What is Time Value of Money?

The time value of money is a concept that shows that today’s money is worth more than future money. We can say that today’s 100 INR is worth more than 100 INR in 2028, because today I can invest it, in the future it has more risk. Due to inflation money loses its value since money today is worth more than money in the future.

According to Wikipedia, the Time Value of money is the concept that money available today is worth more than the same amount in the future due to its potential earning capacity.

Source: Wikipedia



Why Time Value of Money is important

  • Today money is more powerful.
  • To beat Inflation.
  • Compounding is based on TVM.
  • To Make a Clear Investment Decision.

Core Component of Time Value of Money (TVM)

Present Value (PV) – It is the value of money today.

For Example – If you invest ₹500 today, it is its present value.

It is an important concept because all future value calculation cannot be done without PV.

(b) Future Value (FV)

It shows the value of your money after earning interest.

Formula:

Future Value = Amount × (1 + R)^n

Example – If you invest ₹50,000 for 10 years with 10% int.

FV = ₹50,000 × (1 + 10%)^10
= ₹50,000 × (1 + 0.10)^10
= ₹50,000 × (1.1)^10

= (129,687)

Maturity Amount - ₹129,687
Investment - ₹50,000
Interest - ₹79,687

(c) Interest Rate

It is the growth rate of money, it shows how much your money is growing in a time period. Interest can be in the form of -

  • Return on investment
  • Expected returns
  • Cost of borrowing

Example: If the interest rate is 5% / yr it means your money will grow 5% by year.

(d) Time Period (n)

Time Period is the number of years for which your money is invested for example you invested ₹50000 for 5 years. Here your time period of investment is 5 years.

(e) Compounding Frequency (m)

It shows how many times interest is added to a year. Depending on the number of times you receive interest in a year, your returns will also be higher. It can be Monthly , Quarterly, Semi - Annually and Yearly. Compounding Frequency denoted by ( m ).

Formula

FV = PV (1 + r)^(n × m)

3.Concept of Interest

There are two types of interest.

a) Simple Interest

Simple interest is interest added to principal per year. Today it is used for

  • Short Term Loan
  • Gold Loan / Pawn Loan
  • In Car Loan in some cases
  • In schools & colleges for basic finance

Simple Interest = R × P × T

where ,
P = Principal Amount
R = Rate (Interest)
T = Time Period

For Example: 10% rate with ₹50000 amount for 5 year

1 year - ₹50000
2 year - ₹55000
3 year - ₹60000
4 year - ₹70000
5 year - ₹75000

Maturity Amount - ₹75000
Investment - ₹50000
Total Interest - ₹15000

(b) Compound Interest

Compound Interest can be defined as Interest on Interest, social media, youtube, advertisement, blogs etc . You have noticed that many influencers use the word compounding, power of compounding, magic of compounding etc . It comes from compound interest. In simple words compound interest is previous year total (Principal+ Interest) + interest of current year.

Formula:

CI = PV (1 + r)^n

For Example: ₹50000 on 10% rate for 5 year

1 year - ₹50000 (₹50000 + ₹5000)
2 year - ₹60500 (₹55000 + ₹5500)
3 year - ₹66550 (₹60500 + ₹6050)
4 year - ₹73205 (₹66550 + ₹6655)
5 year - ₹80525.5 (₹73205 + ₹7320.5)

Maturity Amount = ₹80525
Your Investment = ₹50000
Interest / Return = ₹30525

Simple Interest vs Compound Interest

Basis Simple Interest Compound Interest
Interest Calculation Interest calculated only on Principal Amount Interest calculated on Principal + Previous Interest
Growth Speed Growth is slow Growth is faster
Common Usage Used in short term loans Used in investments and long term wealth creation
Return Potential Lower returns Higher returns over time

Power of Compounding

These days compounding is viral on social media, youtube etc. You can see several reel shorts about it but what is the power of compounding ? Compounding is the backbone of investing. You can see the magic of compounding over time.

