The time value of money, or 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.
Changes in the price level are reflected in the interest rate. The interest rate is charged by financial institutions on loans (i.e., a mortgage or car loan) to individuals or businesses and TVM is taken into account in setting the rate.
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.
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