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Time Value of Money: Why it Matters to Investors

•6 min read•by Angel One
Once you understand the time value of money, you gain useful insight into how the value of your money changes over time. It is based on a formula used by investors to determine the value of money in relation to its future worth
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You may have heard the phrase, “A bird in the hand is worth two in the bush”, and this may give you a clue about an important concept known as the Time Value of Money or TVM.  Simply put, this concept teaches us that the value of money is not constant; it changes depending on when it is received.  

In terms of money and its worth, a rupee in hand today is worth more than a rupee that you may earn in the future. The money you have today can be used for investment and the earning of capital. A rupee promised only for the future is worth less, as inflation may catch up.   

Key Takeaways 

  • The Time Value of Money (TVM) states that money today is worth more than the same amount in the future.  

  • TVM depends on factors like inflation, interest rates, and investment returns, influencing financial and investment decision-making.  

  • The TVM formula, FV = PV × (1 + I)ⁿ, helps calculate the future worth of present investments over time.  

  • Understanding TVM enables better financial planning, investment comparisons, loan evaluations, and risk assessments for long-term wealth growth.  

What Is the Time Value of Money? 

The Time Value of Money (TVM) is a basic principle that refers to the fact that money is worth more in the present time than it will be in the future. This concept is crucial when you have to make investment choices. TVM states that the value of your money changes over time due to factors such as inflation, interest rates, and the potential to earn returns on your investments. For instance, back in 2013, ₹1,000 had greater purchasing power than it does today.   

Grasping the concept of TVM is critical for investors to make informed decisions with regard to investments,  savings, and financial planning.  

In simple terms, money can grow if it earns interest, increasing its value. On the other hand, the buying power of money erodes with inflation, and its value declines over time.  

Read More About What is Financial Planning 

Power of Compound Interest

You already know that a sum of money, when invested, yields returns over time. Just like money deposited into a high-interest savings account will earn interest over time. Over a period of years, the interest on the principal amount will be added to the principal, making the principal bigger and hence earning more interest. Basically, your interest earns interest. This is known as the power of compound interest.  

You can use an interest rate calculator and choose compound interest to understand how it affects the growth of your money in the long run.  

The Time Value of Money Formula 

You can easily make use of a time value of money calculator online to know how much value your money will have in the future. Although this is a convenient way to compute sums, knowing the time value of money formula helps you better understand the concepts related to TVM.   

The following is the formula to calculate the TVM for the worth of money in the future:  

FV = PV x [1 + I)] ^ N  

Where, 

FV = Future Value 

PV = Present Value 

I = Interest Rate 

N = Number of periods (months or years, typically)  

Let's take an example to calculate the time value of money: 

Imagine you have a sum of 1000 that you want to invest for a period of 1 year at a 10% interest rate compounded annually.  

The future value of that money will be:  

FV = 1000 \times (1 + 0.10)^1  

      = 1100 

What Is Present Value? 

PV or present value refers to the worth of a potential future cash flow in today’s money or today’s rupees. It is an important component of the calculation of TVM. Future cash flows are discounted to the present using the number of periods and the rate of return.   

It does not matter what the present value of your money is; if you invest it at a specific rate of return and a particular number of periods, your investment will grow to the amount determined by the future cash flow.  

What Is Future Value?

FV or future value, as its name suggests, refers to the worth of money at a certain time in the future. In simple terms, future value is the worth of an investment at the end of the duration of the investment.  

It is essentially the worth of a sum of money at a particular time in the future, taking into consideration the effect of compound interest. FV quantifies the amount that an investment will grow over a period of time. When investors are looking for potentially gainful investments, this aspect of the time value of money is critical.  

Effects of Compounding Periods on FV 

Frequent compounding periods can lead to a higher future value as the interest is calculated and added to the principal amount more often.   

If the number of compounding periods is increased from yearly to quarterly, monthly and even daily, the future value of money will have a significant impact. 
 
Let's take the above example and calculate the future value with varying compounding periods.  

  • Quarterly Compounding: 

FV = 1000 \times (1 + 0.10/4)^{4 \times 1} = 1103.81  

  • Monthly Compounding: 

FV = 1000 \times (1 + 0.10/12)^{12 \times 1} = 1104.71  

  • Daily Compounding: 

FV = 1000 \times (1 + 0.10/365)^{365 \times 1} = 1105.16  

From the above calculations, it is evident that the TVM not only depends on the interest rate and the number of years your money will be invested, but also depends on the compounding period. 

How Does TVM Work?

When you calculate the TVM using the time value of money formula, you are attempting to know about a trade-off between present value and future worth. The idea behind TVM is that the future worth of any investment option can be determined. Consequently, this concept helps investors compare several investment opportunities to decide on potentially positive prospects for them.   

The way in which the time value of money comes into effect can be illustrated with the example below:  

Say, Mr. Z decided to invest ₹5,05,00,000 for 5 years at an interest rate of 10%. The value of his investment in the future would be ₹8,05,225.  

When it is possible to know about the future value of your investment over different terms, you can make more informed decisions about investing options, terms, and amounts to invest.  

The Importance of Time Value of Money 

Having a plan to plot out your financial future is paramount to sound investing. Today, people see the necessity of this, and the concept of TVM only aids you in future financial planning. The importance of TVM cannot be stressed more than it already has, and you can find out why below:  

  • Planning Finances: The time value of money concept helps investors set realistic financial goals and decide amounts to invest or save to fulfil financial objectives.  

  • Decisions on Investment Made Easy: The principle of TVM acts as a guide for you to evaluate the appeal and appropriateness of different investment instruments and business opportunities. When you are able to compare potential risks versus returns, you can make informed decisions.  

  • Decisions About Loans: When it comes to taking loans, TVM enables borrowers to assess the real cost of borrowing, while lenders can decide on appropriate rates of interest. 

  • The Assessment of Risk: Time can literally wreak havoc on your wealth, and the most important way that TVM helps investors is in terms of considering the potential effect of changes in interest rates and the impact of inflation.  

Conclusion

In a way, the time value of money is the foundation of investment decision-making. The last thing you want is for your wealth to be eroded, and the time value of money principle works so you can make informed investment decisions now

FAQs

TVM helps people determine how much capital they need to invest today to build a  comfortable retirement corpus in the future.
Inflation can erode the buying power of your money over a period of time, making the future value of rupees worth much less than it is presently.
The TVM may be used for periodic and lump-sum investments in order to calculate the future worth of investments/savings.
Compounding refers to the earning of interest on the initial investment plus on the accumulated interest. Compounding can magnify the growth of capital over time.

The Time Value of Money is generally used to compare and evaluate cash flows occurring at different periods of time. This is done by determining the present value of future money. Doing this helps in making informed financial decisions by comparing investments, calculating loan payments and even valuating assets.

The time value of money and the cost of opportunity go hand in hand. The opportunity cost is the primary reason why money has time value. The future value of money you have today is far less than the current value of money that’s invested to earn interest and returns. If the same money is instead received in the future, there is a loss in potential gain, which is known as the opportunity cost. Hence, the  

Investors highly value the time value of money, as the money available today is worth far more than the same amount in the future due to its potential earning capacity. This helps the investors to make informed financial decisions, it also highlights the effects of inflation, the power of compounding and also the opportunity cost of delayed investment.

For all investors, the time value of money is the principle that an amount of money available today is worth more than the same amount in the future due to its potential to yield high returns. This means an investor must receive a higher return in the future to compensate for decaying gratification and for the risk and effects of inflation, which decreases their money’s purchasing power over time. 

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