Sooner Rather Than Later - The Time Value of Money

person looking at silver-colored analog watch

The Time Value of Money (TVM) is the benefit of receiving money now over receiving the same amount later.

A dollar today is worth more than a dollar tomorrow.

This is because of money's potential. It can be invested in the stock market, earn interest in a savings account or used to start a business. The earlier you have money, the earlier you can take advantage of this potential.

TVM Formula

The TVM formula is a great tool to demonstrate this concept. Below are the variables behind TVM.

FV = future value

PV = present value

r = rate of return

n = # of compounding periods per year

t = # of years

The formula can be used to calculate future value:

FV = PV x [ 1 + (r / n) ] ^ (n x t)

This formula can also be re-arranged to calculate present value:

PV = FV/[ 1 + (r / n) ] ^ (n x t)

The TVM formula can be rearranged to calculate any of the above variables, but today we'll focus on present and future value.

Let's take a look at some examples to demonstrate how we can use this formula.

Example 1 - Jimmy's Future

Jimmy has $1,000, which he plans on investing into a portfolio of index funds for 10 years. Using the future value formula, he can calculate how much his money will be worth after the decade.

Assuming an 8% annual return, the future value of his investment would be:

FV = $1,000 x (1 + (8% / 10) ^ (1 x 10) = $2,158.92

Example 2 - Sarah's Present

Sarah won a bet with her friend Joey. Joey is short on cash right now but agrees to pay her $1,000 in 10 years. Using the present value formula, she can calculate how much her future payment is worth now.

Assuming the same 8% interest, the present value of Sarah's $1,000 prize is only:

PV = $1,000 /(1 + (8% / 10) ^ (1 x 10) = $463.19

Money Now or More Money Later?

It's easy to decide between payment options if the amounts are the same (get paid now!). The present value formula comes in handy when the delayed payment is larger.

For example, if Joey offered $400 now or $1000 in 10 years. She should get paid later and choose the $1000.

$400 is lower than the present value of the $1000 ($463.19).

However, if Joey offered Sarah $500 now or $1000 in 10 years. She should get paid now and choose the $500.

$500 is greater than the present value of the $1,000 ($463.19).

Conclusion

TVM is a core principle in finance. It's the reason lenders charge interest on loans and why you expect interest on savings accounts (essentially a loan you're making to the bank). All else equal, money today is better than money tomorrow. It's a simple concept, but essential to financial decision making.

Comments

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