The concept of the time value of money states that money today is more valuable than a money in the future. This is because money can be invested to generate returns, and inflation diminishes the purchasing power of future money.
Generating inflation-beating wealth is a crucial objective for all investors. The idea behind this goal is quite simple: As time goes on, the value of money depreciates. Time value of money is closely linked to this same core principle. In this article, we explore what is time value of money, how it works, and its importance in the world of finance and investing.
What is time value of money?
The time value of money (TVM) is a fundamental financial principle that asserts that the money you possess today holds greater value than the same amount in the future. This difference in value arises from its potential to earn returns over time. The essence of this concept lies in the idea that money can generate income through investment, meaning that postponing investment equates to missing out on potential earnings.
The value of money fluctuates over time due to various factors, including inflation, changes in rates of return on investment (ROI), and the ability to reinvest your earnings. As a core concept in finance, the time value of money significantly influences decisions related to investing, borrowing, and lending, shaping how individuals and businesses approach their financial strategies.
Example of time value of money
The concept of time value of money explains the basic idea that money available now is worth more than the same amount in the future due to its potential earning capacity. Let’s take an example to explain the time value of money better. Let’s say, you can either receive Rs. 10,000 today or Rs. 10,000 in exactly one year from today. Additionally, we assume there is a possibility of investing the funds at an annual interest rate of 5%.
Scenario 1:
If you accept Rs. 10,000 today, you could invest the sum and earn interest. Earning interest at 5%, your principal amount will grow to Rs. 10,500 in one year.
Scenario 2:
If you receive Rs. 10,000 a year later, you miss out on the year’s interest earnings. You miss out on the additional Rs. 500 credited on the investment at the end of year.
Formula of time value of money
Investors use the following formula for time value of money calculations:
| FV = PV x [1+ (i/n)] (n + t) |
Where,
FV is the future value of money
PV is the present value of money
i is the interest rate
n is the number of compounding periods/year
t is the total number of years
Concept of time value of money - Underlying reasons
Time value of money is an important concept in finance and economics. It is one of the fundamentals that drive investor behaviour in the market. With the meaning of the concept clear by now, let us delve a little deeper and attempt to uncover the reasons why the concept holds importance and has global applicability. These reasons are
Earnings and interest
Everyone works hard to grow their wealth over time. One of the primary ways to grow wealth is to park money in savings and investments and earn interest income. This directly means that with more money in the present, you can grow it into even more wealth over time through investments.
Inflation
Inflation refers to the general rise in prices of goods and services over a given period. It causes the value of money to decrease, making the present rupee in hand more valuable than the same rupee in the future, as its purchasing power would decrease. A major objective of investments is to, over time, beat the decrease in the value of money caused by inflation.
Uncertainty
There is no certainty about the future. There is no guarantee that you will receive money in the future to increase your revenue or wealth at a rate higher than the rise in inflation, whether it be through investments, savings, etc. Thus, people tend to prefer having money in the present over the assurance of possession in the future.
Opportunity costs
If you have money in the present, you have the luxury of choice. You can choose to invest it or save it for a financial venture, among a plethora of other avenues. It may not be possible to have concrete plans if money is not present today, but it is only assured for the future.
How does time value of money work?
As mentioned earlier, time value of money works to estimate opportunity costs. Let’s say, you have two options to receive payment: Either you can receive a payment of Rs. 5,000 today or Rs. 5,500 one year from today. Deciding between the two depends on the returns you can earn from a present investment. The delayed amount of Rs. 5,500 is 5% of the original sum. Thus, if you can earn more than 5% by investing the original sum, you should receive the payment today. Failing to do so would amount to an opportunity cost.
The concept of time value of money also helps investors estimate the trade-off between the present value and future worth of investments. Essentially, it helps you estimate the future value of your earnings from an investment. For instance, you make SIP investments of Rs. 15,000 per month in mutual funds. Let’s assume the expected return rate on your investment is 10%. Using an SIP calculator you find out that the value of your investment in the future will be Rs. 11,71,236 after 5 years. You can carry out similar calculations for other investment options and then compare returns (and risk) to choose the right option.
How to calculate the time value of money?
You can easily calculate the time value of money with the formula mentioned in one of the previous sections of this article. For this, you will need the calculations for present and future values. These calculations incorporate adjustments to cash flows for interest rates and periods, either by discounting the future cash flows to their present value or by compounding present cash flow to a future value.
Significance of time value of money
It will not be a stretch to say that the time value of money is one of the main driving forces behind investments. Let us take another example to explain this. Imagine that you take up two assignments simultaneously. Both these projects are identical except for one key difference. The first project has an assured payout after its completion worth Rs. 1 lakh. On the other hand, the second project comes with the same assurances, but the payout is realised after 3 years. In this case, even though the exact payout is the same, the sooner you receive Rs. 1 lakh in hand, the more value it will have. This is because it can be used to further create wealth through investments, ultimately exceeding the amount by the third year.
