Understanding the time value of money with formulas and examples

In corporate finance and valuation, experts and self-taught people rely on several guiding principles. One of these basic principles is the time value of money.

Whether you’re a financial professional, an entrepreneur breaking ground on a new business venture, or just want to educate yourself on personal finance, understanding the time value of money is critical.

Related: How to calculate the true monetary value of your time

What is the time value of money?

Time value of money is the concept that the value of money today is worth more than the value of the same lump sum in the future, assuming you put today’s money to good use. Three reasons make this principle credible.

1. Opportunity cost

Opportunity cost, also known as implicit cost, compares the value of money today to a future financial payment. In other words, the money you have today can be invested and grow in value over time.

On the other hand, if you wait for a future payment, that money won’t have the same time to accumulate interest as money you receive and invest today. Today’s cash provides instant purchasing power, so put that money to good use.

Related: How to make the most of every opportunity

2. Inflation

Inflation has been a hot topic lately. Inflation is the measure of the increase in the price index of personal consumption expenditures, which shows the cost of goods and services over a certain period.

With inflation being a real and present obstacle in a post-pandemic world, this factor is more important than ever.

The money you have today may not go as far in the future. Inflation can erode the purchasing power of your money over time, so the amount of money you have today is worth more than what it might be worth in the future.

For example, if you have ten dollars in your pocket today, you can see a movie in the theater. However, that same ten dollars in your pocket may not cover the cost of a ticket two years later.

So if you’re looking for a way to spend those ten bucks, you should go to the movies today.

In 2022, inflation rates reached 8.8%. And while economists expect that number to fall to 6.5% in 2023 and 4.1% in 2024, history shows a slowdown in the pace of deflation when rates exceed 8%, as they did in September 2022.

Additionally, if you plan to invest the amount of money you have today, inflation must be factored in to calculate your true return on investment (ROI). To calculate this factor, take the rate of return your money is earning and subtract the rate of inflation.

Related: Americans aren’t saving money right now — and it’s not just because of inflation

3. Uncertainty

The money you have in your hands now is worth more than the hypothetical money you might receive in the future. Until you have the money, it’s not yours. You can make investments or plans only with the money you have.

The uncertainty factor is a reminder that anything can happen, so sometimes, it’s better to plan for the future rather than plan for the future.

Related: 3 ways to overcome uncertainty about the future of your business

Time value of money

There are two critical factors in the equation that must be solved for the time value of money: the present value of money and the future value of money.

Future value is based on the idea that you will invest today’s amount of money. predicts how much a specified amount will be worth on a specified date. The present value formula calculates a future amount using a present amount.

The type of future value is:

  • FV = PV x [ 1 + (i / n) ] (next)

Variables included in TVM formulas include:

  • FV = Future value.
  • PV = Present value.
  • I = Interest or rate of return that can be earned.
  • n = Number of compounding periods per year.
  • t = Number of years.

Example of how to apply the future price formula manually

To give a simple example, let’s say a property you’ve been looking to sell has caught the interest of a buyer. The potential buyer offers you $20,000 to buy it today, but also offers to pay you $500 more if he can buy the same property in two years.

Although a higher payment sounds better, based on the principle of time value of money, $20,000 today is worth more than $20,500 in two years.

You decide to follow this principle and make today’s money work for you. You take the $20,000 the real estate buyer offered you today and deposit the lump sum into a savings account at 2% compounded annually.

To calculate how much money your investment can earn you, plug in the right variables and use the future value formula.

  • FV = 20,000x [ 1 + (.02 / 1) ] (1 x 2)
  • FV = 20,808

By this logic, the $20,000 the real estate buyer pays you today will be worth $20,808 in two years if you invest it according to plan.

However, if you take the two-year $20,500 offer, you’ll lose $308 in interest from your savings account. Again, just because the future offer sounds like more doesn’t mean it will end up being more.

Related: There’s a new way to tap into your home equity without loans or monthly payments

Example of how to implement the future value type from a data processor

If hand calculations aren’t your thing, you can also find future prices using tools like Microsoft Excel and Google Sheets.

To calculate through the data processor, use:

  • =PV(rate,nper,pmt,FV,type)

In this formula, the variables are:

  • Price: Equivalent to “i” in manual type — the interest or discount rate for the period.
  • Number: Equivalent to “t” in manual — the number of periods in which payment is made for a given cash flow.
  • Pmt or FV: Equivalent to “FV” in manual — the payment or cash flow to discount. It is not necessary to include values ​​for both pmt and FV.
  • Type: Time period to receive the payment — use one for the beginning of the period, use 0 for the end.

Time value of money and net present value

A closely related factor you may encounter as you calculate the time value of money and how it relates to investment opportunities is net present value. When you decide to invest, the hope is that you will receive an ROI.

Additionally, a solid ROI not only exceeds your investment amount, but can also make up for any potential losses due to TVM.

Net present value is an equation that predicts future investment growth in today’s dollars. Net present value calculates the time value of money and the declining value of future money to show the final value of your investment.

Related: What should you aim for in ROI? And Mistakes to Avoid

The eternal value of money and annuities

An annuity is a dollar amount that you can receive in a lump sum or in a fixed monthly amount. Annuity generally comes into play in real estate, retirement and pensions. A standard financial calculator can provide the answer to these formulas.

The formula for the annuity varies depending on whether you are trying to calculate:

  • Regular annuities: Payment was made at the end of the recurring period.
  • Annuities due: The payment was made at the beginning of the recurring period.
  • Perpetuity: Annuities that last indefinitely.

When it comes time to figure out how you’d like to handle annuities, the formulas work similarly to the time value of money formula to ensure you’re making the best financial decision.

Related: Annuity Options for Retirement Savings – No Fuss, No Jargon, No Gimmicks

What the time value of money can mean for you

Time value of money is an important concept as it can help you make future financial decisions. It can also help with calculations and estimates in other areas of finance, such as annuities.

As you continue to grow your investment portfolio, remember: Money in your hands today is worth more than the same lump sum in the future. Why; Opportunity cost, inflation and uncertainty.

For more on that budget and decision-making strategies in personal financesvisit Entrepreneur.com.

Leave a Comment