What is Time Value of Money?
Time Value of Money – A Crucial Concept
Time value of money is the name which we all hear every now and then in almost all the fields. No matter you talk about investing your money somewhere, saving your money at home, initiating new projects or buying and selling the properties, the term time value of money is always there.The origin of this term pertains to the field of finance, but the concept applies universally. The concept itself has logic in every instance, but knowing it deeply and understanding it is always important due to its crucial nature.
What is Time Value of Money?
Time value of money amounts being a concept that turns out to be the measurement of the value of money with the changing time. The price you pay to purchase bread today won’t remain same next year; in fact you will definitely see a change.
Tools associated with the time value of money
- The discount factor
- The timeline
We can apply these tools to move money back in time via discounting and forward in time via compounding. We will discuss later some useful shortcuts to compute the present value and the future value of cash flow streams that we commonly come across in practice, streams like an annuity and a perpetuity.
Importance of Time Value of Money
Time value of Money is an important concept which actually is present in the life of every individual. This concept is not only important for the ones investing in projects and properties or running a business. In fact, it plays a great role in the life of an ordinary man as well. Time value of money is an important term for making decisions, a number of personal and professional decisions are being made over the concept as it helps analyzing you the worth of the investment made today after a few years to assist in sound decision making.
Considering the situation of the business, we can see that businesses look for the opportunities to invest in the projects today which lead to profits after a certain number of years. However, they can’t simply invest in everything that comes around; they need to analyze the value of the income being generated at each stage of the project. The entire role of time value of money has to be taken into account before investing and analyzing the expected returns or else the business might face loss.
Even if an ordinary individual is saving money to buy a gadget for instance next year, the value of that gadget today won’t help, in fact analyzing the value of that gadget next year is what matters. If he saves S100 today as the price being quoted in the markets currently the gadget won’t cost $100 next year. It rather will cost more taking an account of time value of money.
Considering an Example
Consider a financial example, if you have a sum of $100 today and have two choices either to spend it all today or to invest it for one year at the rate of 7% yield interest, the person well aware of the concept of time value of money will prefer investing it. The investment being made will take away today $100 but right after one year will come up with $107 which is a benefit of $7. This is the actual game of time value of money that incorporates the worth of a decision over a period of time.