Time value of money is a vast concept which explains the worth of money to time. It refers to the idea that the money you have right now is of more worth than the money you will have in the future. The principle of the time value of money is based on the formula that enables the investors to know insight about the value of money for its future worth. This concept has significance in terms of how time affects the value of money.
For example, one million rupees could be of more worth than now and future. You might have purchased a property of one million rupees in past and after a decade its value has increased to 1.5 million. Determining this difference in the worth, the formula of the time value of money helps in figuring out the worth of the money later. When you invest somewhere, keep in mind that inflation can cause loss sometimes. There is not any certainty that if you are investing somewhere and they are claiming to yield an annual interest of 5% but this might have the risk of loss to tackle inflation of the present and projecting high interest rates.
The current value of money does not remain the same for the future. It alters with time, but one should know about calculating and determining the time value of money to ensure that investments are at the right place and are worth it. For instance, if someone gives you two choices that take 1 lac now or a year later, then you may opt to take it immediately to invest it somewhere and getting revenue after a year. Have you ever heard your parents saying in our childhood we used to buy this candy in 2 rupees and now it is 5 rupees or something like in our time things were not that much expensive? Your parents are explaining to you the same concept which we are trying to convey. This is the time value of money means the value of money changed with time. The property you were purchasing a year back now has more worth.
Imagine that you had lent 5 lac rupees to your friend, and he is saying to pay you back the exact amount immediately or 5.25 lac rupees a year later. You might think to go with this offer, but you have a better option of 12% interest on the investment of 5 lac rupees. You will take back your money immediately from your friend and invest in the new offer as you can get more interest in this investment than your friend. You examine that from where you are getting more revenue in a year and what will be the worth of invested money in the future, this is the time value of money.
Consider another example that you purchased a plot with this money, but if you take it a year later the plot might have been sold to someone else or the price of that plot might have increased. Take another example, that someone offers you to invest 10 lac rupees and he will return with an invest rate of 5% means extra 50,000 rupees a year later. For sure, this will make economic sense for you. In simple words, being offered and getting money today is always better than getting it in the future, and the value of money received today is more than the value of the same money received after a certain period.
Time value of Money Formula
Now taking these general examples to the financial terms, the money you have right now is the present value (PV), the money worth after a specified period is the future value (FV), and the rate the PV increases per year is the Interest rate (I). The formula for the time value of money becomes:
Future value = (Present value) x (1 + interest rate) ^ Number of periods
FV = (PV) x (1 + I) ^ Number of periods
This formula helps people in evaluating that how much current value of money will earn potentially in the future. It is important to understand the effect of inflation on money and why early investment can beat inflation.
Time value of money in other domains
Financial Management: The notion of time value in the domain of financial management has great significance. Money that investors have on hand today can value more than the same money promised in the future. The money promised for the future has no worth because of the risk of inflation, whereas the existing money can earn interest and has more gain. So, it is better to have money now rather than future.
Capital budgeting: The time value of money enables small-business owners to change cash flows as time passes. This method, known as discounting to present value, allows for the choice of today’s amount of money over tomorrow’s money. To use the time value of resources to make capital budgeting decisions, an organization must first predict all the project’s cash flows, both positive and negative. It then calculates the present value of all those cash flows, or how much they are worth in today’s rupees.
Every person and company has financial goals and requirements. Setting manageable targets after defining these priorities helps you to consider these goals from a financial standpoint. The time value of money shows that the money you have now is not the same as the money you will have in the future. When deciding between the prices of assets that yield returns at different times, the significance of the time value of money is factored in.