What is the time value of money and what is its significance?



What is the time value of money and what is its significance?

Time value of money tells us that the value of a dollar today is more than the value of a dollar tomorrow. In easy language, if you are given an option to take 1 lakh rupees today or after 1 year, then you should aim to take the money today itself. The reason is that the cost of commodities rises due to inflation and thereby you are able to buy less quantity of a certain good. Another reason is that you lose the ability to earn interest on the money for 1 year.

For example, Rs.1,00,000 can be put in an FD which can give a return of 7% and therefore growing your money to 1,07,000. Time value of money is sometimes referred to as present discounted value. 

Now, one might question how is this concept relevant and where can it be applied. The answer is that TVM allows you to calculate the present value of any future cash flows and therefore helps in analyzing which investment or an annuity would be a better option to choose i.e. which investment cash inflows will have a higher net present value.

The following are some of the basic variables in the most fundamental TVM formula:
  • Future Value of money (FV)
  • Present Value of money (PV)
  • Interest Rates (I)
  • Number of Compounding Periods Per Year (N)
  • Number of Years (T)

FV = PV[ 1 + (I/N)]^NT

For example, if you have to evaluate which investment is better to take in the below 2 conditions you will have to find out the present value of the money.

1.    Getting Rs.1,22,504 after 3 years 
2.    Getting Rs.1,26,247 after 4 years

It is given that the interest rate is 7%. So if you find the present value by putting in the values in the above formula, you will notice that Rs.1,22,504 is a more viable option as it has higher present value than Rs.1,26,247 after 4 years. The present values for both will be Rs.1,00,000 and Rs.96,313 respectively.

Other applications of the time value of money would involve calculating the present value of an annuity cash inflows. You will have to find the present values separately if the cash inflows are different in different years. However, if the cash inflows are similar during the period of annuity, then you can find the present value of annuity by the below formula.


Consequently, it can be said that the higher the present value of any future cash inflows, the better is the investment for us.

Thanks for reading!

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