You must have heard the proverb ‘time is money.’ The time value of money shows that it’s true. A rupee today is worth more than a rupee a year later. Why? It can grow, earn interest, or be invested. Each day that you do not spend or invest your money, it goes down just a little bit in value.
The time value of money concept applies to everything from saving and investing to business and loan planning. If you want to make your money grow or not lose it to inflation, then you should know how time can influence values.
In this blog, we will help you learn what time value money is, how it works, how to calculate it, and how you can use it in daily life to make better financial choices.
Table of Contents:
What is Time Value of Money?
The time value of money states that a rupee today is worth more than a rupee tomorrow because you can invest it and earn returns. It is a core financial principle and is also known as present discounted value (PDV).
An example of time value of money is ₹1000 now is better than ₹1000 one year later, as in case you invest it now, it can increase and be worth more in the future.
The money value will vary over time due to the interest or returns that you can enjoy by putting the amount in an investment. The longer you invest your money, the more it grows. It is this growth that causes a difference between the present-day money and future money.
Reasons for Time Value of Money
- Risk and uncertainty: There is no guarantee you will have the same money in the future. It is easier to get the money now.
- Inflation: Prices tend to rise with time. Present money can purchase more than in the future.
- Spending: In most cases, individuals like to spend money or utilize it instantly.
- Investment opportunity: You can invest money at present and watch it appreciate over time in the form of interest or returns.
Why the Time Value of Money Matters in Finance
In finance, the time value of money definition means that money in the present is more valuable compared to the corresponding amount in the future because it can generate revenue. TVM can be used to measure the present value of future receipts. This aids in enhancing the right choices of investors, lenders, and people.
Here is why it matters in finance:
1. Financial Planning
The concept of time value of money (TVM) helps you decide how much to invest or save by helping you set realistic financial goals.
2. Investment Decisions
You can compare different investment opportunities based on their potential profitability and risks using the time value of money. It calculates the present value of expected returns, which helps you make better investment decisions by evaluating potential risks versus returns.
3. Loan Evaluation
Borrowers can determine the real cost of loans and the total interest payable over time using the time value of money. Also, lenders use TVM to set an appropriate rate of interest.
4. Managing Risk and Inflation
Time affects the value of money through inflation and changing interest rates. TVM helps to keep these factors in mind to protect your wealth.
5. Capital Budgeting
Time value of money helps companies to evaluate projects by discounting future cash flows and comparing them to initial costs. It helps companies judge whether future cash flows justify current investments.
6. Retirement Planning
Individuals can estimate how much they need to save today to secure a desired retirement income with the help of the time value of money. The calculation is done taking into account inflation and expected investment returns.
How the Time Value of Money Works
Suppose someone offers to pay you one of two ways to do a piece of work. You can take ₹10,000 today or ₹12,000 one year from now. Which one should you choose?
It depends on the return you think you can earn if you invest the money now. If you believe you can earn more than 20% in the next year, it’s better to take the ₹10,000 today, invest it, and end up with more than ₹12,000. But if you expect to earn less than 20%, you’re better off taking the ₹12,000 a year from now, assuming you trust the payment will be made.
This is exactly what the time value of money is about. It shows that money today is more valuable than the same amount in the future because of its potential to grow. There are two key concepts associated with the time value of money:
- Present Value tells you what a future amount is worth in today’s terms.
- Future Value tells you how much your money will grow if you invest it.
The difference between present value and future value depends on the interest rate and how long you wait. The longer the time or the higher the rate, the bigger the gap between present and future value.
With a thorough understanding of the TVM concept, you can start comparing cash flows across time, assess investment opportunities, or make better borrowing decisions.
Key Concepts Behind the Time Value of Money
To understand how the time value of money works, you need to understand three key concepts behind it: present value, future value, and opportunity cost.
Here’s what each one means and why it matters.
1. Present Value (PV)
As you know, money in the future is not worth the same as money today. Present value is about figuring out how much a future sum is worth today, considering a specific rate of return.
For example, if someone offers to pay you ₹2,000 one year from now, and you could earn 5% elsewhere, the present value of that ₹2,000 is around ₹1,904.76 [2000/(1+0.05)].
What it means: ₹2,000 next year is only worth ₹1,904.76 to you today if your money can grow at 5%.
2. Future Value (FV)
Future value tells you how much money you will have later if you save or invest some money now. It simply shows how money grows over time with interest.
If you invest ₹5,000 at 5% per year, it’ll grow to ₹5,788.12 [(5000×(1+0.05)^3)] in 3 years. That’s its future value. This is how you compare different investment opportunities or plan for goals.
3. Opportunity Cost
Each financial choice has its benefits and risks. When you choose to spend or invest your money one way, you give up the return you could have earned elsewhere. That potential return, which is given up, is your opportunity cost.
If you leave your money in a savings account earning 4% while a bond is offering 7%, that 3% difference is the cost of your decision. In long-term investment planning, this difference becomes crucial.
