Meaning of Time Value of Money
The term ‘Time Value of Money (TVM)’ implies that there is a connection between ‘time’ and ‘value of money.’ A simple question can explain this concept – Would you prefer to receive $100 today or after a year? The answer shall always be obviously ‘today.’ Let us understand why we prefer it today. If you receive $100 now, you can deposit it in a bank at, say 10% interest rate; the value of your money after a year will be $110. On the other hand, if you opt to receive money after a year, you will get $100. The first option is preferred because, after one year, you are better off by $10. In the current example, the future value of $100 is $110 or the present value of $110 is $100 and $10 is the time value of money for 1 year.
In other words, the time value of money is defined as a concept that states that purchasing power of money differs with the passage of time. Normally what do we do with money, we either expend or save money. In expenditure, the TMV is understood with inflation, and in savings, it has relevance due to interest rates. From our income, we spend, save, borrow, or invest money in our daily routine. Here we shall see how the time value of money is important and how it affects our daily transactions:
Since inflation is in place, the prices of goods are bound to rise every day. With the same amount of money today, we can buy more goods than we can in the future. So, spending today has more value in terms of more goods than in the future.
We save money to ensure the future because it is certain that we will have needs in the future, but the inflow of money to satisfy those needs is not certain. So, saving money today has value in the future in terms of fulfilling our future necessities.
To fulfill our current needs, we borrow money. For example, to enjoy the benefits of a car today, you borrow money and repay it slowly in the future.
We opt for an investment of our surplus as we know that investing money will maximize the value of our surplus money.
Reasons for Time Value of Money
The question arises, “Why money has time value?” Following are the primary reasons for money changing its value due to the passage of time.
One can control their spending, but he has no control over his income or the inflows. A risk factor is always attached to the inflows. Everyone wants to avoid that risk and prefers cash receipts now.
In this economic trend, the purchasing power of money is falling. Money received today is more useful than money received in the future.
Interest Factor Attached with Investment Opportunities
In a simple world where a certain cash amount is received and paid at a later date, the values are different. The link is the ‘Interest Rate.’ People invest their savings to get a higher value in the near future.
Time value of money is inevitable to understand the various concept of finance. It is nothing but the difference in the value of money between today and sometime later. It helps us answer more complicated questions like ‘$100 today or $200, 6 years later’. Primarily the interest rates help us decide such a dilemma provided the cash flows do not have any uncertainty. The concept of present and future value is very important to solve corporate financial management problems relating to capital budgeting, investment decisions, etc.