Time value of money is a concept that mathematically demonstrates that the money available in the present is worth more than the same amount of money received in the future. Logically also it is true because the present money has a capability of earning interest if it is invested for a specific time, thereby it will grow in future. It is also referred to as net present value (NPV) of money.

This concept provides us the tools to assess the present value of future money. So if you have to choose between two values on money one in the present time and another coming to you in future, then using this concept you can easily compare the two values and choose which one in more beneficial.

Let us understand this by an example:

Suppose someone offers you to choose between Rs. 100/- now and Rs. 115 after two years. Then you will have to estimate by how much amount your present Rs. 100/- will grow after two years, if you invest it now. If it will give you returns more than Rs. 15/-, then you will choose to have Rs. 100/- now, otherwise you would prefer to have Rs. 115/- after two years.

There are two things while assessing time value of money. One is inflation and other is interest on money. Inflation is the appreciation in the price of goods and services. It erodes the value of present money or you can say it reduces the purchasing power of money. For example, you cannot buy one kg of apple in the same amount you used to buy 10 years ago. On the contrary, the interest is the increase in the value of money if you keep invested it for a definite time. You must therefore account for the inflation while considering the returns from the money invested. For example, if the returns from your income is 12% in one year and the inflation is 7% in the same year than the actual purchasing power of your money will increase by 5% only (12%- 7%).

This concept is not only used for individual investment decisions but used for making strategic business decisions also. Suppose a business is projected to give you regular income in future and you have to invest a fixed sum of money in present then using time value of money concept, you can easily calculate after how much time your current investment will be recovered and when your business will become profitable.

Similarly, you can also compare the present value of future returns from your business with your current investment and can decide whether it is profitable to invest in a particular business or not.

Formulas for calculating time value of money

Future value of present money

FV= PV x [1+(i/n)]^{(n x t)}

Where,

FV= future value of money

PV= the present value

i= the interest rate or other returns on your investment

t= the number of years into consideration

n= the number of compounding periods of interest per year

Example

Suppose you earn an interest of 8% on Rs. 12000/- you invested today. The interest in compounded half yearly. Calculate, how much the money will become after six years?

FV₆= 12000 x [1+(.08/2)]^{(2 x 6)} = Rs. 211.67/-

Present value of Future Money

PV= FV/ [1+ (i/n)]^{(n x t)}

where,

PV= future value of money

FV= the present value

i= the interest rate or other returns on your investment

t= the number of years into consideration

n= the number of compounding periods of interest per year

Example

Calculate the present value of Rs. 1200/- which will be received by you after one year. The rate of interest is 6%.

Using the formula of present value of money,

PV= 1200/[1+ .06/1]^(1*1) = Rs. 1132.07/-

Assuming the annual interest rate equal to 10%, you can also convert a series of cash flows into present value which has been demonstrated by the following example.

If a cash flow projected to be obtained from a business by spending Rs. 800/- initially, would you like to invest in the business or not?

The present value calculation of future cash flow is shown in following table:

Net Present Value of future series of cash receivables= Rs. 90.9+ 123.96+75.13+136.6+186.26= Rs. 612.85/-.

From the above calculation, it is clear that Net Present Value of the cash flow is Rs. 612.85/- which is less than the present investment amount. Therefore, it will not be a good decision to invest in that business.

Summary

The time value of money is an important concept which not only helps us in personal matters but in making the business decisions also. Before investing in a project which is projecting some future return either lump sum or in the form of cash flows, the Net Present Value of the future returns should be computed and always be compared with the present investment for making wise decisions.

Read more: Internal Rate of Return (IRR): Uses, Examples and Limitations