What is time value of money?

Definition and examples

Time Value of Money (TVM), also known as present discounted value, refers to the
notion that money available now is worth more than the same amount in the future,
because of its ability to grow.

The term is similar to the concept of ‘time is money’, in the sense of the money itself,
rather than one’s own time that is invested. As long as money can earn interest (which it
can), it is worth more the sooner you get it.

We all know that if we deposit money in a savings account, it will earn interest. That is
why we prefer receiving money now than the same amount at a future date.

Time Value of Money is important in financial management. TVM can be used to

compare different investment options and to solve problems involving mortgages,
leases, loans, savings and annuities.

If you wait one year to get your money, you are losing out on the opportunity to have
that money in the bank now earning interest.
Example of Time Value of Money

Imagine you lent a friend $1,000 and he paid you back today. You immediately deposit
that money into an account that earns 7% annually. It will be worth $1,070 in exactly
one year’s time.

If, on the other hand, you received the $1,000 in one year’s time, it would only be worth
$934.58 ($1,000 ÷ 1.07), assuming a 7% annual interest rate.

If you asked people whether they would prefer to receive $1,000 now or that amount in
one year’s time, they would probably all say they wanted it now, for several reasons:

1. They want to be sure they get the money. Waiting a year increases the risk of not
getting the money.
2. They may want to go out shopping or go on vacation soon, and that money
would be useful.
3. If they invested that money today in a deposit account, the $1,000 would be
worth more in one year’s time. They are aware of the Time Value of Money.

A key concept of TVM is that a series of equally, evenly-spaced instalment payments or

a single lump sum, or receipts of future pledged payments can be converted to an
equivalent value now.

One may also determine the whole thing the other way round, the value to which one
single sum or a series of future payments will have appreciated at a future date.

https://youtu.be/2dFMqnTmcuM

Time Value of Money Formula

The time value of money is an important concept not just for individuals,
but also for making business decisions. Companies consider the time
value of money in making decisions about investing in new product
development, acquiring new business equipment or facilities, and
establishing credit terms for the sale of their products or services.
A specific formula can be used for calculating the future value of money so that it can be compared to
the present value:

Where:

FV = the future value of money

PV = the present value
i = the interest rate or other return that can be earned on the money
t = the number of years to take into consideration
n = the number of compounding periods of interest per year

Using the formula above, let’s look at an example where you have $5,000 and can expect to earn 5%
interest on that sum each year for the next two years. Assuming the interest is only compounded
annually, the future value of your $5,000 today can be calculated as follows:

FV = $5,000 x (1 + (5% / 1) ^ (1 x 2) = $5,512.50

Present Value of Future Money Formula

The formula can also be used to calculate the present value of money to

be received in the future. You simply divide the future value rather than
multiplying the present value. This can be helpful in considering two
varying present and future amounts.

In our original example, we considered the options of someone paying

your $1,000 today versus $1,100 a year from now. If you could earn 5% on
investing the money now, and wanted to know what present value would
equal the future value of $1,100 – or how much money you would need in
hand now in order to have $1,100 a year from now – the formula would
be as follows:

PV = $1,100 / (1 + (5% / 1) ^ (1 x 1) = $1,047

The calculation above shows you that, with an available return of 5%

annually, you would need to receive $1,047 in the present to equal the
future value of $1,100 to be received a year from now.
To make things easy for you, there are a number of online calculators to
figure the future value or present value of money.

Net Present Value Example

Below is an illustration of what the Net Present Value of a series of cash

flows looks like. As you can see, the Future Value of cash flows are listed
across the top of the diagram and the Present Value of cash flows are
shown in blue bars along the bottom of the diagram.

