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.
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.
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.
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:
- They want to be sure they get the money. Waiting a year increases the risk of not getting the money.
- They may want to go out shopping or go on vacation soon, and that money would be useful.
- 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.