In this post, we’ll unpack all you need to know about the Time Value Of Money (TVM), defining exactly what it is, the logic behind it, its role in calculating Discounted Cash Flow and more.
What Is The Time Value Of Money?
The Time Value Of Money (TVM) is a concept that is most often associated with investing. It states that money today is worth more than the same amount of money received in the future.
Understanding Time Value Of Money
From an investment perspective, there is one primary reason why you would prefer to receive money today instead of the same amount of money in the future.
Money that is invested has the potential to increase in value over time due to compound interest, while money that isn’t invested has the potential to decrease in value over time because of inflation.
TVM & Discounted Cash Flow
The Time Value Of Money is an essential component of calculating the Discounted Cash Flow of an investment. It leads to three concepts; Future Value (FV), Discount Rate (DR) and Present Value (PV).
Future Value is how much you believe an asset will be worth in the future. Discount Rate is the rate of return you’d expect from an investment of similar risk.
For example, you may calculate the Future Value of an investment to be $1,000,000 in 10 years with a Discount Rate of 5%. This would mean that the Present Value would be $613,913.25.
It’s not that the business is inherently worth less in the future. Instead it means that $1,000,000 received in 10 years is equivalent to receiving $613,913.25 today given a 5% Discount Rate.
Summary (TL;DR)
Time Value Of Money states that money received today is worth more than the same sum received in the future.
The logic behind TVM is that money that is invested can increase in value over long periods while money that is not invested can decrease in value over long periods.
