Time Value of Money Explained: Formula, Examples, And More

The time value of money (TVM) is a simple concept stating that money available in the present is worth more than the same amount of money in the future. It’s important because it helps investors understand how much future cash flows are worth in today’s terms, aiding better financial decision-making. It can be easily explained with an example:

If you get paid $2,000 for a job, you can invest the money, earn a 10% interest rate, and have $200 more in your bank account after one (1) year. If your client pays you one (1) year late, you will lose $200. That’s why $2,000 now is worth more than the same amount of money one year from now.

Inflation is an important factor when it comes to the time value of money because it tends to erode the purchasing power of money over time. For instance, the price of a gallon of gasoline today has more than doubled from twenty (20) years ago, which means you could have purchased a lot more gasoline for the same amount of money back then than you could today.

The price of gasoline futures over the past 15+ years:

This is the main reason why both purchasing power and inflation need to be factored in when you’re thinking about investing your money.

To calculate the real return on your investment, you have to subtract the inflation rate from the internal rate of return (IRR) of your investment. If the inflation rate is higher than the annualized investment return, you lose money (or at least purchasing power) even if you get a decent nominal return.

So, now that we’ve got a grip on the time value of money concept, let’s take a look at the formula that is used by individuals and businesses who want to make sure they have made the right investment decision. A formula that can be used for calculating the future value of money to compare it to the current value of money is:

FV = PV x [1 + (I / n)] (n x t)

Here’s a breakdown of the individual components of the formula:

• FV: is the future value of money
• PV: is the current value of money
• I: is the interest rate that could be earned
• t: are the number of years it will take
• n: is the number of compounding periods of interest per year

The future value of $50,000 invested for one year at 8% interest is:

FV = $50,000 x [1 + (8% / 1)] ^ (1 x 1) = $54,000

You can also find the net present value of a future amount. For example, how much did Alex invest one year ago if he gained an 8% interest rate and currently has $10,000?

PV = $10,000 / [1 + (8% / 1)] ^ (1 x 1) = $9,259.26

The time value of money and net present value are the key principles of evaluating investments, deciding on which offers a better risk/reward, and what the intrinsic value of stocks is.

TVM impacts investment decisions by allowing investors to compare the value of money received or paid in the future versus the present. It helps determine whether to invest now or later, considering potential gains or losses in value.

Interest rates directly affect TVM as higher rates increase the potential growth of money over time, increasing the present value of future cash flows and vice versa.

Present value refers to the current value of a sum of money to be received in the future, discounting for interest rates. Future value is the amount of money an investment will grow to over time at a specified interest rate.

Compound interest is crucial because it shows how reinvesting interest can significantly increase the future value of an investment compared to simple interest, which can influence investment strategies.

Inflation decreases the purchasing power of money over time, meaning future money might not be worth as much today, making it crucial to factor inflation into TVM calculations to maintain wealth.

Yes, TVM is applicable in personal finance for planning savings, retirement funding, loan repayments, and understanding the cost of credit over time.

Annuities involve regular payments over time, and their valuation uses TVM to determine the present or future value of these cash flows, helping evaluate payment streams and investment products.

Beginners can use financial calculators, spreadsheet software like Excel, and online TVM calculators to perform various TVM calculations without extensive financial knowledge.