Time value of money (TVM) is the fundamental concept in financial management. The simplest meaning of the term is that the value of a certain amount is more in the present than it is in the future. Therefore, getting the same amount of returns in the present instead of the future is insisted upon. This concept is used to compare investments like bonds, mutual funds, and loans. The value of money depends entirely on the value of the market. If the market suffers inflation, the value of money would consequently decrease. Therefore, there is a direct correlation between the two variables.
Time value of money is also called the present discounted value. People invest in financial plans to get a fixed amount in the future, simply to feel a sense of security, even if the money would not hold the same value then as it does now. It is a product of the concept of interests. There are two considerations in calculating the time value of money,
Present value
In simple terms, the present value is an amount that has to be paid today in either installments or sum to get a bigger amount in the future along with a specified rate of interest. The biggest limitation to this component is that the longer you wait for the returns, the lesser will be the value of the future amount.
Future value
Future value is the value of the same amount in the future. It is calculated by adding the rate of interest to be received after the maturity period. The payments for this type of an investment can be done annually or altogether at once.
Theory of time value of money (TVM)
The concept of time value of money affects businesses, governments, and consumers. This theory enables investors to calculate the value of the current amount by using a “risk-free returns” formula. Investment decisions are made based on the results.
The risk involved should be lower than the returns from the investment. The borrower is required to be able to pay the promised amount of money to the investor on the predetermined date. The borrower is expected to pay an interest amount in addition to the principal.
Time value of money is used to estimate or predict future returns considering various risks. Since the investor is agreeing to lend the money to the borrower, considerable risks are involved. The concept supports the hypothesis that the theory of money is directly related to time. It also helps to learn and predict more about the kind of cash flow that can be expected in the future with regard to discounted interests.
Ensure that you invest only when the returns are higher than the risks. In addition, the organization that you are investing in should have a good reputation in the market so that your future returns are assured.
