Definition

The time value of money is the greater benefit of receiving money now rather than later. It is founded on time preference.

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Time Value of Money

Time value of money is a concept according to which the value money present at the current time is worth more than how much the same amount of money will be worth in future. This is because of the potential earning capacity money has. Regarded as one of the core principles of finance, it holds that if the money can earn interest, it is worth more the sooner it is in your hand. So basically, the time value of money incorporates the benefits of receiving the money now than later. It is based on the idea of time preference.

Investments are also highly dependent on the idea of time value of money. Hence, if an investor expects to get a favorable return on their investment in the future, they may forego spending their money now.

Calculation

There is a simple formula to calculate the time value of money:

PV = FV (1 + r)

Where:

PV = the present value of money

FV = the future value of the same amount of money

r = the interest rate applied to the amount

Thus, to calculate the future value of money, you have to discount it to an amount that equals the present value of money. This will give you an idea about how much the money you have right now will be worth in the future and you can take important decisions accordingly then.

From this formula, you can also calculate the present and future values of annuity, as well as, the present and future value of perpetuity.

Why is it better to Receive Money Now?

It is a universal fact that a person will prefer receiving any amount of money now, then receiving the same amount in the future. Why? This is because the interest rate applied on it will increase the net worth of the same money and make it more than the amount in hand today.

For example, if there is an interest rate of 5% applied on the $100 invested today. In a year’s time, the same amount will be worth only $95.24. Hence, the present value of money is greater than the future value of the same amount of money provided that an interest rate is applied on it.

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Time Value Of Money FAQ

Further Reading

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