound interest and the simple interest up, you get the total interest.
What are the Effects of Compounding Periods on Future Value (FV)?
- The number of compounding periods can severely impact the calculations.
- The higher your frequency of compounding, the more interest you earn.
- For example, if you were earning interest every day, then you would have more money compared to if you were earning interest every month.
- Interest rates, therefore, aren’t the only important factor, compounding periods are just as important.
Time Value of Money Formula
- Four variables are used in TVM calculation: Present value, future value, time, and an interest rate
FV = PV * [1 + (i/n)] ^ (n * t)
PV = FV / [1 + (i/n)] ^ (n * t)
What is Present Value (PV)?
- When finding the present value, we discount the money from the future to the present to see how much it is worth today using an appropriate interest rate.
- We generally refer to the calculating of future cash flows as “discounting” because we are reducing those cash flows.
Time Value of Money in Practice
- Say you had a spare $100,000 lying around and you invested it at an interest rate of 10%.
- Now, using the future value formula, you would see that the $100,000 would turn into $110,000 in a year.
- The $110,000 is calculated through the formula mentioned above -> $100,000 (1 + 10%/1) ^ (1*1) = $110,000
- However, if you wanted $110,000 next year, but you could only earn an interest of 8% on the investment at this moment, then how much would you need right now to have $110,000 next year?
- 110,000 / (1+ (8%/1) ^ (1 x 1) = $101,851.85