The time value of money (TVM) is perhaps the most crucial concept in personal finance. It means that an amount expected to be received or paid out in the future is not equivalent to those received or paid out today. It is easy to understand that an amount received today is worth more than the amount received five years from now because today’s amount can be saved or invested, and in five years, you expect it to be worth more than what it is today. Therefore, the time value of money involves two components: future value and present value.
It also reflects that money today has a greater purchasing power than the same amount in the future due to inflation.
It’s rightly said: Time is money!
Suppose a person is given a choice to receive Rs 1,000 today or after two years. Which option should the person choose?
A person should choose to receive the money today. After all, if cash is accepted today, it could be invested, which in two years may be much more than the original Rs 1,000.
How to Calculate Time Value of Money?
The time value of money is the concept that money today is worth more than the same money in the future. It’s a mathematical formula that can calculate how much an investment will be worth at any time.
The formula for calculating TVM is as follows:
Formula to find Present Value:
Formula to find Future Value (same as Compound Interest)
Where P=Present, V=Value, F=Future Value, i=interest rate, n= period
Why Should You Consider Using the Time Value Formula for Your Investments?
When is it best to invest? If you are investing in stocks, it’s best to invest when they are at their lowest price point. If you are investing in bonds, it’s best to invest when interest rates are at their highest.
The time value formula can be used for investments like stocks, bonds, real estate, and other assets with a fixed cash flow over a given period.
Two Common Questions in Time Value of Money
To illustrate the time value of money, two questions in personal finance are commonly asked:
- What will an investment (or a series of investments) be worth after some time? This question asks for a future value.
- How much has to be put away today (or as a series of investments) to provide some rupee amount in the future? This question asks for a present value.
The above two questions ask values many variables, like interest rate, period, initial or regular investment, and future available amount if an estimate needs to be made for initial investment.
What are Some Investment Strategies That Follow the Time Value of Money Formula?
Investment Strategies that Follow the Time Value of Money Formula:
- Present Value of Future Cash Flow – This investment strategy is to buy a company’s stock that is expected to generate a higher future cash flow than it is currently worth.
- Future Value of Present Cash Flow – This investment strategy is to sell a company’s stock that is expected to earn a higher cash flow than what it is worth today.
Conclusion: Start using the Time Value Model for your Investments Today
The Time Value of Money (TVM) is a model that calculates the present value of future cash flows. It was developed by American economist and Nobel laureate Robert J. Merton in 1973.
This model can calculate investments and determine the best course of action for your money in the future. The TVM is a handy tool for financial decision-making, especially regarding investments. It helps us make more informed decisions about our money, ultimately leading to better investment returns.