The time value of money refers to the idea that there is generally a greater benefit to receiving a sum of money now rather than an identical sum later. It may be seen as an implication of the later developed concept of time preference.
The time value of money refers to the observation that it is better to receive money sooner than later. Money you have today can be invested to earn a positive rate of return, producing more money tomorrow. Therefore, a dollar today is worth more than a dollar in the future.
The time value of money is among the factors considered when weighing the opportunity costs of spending rather than saving or investing money. As such, it is among the reasons why interest is paid or earned: interest, whether it is on a bank deposit or debt, compensates the depositor or lender for the loss of their use of their money. Investors are willing to forgo spending their money now only if they expect a favorable net return on their investment in the future, such that the increased value to be available later is sufficiently high to offset both the preference to spending money now and inflation (if present); see required rate of return.
Overview The time value of money compares cash flows that occur at different dates by converting them to a single valuation date (often called “time 0”). In a simple discrete-time model, time is measured in equal-length periods and a constant effective interest rate is applied once per period.
If an amount is invested at time 0, its value after periods (the future value) is
Discounting reverses this relationship, such that the present value of a sure amount due at time is
The factor is the accumulation factor over periods, and is the corresponding discount factor.
For a sequence of dated cash flows (positive for receipts and negative for payments), present value is the discounted sum of each cash flow:
This discounted-sum form underlies net present value calculations used in valuation and capital budgeting.
Nominal and real analyses must be kept consistent. Nominal cash flows are discounted at nominal rates, while real cash flows (with general inflation removed) are discounted at real rates; mixing conventions changes results mechanically even when the underlying economics is unchanged.
History Charging or paying interest, compounding balances over time, and comparing payments at different dates long predate the modern terminology. Historical accounts of actuarial practice describe the use of compound interest in business transactions from the Middle Ages onwards, with systematic mathematical treatments of life-contingent payments developing later alongside probability theory and mortality data.
The pricing of annuities and other long-dated contracts was an important context for the development of formal present-value techniques. Modern historical work on financial economics traces key advances to the valuation of life annuities using discounted expected value methods and relates these developments to the emergence of life tables and to computational methods for discounting contingent cash flows.
Poitras discusses seventeenth-century contributions associated with Johan de Witt and Edmond Halley, and Lewin notes them in an actuarial history context: de Witt's correspondence with Jan Hudde (1671) addressed valuation of life annuities, and Halley's 1693 work showed how a life table could be applied to annuity pricing using empirical mortality data.
Early economic thought about lending, usury, and the purchasing power of money forms part of the background for later theories of discounting and interest. In the sixteenth and early seventeenth centuries, scholars associated with the University of Salamanca discussed the changing purchasing power of money and the moral and legal status of credit within a scholastic tradition that addressed monetary and commercial questions alongside theology and law.
Some modern accounts read Martín de Azpilcueta's discussions of money and exchange as anticipating elements of later interest theory, but specialist scholarship cautions against treating his work as an early statement of modern time-preference theory and notes that he continued to condemn usury in general.
In economics, Irving Fisher’s The Theory of Interest (1930) formalised an account of intertemporal valuation that links interest to impatience (time preference) and investment opportunities and influenced later treatments of discounting and present value in economic analysis and finance.
Calculations Time value of money problems involve the net value of cash flows at different points in time.
In a typical case, the variables might be: a balance (the real or nominal value of a debt or a financial asset in terms of monetary units), a periodic rate of interest, the number of periods, and a series of cash flows. (In the case of a debt, cash flows are payments against principal and interest; in the case of a financial asset, these are contributions to or withdrawals from the balance.) More generally, the cash flows may not be periodic but may be specified individually. Any of these variables may be the independent variable (the sought-for answer) in a given problem. For example, one may know that: the interest is 0.5% per period (per month, say); the number of periods is 60 (months); the initial balance (of the debt, in this case) is 25,000 units; and the final balance is 0 units. The unknown variable may be the monthly payment that the borrower must pay.
For example, £100 invested for one year, earning 5% interest, will be worth £105 after one year; therefore, £100 paid now and £105 paid exactly one year later both have the same value to a recipient who expects 5% interest assuming that inflation would be zero percent. That is, £100 invested for one year at 5% interest has a future value of £105 under the assumption that inflation would be zero percent.
