The Concept of Time Value of Money (TVM)
The time value of money (TVM) states that money available now is worth more than the same amount in the future due to its potential to earn interest. This core finance principle underlies calculations of investment value, loans, bonds pricing, and retirement planning. Understanding TVM helps individuals and businesses make informed financial decisions by weighing opportunity costs and timing of receiving or spending money.
How TVM is Utilized in Financial Calculations
TVM calculations are based on: the present vs future money amounts, the number of payment periods, whether compounding periods are annual/semi-annual/quarterly/monthly, and assumptions about interest/discount rates. By inputting these variables into standard TVM formulas, the "present value" and "future value" of monetary amounts can be estimated and compared.
Importance of TVM in Financial Decision Making
Overall, recognizing that a dollar today is worth more than a dollar tomorrow is key to saving, investing, retirement planning and other personal and business financial decisions. Evaluating tradeoffs around timing and earnings potential is fundamental to maximizing the usefulness of money over both the short and long term. Risk and uncertainty also underlie TVM calculations. An amount to be paid now holds less risk than the same amount promised to be paid years later.