The time value of money is the idea that a dollar today is worth more than a dollar tomorrow.
Understanding the Time Value of Money
The concept of the time value of money comes from the notion that a rational investor would rather have a dollar now than in the future. Any dollar collected now could be invested, and the value would be that dollar plus any amount that could be added to it by investing until the future period. As an example, if somebody offered you $100 today or $100 in a year and you could get 5% interest on your savings account at the local bank that $100 today is worth $105 to you in 12 months. In this case, your opportunity cost of accepting $100 in the future would be $5 as you could have made $5 by collecting the $100 now and investing for 12 months.
Another reason that money is typically worth more in future is inflation. Inflation refers to the increase in the cost of living as the price of goods and services rise. You can learn more about inflation HERE, but for the purposes of this discussion, all you need to know is that inflation dictates that as the price of goods and services increase the value of your dollar decreases.
How Do I Calculate the Time Value of Money?
Generally speaking, the time value of money can be calculated using the following formula:
FV = PV x [ 1 + (i / n) ] (n x t)
- FV = Future value of money
- PV = Present value of money
- i = interest rate
- n = number of compounding periods per year
- t = number of years
After reading how inflation decreases the value of your money you may ask why we don’t just spend all of our money now, it’s worth more. Although you are correct, through investing, it is possible to achieve a return higher than that lost by inflation. Meaning the theory supports investing earlier to generate the best possible returns. The time value of money can also help us determine how much something is worth and what we should be willing to pay for it now or in the future.