Time value of money (TVM) refers to the financial concept that money available for use at the present is more valuable than that identical amount would be in the future. This is due to the money’s potential earning capacity. Essentially, time value of money means that if the money can earn interest, then that money is more valuable the sooner it is received and subsequently invested. The future value of the money increases at a rate proportional to the interest that would be gained over a given amount of time.
To illustrate this principle, consider the consequences of investing $1,000 that earns a simple 5% interest annually over the course of a year. After one year, the $1,000 will have matured into $1,050. Had the $1000 not been invested over that one-year period, and consequently not been drawing interest, the investor would have earned $50 less than he could have.
To add additional insight, say Adam recently won a cash prize of $1,000. He is given a choice between payment options. He may either opt to receive the money immediately, or he may choose to receive the money in a year. Adam chooses to receive payment immediately. He takes his money and invests it, earning 5% interest per year. This means that Adam has earned $50 from his money by simply making one deposit.
How to Calculate your Future Value
The previous examples were relatively simple and assumed that a period of time equal to only one year had passed between the present and future values. If more time is added, then an equation is needed to determine the future of the funds. The equation used to determine future value is as follows:
FV=PV x (1+r)^t
In this equation, FV and PV equal future and past values, respectively, while r refers to the risk adjusted interest rate, and t is the amount of time in years that will have passed between the FV and PV. Thus, if Adam’s $1,000 will be invested for three years with a risk adjusted interest rate of 5%, the equation would look like this:
FV=1,000 x (1+0.05)^3
By using this formula, Adam can discover that his future value after three years will be $1,158, rounded up. If he just holds onto the money for three years, Adam would be losing his potential earnings of $158. Knowing this, Adam would be able to determine the best course of action to take with his recently acquired funds.
