The Time Value of Money (TVM) is a concept often used in various investment appraisal tools. Time value of money represents the concept that the cash flows received from an investment aren’t the only thing that matters when making decisions about it. The timing of these cash flows also matters. Apart from investment appraisal, the time value of money is also a crucial concept in other areas of a business.
According to the TVM concept, the earlier the timing of cash inflows is, the better it is for the business. Similarly, the later the timing of cash outflows is, the more beneficial it is. The fundamental principle or idea behind the concept is that money earns interest. Therefore, money received now can earn more interest than if received a year later. Similarly, money paid one year later can earn interest before being paid off.
How does time value of money work?
As mentioned above, the time value of money assumes that a business can earn interest on its money. Therefore, the more it keeps that money, the more interest it will generate. For example, if a company has to receive $1,000 from its customers, which it can invest in the bank for a 10% annual interest. Therefore, if the company receives the amount today, it can earn $100 interest in one year. Hence, one year later, the company will have $1,100 instead of $1,000.
However, if the company receives the amount one year later, it will forego the interest income on it. Thus, it will only have $1,000 in one year instead of $1,100. Therefore, the time value of money is crucial when it comes to the cash flows and money of businesses.
What is the time value of money formula?
The time value of money concept determines the future value of cash flows or money. Therefore, the formula to calculate TVM is as follows.
FV = PV x (1 + i)n
In the above formula, ‘FV’ represents the future value of cash flows or money. Similarly, ‘PV’ signifies the present value of cash flows. ‘i’ denotes the interest rate in the market. Finally, ‘n’ represents the number of years for which the business can use the money. The formula for the time value of money is similar to that of compounding or compound interest.
However, the above formula isn’t the only way to calculate the time value of money. In some instances, the formula may also change based on several factors.
Example
A company, Blue Co., can invest $10,000 for 5 years to earn a 10% annual interest. The future value of the money for the company considering the time value of money will be as follows.
FV = PV x (1 + i)n
FV = $10,000 x (1 + 10%)5
FV = $16,105
Therefore, if Blue Co. invests the amount today, it will receive the $16,105 in 5 years. Hence, the company can make a profit of $6,105 ($16,105 – $10,000) according to the time value of money.
Conclusion
Time value is a crucial concept which signifies that the timing of cash flows or money is as important as its value. It is because TVM assumes that businesses can invest the money and earn interest income from it. Therefore, TVM states that the earlier a business receives money, and the later it pays it back, the more beneficial it is.
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