Financial Management – The Time Value of Money

The use of the words Time Value and Money together goes to show that there exists some close link between Money and the Value of Time. It has long been considered an unspoken golden rule of accounting, and this certainly is so.

The concept of the time value of money (TVM) indicates that financial management is based on the thought that a rational investor would rather have that money now than the same amount at a future date because of the potential it holds for being used for earning through it.  This is because the money has the potential for increasing in value over time, as seen in the case of fixed deposits. When all else remains equal, the closer to the present money is received, the more value it holds. So, even the smallest amount of money is worth more the sooner one receives it.

Formula for TVM

The formula for TVM is situation-dependent, with a little variation from the generalized formula, specifically for the situation. The formula that computes TVM takes into account the present payment, future value, rate of interest, and time. A key determinant for the formula for TVM is how many compounding periods there are for every time frame. 

The formula for TVM is:

FV = PV x [ 1 (i / n) ] ^{(n x t)}

Where, 

• FV = Future value of money
• PV = Present value of money
• i = Interest rate
• n = No. of compounding periods annually
• t = No. of years

For example, a person invests INR 2,000,00.00/- for a 5 year period at an interest rate of 10%, this investment’s (INR 2,000,00.00) future value will be:

FV = 2,00,000 X [ 1 (10%/1) ] ^(1X5)

= INR 3,22,102/-

Effect of Compounding Periods on Future Value

TVM can be hugely affected by how many compounding periods are being considered. Let us look at an investment of INR 10,000 for a year at 10% interest.  This could be calculated as a single compounding period of 1 year, or quarterly compounding of 4, or monthly compounding of 12 periods, or even daily compounding of 365 periods.  

Here are some of the future value calculations. 

• Quarterly Compounding: FV = 10,000 x [1 (10% / 4)] ^ (4 x 1) = 11,038
• Monthly Compounding: FV = 10,000 x [1 (10% / 12)] ^ (12 x 1) = 11,047
• Daily Compounding: FV = 10,000 x [1 (10% / 365)] ^ (365 x 1) = 11,052

It is important to note that while interest rate is a huge determinant in the future value of money, also of importance are the time horizon and equally important is the number of times annually that compounding calculations get computers. 

Here are some simple yet key points associated with the time value of money in financial management.  

Money that is received now is more valuable than the same amount received later.  Stemming from this fact is opportunity cost, a concept that is simple yet important to understand as well as implement. If money is received today, it can be invested to increase, while the same money coming in the future will not provide these positive returns. TVM is used to invest in related decisions. It is also at the core of discounted cash flow analysis (DCF).it is at the core of risk management and every area of financial planning. 

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