The time value of money demonstrates that the money you possess today is more valuable than that even in the future due to its capacity to multiply. To calculate future or present value, we assume the interest rate is compounded annually (unless stated otherwise). Here is the formula:
Now that you understand what future value means, here is how to calculate it using the formula:
The formula for the FV is:
FV = PV×(1+r)^n
Where,
- FV = Future Value (what the money will be worth)
- PV = Present Value (the amount you have now)
- r = Interest rate (in decimal)
- n = Number of periods (years, months, etc.)
Example:
Let’s assume you have invested ₹10,000 for 3 years compounded annually in a savings account with a 20% compounding interest rate. It will grow to:
FV = ₹10,000 × [(1 + 0.20)^3 ]
FV = ₹10,000 ×1.728
FV = ₹17,280
Now that you understand what present value means, here is how to calculate it using the formula:
The formula for the PV is:
PV = FV/(1+r)^n
Where:
- PV = Present Value (how much you need to invest now)
- FV = Future Value (your target amount)
- r = Interest rate (decimal)
- n = Number of periods
Example:
Let’s say you want ₹15,000, 5 years from now, and you can earn 5% interest annually. How much do you need to invest today?
PV = 15000/(1+0.05)^5 = 15000/1.27628 = ₹11,752.90
So, if you invest ₹11,752.90 today at 5% annual interest, you will have ₹15,000 in 5 years.
You do not need to do manual calculations to figure out the present and future value of the money you currently hold or the current value of the money you will get in the future. A time value of money calculator can help you calculate as well as understand what the value of your money will be today and tomorrow.
The Power of Compounding: Time and Growth
Compounding is how the time value of money plays out in real life. It shows why ₹10,000 today is worth more than ₹10,000 tomorrow, because that ₹10,000, if invested, keeps growing on its own over time.
By investing money, you do not only make a return on the principal. You are also making money on your returns. It is a snowball effect where your returns generate more returns, and you make even more on top of what you have earned before, which is compounding.
The compounding frequency refers to how often interest is added to your investment – daily, monthly, or yearly. The more often it compounds, the quicker your money grows.
Let’s say you invest ₹1,00,000 at 10% annually.
| No. of Years | Future Value (₹) at 10% Annual Return |
| 0 | 1,00,000 |
| 1 | 1,10,000 |
| 2 | 1,21,000 |
| 10 | 2,59,374 |
| 20 | 6,72,750 |
| 30 | 17,44,950 |
In the first 10 years, your money more than doubles. In the next 10 years, it will be more than double again. But in years 20 to 30, the gain is over ₹10 lakh. That is the power of the time value of money in action. The value of money grows with time because of compounding.
The TVM concept says money today is more valuable than the same amount in the future. But compounding turns that into an advantage. By investing early, you create more future value because time and growth feed off each other.
The sooner you invest, the more time you give your money to compound and the more future value you create. That is how the time value of money becomes wealth in real life.
Impact of Inflation on Time Value of Money
You might have noticed that over time, the prices of goods and services have increased. Why? It’s because of inflation. And as the prices rise, the value of money falls, indicating that the same amount of money will buy fewer things in the future. This is the core principle of the time value of money.
Let’s have a look at the impact of inflation on the time value of money:
1. Erosion of Purchasing Power
Inflation reduces the real purchasing power of your money. If inflation is 10%, then something that costs ₹1000 today will cost about ₹1100 next year. So if you keep 1000 rupees in your wallet and do nothing with it, you lose its worth just by waiting. This is why money loses its value over time if it is not growing.
2. Impact on Savings and Investments
If the inflation rate is 8% but your saving earns only 6%, you are effectively losing your money. Your account balance may increase, but its purchasing power may not. You must consider the impact of inflation on their returns. The real value of your investment is declining if it grows more slowly than inflation. Further, your real goal should be not just to grow money, but also to grow it faster than inflation.
3. Real and Nominal Returns
Nominal return is the return that you see on paper. For example, if your mutual fund gives you 10% in a year, that is the nominal return. In contrast, real return is what you get after removing the effect of inflation. If inflation is 6%, then your real return is only 4%. So, when you are planning for long-term goals like retirement or purchasing a car, this matters.
The formulas for nominal and real returns are:
Nominal Return = (Current Value - Original Investment)/ Original Investment *100
Real Return = ((1+ Nominal Rate)/ (1+ Inflation Rate)) - 1
How the Time Value of Money Impacts Investment Decisions
When you start investing, you are deciding how to make today’s money into more tomorrow. In such a case, the time value of money (TVM) concept helps you compare the future value of different investment options. So, you are not just running behind high returns but also understanding what they value over time.
TVM allows you to compare choices to see whether an investment or business opportunity is truly worth it or not. Additionally, it helps you balance potential risks against expected returns so your decisions are well-informed, not impulsive or sudden.
