Time Value of Money (TVM): Definition
Time value of money (TVM) is the concept that money paid or received in the future is not as valuable as money paid or received today because the money received today can be invested and, therefore, has the potential to increase in value.
Time Value of Money: Explanation
Perhaps you’ve seen the adverts claiming that if you invest $2,000 a year in an Individual Retirement Account (IRA) starting from age 30, you will accumulate over $500,000 by the time you retire at age 65.
As the advertisements claim, you will receive substantially more than the $70,000 ($2,000 x 35 years) you invested. This is due to the interest that you will earn on your investment.
This points out the importance of interest and how quickly it accumulates over a period of time.
With this in mind, the focus of this article is on the time value of money and how this concept is used in personal and business financial decisions.
All investment decisions involve giving up a certain amount of money today in the hope of receiving a greater amount at some future time. To determine whether you have made a wise investment, you must consider the time value of money.
Suppose you need to evaluate the following investment opportunity: a real estate developer has offered to sell you a vacant lot today for $100,000 and guaranteed to repurchase it 10 years later for a minimum of $250,000.
Does that sound like a good investment?
Although it’s tempting to say yes because you would be making a profit of $150,000, you must also consider the time value of money.
When you do, you’ll realize that the $250,000 you will receive in 10 years is not really comparable to the $100,000 you have to give up today.
This is because the money that you will receive in the future will not be as valuable as the money you receive today. This is due to the fact that money received today can be invested and, as a result, may increase.
In our example, if you did not make the investment but instead put the $100,000 in a savings account that earned 12% interest per year, you would accumulate over $310,000 at the end of 10 years.
Concepts Related to Time Value of Money (TVM)
The best way to analyze investment opportunities is to determine the rate of return they offer. In the above example, if you invested $100,000 today and received $250,000 in 10 years, you would earn a rate of return of about 9.6%.
You can compare this rate of return with those of other investments of similar risk and logically decide which one presents the best opportunity.
To do this, as well as similar types of analysis, you must understand five concepts related to the time value of money:
- Simple vs. compound interest
- Future value of a single amount
- Present value of a single amount
- Future value of an annuity
- Present value of an annuity
The table below summarizes the main concepts related to the time value of money.
|Future value of a single amount||How much will $5,000 grow to at the end of 5 years if deposited today and 12% interest is compounded annually?|
|Present value of a single amount||What is the value today of receiving $10,000 at the end of 10 years, discounted at 10% compounded quarterly?|
|Future value of an annuity||How much will $2,000 a year deposited in a bank at the end of each of the next 10 years accumulate to at the end of 10 years?|
|Present value of an annuity||What is the value today of receiving $6,000 at the end of each of the next 7 years, discounted at 10% per year?|