TL;DR
The Time Value of Money (TVM) is an important financial concept that recognises money’s changing value through time. Because of the possibility of growth and the influence of inflation on purchasing power, money obtained today is more valuable than money received tomorrow. Understanding TVM is critical for making sound financial decisions and assessing investment opportunities. A variety of equations can be used to express TVM mathematically.
Introduction
The Time Value of Money (TVM) is a fundamental concept in finance that recognises the idea that money’s worth changes over time. It is based on the principle that receiving money today is more valuable than receiving the same amount in the future due to its potential to earn interest, generate returns, or experience inflation. Conversely, money’s value decreases over time, meaning that a specific sum of money will have less purchasing power in the future than it does today.
The Time Value of Money is Introduced
The temporal value of money (TVM) is a financial/economic concept that states that obtaining a quantity of money now is preferable to receiving an identical amount later. This decision contains the concept of opportunity cost. By choosing to get the money later, you forego the opportunity to invest it or use it for another useful activity in the meantime.
Consider the example explain. You lent $1,000 to a friend a while ago, and they’ve contacted you to return it. They’re offering you $1,000 today if you pick it up, but they’re departing tomorrow on a year-long world tour. They would, however, reimburse the $1,000 in 12 months.
If you’re feeling very lazy, you can wait 12 months. However, because of the TVM, you should have it soon. You have 12 months to deposit it in a high-interest savings account. You could even benefit from it if you invest wisely. Inflation also means that your money will be worth less a year from now, so you will be paid less in actual terms.
What your friend would have to pay you in 12 months to make the wait worthwhile is an intriguing issue to investigate. To begin, your friend would have to at least cover your prospective earnings throughout the 12-month waiting period.
What Is the Difference Between Present and Future Value?
The TVM Formula neatly summarises this entire topic. But, before we get there, there are some more calculations to make: the present value of money and the future value of money.
The present value of money informs you of the current value of a future sum of money, discounted at the market rate. Using our example, you could be curious as to what $1,000 from a buddy is actually worth today.
The future fee is the inverse. It takes a sum of money now and calculates how much it will be worth in the future at a certain market rate. As a result, the future value of $1,000 in a year includes a year’s worth of interest.
How to Determine Future Value of Money
Money’s future value (FV) is easy to calculate. Returning to our earlier example, we’ll use the interest rate (2%) as a potential investment opportunity. The one-year future worth of the $1,000 you receive today would be:
FV = $1,000 * 1.02 = $1,020
Assume your friend has just informed you that their trip will last two years. The following is the future value of your $1,000:
FV = $1,000 * 1.02^2 = $1,040.40
It’s worth noting that we’ve assumed compounding interest in both of these scenarios. We can generalise our future value formula as follows:
FV = I * (1 + r)n
I denotes the initial investment, r is the interest rate, and n denotes the number of time periods.
It’s worth noting that we can also substitute I for the present value of money, which we’ll discuss later. So, why should we care about the future value? Well, it aids us in planning and determining what money invested today may be worth in the future. It also helps us with our prior scenario, when we need to decide whether to take some money now or later.
How to Determine the Present Value of Money
Calculating money’s present value (PV) is comparable to calculating its future value. All we’re doing is estimating what a sum in the future would be worth now. In order to accomplish this, we reverse the computation for future value.
Assume your friend informs you that after a year, they will give you $1,030 instead of $1,000. However, you must determine whether or not that is a decent deal. We may do this by computing the PV (assuming the same 2% interest rate).
PV = $1,030 / 1.02 = 1,009.80
Your friend is truly giving you a good deal here. The present value is $9.80 greater than what you would receive today from your friend. You’d be better off waiting a year in this scenario.
Consider the following general formula for determining PV:
PV = FV divided by (1 + r)n
As you can see, FV and PV may be rearranged to give us our TVM formula.
Compounding and Inflation’s Effects on the Time Value of Money
Our PV and FV formulas serve as excellent bases for studying TVM. We’ve already discussed compounding, so let’s go through it again and see how inflation can alter our numbers.
The effect of compounding
Over time, compounding has a snowball effect. What begins as a little sum of money can grow much larger than a sum with merely basic interest. We looked into compounding once a year in our previous model. However, you can compound more frequently than that, say once a quarter.
We may accomplish this by making minor changes to our model.
PV * (1 + r/t)n*t = FV
PV denotes Present Value, r denotes Interest Rate, and t denotes the number of compounding periods each year.
Let’s use our 2% annual compounded interest rate on $1,000.
FV = $1,000 * (1 + 0.02/1)^1*1 = $1,020
Of course, this is the same as what we calculated earlier. However, if you have the opportunity to compound your earnings four times a year, the outcome is higher.
FV = $1,000 * (1 + 0.02/4)^1*4 = $1020.15
A 15-cent gain may not appear to be significant, but with greater sums and over longer time periods, the difference can become significant.
The Effect of Inflation
We have not yet considered inflation in our calculations. What use is a 2% annual interest rate when inflation is 3%? In times of strong inflation, it may be preferable to enter the inflation rate rather than the market interest rate. Wage discussions are one common example of this.
Inflation, on the other hand, is much more difficult to quantify. For starters, there are various indices available that calculate the increase in the price of products and services. They frequently produce varying figures. Inflation, unlike market interest rates, is similarly difficult to forecast.
In short, we don’t have much control over inflation. We can incorporate a discounting factor for inflation into our model, but as previously said, inflation can be highly unpredictable in the future.
How Does the Time Value of Money Affect Cryptocurrency?
There are numerous possibilities in cryptocurrency where you can select between a sum of cryptocurrency now and a different quantity afterwards. Staking with a lock is one example. You may have to choose between keeping your one ether (ETH) now and locking it and receiving it back in six months with a 2% interest rate. You might locate another staking opportunity with a higher return. Some easy TVM calculations can assist you in locating the optimum product.
In a broader sense, you may be wondering when you should buy Bitcoin (BTC). Although Bitcoin is generally referred to as a deflationary currency, its supply increases gradually until a certain point. This implies that it currently has an inflationary supply. Should you buy $50 in Bitcoin today or wait until your next salary and buy $50 next month? TVM would prefer the former, but the reality is more complicated due to the shifting price of BTC.
Final Thoughts
Although we’ve officially defined TVM, you’ve probably been using the term intuitively already. Interest rates, yields, and inflation are all prominent economic concepts in our daily lives. Large corporations, investors, and lenders will greatly benefit from the formalised versions we worked on today. Even a fraction of a percent can make a significant difference in their profitability and bottom line. As crypto investors, we believe it is still a concept worth considering when selecting how and where to invest your money for the highest results.