What Is the Time Value of Money?
Time value of money is a concept in finance that states that money received in the future is worth less than money received in the present.
The difference in value between current and future money is due to the interest that could be earned on the present amount. In other words, the discount between future money and present money arises from the money’s opportunity cost.
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Example of the Time Value of Money
For example, suppose that you are promised $1,000 in one year. If you can earn a 5% annual return on your money in a low-risk investment, the $1,000 to be received in one year is worth $952.38 ($1,000 divided by 1.05).
Compounding and Discounting
The two mathematical tools involved in the time value of money concept are compounding and discounting. Compounding involves calculating the future value of a present sum, assuming reinvestment of interest. Discounting involves calculating the present value of a future amount, assuming reinvestment of interest.
Key Variables in Time Value of Money Calculations
For both compounding and discounting, the two key variables are the interest rate and the length of time. In this sense, the interest rate is the mechanism through which current money is equivalent to future money.
Interest Rates and Risk
The interest rate used in time value of money calculations depends on the risk of the investment. If the investment poses a very low risk, a low interest rate is appropriate. However, if the investment poses a higher risk, the interest rate must be increased to account for the higher risk, with the higher interest rate widening the discount between the present value and future value.
Key Takeaways
- The time value of money states that money received today is worth more than money received in the future.
- The difference in value arises from the opportunity to earn interest on present funds.
- Compounding calculates the future value of money invested today.
- Discounting calculates the present value of money to be received in the future.
- Interest rates and time are the key variables used in time value of money calculations.