The time value of money (TVM) assumes a dollar in the present is worth more than a dollar in the future because of variables such as inflation and interest rates. Inflation is the general increase in prices, which means that the value of money depreciates over time as a result of that change in the general level of prices. A dollar in the future will not be able to buy the same value of goods as it does today.
Changes in the price level are reflected in the interest rate. The interest rate is charged by financial institutions on loans (e.g., a mortgage or a car loan) to individuals or businesses and TVM is taken into account in setting the rate. Also, the interest rate is what individuals earn on their money by investing it, rather than letting it sit idle in cash, hence another reason why a dollar today will be worth more than a dollar in the future.
In fact, one dollar today is worth half as much (in terms of purchasing power) as the same dollar two decades ago and just one-third as much as three decades ago.
- The time value of money is a concept that states a dollar today is always worth more than a dollar tomorrow (or a year from now).
- One reason for this is the opportunity costs of holding cash instead of investing in higher-return projects. It also arises due to inflation.
- Because of time value, investments bear interest or are expected to appreciate in value. The value today can be estimated using discounted cash flows analysis.
Discounted Cash Flows
TVM is also described as discounted cash flow (DCF). DCF is a technique used to determine the present value of a certain amount of money when received at a future date. The interest rate is used as the discounting factor, which can be found by using a present value (PV) table.
A PV table shows discount factors from time 0 (i.e., the current day) onward. The later money is received, the less value it holds, and $1 today is worth more than $1 received at a date in the future. At time 0, the discount factor is 1, and as time goes by, the discount factor decreases. A present value calculator is used to obtain the value of $1 or any other sum of money over different time periods.
For example, if an individual has $100 and leaves it in cash rather than investing it, the value of that $100 declines. However, if the money is deposited in a savings account, the bank pays interest, which depending on the rate, could keep up with inflation. Therefore, it is best to deposit the money in a savings account or in an asset that appreciates in value over time. A PV calculator can be used to determine the amount of money required in relation to present versus future consumption.
It's also important to look at opportunity costs when considering TVM and the use of a dollar. For example, if you own a company and purchase a new piece of machinery that results in a return of 3% a year, but you could have put those same funds in an investment account and received a return of 5% a year, the opportunity cost is the 2% you forgo by purchasing the machinery.
The same theory can be applied if you make an investment returning X amount, but that amount is significantly lower than the high annual percentage rate (APR) on your credit card being incurred on debt that you have not paid off. The time value of money always involves an opportunity cost.
When inflation heats up, the Federal Reserve steps in and raises interest rates (specifically the federal funds rate), which makes the cost of borrowing more expensive and helps keep the purchasing power of the dollar up.
The Bottom Line
The time value of money is a simple truth that states that a dollar today is not the same value as a dollar at a future date due to the economic realities of inflation and interest rates. Investing money today and earning interest on it that outperforms the rate of inflation will ensure that your money today continues to be worth more than the same amount of money in the future.