Time Value of Money (TVM): A Detailed Study with Example
---
Definition of Time Value of Money
The Time Value of Money (TVM) is a fundamental financial principle which states that a sum of money today is worth more than the same sum in the future, due to its potential earning capacity. This concept is based on the idea that money can earn interest, and therefore, any amount of money is worth more the sooner it is received.
---
Key Concepts of TVM
1. Present Value (PV): The current value of a future sum of money, discounted at a specific rate.
2. Future Value (FV): The amount of money an investment will grow to over a period of time at a given interest rate.
3. Interest Rate (r): The return that can be earned on an investment or charged on a loan.
4. Compounding: The process of earning interest on both the principal and the previously earned interest.
5. Discounting: The process of determining the present value of a future amount.
---
Formulas Used in Time Value of Money
1. Future Value (FV) Formula:
FV = PV \times (1 + r)^n
2. Present Value (PV) Formula:
PV = \frac{FV}{(1 + r)^n}
Where:
= Present Value
= Future Value
= Interest rate per period
= Number of periods
---
Example:
Suppose you are offered ₹10,000 now or ₹12,000 after 2 years. The annual interest rate is 9%. Which option is better?
Step 1: Calculate the Present Value of ₹12,000 received after 2 years
The present value of ₹12,000 after 2 years is approximately ₹10,099. Since ₹10,099 (PV) > ₹10,000 (immediate cash), it is financially better to wait and receive ₹12,000 after 2 years if you can earn 9% interest.
---
Applications of Time Value of Money
1. Investment Decisions – Evaluating projects using Net Present Value (NPV) and Internal Rate of Return (IRR).
2. Loan Amortization – Determining EMIs and outstanding loan balances.
4. Valuation of Bonds and Shares – Calculating the present value of future cash flows.
5. Lease vs. Buy Decisions – Comparing long-term costs of leasing or purchasing assets.
---
Importance of TVM in Finance
Accurate Valuation: Helps in understanding the real worth of money and investments.
Financial Planning: Supports long-term planning by comparing today’s decisions with future outcomes.
Informed Decision-Making: Enables managers, investors, and individuals to make better investment and financing choices.
---
Conclusion
The Time Value of Money is an essential concept in financial decision-making. It emphasizes that receiving money earlier is better because of its earning potential. Whether you're saving, investing, borrowing, or making business decisions, understanding TVM helps you evaluate choices accurately and maximize financial outcomes.
