Time Value of Money (TVM)
Time value of money is the concept that the value of a dollar to be received in future is less than the value of a dollar on hand today. One reason is that money received today can be invested thus generating more money. Another reason is that when a person opts to receive a sum of money in future rather than today, he is effectively lending the money and there are risks involved in lending such as default risk and inflation. Default risk arises when the borrower does not pay the money back to the lender. Inflation is the rise in general level of prices.
Time value of money principle also applies when comparing the worth of money to be received in future and the worth of money to be received in further future. In other words, TVM principle says that the value of given sum of money to be received on a particular date is more than same sum of money to be received on a later date.
Few of the basic terms used in time value of money calculations are:
When a future payment or series of payments are discounted at the given rate of interest up to the present date to reflect the time value of money, the resulting value is called present value.
Read further: Present Value of a Single Sum of Money and Present Value of an Annuity
Future value is amount that is obtained by enhancing the value of a present payment or a series of payments at the given rate of interest to reflect the time value of money.
Read further: Future Value of a Single Sum of Money and Future Value of an Annuity
Interest is charge against use of money paid by the borrower to the lender in addition to the actual money lent.
Read further: Simple vs. Compound Interest
Application of Time Value of Money Principle
There are many applications of time value of money principle. For example, we can use it to compare the worth of cash flows occurring at different times in future, to find the present worth of a series of payments to be received periodically in future, to find the required amount of current investment that must be made at a given interest rate to generate a required future cash flow, etc.
Written by Irfanullah Jan