Definition of Time Value of Money

Money certainly has value; but the value of money today is not the same as the value for tomorrow. This year you may have $10,000, but next year the same money will have less value. This difference is not due to the passage of time per se, but the changing economic situations with time. The difference in the value of money between the present and the future is referred to as the time value of money (TVM).

The time value of money is a concept in financial management which suggests that money in the present is worth more than the same amount of money in the future. This concept is based on the fact that money today can be invested to earn more returns in the future.

Assume that someone wants to give you $120,000 today or spread it over the next 12 months with payments of $10,000 per month. Which option do you take? Based on the time value of money, the $120,000 today is better because you can invest in it to generate more income. Furthermore, if you spend the money today, you buy more items than you can buy with the same money next year because items will become more expensive over time.

The concept of time value of money is important to learn because it helps a person to decide what they can do with their money. You can decide which job pays better by looking at time value of money and the frequency of the payments they make. Time value of money is also used to choose investment options among various alternatives. Once an individual invests their money in an asset, their investment grows over time. Whether you choose a savings account, bond, or mutual funds, the money will grow through compounded interest earned. However, money that is kept without any investment will lose value. Thus, it makes little sense to keep your money in cash because it will lose value in the future.

Inflation erodes the value of money, and reduces the purchasing power of a consumer. If someone keeps money in cash, they may not be able to buy enough goods when inflation hits the economy. For instance, if you had $10,000 to buy fuel last year when the prices were $100 per litre, you could buy 100 litres of fuel at the time. If the price rises to $200 this year, you can only be able to buy 50 litres of fuel this year.

Inflation and purchasing power must be factored in when you invest money because to calculate your real return on an investment, you must subtract the rate of inflation from whatever percentage return you earn on your money.

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