“You need to understand the entire concept of money; how it's viewed, its purpose & how it works”
What is the Time Value of Money?
Time Value of Money is one of the core concepts used in Finance. According to this concept money has more value in the current rather than in future. One of the main reasons for it is that money can grow if we invest it. But investment done later means lost opportunity cost.
If we think practically then every investor wants money today rather than getting it in future. The same money that he gets today can be invested and it will grow in future. On the other hand, if gets the same money in future he will incur opportunity cost.
Some of the practical applications of Time value of money are:
We can take a very basic example to understand it. Suppose we put money in the bank, then we know that it will accumulate interest over a period of time. That same money we deposited today will grow in 3 years.
Likewise, as time will pass it will grow more and more. This is the power of money compounding over a period. Whereas, if we do not invest money and keep it in cash then it will erode and there will be no growth.
Take a $100 bill and put it in a drawer. Open it after 5 years. What will you see? Either it is eroded or the same. But if at that time you thought about depositing it in a bank then this $100 would be $150 or even more. You lost additional money that could have accumulated.
Moreover, this $100 will buy you less after 5 years then it would have bought you before. Reason being inflation. The purchasing power declines as inflation hits. Inflation devalues the currency.
Let us take one more example. Suppose you have the option to take $1000 now or $1000 after 1 year. What will you do? There can be mixed opinions. But the truth is that $1000 now will be more fruitful. It has more value then $1000 after 2 years.
You can retrieve a lot more with those $1000 now then in future. In short we can draw a simple conclusion- “If you are in for a delayed payment, then you have missed an opportunity.”
Effect of Compounding on Time Value of Money
We read above that the power of money increases when it compounds. What does compounding of money mean? If money is not invested then it will lose its value. Compounding is the result of time value of money.
In simple words, Compounding means the accumulation of interest or any growth in money that happens over a period of time, when money is invested. A simple example- Suppose you have $1000 and you invest it for 20 years at the rate of 10% per annum.
After 20 years $1000 will become $6727. It is compounding. The interest gets added each year for 20 years at 10% until $1000 becomes $6727. What happens if you remove the interest compounded? Then $1000 will remain $1000 only.
Reasons Why People have a Time Preference of Money
Time Value of Money offers people insights of what is best for them. Be it an individual or a company everyone has the right to have a time preference of money. Given below are some of the reasons why people have such preferences.
There are many people that prefer consumption in the present rather than in the future. It is because their currency demands and urges for goods and services are driving them.
Another reason can be a psychological threat in mind that they may not be able to buy a certain commodity or service in future.
This threat can be due to illness, lack of money, and death. They may even think that the product will not be available in the future. Therefore, consumption is one of the reasons why people develop a time preference of money.
There are so many attractive investment opportunities for people that want to have cash now rather than in the future. They develop a time preference of money because of investment opportunities.
The best example related to this is mentioned above, wherein you have the option to take $1000 or now or after 2 years.
Having money now gives a sense of relief to people. There is always an uncertainty as to whether you will have money in the future or not. For a company, the debt collection cycle should be minimum.
They never know when the debtor becomes insolvent and the money is lost. It is better not to sell on credit. These uncertainties make people develop a time preference of money.
If the economy is going through an inflationary stage then, the money in hand will always have more worth than money that you will have in future. The basket of goods and services that you can buy now with money will always be more than what you can buy in future.
Also Read | Amortization vs Depreciation
Formula of Time Value of Money
The concept of Time Value of Money is a key concept in Finance and economics. Big and small companies use this concept to take investing decisions, acquisitions decisions and product development decisions as well. The formula used to calculate the future value of money is given below:
Formula of Time Value of Money
FV= Future value of money
PV= Present Value
i= interest rate
t= number of years
n= period of compounding
Let us take a basic example to understand the formula better. Suppose you have $10,000 and you get a 10% interest each year for the coming 2 years. Compounding is done annually. What will be the future value of $10,000 that you have now?
Future Value can be calculated using the formula mentioned above. We need to put all the values and the equation we get is:
Solving it we get, FV= $12,100.
We can also use this formula to calculate the PV, if we FV is given to us. Let us take an example. Suppose you will get $1,200 after 1 year and get a 6% interest on it. What will be the present value that you need to invest in order to get $1,200 after a year?
Again we use the same formula and substitute the values that we have. The equation that we get is:
This gives the PV= $1132.
Even though it takes a few seconds to solve the equation, you can find multiple online tools that will help you to get faster results. From a company’s point of view, such simple calculations are not done when they use this concept.
More numbers, more data and even more analysis needs to be done in order to reach the right decision. Therefore, computers and online tools provide better aid to them.
Also Read | A Detailed Introduction to EBITDA
Importance of Time Value of Money
Every company needs to make decisions and the time value of money helps in making the right ones. The importance of Time Value of Money in different fields is given below.
Time value of money helps to estimate the value of cash flows. It helps to find the opportunity cost of investments. If the currency devalues then it gives rise to inflation and the purchasing power of the people also gets affected.
So, if we are to receive money in future for the investments then its opportunity cost will be high due to inflation. Not only will the opportunity cost be high but there will be risk and confusion about the recovery.
Ultimately, we can say that the currency cash flows are worth more than what we will receive in the future. Time Value of Money is important in financial accounting as well. When we know that present funds are more valuable, we can invest them now to generate better outcomes in future.
If the money has power to multiply and gain interest then according to the concept of Time Value of Money, it is better to earn in cash now then later. The conclusion that we have is- Better to raise cash now then in future.
The whole calculation and concept of Capital Budgeting revolves around Time Value of Money. Managers and analysts in companies need to be flexible. When companies buy fixed assets like machinery or they invest in expansion or acquisition, return is not quick.
It takes time to get the returns on investments made. In capital budgeting we make decisions based on the cash flows that a machinery is worth buying or not. Negative NPV (Net Present Value) means that it is better not to invest and vice-versa.
What we need is a Discount Rate. With this rate we can find what is the current value of the future capital. In order to find the discount rate, we look at different factors. These factors are:
If the discount rates are not calculated precisely then the whole calculation will be erroneous and the results will also be vague. Therefore, each factor should be closely monitored and exact figures of discounting rates must be computed.
Cash flows are converted into PV and then calculations are made to decipher the results. Everything is based on the formula of Time Value of Money.
While making financing decisions, time value of money holds utmost importance. It will tell whether you will live without any financial trouble in future or you will have everything today but suffer tomorrow due to the financial crunch.
Time Value of Money helps to understand the consequences of the decisions you make. Large and small businesses have to be careful when they invest money in different pursuits.
The basic principle is that- the capital you have now is worth more than what you will have tomorrow. Current capital is more expensive because you never know when inflation will hit and your capital will have lesser value.
Time Value of Money teaches the financial experts that the same money in future will not be worth it. While making financial decisions, the option that offers easier and faster returns on investments is always chosen. Option that takes more time can be complex, confusing and at the same time more riskier.
Also Read | Purchasing Power
Every company has certain financial goals and it needs to set some attainable targets to achieve that goal. Time value of money is what will help you set those targets and achieve the goals. It will help you understand the worth of your money.