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Time Value of Money (TVM): Definition and Formula

Sarmaaya Desk
Sarmaaya Content Team

Key Takeaways

  1. Time value of money (TVM) is also known as ‘present discounted value’
  2. Time value of money talks about the concept of money being worth more now compared to the same amount in the future
  3. Formula to calculate Time value of money TVM which also known as Future Value of Money
  4. Time value of money explains the benefit of receiving money now rather than in future and is rooted in time preference.

What is the Time Value of Money (TVM)?

Time value of money (also known as ‘Present Discounted value) talks about the concept of the worth of money being more now compared to the same amount in the future. Hence, investors prefer receiving money today, rather than receiving the same amount of money in the future due to its potential of increasing value over the given time period (compounding in value) – provided a certain interest rate is applied.

Calculating Time Value of Money (TVM)

The generalized formula for Time Value of Money (TVM) is as follows:

Where: 

FV is Future Value of the money

PV is Present Value of the money

N is Number of compounding periods 

I is Interest rate

T is number of years

It is important to know that the exact formula for time value of money may slightly vary depending on the nature of the question.

The following example illustrates the use of the given formula:

Assuming an investment of $100,000 for one year at 10% interest, the future value of the money is as follows:

FV = $100,000 x [1 + (10% / 1)] ^ (1 x 1) = $110,000

Understanding Future Value for Money

Time Value of Money is very centric when it comes to calculating the intrinsic value of shares and potential investment opportunities in projects and companies. Even if a person is not aware of it, TVM plays an important role in decision-making and recommendations for investments.

 

Therefore, investors will have a better understanding regarding when to invest, which in the long run would prove to be fruitful for them. TVM explains the benefit of receiving money now rather than in the future and is rooted in time preference. It further helps explain the existence of interest rates.

While looking at TVM, we should consider inflation and the impact it has on the purchasing power of people. It is a commonly known fact that inflation adversely affects a person’s ability to buy goods and services, thereby reducing the purchasing power of the consumer. Hence, we need to calculate the real return on investment (ROI) while considering inflation. If the given results show us less profitability than inflation, this could mean that even if we’re making money, we could just as well be losing our purchasing power.

 




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