Let's Understand Compounding with an example - Suresh and Mahesh are two friends. At the end of May they had their salary, Mahesh was a stingy person, he saved ₹35000 from his ₹50000 salary. On the contrary Mahesh was a heavy partier person, he wasted ₹49000 in party but remaining ₹1000 he invested in Systematic Investment Plan (SIP )with 19% return for 30 years. Every month both friends repeat this.

After completion of 30 years, Suresh was shocked because his savings was ₹1.26 crore but Mahesh Investment was ₹1.32 crore. This is the magic of Compounding or Compound Interest.

Three pillars of compounding:

  • High Interest Rate
  • Time Horizon
  • More Compounding Frequency

Compounding Frequency– How many time interest added to principal in a year (monthly, quarterly, semi-annual, annual)

Annual < Semi Annual < Quarterly < Monthly

Future Value in TVM explained

Future Value (FV)– It is another important concept of time value of money (TVM). Show the value of today's money in the future after earning interest.

  • SIP Planning
  • In Retirement Planning
  • In Future Investment Growth
  • Long term wealth calculation

FV (Annual Compounding) - Annual compounding means your interest is added to your principal annually.

FV = PV × (1 + R)^n

Let's simplify it with an example Mahesh Invest ₹15000 for 2 year at 10% interest

PV – The value of money today
n – Time Period
r – Interest Rate

FV = PV × (1 + R)^n

⇒ ₹15000 × (1 + 10%)²
⇒ ₹15000 × (1.1)²

FV = PV × (1 + R)^n
⇒ ₹15000 × (1 + 10%)²

⇒ ₹18150 – maturity amount

Mahesh Investment was ₹18150 after two years, he got ₹3150 returns which are more dependent on time. You can earn more returns if you invest your money for a long term from 20 years or more.

Future Value (FV) with Compounding Frequency

Compounding Frequency – It is a golden concept of Investment means In a year how many times interest added to principal. Your Return will be more if interest is added more times.

FV = PV (1 + r/m)^(m × n)

m = How many times interest added to principal

Monthly Compounding

Ex. Investing ₹10000 at 12% annual return for a year

m = 12
r = 0.12

FV = ₹10000 (1 + 0.12/12)^(12 × 1)

= ₹10000 (1.01)^12

= ₹11268

Total Deposit ₹10000
Interest ₹1268

Future Value ( FV ) effects by Interest Rate, Time and Compounding Frequency, so before investing you should decide how to manage them to earn more returns.

Present Value in Time Value of Money (TVM ) explained

Present Value – Present Value means value of future money in present time after earning interest on it. Present Value is little harder than Future Value because it is confusing so lets understand with an example -

Suppose that Mayank is the owner of Mayank Electronics. He sold ₹1.78L goods to Suresh. Suresh says that I will return your money after 3 Years with (He was passing from hard financial crises) Mayank was a good person, he accepted his deal. But what is the value of those ₹3L today the value of today of the money is its present value. The process of finding Present Value from Future Value is called Discounting.

Why is Present Value Important?

  • You haven't power to invest future money.
  • Inflation
  • Opportunity cost

PV = Future Value / (1 + r)^n

Example - someone promises to give you ₹1,000 after 1 year. If the interest rate is 10% per year, then the Present Value (PV)

Future Value (FV) = ₹1000
Interest Rate (r) = 10% = 0.10
Time (n) = 1 year

Formula:

PV = FV / (1 + r)ⁿ

Solve -

PV = ₹1000 / (1 + 0.10)¹
PV = ₹1000 / 1.10
PV = ₹909.09

Since, Present Value is ₹909.09.

Present Value concept is important as well as future value (FV).

Basic Discounting explain

Discounting – This process of converting future value in present value is called Discounting. since we cannot use future money. It has risk and inflation so we discount future cost in present value.

Lets take an example Sanjay will receive ₹5000 on 31 march from Vishesh. So he will discount the Future Value to find the present value.

