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Chidi Ekebere Time Value of Money (TVM) Discussion

Student Response needed with one reference

Time value of money (TVM) simply means that a sum of money is worth more now than the exact same sum of money in the future. The concept is a core financial principle that sum of money in hand has more value than the said sum to be paid in the future (Fernando, Para. 2021).

In most organizations, decision-makers find TVM concept essential in decision-making processes for some critical aspects of finance such as capital budgeting and valuation (Elearnmarkets, 2021).

Investors prefer to receive money today rather than the same amount of money in the future because a sum of money, once invested, grows over time. For example, money deposited into a savings account earns interest. Over time, the interest is added to the principal, earning more interest, which is the power of compounding interest.

If it is not invested, the value of the money decreases over time. If one hides $1,000 in a mattress for three years, there will be a loss of the additional money it could have earned over that time if invested. It will have even less buying power when retrieved because inflation has reduced its value (Fernando, 2021).

The concept of the time value of money can help guide investment decisions. For instance, suppose an investor can choose between two projects: Project A and Project B. They are identical except that Project A promises a $1 million cash payout in year one, whereas Project B offers a $1 million cash payout in year five. The payouts are not equal.

The $1 million payout received after one year has a higher present value than the $1 million payout after five years (Fernando, 2021).

Depending on the exact situation, the formula for the time value of money may change slightly. For example, in the case of annuity or perpetuity payments, the generalized formula has additional or fewer factors. But in general, the most fundamental TVM formula considers the following variables:

FV = Future value of money

PV = Present value of money

i = interest rate

n = number of compounding periods per year

t = number of years

Based on these variables, the formula for TVM is:

FV = PV x [ 1 + (i / n) ] (n x t)

Below is an example of the calculation and application of Time Value of Money:

Assume a sum of $10,000 is invested for one year at 10% interest compounded annually. The future value of that money is:

FV = $10,000 x [1 + (10% / 1)] ^ (1 x 1) = $11,000

The formula can also be rearranged to find the value of the future sum in present day dollars. For example, the present-day dollar amount compounded annually at 7% interest that would be worth $5,000 one year from today is:

PV = $5,000 / [1 + (7% / 1)] ^ (1 x 1) = $4,673 (Fernando, 2021).

The number of compounding periods has a dramatic effect on the TVM calculations. Taking the $10,000 example above, if the number of compounding periods is increased to quarterly, monthly, or daily, the ending future value calculations are:

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

This demonstrate that TVM depends not only on the interest rate and time horizon but also on how many times the compounding calculations are computed each year (Fernando, 2021).

Time value of money influences the decision-making process in most if not all areas of finance. It is the central concept in discounted cash flow (DCF) analysis, which is one of the most popular and influential methods for valuing investment opportunities.

It is also an integral part of financial planning and risk management activities. Pension fund managers, for instance, consider the time value of money to ensure that their account holders will receive adequate funds in retirement (Fernando, 2021).

References:

Fernando, J. (2021, December 30). Time value of money (TVM). Investopedia. Retrieved January 18, 2022, from https://www.investopedia.com/terms/t/timevalueofmoney.asp

Time value of money – formula and applications of TVM. Elearnmarkets. (2021, October 25). Retrieved January 18, 2022, from https://www.elearnmarkets.com/blog/understanding-the-time-value-of-money/

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