This principle allows for the valuation of a likely stream of income in the future, in such a way that annual incomes are discounted and then added together, thus providing a lump-sum "present value" of the entire income stream; all of the standard calculations for time value of money derive from the most basic algebraic expression for the present value of a future sum, "discounted" to the present by an amount equal to the time value of money. For example, the future value sum to be received in one year is discounted at the rate of interest to give the present value sum
Some standard calculations based on the time value of money are:
Present value: The current worth of a future sum of money or stream of cash flows, given a specified rate of return. Future cash flows are "discounted" at the discount rate; the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to valuing future cash flows properly, whether they be earnings or obligations. Present value of an annuity: An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period for an annuity due. Present value of a perpetuity is an infinite and constant stream of identical cash flows.
Future value: The value of an asset or cash at a specified date in the future, based on the value of that asset in the present. Future value of an annuity (FVA): The future value of a stream of payments (annuity), assuming the payments are invested at a given rate of interest.
There are several basic equations that represent the equalities listed above. The solutions may be found using (in most cases) the formulas, a financial calculator, or a spreadsheet. The formulas are programmed into most financial calculators and several spreadsheet functions (such as PV, FV, RATE, NPER, and PMT).Hovey, M. (2005). Spreadsheet Modelling for Finance. Frenchs Forest, N.S.W.: Pearson Education Australia.
For any of the equations below, the formula may also be rearranged to determine one of the other unknowns. In the case of the standard annuity formula, there is no closed-form algebraic solution for the interest rate (although financial calculators and spreadsheet programs can readily determine solutions through rapid trial and error algorithms).
These equations are frequently combined for particular uses. For example, bonds can be readily priced using these equations. A typical coupon bond is composed of two types of payments: a stream of coupon payments similar to an annuity, and a lump-sum return of capital at the end of the bond's maturity—that is, a future payment. The two formulas can be combined to determine the present value of the bond.
An important note is that the interest rate i is the interest rate for the relevant period. For an annuity that makes one payment per year, i will be the annual interest rate. For an income or payment stream with a different payment schedule, the interest rate must be converted into the relevant periodic interest rate. For example, a monthly rate for a mortgage with monthly payments requires that the interest rate be divided by 12 (see the example below). See compound interest for details on converting between different periodic interest rates.
The rate of return in the calculations can be either the variable solved for, or a predefined variable that measures a discount rate, interest, inflation, rate of return, cost of equity, cost of debt or any number of other analogous concepts. The choice of the appropriate rate is critical to the exercise, and the use of an incorrect discount rate will make the results meaningless.
For calculations involving annuities, it must be decided whether the payments are made at the end of each period (known as an ordinary annuity), or at the beginning of each period (known as an annuity due). When using a financial calculator or a spreadsheet, it can usually be set for either calculation. The following formulas are for an ordinary annuity. For the answer to the present value of an annuity due, the PV of an ordinary annuity can be multiplied by (1 + i).
Formula The following formula use these common variables: PV is the value at time zero (present value) FV is the value at time n (future value) A is the value of the individual payments in each compounding period n is the number of periods (not necessarily an integer) i is the interest rate at which the amount compounds each period g is the growing rate of payments over each time period
Future value of a present sum The future value (FV) formula is similar and uses the same variables.
Present value of a future sum The present value formula is the core formula for the time value of money; each of the other formulas is derived from this formula. For example, the annuity formula is the sum of a series of present value calculations.
The present value (PV) formula has four variables, each of which can be solved for by numerical methods:
The cumulative present value of future cash flows can be calculated by summing the contributions of FVt, the value of cash flow at time t:
Note that this series can be summed for a given value of n, or when n is ∞.http://mathworld.wolfram.com/GeometricSeries.html Geometric Series This is a very general formula, which leads to several important special cases given below.
Present value of an annuity for n payment periods In this case the cash flow values remain the same throughout the n periods. The present value of an annuity (PVA) formula has four variables, each of which can be solved for by numerical methods:
To get the PV of an annuity due, multiply the above equation by (1 + i).
Present value of a growing annuity