The time value of money (TVM) is the concept that the money you have today is worth more than the same amount in the future.
The reason for this is that the money you possess can be invested and increase in value. For example, you can invest the money in a Fixed deposit and earn a 7% annual interest rate. Your $100 becomes $107 at the end of an year. This means, a sum of $107 an year from now is worth $100 now (it’s present value). $114.49 two years down the line is worth $100 today. Essentially, the sooner you can get the money, the more valuable it is. Time and money are related, just like space and time! Well okay, not exactly the same. But, you get the idea.
With that out of the way, let’s introduce a few concepts related to Time Value of Money:-
This is the amount of money you currently have.
The amount your money is going to be worth at any point in the future. As long as you are earning an interest over time, this figure will always be higher than the Present Value.
This represents the equal unit of time for which you will invest your money (or even repay your debt). Usually it is in years. But, it could also be a day, month or quarter.
The rate of interest for your investment over a single period. Usually represented in percentage such as 7% or even as a decimal value from 0 to 1 (where 1 implies 100%).
The payment amount you receive regularly over a period of time. The time period and amount are same across multiple such payments.
Given any four of the above variables, you can calculate the missing variable by using simple math. For example:-
Let’s say you invest $1000 (Present Value) today at the rate of 10% (Interest Rate) for 2 Years (The number of periods). You will receive $1210 (Future Value) after 2 years.
The formula for calculating the above is as follows:-\(FV = PV * (1 + I) ^ N\) Tags: finance