Time Value Of Money

Time Value of Money

The time value of money (TVM) or, discounted present value, is one of the basic concepts of finance and was developed by Leonardo Fibonacci in 1202. The time value of money (TVM) is based on the premise that one will prefer to receive a certain amount of money today than the same amount in the future, all else equal. As a result, when one deposits money in a bank account, one demands (and earns) interest. Money received today is more valuable than money received in the future by the amount of interest we can earn with the money. If $90 today will accumulate to $100 a year from now, then the present value of $100 to be received one year from now is $90.

To fully understand time value of money one must first understand a few terms. Present value and future value are totally different. They also have their disadvantages and advantages; it just depends on how they are used. Of course, present value is what you have right now at this present time. While future value is the amount of money you will have at a given time in the future. Future value has a tendency to be deep; meaning that who knows the future. Interest rates fluctuate everyday; so one can be losing while the other is gaining. Money is known to be worth more now in the present time than in the future. It is worth more now because you can invest it and earn interest. Ben Franklin once said, "The inherent ambiguity of the value of time promotes accommodations and rationalization and may explain the rather obvious observation that most people are a lot more willing to waste time than money." Money is easy access, whereas the opportunity cost for time is vague. Money is readily exchangeable, time is not, and it is perishable. So observing this statement, money will always be around. Time never goes backwards only forward. If you actually think about it, people have plenty of opportunities each and everyday to spend (or waste) their time, but the transactions may be more informal than those involving money. So, when considering the present and the future, there is an enormous decision to make.

Time value of money serves as the foundations of notion in finance. Finances are the way of life when handled properly. Finances help map out time accordingly; meaning that several situations or circumstances may arise so knowing where the money is going to come from will help balance the situation. Several institutions such as banks and investment companies are just a few institutions that serve as financial stability. They evaluate credit on individuals and glance at what can be afforded. Their ultimate goal is for their customers to reap the best reward or benefit when it comes to money. Making your money grow productively is important. Saving money now helps to secure your future. Valuing the time of money means putting money in the proper place in order for it to prosper to its fullest; that is where financial advisors come in play. Organizing your finances to distinguish between savings and investments can be difficult; it just depends on your status. Think of savings as money set aside to take care of needs and emergencies as they arise such as car or home repairs and doctor visits, as well as planned expenditures in the future such as putting a down payment on a home. Investing your money is more for the long term, such as retirement or even inheritance for the loved ones that are left behind.

Security of anyone's money rather than rate of return is more important because you want the money to be available when needed. So investing might not mean all the money just a portion of it to see how it will mature. So the circumstance will always determine the way money is handled. CDs and money market accounts are a few common ways to invest your savings money, because interest fluctuates at different locations and times of the year. These short-term investments are commonly referred to as cash. Putting your savings into stocks or stock mutual funds is not always a wise idea because there might not be enough time to ride out disadvantages that may come about.

Now, investing as opposed to saving is a long-term activity to make your money grow at a rate in excess of taxes and inflation. There are investors set in place to guide society on choosing the correct or more reliable investment. Valuing investing may seem to go against conventional investment wisdom in many cases because value investors tend to seek out several stocks that they might believe the market has undervalued. So in other words they will put their faith or trust in other markets to see if there is money available. Smaller companies do not get as much publicity as the larger companies receive. Society believes that the smaller company cannot pull in as much business in order for someone to invest in them. Investing can be dangerous at times because of economic uncertainty in the corporate world. Companies' stocks fluctuate everyday, so it can be looked at as gambling. So people that invest in companies that do not have a good reputation with stocks often loose money.

TVM also takes into account risk aversion - both default risk and inflation risk. 100 monetary units today is a sure thing and can be enjoyed now. In 5 years that money could be worthless or not returned to the investor. There is a residual time value of money, beyond compensation for default and inflation risk, that represents simply the preference for money now versus later. Inflation-indexed bonds notably carry no inflation risk. In the United States for instance, Treasury Inflation-Protected Securities carry neither inflation nor default risk, but pay interest.

To adjust for this time value, we use three simple formulae:

1. Present Value: This formula is used to discount future money streams. It converts future amounts to their equivalent present day amounts. PV = FV/(1+rate)*number of periods

Example: $100.00 1 year from now with expected rate of return of 5%, PV = 95.24

PV = 100(1 + .05) to the 1st power.

PV = 95.24

2. Future Value: This formula is used to compound today's money into the equivalent amount at some time in the future (i.e., to compund money either in a lump sum or streams of payment). FV = PV x (1 + r)*number of periods

Example: $100.00 invested today at an interest rate of 5% for 1 year

FV = 100 x (1 + .05) to the 1st power

PV = 105.00

3. Annuity Amount. This formula is used to discount a series of periodic payments of equal

amounts at equal time intervals.