Time value of money or in common abbreviation simply TVM is the very fundamental that the entire field of finance and commercial real estate are building upon. When we are dealing with savings, loans, mortgages, investment, and many other financial decisions, TVM is there.
First, you might ask, “Why does money have time value?”
One simple question, would you choose of receiving 1000 dollars today or 1000 dollars in 12 months time? Which option would you rather take? Let’s take a look at an example below:
Mr. A, Mr. B, and Mr. C start working at 25 years old, and each of them saves 1000 dollars every month until their retirement in 65,
Mr. C is an old-minded and conservative person had saved all the money in a safe deposit locker, and in 40 years, he had saved an amount of 480k,
Mr. B, he who lived a balanced lifestyle, saved his money in a bank saving account with an annual rate of 1%, 40 years later, the saving amount becomes 592k.
As for Mr. A, who is very positive in the stock market, undertook an aggressive investment strategy, and had gained himself an annual average return of 8% from the market. How much do you think he had earned? He had more than 3 million after 40 years!
TVM is the very fundamental that the entire field of finance and commercial real estate are building upon!
Have you noticed? Although all three of them started at the same age and save the equal amount of money within the said period. In your opinion, do you think that Mr. Conservative had made a good financial decision? Do you think that the dollar saved in his safe had the same value as today?
Understanding that Time value of money is the economic principle that a dollar received today has greater value than a dollar received in the future. A dollar that you have today is worth more than what you will receive a dollar in the future because you can invest it and earn interest. Therefore, clearly one would choose to pick A over B, you will choose to receive the 1000 dollars now.
From this example, you can see that there are 5 components of TVM, that is:
- Periods are evenly spaced intervals of time. They are intentionally not stated in years since each interval must correspond to a compounding period for a single amount or a payment period for an annuity
- Payments are a series of equal, evenly spaced cash flows. In TVM applications, payments must represent all outflows (negative amount) or all inflows (positive amount).
- Interest is a charge for borrowing money, usually stated as a percentage of the amount borrowed over a specific period. Simple interest is computed on the original amount borrowed. It is the return on that principal for one time period. In contrast, compound interest is calculated each period on the original amount borrowed plus all unpaid interest accumulated to date.
- Present Value is an amount today that is equal to a future payment, or series of payments, discounted by an interest rate. The future amount is a single sum that one will receive at the end of the last period as a series of equally spaced payments (an annuity) or both. Since money has time value, the present value of a promised future amount is worth less the longer you have to wait to receive it.
- Future Value is the amount of money or investment with a fixed, compounded interest rate will grow to by some future date. The investment is a single sum deposited at the beginning of the first period, a series of equally spaced payments (an annuity), or both. Since money has time value, we naturally expect that future value is greater than the present value. The difference between the two depends on the number of compounding periods involved and the going interest rate.