Question

What is the concept of the time value of money and how is this concept used in an everyday context. Please provide an example to enhance the discussion.

Course：Business Finance

use your own words to answer

Answer 1

Time value of money

The value of money today will worth more than the given same amount of money tomorrow. Money keep depreciating as it is a fiat in nature, it means government can control supply of money.

Money quantity doesn’t remain finite for long period it is created to ease the transaction between two parties having different goods and services. Barter needs exact match for exchange but in case of money we don’t require exact match.

Time value of money can be understood better with three basic concepts of time, interest rate and value.

1)      Time - The time is important factor to understand the depreciation of money. The value of commodity keeps rising and the value of money keeps depreciating. The price ($100) of 1 bag of rice today cannot be purchased with same amount ($100) after 5 years. This is because the value of money will fall in terms of rice. Rice is limited in supply and money supply can be in abundance.

2)      Interest rate: Interest rate is applied to money. Interest rate offered by banks is to cater the inflation or rise in price of goods, product and services which an investor desire to buy in future. Interest rate is applied to investment and it can be annual, quarterly, monthly compounding depending on offer. Keeping money ideal will decay the value of money hence interest rate brings appreciation in future for investment done today.

3)      Value: The value of money always relative in nature. If we see value of money in comparison of gold in last 4 years we will not find the much appreciation in gold value. The value of gold remained stagnant in last 4 years but when we will compare the price value of money against Bitcoin the cryptocurrency then the value of money seems to be highly depreciated in last 4 years. Hence, the value of money is relative and we should see value of money at overall level.

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Few more concept which can be used to calculate time value of money:

Future value of money means money today growing at some rate (interest rate)

Future value = Present value x (1+Rate)^Years

Present value of future cash flow means money worth today at some discounting rate.

Present value = Future value / (1+Rate)^Years