Uses of time value of money concept
With the immense significance of the concept of the time value of money, it can be understood that it will have a very wide applicability and use. Some of its key uses are highlighted below:
- Used in the analysis of discounted cash flow to assess opportunities for investment.
- Used to understand how inflation depreciates the value of a currency over time.
- Vital in making strategic financial decisions about the procurement and acquisition of funds and assets.
- Used to make crucial decisions about loans and financing options.
- Used by financial managers to narrow down potential investments with the goal of wealth maximisation.
Techniques for estimating time value of money
There are two primary techniques of estimating the time value of money. We have covered both below:
Present value method
Also known as the discounting technique, the present value method estimates the present value of money that’s to be received in the future. A discount rate is applied to the amount of money to be received in the future to arrive at the present value.
Future value method
Also known as the compounding technique, the future value method estimates the future value of investments. In simple terms, this method quantifies how much your present investment will grow over a specific period of time. Since this method takes the compounding benefits into account, the time value of money must be estimated at a specific compounding ROI.
Importance of time value of money in finance
The concept of time value of money holds paramount significance in the world of finance. In fact, almost every aspect of financial decision-making is affected by this pivotal concept. Here’s a few reasons why time value of money is an indispensable concept:
1. Investment decisions
Understanding the time value of money helps investors compare investment instruments. Evaluating opportunities helps you pick investments - including mutual fund schemes - that offer the best value of money in the future.
2. Business decisions
Apart from personal finance, time value of money is also used to assess business opportunities. For instance, companies calculate the time value of money to decide if long-term projects are worth investing in. They compare the present investment with the future returns to evaluate opportunity costs and make investment decisions.
3. Loan evaluation
The concept of time value of money plays an essential role in determining the actual cost of borrowing. Calculating the time value of money helps borrowers estimate how much more they will pay back by the end of the loan term.
4. Retirement planning
Time value of money is crucial when undertaking retirement planning. It helps understand how much money you need to be saved now to have enough for the future and how your investments will grow over time. It essentially helps ensure that your retirement fund is enough to finance the golden years, considering the impact of inflation.
5. Impact of inflation
The concept is used to understand how the rise in price levels impacts the purchasing power of money.
How does time value of money impact investment decision-making?
The time value of money serves as a guidepost to investment decisions. It directly helps people assess opportunity costs to make accurate predictions of what their money could be worth in the future. In this manner, it assists the investment decision-making process and encourages people to invest more.
As an investor, utilising the concept of the time value of money, you can make sound financial decisions. These decisions also have to be aligned with your financial objectives to fetch you the desired returns. In the modern day, there are numerous avenues and options available for investments for individual investors as well as businesses.
Time value of money and inflation
Time value of money is intrinsically linked to inflation. When prices of goods and services rise due to inflationary pressures, the time value of money and its purchasing power declines. For instance, you can buy fewer things today with a Rs. 500 note than you could a decade back. This is because inflation has eroded the purchasing power of your money. Thus, to estimate your real returns on investment, the inflation rate needs to be subtracted from your returns. If the inflation rate is higher than your rate of returns, then you are actually losing money in terms of purchasing power.
How does inflation impact the time value of money?
Inflation erodes the purchasing power of money over time, directly impacting the time value of money. As the general price level of goods and services rises, the same amount of money can buy fewer items in the future compared to today. This decline in purchasing power means that a sum of money today is worth more than the same sum in the future because it can be used to acquire more goods or services now.
For investors, inflation reduces the real return on investments, making it crucial to earn a rate of return that exceeds the inflation rate to preserve the value of their money. In lending and borrowing, inflation expectations are often factored into interest rates to compensate for the anticipated decrease in money’s value. Thus, inflation plays a significant role in financial planning, highlighting the importance of considering time value when making investment decisions or evaluating future cash flows.
Key takeaways
- The time value of money (TVM) emphasises that money today is worth more than the same amount in the future due to its earning potential.
- Investing earlier maximises growth opportunities, while delaying investments results in missed earning potential.
- Inflation erodes the purchasing power of money over time, making current money more valuable than future money.
- To maintain the value of money, investment returns need to exceed the inflation rate.
- TVM significantly influences financial decisions in areas like investing, borrowing, and lending, highlighting the need to consider future cash flows and returns when planning finances.
Conclusion
In a nutshell, time value of money focuses on the fact that the value of money you hold in the present will not remain the same in the future. Early investment of your idle funds will help maximise returns over time due to the power of compounding. Understanding this concept can help you plan ahead for the impact of inflation on your investments and make smarter financial choices.
Investing in mutual funds can help you potentially secure inflation-beating returns while diversifying your portfolio. You can make SIP or lumpsum investments to preserve the time value of money and watch your funds grow over time. You can tailor your portfolio to align with your goals and risk appetite on the Bajaj Finserv Mutual Funds Platform. This digital platform allows you to compare mutual funds and choose from over 1000 MF. Moreover, you can access easy tools like Step Up SIP Calculator and Lump Sum Calculators to estimate your contributions and returns.
