Understanding the Time Value of Money

Time Value of Money (TVM) is the concept where investors prefer the idea of receiving money now than in the future. For example, if you are given the option of choosing to receive $1000 today or $1000 after 2 years, it is better to choose receiving $1000 today because it has more value and utility. The money can be used to re-invest and gain interest. TVM can be broken down to Present value (PV) and Future Value (FV).

Present Vale and Future Value

Present value helps us understand how much the cash that will be received in future is worth today. Future value helps us determine how much the cash received today is worth in future. Both PV and FV can be determined with the help of formulas below.

PV = FV / (1+ r)^ t

FV = PV * (1 + r) ^t

where,

FV = Future value of money

PV = Present value of money

r = interest rate

t = number of years

Conclusion

Just as the phrase “time is money”, the value of the money that we have today will not be the same in future. By understanding the concept of TVM, one could identify the difference between good and bad investments. Analyzing these choices requires a spectrum of tools apart from the basic formula presented above. Whatever is the case, the basic idea is to create the cash flows. If TMV is not utilized properly by a company, it might even lead to financial disasters.

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