Discount Rate

Discount Rate – It is the rate which you expect. For Example I will get money from my Debtor after three years at ₹80 what rate if I invest ₹700 today.

Where Present Value is used

  • To calculate Stock Valuation
  • In Planning to Retirement
  • In calculation of Net Present Value (NPV)
  • To take best investment decisions

Conclusion – Present Value is important as well as Future Value. The major difference between FV and PV is compounding and discounting. If you understand these then you will easily control another concept of Time Value of Money.

Concept of Annuity

Annuity – Annuity means when money is paid or received in a periodical time. The length can be a year or a month quarterly. These are many examples of annuity like ENT SIP and salary of years payments it received in regular intervals.

Types of Annuity

There are two types of Annuity

a) Ordinary Annuity – When the payment is made at the end of the interval period for Example loan & plans EMI.

b) Annuity Due – When the payment is made at the beginning of the period for example case can be my office rent on the first day of month then I will pay 4 till stay.

Future Value of Annuity

Future Value of Annuity says total amount will be the future value of regular investment

Formula

FV = P × [(1 + g)^n − 1] / g

where P stand for the amount you paid in a period

Present Value of Annuity

PV of Annuity – value of regular payments made in future.

PV = P × [1 − (1 + g)^−n] / g

This is the basic information about Annuity if you want to learn more about it, so follow us on Instagram and get grow financially.

Applications of Time Value of Money (TVM)

The concept of Time Value of Money is used widely in Finance and Business, maybe the core of any money decision without Time Value of Money (TVM). The value of money changes over time because of this Time Value of Money plays an important role in taking Investment Decisions, Business Valuation, Capital Budgeting, Stock Valuation, Retirement Plan, Personal finance planning etc.

Investment Decision – When any person has several investment options, Time Value of Money helps to choose a better option to invest because with the help of TVM we can understand the value of future amounts in present time. It becomes easier to take a better option.

Business Valuation – Many of transactions in business are credit. Time value of money helps to calculate the present value of the receivable money, profits, gains etc. By the help of TVM we can calculate and understand the actual value of business.

Capital Budgeting – To execute any business project easily capital budgeting is highly important. Time Value of Money helps in calculating the profits and gains of a project in future. By the help of this concept,future cash flows convert to present value to understand that it is beneficial to invest on that project.

Retirement Planning – Long term planning like retirement there is a use of TVM. This concept helps to understand how much money one should invest to receive a fixed amount in the future.

Stock Valuation – To calculate the real value of shares, its future earnings, dividends of the company are discounted in present value, so here this concept play important role.

Personal Financial Planning – The concept is widely used in personal finance planning to beat inflation to get financial freedom for long term financial planning etc. Everywhere we use Time Value of Money as primary.

Conclusion

Time Value of Money is one of the most important concepts in finance. Explain that today's money is worth more than money in the future. The concept helps us to understand what is the value today of money we will pay or receive. It helps investors, businesses and individuals to make better financial decisions. TVM is widely used in investment decision, business valuation, capital budgeting, retirement planning, stock valuation and personal financial planning as we understand the topic.

Therefore, every person should understand the Time Value of Money to make clear financial decisions whether it is business finance or personal finance.

Frequently Asked Questions (FAQs)

What are the factors of Time Value of Money?

Time Value of money depends on three factors:

Opportunity Cost - In Time Value of Money opportunity cost is the Possible returns you can earn but you lost because of choosing another option instead of that. In TVM it shows returns but there are many use of opportunity cost.

Inflation: Inflation is the main factor of this concept. Inflation means an increase in the price of things. It depends on scarcity, meaning demand is unlimited but supply is limited so, it results in Inflation with decreasing the purchasing power.

Uncertainty - Means the money which will receive in future has risk it has uncertainty.

What are the 5 major components of Time Value of Money?

The 5 major components of TVM are Future Value, Present Value, The rate of interest, Time Period and Compounding Frequency.

We explain these topics in depth above.

What are the four principles of money?

The four principles of money are Investing, Income, Saving and Spending.