Time value of money (TVM) is the most fundamental and important concept in finance. This concept basically means that money you have at hand is worth more than the money that will be available in the future / after some time. In other words, a dollar is worth more today than if you were given it in the future. And, this is so because of the time gap, the uncertain future, the impact of inflation, and so many other financial and economic factors. The TVM concept serves as the basis for many other financial concepts and also helps in decision-making. The age-old proverb “one bird in hand is more than two in the bush” confirms this fact to the point. This concept is better understood and the importance of time value of money in financial decision-making is therefore crucial for all of us.
Importance of Time Value of Money
The basic idea and underline of this concept is very simple. Time Value of Money means that we should always prefer to get the funds / money now rather than getting it in the future, but this is subject to the overriding caveat that other things are the same.
The future is uncertain, and even if someone promises to pay you fixed interest in the future, it is still risky, so in order to make a decision on which option to choose, we need to establish a relationship between the present and future cash flows. This would definitely help us make a better and more calculated decision. And, at this point, in deciding the preferred option, the TVM concept comes in handy. It helps us to clearly understand and bridge the gap between the present value (PV) and future value (FV) of the money under consideration.
TVM bridges the gap between the two with the help of a discount rate. PV, FV and discount rate are the three components of TVM. Together, these three components help in almost all types of financial decision making.
Yes, TVM helps bridge the gap between PV and FV, but why bridging this gap is important? The following points will help explain this, and they will also explain the importance of time value of money:
Time Value of Money and Compounding
The compounding effect is perhaps the most important application of the TVM concept. In compounding interest investment, apart from yearly interest on the principal, interest is also calculated on earlier years’ interest. In other words, the investor earns interest on the principal, as well as on all the interest on previous years. Various authors and experts have already called compounding the ninth wonder of the world; interest on interest has a spiralling impact on the funds. So, in order to get the maximum benefit, you have to stay invested for a long time and enjoy the benefits of compounding.
For example, to understand and appreciate the compounding concept, suppose a bond pays a 5% return on $1,000 over five years, in which case the bondholder receives $50 per year, or $250 over five years.
Now, suppose you put the same amount into a deposit account with the same interest rate at maturity. In this case, your annual interest rate continues to increase with each year / period. In the first year, we receive $50 in interest, but in the second year, the interest amount will increase to $52.50 and so on for all subsequent years. This is because you also earn interest on the unpaid interest of the previous year. The unpaid interest portion is treated as principal which continues to earn interest until maturity. After five years, the final payout is $1,276.
The reason why you got more money in the second case is the duration of your investment or the fair value of your money.
Financial Management And Time Value of Money
Since the money is worth more now than the same money in the future, TVM is therefore important for financial management. You can always use the funds to make an investment and receive interest. However, when investing you must take into account the opportunity costs.
Opportunity costs exist wherever options are available. Opportunity costs are therefore the benefit or interest that one forgoes when one prefers one investment over another. Or, to put it simply, opportunity costs are the next best available and preferred investment. Therefore, when deciding on an investment, one should consider its opportunity costs. Opportunity costs are a TVM concept and help in decision making.
Capital Budgeting And Time Value of Money
TVM is very useful in capital budgeting as it helps management to get an idea of their cash flows. In capital budgeting, we discount the future cash flows to their present value to determine whether the project is worthy of investment or not.
When a company plans to make investments, for example in machinery, to take over another company, etc., it wants to get an idea of whether that investment will pay off or not. Or companies need to know whether the cash flows from the investment are sufficient to recoup at least the initial outlay. The TVM helps a business in deciding and analyzing this aspect with the use of a discount rate.
In the financial world, this discount rate is used to discount and determine the present value of expected future cash flows. This discount rate depends on several factors, such as the ongoing interest rate, risk level, expected return, and more. Arriving at a discount rate is a difficult task. Of course, it becomes easy to arrive at the present value of all future cash flows once you are done with the discount rate. However, once you have it, you can easily determine the present value of future cash flows.
Personal Finance Decisions And Time Value of Money
The importance of time value of money is not only for corporate decision-making, but also on a personal level. Knowing the TVM concept will help you see the financial impact of every financial decision you make. It would help you plan your financial goals and help you meet financial challenges. It would also help you compare and evaluate two or more investment options.
For instance, someone asks you to lend him $5000 now for $5,500 a year later. At first glance, it seems like an attractive investment option, as you get an extra $500. However, you need to consider the TVM to get the real picture. If the PV of the future amount is smaller than the current amount, then this investment is not worth it. And if the PV of the future amount is more, then you should opt for this investment.
You can also use the TVM concept when buying insurance. Almost all of us blindly trust what our brokers say, that after n years we would get x times as much if we now invest y amount now. However, you can always use the TVM concept to evaluate an insurance proposal. And can very well understand what rate of interest the insurance company will be giving out on your investment during the term of the insurance. The offer of giving an X-time return looks quite attractive on the face of it. However, once we try to look at the present value and rate of return, the attraction is sometimes over.
Other real-life applications of TVM that you can easily apply in your daily life include:
- If you are planning to buy a property and then rent it out, the TVM concept can help you determine the rental amount you should charge.
- If you are planning to buy a property in the future and want to know how much to save, then TVM can also help.
Investing and Time Value of Money
Because of inflation, prices will rise over time. And the value of the available money will decrease over time. Therefore, the money you have is worth more today than in the future. Therefore, it is very important that you invest the money instead of keeping it in yourself or in a normal bank account. And, the TVM helps you make the better investment decision based on the following factors:
Inflation – it is the continuous rise of the price level. The money in your pocket has more purchasing power today than in five years thereafter. Therefore, an appropriate investment can only maintain or increase the value of your money over time.
Risk – the future is uncertain, so you may lose some or all of your money in the future, but you can reduce your risk by investing it right now.
Investment Opportunity – There are many ways and options in which you can invest your money. However, you lose the opportunity if you wait to invest your money. Any delay will lose the value of your money.
The time value of money is a straightforward concept with many applications in the real world. It helps to explain the power of time financially and helps you achieve your financial goals and find suitable investment opportunities.
Time Value of Money plays a crucial role in investment decisions. The investor evaluates the present value of future cash inflows and compares this with the current cash outflows to estimate the additional return that can be expected from this investment over time in terms of current period.
The value of the dollar in the present is higher than it will be in the future because of inflation. Due to inflation, the value of money / purchasing power of the dollar decreases. Today, one dollar has more purchasing power than tomorrow.