What It Measures
Time Value of Money (TVM) is one of the most important concepts in the financial world. If a business is paid $1 million for something today, that money is worth more than if the same $1 million was paid at some point in the future. The reason money given today is worth more is straightforward: If I have money today, I have the potential to earn interest on the capital.
TVM values how much more a given sum of money is worth now (or at a specific future date) compared to in the future (or, in the case of a future payment, a date that is even further in the future). TVM calculations take into account likely interest gains, discounted cash flow, and potential risk, to create a value figure for a specific amount of money or investment opportunity.
Why It Is Important
If company A has the opportunity to realize $10,000 from an asset today, or two years in the future, TVM allows the company to calculate exactly how much more that $10,000 is worth if it’s received today, as opposed to in the future. It is important to know how to calculate the time value of money because it means you can distinguish between the value of investment opportunities that offer returns at different times.
How It Works in Practice
If a business has the option of receiving a $1 million investment today or a guaranteed payment of the same amount in two years’ time, you can use TVM calculations to show the relative value of the two sums of money.
Option A, take the money now: The business might accept the $1,000,000 investment immediately and put the capital into an account paying a 4.5% annual return. In this account, the $1,000,000 would earn $92,025 interest over two years (annually compounded), making the future value of the investment $1,092,025. This can be expressed using the following formula:
Future value = 1,000,000 × (1 + 0.045)2
which might be expressed as:
Future value = Original sum × (1 + Interest rate per period)No. of periods
Obviously, the present value of the $1 million if it is received today would be $1 million. But if the money isn’t received for another two years, we can still calculate its present and future values.
The present value of a future $1 million investment is based on how much you would need to receive today to receive $1 million in two years’ time. This is done by discounting the $1,000,000 by the interest rate for the period. Assuming an annual interest rate of 4.5%, we can calculate the present value using the following formula:
Present value = Future value ÷ (1 + Interest rate per period)No. of periods
Using this formula, we can see that the present value of a future payment of $1 million in two years’ time is:
1,000,000 ÷ (1 + 0.045)2 = $915,730
In other words, the investment in two years time is the equivalent of receiving $915,730 today, and investing it at 4.5% for two years.
Tricks of the Trade
There are five key components in TVM calculations. These are: present value, future value, the number of periods, the interest rate, and a payment principal sum. Providing you know four of these values, you can rearrange the TVM formulae to calculate the fifth.
When calculating TVM, you may sometimes need to supplement the calculation to discount future payments to take account of risk as well as time value. Discount rates can be adjusted to take account of risks like the other party not paying you back (default risk) or the fact that the item you intended to purchase has become more expensive, reducing the buying power of the money. In this case, the company lending the principal sum might insist on a higher interest rate to compensate for the risk.
If a future payment is not certain, you can use the capital asset pricing model to calculate the risk involved.