Time Value of Money Introduction, Meaning & Definition, Need14/07/2020
The time value of money (TVM) is the concept that money available at the present time is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also sometimes referred to as present discounted value.
There is no reason for any rational person to delay taking an amount owed to him or her. More than financial principles, this is basic instinct. The money you have in hand at the moment is worth more than the same amount you ‘may’ get in future. One reason for this is inflation and another is possible earning capacity. The fundamental code of finance maintains that, given money can generate interest, the value of a certain sum is more if you receive it sooner. This is why it is called as the present value.
Basically, the time value of money validates that it is more beneficial to have cash now than later. Say, if you invest a Rs. 100 today the returns will be more compared to the same investment made 2 months from now. Moreover, there is always a risk that the borrower might delay even more or not pay at all in the future.
The time value of money draws from the idea that rational investors prefer to receive money today rather than the same amount of money in the future because of money’s potential to grow in value over a given period of time. For example, money deposited into a savings account earns a certain interest rate and is therefore said to be compounding in value.
Further illustrating the rational investor’s preference, assume you have the option to choose between receiving $10,000 now versus $10,000 in two years. It’s reasonable to assume most people would choose the first option. Despite the equal value at time of disbursement, receiving the $10,000 today has more value and utility to the beneficiary than receiving it in the future due to the opportunity costs associated with the wait. Such opportunity costs could include the potential gain on interest were that money received today and held in a savings account for two years.
Basic TVM Formula
Depending on the exact situation in question, the TVM formula may change slightly. For example, in the case of annuity or perpetuity payments, the generalized formula has additional or less factors. But in general, the most fundamental TVM formula takes into account the following variables:
- FV = Future value of money
- PV = Present value of money
- i = interest rate
- n = number of compounding periods per year
- t = number of years
Based on these variables, the formula for TVM is.
FV = PV x [ 1 + (i / n) ] (n x t)
Need of Time Value of Money
Advantages of the Net Present Value Method
The most important feature of the net present value method is that it is based on the idea that dollars received in the future are worth less than dollars in the bank today. Cash flow from future years is discounted back to the present to find their worth.
The NPV method produces a dollar amount that indicates how much value the project will create for the company. Stockholders can see clearly how much a project will contribute to their value.
The calculation of the NPV uses a company’s cost of capital as the discount rate. This is the minimum rate of return that shareholders require for their investment in the company.
Disadvantages of Net Present Value
The biggest problem with using the NPV is that it requires guessing about future cash flows and estimating a company’s cost of capital.
The NPV method is not applicable when comparing projects that have differing investment amounts. A larger project that requires more money should have a higher NPV, but that doesn’t necessarily make it a better investment, compared to a smaller project. Frequently, a company has other qualitative factors to consider.
The NPV approach is difficult to apply when comparing projects that have different life spans.