Time Value Of Money

Definition of "Time value of money"

Written by

Gabriel Tulier

RLL Real Estate Group

People say time is money. The old-age cliche applies more than ever in our case as we define what the Time Value of Money (TVM) means. 

You’ll find the term time value for money frequently used in the miscellaneous world of finances. The most straightforward explanation of how time value for money (often referred to as present discounted value) works goes as follows. A dollar today is worth more than a dollar at some future date. 

It is the rationale behind compounding for future value or discounting for present value. As a result, the cash on hand or any capital you own is worth more than the same amount to be paid in the future. 

How does the time value of money work?

What’s significant about money in the context of investing, spending, and saving money? Let’s establish the basic parameters. We must highlight how much money is at stake. The timing of the money is also crucial, meaning when will get that amount. Would you prefer to have $200 today or in six months? The answer is clear as a bell. 

The US economy is currently exposed to financial uncertainties; we’re looking at you, inflation and recession! The prices of goods and services you wish to purchase or benefit from in half a year can (and are likely to) increase. Then, inflation could wreck your money’s worth. 

Example of the time value of money 

Suppose you’d have to choose between $200 today and $220 in six months. If you’re okay with either, we have discovered the equivalent amounts in time and determined your time value of money! To put it plainly, $200 today equals $220 in half a year, or $200 is the present value of $220 in six months from now. 

How can you calculate the time value of money?

According to Investopedia, the basic formula for TVM considers money’s present and future value, the number of years, and the interest rate. The number of compounding periods for each year is another significant formula element. 

A compounding period covers the interval between the last time the interest rate was compounded or established and the next time it will determined again. For instance, a yearly compounding implies that an entire year passes before the Federal Reserve compounds the interest rate again.

FV = PV x (1+i/n)n×t

FV (the future value of money) equals PV (the present value of money) multiplied by one plus the interest rate subdivided by the number of compounding years to the power of compounding periods number per year times the number of years.

Suppose you invest $20,000 for one year at a 10% interest rate compounded annually. Let’s calculate its future value in one year.

You calculate the sum in the brackets first. 1+ 10%/1 equalling 1.1. Then, you raise to the power of 1 times 1, equalling one. In the end, the sum of brackets stays at one point one percent. You multiply this 1.1 percent by the present value, $20,000, amounting to $22,000. So, the future value of your sum will be $22,000.

Internal Rate of Return joined by Net Present Value also has the time value of money at its core. 

How does opportunity cost relate to the time value of money?

The concept of opportunity cost is central to the time value of money. You can increase your revenues if you invest your money, producing a good return over time. For example, you can invest substantial capital in real estate and secure a life without financial worries. 

Money that is put aside uninvested depreciates over time. As a result, a sum anticipated to be paid in the future will undeniably lose value in the interim.

Conclusion

The time value of money means that available funds presently are worth more than the same amount at any given future moment. With the rate of return, you can convert from the present value to its future worth, and it also applies vice versa.