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Understanding The Time Value of Money

The document discusses the time value of money (TVM), which refers to the concept that money available at the present time is worth more than the same amount in the future due to its potential to earn interest. TVM means that investors prefer receiving money now rather than later as money can grow over time through interest-earning investments. TVM also considers the effects of inflation, which reduces the future purchasing power of money. TVM calculations are used in finance to evaluate investment opportunities and aid in decision making.

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MARL VINCENT L LABITAD
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24 views

Understanding The Time Value of Money

The document discusses the time value of money (TVM), which refers to the concept that money available at the present time is worth more than the same amount in the future due to its potential to earn interest. TVM means that investors prefer receiving money now rather than later as money can grow over time through interest-earning investments. TVM also considers the effects of inflation, which reduces the future purchasing power of money. TVM calculations are used in finance to evaluate investment opportunities and aid in decision making.

Uploaded by

MARL VINCENT L LABITAD
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Understanding the Time Value of Money (TVM)

Investors prefer to receive money today rather than the same amount of
money in the future because a sum of money, once invested, grows over
time. For example, money deposited into a savings account earns interest.
Over time, the interest is added to the principal, earning more interest. That's
the power of compounding interest.

If it is not invested, the value of the money erodes over time. If you hide
$1,000 in a mattress for three years, you will lose the additional money it
could have earned over that time if invested. It will have even less buying
power when you retrieve it because inflation reduces its value .

As another example, say you have the option of receiving $10,000 now or
$10,000 two years from now. Despite the equal face value, $10,000 today
has more value and utility than it will two years from now due to the
opportunity costs associated with the delay. In other words, a delayed
payment is a missed opportunity.

The time value of money has a negative relationship with inflation.


Remember that inflation is an increase in the prices of goods and services.
As such, the value of a single dollar goes down when prices rise, which
means you can't purchase as much as you were able to in the past.
Keep in mind, though that the TVM formula may change slightly depending
on the situation. For example, in the case of annuity or perpetuity payments,
the generalized formula has additional or fewer factors.

The time value of money doesn't take into account any capital losses that you
may incur or any negative interest rates that may apply. In these cases, you
may be able to use negative growth rates to calculate the time value of
money
Effect of Compounding Periods on Future Value
The number of compounding periods has a dramatic effect on the TVM
calculations. Taking the $10,000 example above, if the number of
compounding periods is increased to quarterly, monthly, or daily, the ending
future value calculations are:
This shows that the TVM depends not only on the interest rate and time
horizon but also on how many times the compounding calculations are
computed each year.

How Does the Time Value of Money Relate to Opportunity


Cost?
Opportunity cost is key to the concept of the time value of money. Money can
grow only if it is invested over time and earns a positive return. Money that is
not invested loses value over time. Therefore, a sum of money that is
expected to be paid in the future, no matter how confidently it is expected, is
losing value in the meantime.

Why Is the Time Value of Money Important?


The concept of the time value of money can help guide investment decisions.
For instance, suppose an investor can choose between two projects: Project
A and Project B. They are identical except that Project A promises a $1
million cash payout in year one, whereas Project B offers a $1 million cash
payout in year five. The payouts are not equal. The $1 million payout
received after one year has a higher present value than the $1 million payout
after five years.

How Is the Time Value of Money Used in Finance?


It would be hard to find a single area of finance where the time value of
money does not influence the decision-making process. The time value of
money is the central concept in discounted cash flow (DCF) analysis, which is
one of the most popular and influential methods for valuing investment
opportunities. It is also an integral part of financial planning and risk
management activities. Pension fund managers, for instance, consider the
time value of money to ensure that their account holders will receive
adequate funds in retirement.

What Impact Does Inflation Have on the Time Value of


Money?
The value of money changes over time and there are several factors that can
affect it. Inflation, which is the general rise in prices of goods and services,
has a negative impact on the future value of money. That's because when
prices rise, your money only goes so far. Even a slight increase in prices
means that your purchasing power drops. So that dollar you earned in 2015
and kept in your piggy bank buys less today than it would have back then.

How Do You Calculate the Time Value of Money?


The time value of money takes several things into account when calculating
the future value of money, including the present value of money (PV), the
number of compounding periods per year (n), the total number of years (t),
and the interest rate (i). You can use the following formula to calculate the
time value of money: FV = PV x [1 + (i / n)] (n x t).

The Bottom Line


The future value of money isn't the same as present-day dollars. And the
same is true about money from the past. This phenomenon is known as the
time value of money. Businesses can use it to gauge the potential for future
projects. And as an investor, you can use it to pinpoint investment
opportunities. Put simply, knowing what TVM is and how to calculate it can
help you make sound decisions about how you spend, save, and invest.

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