The concept of time value of money (TVM) is basically defined as follows: the benefit of having a stipulated sum of money today is greater than the benefit of having the same amount of money in the future.
One important premise of time value of money is the concept of ‘equivalence.’ A study of TVM makes analysis of former, current, and future investments as financially equivalent as possible. TVM does not factor non-quantitative elements such as wants and wishes and personal preferences. An understanding of TVM helps companies and individuals when analyzing their current and future investments.
The Time Value of Money is primarily applied to the following two types of cash flows:
- A Single Dollar Amount (known as a lump sum)
- An Annuity (a stream of equal payments that are received or paid at equal durations over time)
The Time Value of Money concept provides information about the following aspects:
The future value of an amount invested today
The present value of an amount you will receive in the future
The future value of an amount you deposit annually
The present value of an amount if you take annual payments
A couple of terms used in time value of money (TVM) calculations are as follow:
Present value (PV) is the current worth of future cash given an established rate of return and a time period, usually in years. The PV formula is the basic formula behind all aspects of time value of money.
- Read more: Present Value
An expected value in the future is ‘discounted’ to reflect today’s value, assuming a positive return on investment or inflation rate.
- Read more: Future Value
Interest is the cost of money, or the amount one party (the bank) will pay another (a bank depositor) to use their money. One is the borrower and the other the lender.
Applications of Time Value of Money
The time value of money principle finds its applications in several financial concepts such as:
- Net Present Value (NPV)
- bond valuation,
- stock valuation,
- cost of capital,
- capital budgeting,
- Internal rate of return