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Understanding the Time Value of Money

By: Elite Legacy Education, August 29, 2017

You may not like what we’re about to say, but did you know that the value of your savings can decline year over year if you’re not generating a return from it? Yes, you heard that right. This is true when the level of inflation is greater than the interest rates, dividends or capital gains you’re earning on your investments. Essentially, your money is devaluing each year when this condition holds true. So pay attention if you want to better manage your money starting with a simple concept known as the time value of money (TVM).

 

What does the time value of money refer to?

 

The time value of money (TVM) concept refers to the idea that your money is worth more today than it is at some point in the future. Specifically, it has greater purchasing power now than it ever will. There are two reasons for this – interest and inflation.

 

Interest rates are a contributing factor since money held today can be invested. Once invested it will earn a specified rate of return, in other words the going interest rate. When you compare this to the same amount of money received at some point in the future, you miss out on significant earnings. All of those years between that future date and today are lost periods of compounding interest.

 

Inflation rates, on the other hand, are a similar story. In general, inflation rises in the long run. With inflation comes less purchasing power per dollar. It then makes sense that a dollar held today has more purchasing power than that same dollar at some point in the future. Based on the nature of interest and inflation rates, it is far better to have money today compared to some future cash flow of an equivalent amount.

 

Why is TVM an important concept to understand?

 

It’s important to understand the concept of TVM for many reasons. Take a moment to think about it. When would it be useful to know that a dollar today is worth more than at some point in the future? Well, how about when it comes to your personal savings account? You will likely want to know how much your savings are going to be worth so you don’t overestimate your future purchasing power. Also, consider investment scenarios where you expect to receive a cash flow at some point in the future. If you account for these cash flows in terms of today’s purchasing power, you will be overestimating the purchasing power of this cash flow. These are just two examples that demonstrate the relevance of TVM.

 

When do you apply TVM to a financial calculation?

 

There are three criteria that must be met in order for it to make sense to use TVM in a financial calculation. These include:

  1. Comparison between two separate time periods. Typically, this involves a calculation between today and some point in the future. It could also be two distinct points in the future. Essentially this is required so you can find the difference between the two time periods. Generally, you will want this difference to be greater than a year, unless you are dealing with a situation of hyperinflation. Anything less than a year doesn’t need to be discounted.
  2. Present and future cash flows involved. Similar to the requirement of two time periods, you must be looking to compare the value of a cash flow between two time periods. These should correspond to the two time periods selected above.
  3. Existence of interest and inflation rates. As long as these rates do not equal zero, you will always want to apply the TVM concept.

 

How to apply the TVM concept.

 

There are two main formulas involving TVM, which deal with the present value of a cash flow, as well as the future value of cash flow.

 

  • Present Value: Used to determine the value of a present cash flow at some point in future. This formula considers the relevant interest and inflation rates to determine how much a specified cash balance will grow to in a certain number of years.

 

FORMULA: PV = FV / (1 + interest rate) ^ number of time periods

 

  • Future Value: Used to determine the value of a future cash flow in terms of today’s dollars. This formula translates a future cash balance into an amount equal to its purchasing power expressed in today’s dollars.

 

FORMULA: FV = PV * (1 + interest rate) ^ number of time periods 

 

Now you have no excuse for your savings accounts to be decreasing, rather than increasing. Be sure to learn about all the ways Elite Legacy Education can help you reach your goals.

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