What Time Value of Money with Example

What is the Time Value of Money?

The time value of money is the conception that a sum of money is worth more valuable now than the same sum will be at a future date due to its earnings potential in the short-term.

This is a primary principle of finance that a sum of money in the hand has greater value than the same sum to be paid in the future.

Breaking Down Concept with Example

Investors desire to receive cash today rather than the same amount of cash in the future because a sum of money, once invested, grows over time. For instance, If you deposit cash into your savings account in any commercial bank of United States, over time, you will earn interest on the principal amount you deposited in saving account, That’s the power of compounding interest.

If that cash is not invested, then value of the money degrade over time. If you hide $1,000 in a safe for 2 years, you will lose the additional money it could have earned over that time if invested. It also will have less buying power when you retrieve it due to inflation has decreased its value.

Let consider another example, if your friend give you choice to take $5000 today or get it after 2 years, what will you choose? You should chose to take $5000 today rather than after 2 years.

Formula for Time Value of Money

In general, the most fundamental TVM formula is:

FV = PV x [ 1 + (i / n) ] ^{(n x t)}

Formula for Time Value of Money

Whereas,

• FV = Future value of money
• PV = Present value of money
• i = interest rate
• n = number of compounding periods per year
• t = number of years

Problem on Time Value of Money

A sum of $5,000 is invested for one year at 5% interest compounded annually. What will be the future value of that money ?

Solution:

Data

t=1 year

i= 5%

n=1

PV= $5,000

FV=?

Here in this question we have to find future value of money, and formula for future value is:

FV = PV x [1 + (i / n) ] ^{(n x t)}

So, put the values on the formula given above:

FV = $5,000 x [1 + (5% / 1)] ^ (1 x 1)   =     $5,250 Ans.

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