Investments

What is the Time Value of Money?

Time value of money is an important financial concept taken into consideration in various aspects of life when it comes to money management. As money appreciates and depreciates over time due to forces of inflation and deflation, it is important to keep track of its intrinsic value. The fact that $1,000 now cannot buy the same number of items in future, as it does now, calls for extra caution when dealing with money and investments.

Time value of money is a concept that underscores the value of money may be worth more now, than in future. Similarly, if the same amount of money is invested in a financial product that earns interest it should earn more interest for it to be worth more. Therefore, accepting money at the present is more instinctive than opting to take the same amount of money in the future.

For this reason, the time value of money is often referred to as the net present value of money. This is because the value of money at the present may necessarily not retain the same intrinsic value in the future, taking into consideration appreciation and depreciation factors.

Factors Influencing Time Value of Money

Inflation and purchasing power are the two main factors that influence the value of money over time. Similarly, the two factors should always be considered when trying to understand the true value of money at present and what it is likely to be worth in the future.

Inflation is one of the factors that erode the value of money over time. As prices of goods and services increase, the amount of money used to pay for such items increases on money losing value. For instance, a $100 bill bought more items in the early 2000s than it does now.

Similarly, the number of items that a given sum of money can purchase now will be quite different from what it can purchase in two years. This is partly because the purchasing power of money tends to depreciate as time passes.

While investing any sum of money, it is important to factor in inflation and purchasing power. The rate of inflation should always be subtracted from whatever percentage of return one is guaranteed to earn on the money at hand.

Therefore, if the rate of inflation were much higher than the rate of return it would be wise to take money in and use it rather than holding it. A higher rate of inflation compared to the rate of return essentially means trouble. Even though an investment will show a positive return one would essentially lose money given the high inflation

Understanding Time Value of Money

Assume somebody offered to pay you $10,000 or hold back the money and payback $11,000 after one year. Instinctively it would be difficult to determine the best thing to do outright. However, with a clear understanding of what the time value of money means, the decision is not that difficult.

You can decide to take the $10,000 now if you have a strong conviction that you can use the amount to generate much more than the additional $1,000 the person is willing to pay after one year. However, if you are not sure the $10,000 offered now will be 10% more after one year, and then it will be wise to postpone the payment until the extra year has elapsed.

Time Value of Money Importance

Understanding the time value of money is crucial to investors looking to make investments that would generate returns after a certain period. The concept makes it easy to understand the actual value of a given sum of money now and its possible value in the future.

For instance, an investor looking to invest $10,000 now in a financial product likely to earn an interest of $10% would pay close watch to inflation. If the inflation level were more than 10% then it would not be wise to go forth and make the investment. Inflation of as much as 15% and rising would essentially mean the investment would be less valuable and amount to a loss of more than 5% given the expected 10% return.

Time value of money finds use in valuing investment opportunities allowing investors to make informed decisions taking into consideration the rate of return and the underlying inflation. The concept also finds great use in risk management whereby pension fund managers are tasked with the responsibility of ensuring account holders have a sufficient amount of money to use in the future on investments made at the present.

Conclusion

The time value of money is an important financial concept that affirms the value of money now, may not be the same in the future. Similarly, the amount items that a given sum of money can buy now will always be different from what it can buy in future.

Ruchi Gupta

Ruchi Gupta covers various beats from finance to technology and from lifestyle to hobbies. She has an MBA in Finance. Ruchi enjoys writing on celebrities and political news. She likes traveling and exploring places.

Related Articles

Back to top button