What is the concept of time value of money?
As a finance professional, I explain TVM this way: It's the mathematical relationship between money at different points in time. The core principle is that money has earning potential - a dollar today can work for you and grow.
Key components of TVM: - Present Value (PV): What money is worth today - Future Value (FV): What money will be worth after earning interest - Interest rate (r): The growth rate - Time period (n): How long the money grows
The basic formula: FV = PV × (1 + r)^n
This means $100 invested at 5% for one year becomes $105. Conversely, $100 received one year from now is worth less than $100 today (you'd need to discount it).
TVM explains why: - Starting retirement saving early is so powerful (compound interest) - Lottery winners take lump sums smaller than the announced jackpot - Businesses evaluate projects using discounted cash flow analysis
It's arguably the most important concept in finance - once you understand it, many financial decisions become much clearer!
The time value of money (TVM) is a fundamental financial concept that basically means money available today is worth more than the same amount in the future. Here's why this matters:
- Inflation: Money loses purchasing power over time due to rising prices
- Opportunity cost: Money you have now can be invested to earn returns
- Risk: Future payments are uncertain - you might not receive them
Simple example: If someone offers you $100 today or $100 next year, you should take the $100 today because you could invest it and have more than $100 in a year. Even just putting it in a savings account would earn interest.
This concept is why banks pay interest on deposits and charge interest on loans. It's the foundation for calculating investment returns, loan payments, retirement planning, and virtually all financial decisions. Understanding TVM helps you make smarter choices about saving, investing, and borrowing!