Time line is an important tool of time value of money that provides

insight to the analyst about the timing and the amount of each cash
flow in a cash flow stream, as depicted a head. It may be noted from,
figure 4.1 that Time 0 is today, Time 1 is one period from today, or the
end of period 1; time 2 represents two periods from today or the end of
period 2; and so on.
Cash flows shown directly below the tick marks, and interest rates are
depicted directly above the time line. Interest rate is 10 percent for
each of the three periods. Cash flow of Rs. 100 made at the beginning
of the time 0 is an outflow (investment), shown with minus sign. The
time 3 value is an unknown inflow and is not shown as minus sign
which implies a plus sign. New cash flows-occur at times 1 and 2.
In case interest rate changes in subsequent periods, it has to
be shown along the time line, as exhibited below:

Present Value
Definition of Present (or Discounted) Value
It can be defined as today’s value of a single payment or series of
payments to be received at a later date, given at a specified discount
rate. The process of determining the present value of a future
payment or a series of payments or receipts is known as discounting.

Present Value Example with Discounting of

Money
In absolute terms, discounting is the opposite of compounding. It is a
process for calculating the value of money specified at a future date in
today’s terms. The interest rate for converting the value of money
specified at a future date in today’s terms is known as the discount
rate.

We will take a reverse example of future value as explained above. Mr.

A has an offer to get $1331 after 3 years if he pays $975 today. A
market interest rate is 10% with annual compounding. What should
Mr. A do? To pay $ 975 or not. To decide whether he should pay $975
or not, he should be able to compare his proposed outflow of today
with today’s value of $1331 to be received after 3 years. Referring to
the table above, we know that the present value of $1331 after 3
years is $1000. So, Mr. A should definitely pay $975 because there is a
clear-cut benefit of $25 over and above the interest earnings.

This calculation process of present value is known as discounting, and

the sum arrived at after discounting a future amount is known as
Present Value.

Present Value Formula and its Explanation

The formula to calculate the present value is as follows:

PV = FV / (1+r)n

Or

PV = FV * 1/(1+r)n

Where,

PV=Present value or the principal amount

FV= FV of the initial principal n years hence

r= Rate of Interest per annum

n= number of years for which the amount has been invested.

In this equation, ‘1/(1+r)n‘ is the discounting factor which is called the

“Present Value Interest Factor.”

Our current example can be easily solved with the formula –

PV = FV * 1/(1+r)n

PV = 1331 * 1/(1+10%)3

PV = 1331 * 1/(1+0.10)3

PV = 1331/1.13

PV = 1331/1.331

PV = 1000
Future Value
Definition of Future (or Compounded)
Value
It can be defined as the rising value of today’s sum at a specified
future date given at a specified interest rate. The compounding
technique calculates it.

Table of Contents

1. Future Value
1. Definition of Future (or Compounded) Value
2. Future Value Example with Compounding of Money
3. Future Value Formula and its Explanation
4. Multiple Compounding Periods
 5. Rule of 72 Trick
6. Formula for Rule of 72
2. Present Value
1. Definition of Present (or Discounted) Value
2. Present Value Example with Discounting of Money
3. Present Value Formula and its Explanation
4. Present Value vs. Future Value: Interest Factors (PVIF) and (FVIF) Tables
5. Calculator Trick

Future Value Example with Compounding

of Money
Compounding of money is the value addition in the initial principal
amount after defined intervals at a given interest rate. For example, if
Mr. A invests $1,000 for say 3 years @ 10% interest rate
compounding annually, then the income will rise as follows:

Principal at the beginning 1,000.00

First Year: Interest for one year (1000*0.10) 100

Principal at the end 1,100.00

Principal at the beginning 1,100.00

Second Year: Interest for the year (1100*0.10) 110

Principal at the end 1,210.00

Third Year: Principal at the beginning 1,210.00

 Interest for the year (1210*0.10) 121

Principal at the end 1,331.00

This calculation process is known as compounding, and the sum

arrived at after compounding the initial amount is known as Future
Value. In our example, the future value of $1000 is $1331 after 3
years @ 10% interest rate compounding annually. Similarly, a present
value of $1331 is $1000 under the same conditions.

Future Value Formula and its Explanation

This was a very simple example. In practical use, there can be 20
years in place of just 3 and more frequent compounding than annual.
Following the formula helps determine the future value of any sum
very easily.

FV = PV (1+r)n

Where,

PV = Present value or the principal amount

FV = FV of the initial principal n years hence

r = Rate of Interest per annum

n = a number of years for which the amount has been invested.

