Definition: The time value of money (TVM) is an economic principle that suggests present day money is worth less than money in the future because of its earning power over time.
What Does Time Value of Money Mean?
What is the definition of time value of money? Put simply a dollar today is worth more than a dollar next year because money can be invested today and earn interest. TVM relates to three basic parameters: inflation, opportunity cost, and risk.
Inflation is reducing the purchasing power of money because it increases the prices of goods and services. Therefore, over time the same amount of money can purchase fewer goods and services.
Opportunity cost refers to the loss of investment opportunities and the benefit associated with them due to the commitment of money to another investment for a specific period of time.
Risk relates to the investment risk that investors undertake when putting their money into investment assets.
Let’s look at an example.
Example
Maria has invested $1,000 at 8.5% annual interest rate for 5 years. The inflation rate at the time of the investment is 2.5%.
- In year 1, she receives $1,000 x (1+8.5%) = $1,085
- In year 2, she receives $1,085 x (1+8.5%) = $1,177.23
- In year 3, she receives $1,177.23 x (1+8.5%) = $1,277.29
- In year 4, she receives $1,277.29 x (1+8.5%) = $1,385.86
- In year 5, she receives $1,385.86 x (1+8.5%) = $1,503.66
In this case, the time value of money is the compensation that Maria has received for investing $1,000 at 8.5% annual interest rate for 5 years.
The question for Maria is: would she prefer to have $1,000 today or $1,000 in 5 years?
If the inflation rate rises during the period of 5 years, Maria’s investment will worth less, or she may even realize a loss. Inflation causes the general price level to rise, thus affecting the purchasing power of consumers. Consumers are purchasing fewer goods, the revenues and profits of firms decline, and the economy slows down before getting stable again.
If the interest rates change during the period of 5 years, the accumulated amount in Year 5 will be affected.
Therefore, ceteris paribus, Maria will realize a profit on her investment in the future. However, the present value of $1,000 is known as opposed to the future value of $1,000, which is an estimate based on today’s factors.
Summary Definition
Define Time Value of Money: TVM means that one-dollar today is worth more than one-dollar tomorrow because of interest and inflation.
