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. 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 that is only promised for the future is worth less as inflation may catch up.
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 present times than it will be in the future. This concept is crucial when you have to make financial and investment choices. TVM states that the value of your money changes with time because of variables like inflation, rates of interest, and the potential of earning returns on your investments. If you think about it, back in 2013, Rs. 1,000 had greater purchasing power compared to its value in today’s times. Grasping the concept of TVM is critical for investors to make informed decisions with regard to investments, savings, and financial planning
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In two possible scenarios concerning TVM, money could potentially grow if it earns interest, and this results in the growth of its value. On the other hand, the buying power of money becomes eroded with inflation, and its value is reduced in the future.
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 to understand the concepts related to TVM better. The following is the formula to calculate the TVM with regard to the worth of money in the future:
FV = PV x [1 + I)] ^ N
FV = Future Value
PV = Present Value
I = Interest Rate
N = Number of periods (months or years, typically)
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. The future cash flow is discounted back to the present date with the use of the number of periods and the rate of return. It does not matter what the present value of your money is, but if you invest it at a specific rate of returns and a particular number of periods, your investment will grow into the amount determined by the future cash flow. The time value of the money formula becomes clear when you grasp the concept of present value.
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, you could say that future value is the worth of an investment at the end of the duration of the investment. Future value 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.
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 the way TVM works is that it is possible to determine the future worth of any investment option. Consequently, this concept works to help investors compare several investment opportunities to decide on potentially positive prospects for them.
The way in which the time value of money goes into effect can be illustrated with the example below:
Say, Mr. Z decided to invest Rs. 5,00,000 for a period of 5 years at a rate of interest of 10%. The value of his investment in the future would be Rs. 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 the 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 fulfill 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.
The time value of money is the foundation of investment decision-making, so to speak. By now you have realised that the value of the money you hold presently will not be the same in the future. This may prompt you to invest to increase your current wealth and build it into a substantial corpus so that you can avoid the brunt of inflation and rising costs. 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. Having said that, you may want to begin your investment journey by opening a Demat account with Angel One and getting a solid start on investment.
What is the significance of the TVM in retirement planning?
TVM helps people determine how much capital they need to invest today to build a comfortable retirement corpus in the future.
How does inflation impact the Time Value of Money?
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.
Can the TVM be applied to periodic and lump-sum investments?
The TVM may be used for periodic and lump-sum investments in order to calculate the future worth of investments/savings.
What is the role of compounding in the TVM?
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.