Understanding The Concept Of Time Value Of Money With Examples

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One of the fundamental concepts of theoretical finance is the “time value of money”. Unfortunately, the idea is so abstract and mathematical that finance students find it immensely hard to get a good grasp of its basic concept. As a result, they look for essay help from essay writers who will provide them with exclusive assignment help online. Let’s find out the basic ideas of money’s time value if it is also a part of your computer assignment. This blog discusses the fundamentals of this theory with several examples.

What are the definition and basic concepts of the time value of money?

TVM to the time value of money means the certain sum of money is more now than its value in the future. The excess in value is attributed to earning potential during this interim period. The alternative name for the time value of money theory is the “present discounted value”. Let us understand the concept of the time value of money in the subsequent sections.

Detailed understanding of the time value of money.

Most investors would like to draw a particular amount of money today rather than some day in the future. Because once you invest a sum, it will grow in the future. For instance, once you deposit a sum of money in a bank account, it will grow in the future due to the added interest on it. But if you keep $10000 in your pocket for five years it will stay idle and you will lose the earnings it would make throughout that period. Thus, the buying power of the same amount is far less after a certain period in the future. As you retrieve, the money inflation will ensure that the value is less in the future.

Another example

Suppose you gain an opportunity to earn $5000 today and the same amount three years down the line. Despite having the same digits in number, the real value of the $5000 in the future is much less due to fewer utilities. The opportunity cost of the value will be lowered due to the 2 years delay. In short, it can be said that you will miss the opportunity if you receive a delayed payment of the value.

Relationship with inflation

The relationship between the time value of money and inflation is inversely proportional. Inflation refers to a price increase in goods and services. It means you can’t purchase the same amount with the same money in the future as you will purchase now.

What is the formula for the time value of money?

The fundamentals of the time value of money have two main determinants. They are

Present value of money and
Future value of money.

Here is the formula for the time value of money based on these two variables.

FV= PV (1+ i/n) n×t

The symbols indicate the following.

FV= Future value of money
PV= Present value of money
i= Interest rate
n= number of periods compounding every year
t= number of years.

It is to be noted that the formula of the time value of money changes from time to time. For instance, if we have perpetuity or annuity of payments, the general formula for the time value of money will have fewer or additional components.

Note

We do not consider capital losses while calculating the time value of money. Also, it is not applicable if you have any adverse interest associated with the amount. In such cases, you can use the concept of negative growth rates to calculate the time value of money.

Give an example of the time value of money.

Let’s look at a hypothetical example to show how the concept of the time value of money operates.

Suppose with 10% of annual compound interest, a total of $10000 is invested for a year. The future of money here is,

FV = $10000 × (1+10%/1)1×1

Result = $11000.

Finding the present value using the same formula

You can rearrange the formula to find the future sum with the dollar’s value in the present day. For instance, a sum of $5000 will be derived at 7%interest on the following formula.

PV= [($5000/(1+7%/1)]1×1

Result = $4673

What is the relationship between the time value of money to opportunity cost?

The concept of opportunity cost is central to the time value of money. If a sum of money has a prospect of return over time, it will only grow. On the other hand, a sum that is not invested anywhere automatically loses some of its value over time. It means an amount to be paid at some time in the future is, by default losing its value. Here the amount of confidence associated with the value is immaterial. This is how opportunity cost is related to the time value of money.

What is the importance of the time value of money?

The idea of the time value of money can be used to make investment decisions in the future. Let’s take an example.

Let’s assume a person has choices between investing in two projects. Project M and Project N. They have all parameters in common except Project M offers a cash payout of $ 1 million after a year, and project N has a cash payout proposal for 5 years. Thus, you cannot equate the payout. However, the present payout value for project M is higher than that of project N due to the time duration of the projects.

How would you use the time value of money in finance?

You cannot find a single finance area where the concept of the time value of money is not used as a decision-making idea. It is the main concept behind discounted cash flow analysis or DCF. DCF is one of the most influential and popular methods of deriving values for investment opportunities. It is an inalienable entity of risk assessment and financial planning. For instance, pension scheme managers give prime importance to the time value of money theory to derive the receivable value after retirement.

What is the impact of inflation on the time value of money?

Many factors can be responsible for a changing time value for money. If something has a straightaway negative impact on the future value of money, it is inflation. Because the value of the money only takes you to a certain extent when prices will rise. Your purchasing power will decrease even if you encounter a slight price rise. If you save $20 in 2018 and keep it under your bedsheet, it will buy fewer products than it would have back then.

What is the method of calculating the time value of money?

You need to consider several factors to calculate the monetary value of the future. They are

Present value of money (PV)
Compounding numbers of periods in every year (n)
Number of total years (t)
And the rate of interest ( r ).

To calculate the time value of money, you need to use the following formula.

FV= PV (1+ i/n) n×t.

What did we derive at the end?

We all know that the value of present-day dollars will never be the same in the future. This is equally true about the money value of the past. This is called the time value of money in short. Business people generally use this concept to gauge the value of money in the future and how much they have to invest in future projects. You can use this money to measure investment opportunities if you are an investor. So, with the concept well within your grasp, you can make sound investment decisions in the future.