Time value for money
What is the time value for money
According to the financial theory known as the time value of money, a dollar is worth more now than it will be later. You can invest your current money to earn a profit, but inflation will lower its future value by the same amount.
How does time value for money
Let's use a practical example to make this easier to understand. Let's say someone gives you Rs. 5,500 in a year or Rs. 5,000 immediately. Waiting could seem alluring, but only if you can't make more than 10% on the Rs. 5,000 in a year. The idea enables you to make a comparison between your potential earnings now and your future promises.
Take the money immediately if your existing investment can generate more than the amount that was postponed. Additionally, consider Systematic Investment Plans, or SIPs. You would have about Rs. 11.7 lakh in five years if you invested Rs. 15,000 a month at a 10% annual rate. That is the advantage of making investments early and being aware of the trade-offs between "now" and "later."
Time value of money formula
Once you understand the concept, the next step is knowing how to calculate it. Here’s the formula that helps you estimate how much your money will be worth in the future:
Future Value (FV) = Present Value (PV) × [1 + (i/n)] ^ (n × t)
Where:
PV = Today’s money (present value)
FV = What it will grow into (future value)
i = Interest rate (or expected return)
n = Number of times interest is compounded in a year
t = Number of years
This simple formula helps you figure out how today’s savings can multiply over time when invested at a given return rate. It's a useful tool whether you're planning for retirement, a child’s education, or just building wealth.
Example of time value of money
Let’s say you’re given a choice: Rs. 10,000 today or Rs. 10,000 after one year. What should you choose?
If you take it today and invest at 5% interest, you’ll end up with Rs. 10,500 in a year. That extra Rs. 500 is what you earn by acting early.
But if you wait a year to get the Rs. 10,000, you miss out on that interest. That’s a real opportunity cost. This is why the same amount of money is worth more now than later—because you can make it grow if you have it today.
Significant of time value of money
The time value of money influences practically every financial decision you make, so it's not just a theory from a finance textbook. This idea aids in long-term thinking whether you're choosing an investment, making retirement plans, or managing a business. Which would you choose, for instance, if two enterprises offered you Rs. 1 lakh, but one paid now and the other in three years? It makes sense that most individuals would pick the option that pays today. Why? Because you can make it grow by investing that Rs. 1 lakh today. It might be worth a lot more by the third year. That is the magic of the time value of money: it makes your money work for you as soon as possible, allowing you to use it more wisely.
Time worth of money is important in finance
The temporal value of money (TVM) is a key tool in finance and isn't simply for personal savings. TVM is utilised practically everywhere, whether it is by a large corporation, a bank, or an individual investor. The reason for this is that every financial choice you make entails weighing your current expenses against your future returns. And TVM assists you in doing so.
Imagine you are faced with the task of selecting between two mutual fund schemes. One offers consistent growth beginning today, while the other promises superior returns in five years. Knowing TVM enables you to evaluate your decisions in light of the future value of your money. It is also used to assess loans, determine the value of a business venture, and make plans for major life events like retirement. To put it briefly, TVM serves as the prism through which prudent financial choices are made.
What effect does the time value of money have on choosing an investment?
In essence, you are choosing how to convert today's funds into more tomorrow when you are choosing where to invest. TVM can help with that. It assists you in evaluating the potential future worth of various investment possibilities so that you are not only pursuing profits but also comprehending their true value throughout time. For instance, TVM enables you to assess the true value of two mutual fund alternatives based on time and inflation if their returns differ. It makes your decisions more clear. Furthermore, it goes beyond personal finance. Companies use TVM to determine if it makes sense to invest in a new product or enter a new market. They can more accurately assess risk vs benefit by accounting for time and returns.
Inflation and the time value of money
The unseen factor that erodes the value of your money is inflation. And it's a major factor in why TVM is so important. Here's a straightforward way of thinking about it: Rs. 500 now is worth less than it was five years ago, and it will be worth much less in five years. Your money must increase in order to keep up with inflation since it reduces purchasing power.
Even if you see profits on paper, you are actually losing money if your assets don't generate more than the rate of inflation. By taking inflation into consideration when you plan your finances, TVM helps you preserve the real-world worth of your money in addition to growing it. Your investments must increase more quickly than prices in order to beat inflation. Mutual funds that are carefully picked might help you maintain and increase your wealth over time.
How does inflation impact the time value for money
Over time, inflation has a direct impact on the value of your money in addition to making items more costly. In a few years, the same Rs. 1,000 you have now probably won't buy as many groceries, as much fuel, or as many services. That is the gradual reduction of your purchasing power due to inflation. Put this to use with your assets now. In real terms, you are losing value if you are generating 5% yields while inflation is 6%. Because of this, earning returns alone is insufficient; you also need returns that outpace inflation.
Knowing this makes your planning more intelligent.Inflation considerations assist guarantee that your money not only grows but also retains its actual value over time, whether you're diversifying your portfolio or selecting mutual funds with long-term growth potential.