Time value of money is a beneficial concept that enables you to understand what money is worth in terms of time. It consists of a formula that is typically used by investors to gain more insight into the value of money in relation to its future worth. The importance of time value of money is based on determining how time affects the value of money.
The time value of money basically refers to the principle of money being worth more currently than it will be in the future since the money you have at the moment has the potential to increase. This is mainly attributed to inflation.
For instance, what $100 could purchase a decade ago would be substantially more than what it can now. Considering this difference, the formula of the time value of money is useful for figuring out the current value of your money and how much it may be worth later.
When it comes to making investments, there is a level of risk that you need to keep in mind regarding the time value of money. For instance, investing $1000 in a company that is projected to yield an annual return of 5% is not a certainty. In this situation, you take the risk of making a loss in exchange for an opportunity to beat inflation in order for the value of your money to rise in the future.
Time is Money
The present value of money is not the same as what its future value will be. Being aware of how to establish the time value of money by calculating the present and future value is important for determining what investments are worth at different times.
If someone offers you the chance to choose between taking $500 now or a year later, you may opt to have the money immediately. In general, being given the money today is better than getting it in the future because you will not be compelled to wait for the funds.
Taking the money now may enable you to purchase a computer but if you decide to take the money after a year, you can still buy the computer later but there will be a cost. Inflation might result in the computer costing an extra $100. Alternatively, that particular computer may no longer be available in the market or you have to incur the time cost of waiting for the money. Since taking the money now does not cost you anything, it would be logical to possess it right away.
However, there is value in being paid in a year when the money would be worth the same as the aforementioned $500 today. If the amount is $550, for example, you would not be affected if you are choosing between $500 today and getting $550 the following year because the $50 is a worthwhile gain.
In another example, if someone offers to give you $10,000 today or tells you to wait for 3 years to get $12,000, your decision would ideally be based on the investment return you expect from $10,000 within 3 years. Investing $10,000 in a 3-year project at a 5% interest rate means that you will have a future value of $11,576.25. This means that you would earn less than $12,000 and it would make more economic sense to get the $12,000 in 3 years.
In financial terms, the money you get today is known as the Present Value (PV), which is what the money is currently worth. Future Value (FV) refers to what the money will be worth after a specified time period. Interest Rate (I) is the rate you are paid each year to not have access to the money.
The formula FV=PV x (1+I) ^number of periods is used to help people comprehend the current value of money in relation to the amount that it can potentially earn in the future. This is essential for understanding how inflation affects your money and why it is important to invest early to increase the value of money by beating inflation and allowing it to have time to grow. You can use an online financial calculator to solve time value of money equations.
Time Value of Money and Financial Management
Time value acknowledges the worth of cash flows increase in the future due to financial decisions that take the opportunity cost of the money into account. As money has a tendency of losing value over time, this results in inflation that diminishes buying power.
On the other hand, the cost of getting funds in the future instead of now shall incur a greater cost that goes beyond the actual loss of its value because of inflation. The loss of extra income is also factored into the opportunity cost of not accessing the money now, which can be earned by having the money earlier.
Additionally, being given cash in the future instead of now might constitute some uncertainty and risk in regards to recouping the funds. Consequently, present cash flows are worth more than future cash flows. Time value of money is important in financial management because the cash you have today has a higher value than cash that you are anticipating in the future.
You can use the money available today to make an investment and earn interest. As long as money has the potential to earn interest, the principle of the time value of money emphasizes that cash is worth more when it is received earlier, regardless of the amount. In the most basic and simple terms, it is better to have your cash now than to have it later. The sooner you are able to earn or save money, the quicker it can work for you. 36.2% of families in America have savings for liquidity.
Time Value of Money in Capital Budgeting
Time value of money is a crucial concept in capital budgeting because it makes it possible for business owners to be flexible with their cash flows over time. This is called discounting to present value and considers how the money received today is preferable to receiving money tomorrow.
When a business makes a decision to invest money in new equipment, a strategic purchase, or expansion, it may be a while before this investment yields a return. Businesses need to determine whether cash flows in the future are worth making an investment upfront.
The discount rate is a major factor in the time value of money. This rate is used by businesses to convert future money into today’s amounts. The rate is influenced by several things that include the interest rate for borrowing funds, the risk associated with the project, the return demanded by investors, and the return the company can earn from investing.
While determining the discount rate may seem to be a complex task, it is essential for companies to have a fairly accurate number to avoid making detrimental capital budgeting choices.
In order to come up with capital budgeting decisions based on the principle of time value money, companies begin by approximating the positive and negative cash flows that the project entails. These are subsequently converted into their present value or what the cash flows are currently worth.
Time Value of Money and Financial Decisions
Being aware of why the time value of money matters in financial decision making can determine whether you will have everything you need for the rest of your life or live the way you want to now while dealing with financial challenges tomorrow. The concept of the time value of money lets you understand the financial implications of every financial decision you make.
Businesses usually have to be careful with resources when they want to invest in their operations. One of the aspects they need to consider while deciding how to invest is that money today is more valuable than a similar amount in the future under regular inflation. From a financial perspective, the time value of money involves comparing how much an amount of money is worth presently to the same value later on.
This concept is crucial when you need to consider whether a financial decision that leads to $10,000 in revenue in a year has the potential to be more worthwhile than a decision that leads to $11,000 in revenue after a couple of years, for instance. Although $11,000 is a larger amount, you can make more money by earning $10,000 and investing it over the same period of time. All you would need is a reasonable return rate to reap the benefits.
When making comparisons between the time periods required to produce income from an investment, any decision that leads to getting money faster is usually the preferred option. Taking a longer time to earn revenue on investments may result in challenges that make it harder to increase earnings on a short-term basis.
Every individual and business has financial objectives and needs. After identifying these objectives, setting manageable goals allows you to understand these goals from a financial point of view. Calculating the time value of money demonstrates that the money you have now does not have the same value as the money you will have in the future. The importance of time value of money is incorporated in choices between the values of investments that yield returns at varying times.