Take, for example, two mutual funds that offer different returns over different periods. TVM considers inflation and duration to get the actual worth of those returns in present-day terms. So, it gives you both clarity and accurate information about returns.
It is not just about personal investing. Businesses use TVM to decide if launching a new product or entering a new market makes financial sense. By factoring in time and return projections, they can make smarter calls about risk and reward.
Techniques to Apply the Time Value of Money
The concept of time value of money is about how money loses value over time if you don’t invest it or earn interest on it. The techniques of time value of money below build on the concept we discussed earlier- PV, FV, and opportunity cost.
Below are the main techniques:
1. Present Value (PV)
Present value calculates how much a future amount of money is worth today by adjusting for the time and interest.
2. Future Value (FV)
It shows how much an amount invested today will grow to after earning interest over a period.
3. Discounting Cash Flows
When cash amounts are received at different times, this technique converts each to its value today for precise comparison or totaling.
4. Annuities
This involves calculating the total value of a series of equal payments made regularly over a set time frame.
5. Perpetuities
This calculates the present value of an endless stream of equal payments.
6. Net Present Value (NPV)
NPV measures an investment’s profitability by subtracting the initial cost from the sum of discounted future cash flows.
7. Internal Rate of Return (IRR)
IRR is the rate that makes an investment’s net present value (NPV) zero, indicating the expected rate of return.
Practical Applications of Time Value of Money in Business
The time value of money (TVM) plays a key role in many business decisions:
1. Project Selection
The primary application of TVM is discounting future cash flow. Companies list all project cash flows to evaluate sustainability. The future values are discounted to their present value with the help of TVM formulas. Some businesses do discounting using the weighted average cost of capital (WACC), which reflects the average rate a company is expected to pay to finance its assets, through equity and debt.
By including the initial investment in these discounted cash flows, one gets the Net Present Value (NPV). Organisations tend to choose a project that has the greatest NPV. That is why TVM is essential in management decisions. Another popular method is the rate the discounted cash flows are equal to the initial investment, which is called the Internal Rate of Return (IRR).
2. Sinking Fund
Companies regularly set money aside to repay debentures later. Although the total amount required is fixed, the size of each periodic payment depends on the compounding frequency and interest rate. Time value of money formulas help to compute these payments, so the fund grows to the needed amount. Sinking fund calculations use the future value of annuity formulas, modified for interest over time.
3. Capital Recovery
Generally, loans are repaid in installments by companies or organisations. Once the number of installments is determined, the time value of money formulas help to identify the size of each payment, considering the interest over time.
4. Deferred Payment
Sometimes companies delay loan interest payments, allowing interest to build up before starting repayments. Because the loan’s value changes during this period, TVM is used to calculate how much to pay once repayment begins.
5. Implicit Rate of Return
In some investment schemes, a large amount is invested upfront, and returns are paid periodically as an annuity. TVM helps identify the interest rate built into the annuity’s value.
Conclusion
The time value of money is a core idea in financial planning. It influences everything from whether you should buy or lease an asset to whether an investment is worth making. Future value shows how time affects the worth of money, which is why starting early always gives you an edge. Most financial advice, whether people realize it or not, is built on this idea. The key takeaway is simple: the earlier you invest, the more you gain. Both individuals and businesses can use this concept to make smarter financial decisions.
Time Value of Money – FAQs
Q1: What is the relationship between opportunity cost and the time value of money?
Ans. The time value of money indicates that delaying investment of money creates an opportunity cost in the form of lost potential earnings. The higher the potential returns available, the greater the opportunity cost of delaying.
Q2: Why is the time value of money important?
Ans. The concept of time value of money typically helps businesses or individuals to make better decisions. For example, you have to choose between two projects, A and B. Both projects are the same except that Project A promises ₹1 crore cash payout in a year, whereas Project B proposes a ₹1 crore cash payout in five years. Now, the time value of money helps you understand that ₹1 crore in one year has a higher present value than in five years. That simply means Project A is better than Project B.
Q3: How does inflation affect purchasing power over time?
Ans. Inflation is the rate at which prices of goods and services go up over time. And we know what happens when prices rise: you get to buy fewer things for the same amount. So, if your income does not increase at the same rate, you would not be able to purchase as much as before. That’s how inflation affects purchasing power over time.
Q4: How does the time value of money affect financial planning?
Ans. The time value of money (TVM) significantly impacts financial planning by highlighting that money available now is worth more than the same amount in the future due to its potential earning capacity and the effects of inflation.
Q5: What is time value of money in financial management?
Ans. The time value of money in financial management is the concept that today’s money is worth more than in the future, considering the same amount. This is due to its potential earning capacity.
Q6: How does the concept of time value of money relate to simple and compound interest?
Ans. It is important to know whether you are using simple interest or compound interest when calculating the future value or present value of money. Simple interest calculates the interest earned only on the original investment, whereas compound interest calculates the interest earned on both the principal and accumulated interest. TVM generally uses the concept of compounding.