In this equation, (1+r)n is the compounding factor that calculates the

principal amount along with interest and interest on interest. It is
called the “Future Value Interest Factor.”
Now, if we solve the above example with the given formula, we get

=1000(1+0.10)3 = Rs. 1,331/-

The formula is helpful to calculate the amount invested for longer

maturity periods, say 10-20 years, very quickly and easily.

For calculation, you can use FVIF Calculator

Multiple Compounding Periods

The compounding period refers to the no. of years/months for which
the interest is made due. These can be monthly, quarterly, half-yearly
and annually, etc. For example, if the interest is charged on a monthly
basis, then the annual interest rate ‘r’ shall be divided by 12, and no.
of years’ n’ shall be multiplied by 12. So, when the frequency of
compounding is more, the effective interest amount is also more.

Rule of 72 Trick
There are a general question in an investor’s mind How many years
will it take to double my money? ‘Rule of 72‘ is a user-friendly
mathematical rule used to quickly estimate the ‘rate of interest’
required to double your money given the ‘number of years of
investment and vice versa. It is specifically called the rule of 72
because the number 72 is used in its formula.

Formula for Rule of 72

For calculating the number of years required to double your money
given the rate of interest, the formula is:

Number of years = 72 / Interest

Example: At 8%, money takes 72/8 or 9 years to double it.

Or

For calculating the rate of interest required to double your money

given the number of years of investment, the formula is:

Rate of Interest = 72 / Number of years

For example, a 10-year investment requires a 72/10 or 7.2% rate of

interest p.a. to double itself.

Present Value vs. Future Value: Interest

Factors (PVIF) and (FVIF) Tables
PVIF and FVIF tables are available to facilitate the ease of calculations.
Following is an example of an FVIF table with various periods and
percentages of interest. For example, in our case, we have to look for r
=10 and n= 3; the value is 1.331. From this only, we can find PVIF by
dividing it by 1, 0.751 (1/1.331), or a separate table is also available.

FVIF Rate of Interest (r)

Period (n) 1% 2% 3% 4% 5% 6% 7%

1  1.010  1.020  1.030  1.040  1.050  1.060  1.070

2  1.020  1.040  1.061  1.082  1.103  1.124  1.145

3  1.030  1.061  1.093  1.125  1.158  1.191  1.225

4  1.041  1.082  1.126  1.170  1.216  1.262  1.311

5  1.051  1.104  1.159  1.217  1.276  1.338  1.403

 6  1.062  1.126  1.194  1.265  1.340  1.419  1.501

7  1.072  1.149  1.230  1.316  1.407  1.504  1.606

PVIF Rate of Interest (r)

Period (n) 1% 2% 3% 4% 5% 6% 7%

1 0.99 0.98 0.971 0.962 0.952 0.943 0.935

2 0.98 0.961 0.943 0.925 0.907 0.89 0.873

3 0.971 0.942 0.915 0.889 0.864 0.84 0.816

4 0.961 0.924 0.888 0.855 0.823 0.792 0.763

5 0.951 0.906 0.863 0.822 0.784 0.747 0.713

6 0.942 0.888 0.837 0.79 0.746 0.705 0.666

7 0.933 0.871 0.813 0.76 0.711 0.665 0.623

Present Value Table

Calculator Trick
This table can be easily made over the calculator. Let the interest rate
be 1%. The steps are:
 1. First, convert the percentage to decimals: 1/100=0.01
2. Add 1: 1+0.01= 1.01
3. Now Divide 1 by the step 2 result: 1/1.01=0.990
4. Now press equal to sign (=) on the calculator so many
times as the number of years,  and you will get the series
on factors year-wise. You can match the results with the
table.
5. Prepare your own table as per the rate of interest.
Thus, the above concepts enable us to judge in certain terms whether
it is beneficial to receive or spend money now or later. This concept is
widely used for project decisions and evaluation. One can make
general decisions for projects by calculating their payback period. But
accurate decisions call for calculating the present value of future
income so that we know the exact returns the project will give and
thus can decide upon the project’s viability. Similarly, if the future
value of a certain amount is calculated, it adds attractiveness to the
investment proposals.