What is the Time Value of Money?
The time value of money is a fundamental concept in financial management. It basically says that having money in hand today is more valuable than the promise of receiving the same amount in the future.
This idea spins around the fact that the money you have right now has the potential to earn more through interest or investments.
The time value of money boils down to a simple preference for having money today rather than waiting for it. This is why we see interest being either paid or earned. It's a way to compensate for the value of having money now rather than later.
Understanding the Time Value of Money
The time value of money is an essential idea to consider because your money, once put to work, can increase over time. Even if you just place it in a savings account or a fixed deposit, your money can earn extra interest.
On the other hand, money left idle loses value as time passes. Think about what you could purchase with ₹100 in your youth compared to what it can buy today. This happens because inflation and missed investment opportunities reduce the worth of your dollars. If you keep your money hidden away for a decade, not only will it have less purchasing power due to inflation, but you'll also forego the interest it could have generated through investments.
The time value of money serves as a foundational concept that underpins nearly every financial and investment decision. Whether you're considering taking out a loan, negotiating your salary, or making a major purchase, employing the time value of money can help you assess the most financially prudent course of action.
The Formula of the Time Value of Money
FV = PV[1 + (i / n)]^(n * t)
In this formula,
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FV stands for the future value of money.
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PV represents the present value of money.
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i is the interest rate.
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n denotes the number of compounding periods per year.
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t is the number of years.