The time value of money is a key concept in finance which bases for numerous financial activities. It explains the basic principle that change of value of money over time which means a rupee received today is more valuable than a rupee received in future.
Imagine that you had two choices after winning a monetary award. Ten thousand dollars can be given to you now or in three years. If you are like most individuals, you would prefer to have the $10,000 today. Any reasonable individual might have the same amount of money now, so why would they postpone payment until later? For most people, it is merely instinctual to take the money now. It appears preferable to have money now rather than later, as evidenced by the time value of money (TVM).
Common belief on TVM is that it is only relevant to accountants, bankers, or finance professionals. Regardless of one’s background or profession, this idea is crucial for everyone. In our day-to-day life, we make lots of financial decisions like whether to spend or save, taking a loan or planning for the future etc. Especially, when it comes to investing, the time value of money is crucial since it can assist you in selecting the best investment.
To find out where your money can increase the greatest when choosing between fixed-income securities, you can apply the time value of money principle. More importantly, you can calculate how much money you will need to maintain your current lifestyle and pay your living expenditures by using the time value of money. To find out if your current savings will be enough when you eventually retire, you may calculate how much they will be worth.
Reasons behind time value of money
Although the time value of money theory maintains that the value of money fluctuates over time, there are a number of factors that influence this. These include risk, inflation, and a widespread investor preference for easily available assets. These factors are explained in more detail in the sections that follow.
Risk and uncertainty: The future is unpredictable by nature. Although people or organizations may be able to manage when they invest or spend money (cash outflows), they frequently have little control over when or how much money will come in (cash inflows). The promise of obtaining money tomorrow is never as valuable as receiving it today because of this unpredictability.
Inflation: Over time, inflation gradually reduces money’s purchasing value. The same amount of money can purchase less products and services in the future than it can now in an economy that is experiencing inflation, as Sri Lanka has recently experienced. Future money has less real value because of this reality. This is taken into consideration by the Time Value of Money.
Consumption preference: Human beings prefer to consume goods and enjoy services now rather than later, a concept known as positive time preference. The idea is rooted in psychology and basic human behaviour: we tend to prioritize immediate satisfaction over delayed gratification. TVM reflects this preference by placing higher value on current money, which can be spent or used to meet urgent needs or desires. This concept also influences credit behaviour; people are often willing to pay more in interest just to have money immediately rather than wait and save.
Investment opportunities: The ability to invest money and generate a return is another crucial factor contributing to its increased value today. A rupee earned today can be invested in a business, put into a savings account, or used to buy stocks, all of which will generate income or increase in value over time. Money has more time to compound and can be used sooner if it is received earlier. The core of TVM is this opportunity cost of waiting. When making financial decisions like capital budgeting, loans, or assessing company ideas, it encourages people and organizations to consider the timing and manner of cash flow.
Key terms in TVM Future Value of Money
The value of a sum of money at a particular future date, depending on a specified interest rate and period, is known as its future value. It shows how much money is placed now will increase in value over time as a result of investment. Three essential components are required to determine future value: the initial investment, interest rate, and investment duration. This computation aids in figuring out how money increases as a single, lump-sum investment or as an annuity, which is a series of regular, evenly spaced payments. Interest builds up overtime in both situations, raising the initial value. Planning retirement money, investments, or savings requires an understanding of future worth.
Present Value of Money
The present value of money is the amount of money that would be needed today to equal a desired future sum of money that has been discounted by a suitable interest rate, whereas the future value of money determines the value of an investment in the future. A long-term investment, a single payment that will be received or given at a specific future date, or a sequence of equal payments made at equal intervals over time could all contribute to the future sum of money.
Application of TVM Loan Amortization
An amortization schedule is usually used to illustrate loan amortizations. A table that lists every payment needed to settle an amortized loan is called a loan amortization schedule. Every row in the table displays the amount of the payment required to cover the interest that has accumulated, the amount utilized to lower the principal, and the remaining loan balance at the conclusion of the period. Since most mortgages are amortized loans, the homeowner can use the amortization schedule to keep track of how much of each payment goes toward debt reduction and how much goes toward interest payments.
Financial Calculations
In order to decide how best to advise clients on asset management, financial planners invest a lot of time in performing calculations to evaluate the present and future values of money. A crucial computation in a number of financial activities, including asset purchases, securities investments, debt repayment, and tax calculations, is figuring out the time value of money.
In particular, tax lawyers are frequently compensated to advise clients on how to handle their tax obligations. In order for a client to comply with the applicable tax laws while safeguarding and optimizing their personal and business assets, tax attorneys must carry out complex tax computations to ascertain whether and to what extent tax obligations can be postponed, as well as how to best arrange tax reporting and repayments.
When making financial decisions, the Time Value of Money (TVM) idea is essential. It emphasizes that a rupee now has greater value than a rupee tomorrow because of its potential for growth.
Through the comprehension and utilization of TVM concepts, including present value, future value, and discounting, both individuals and companies can make well-informed choices about loans, savings, and investments. Long-term financial stability and growth are facilitated by mastery of these ideas, which also allow for more precise financial planning.
The writer is a lecturer, Faculty of Management Studies, The Open University of Sri Lanka
