Importance of Time Value of Money

Time Value of Money (TVM) is an important concept in finance because it provides the foundation for investment and consumption decisions. It is helpful in various aspects of finance, from negotiating a salary, making purchase decisions, to choosing an investment project. TVM enables individuals and organizations to evaluate various investment options and make the best financial decisions. This concept helps us understand the difference between the present value and future value of our money. Time value of money is important in the following ways:

Compounding Interest: TVM is used to calculate the present value of interest earned on an investment as well as on the interest itself. Compounding interest occurs when an investment or savings earn interest, and then the same interest earns more interest in subsequent years. In this regard, an investment can earn interest on the principal amount and all interest from previous years. Interest on interest has a compounding effect on money. For example, if you have $100 and save it in an interest earning account with 10% interest, you get $110 in the second year. For the third year, your interest will be 10% of KES 110 instead of KES100, which includes the interest of the previous year.

Financial Management: The concept of present value of money is important when making decisions in financial management because managers need to understand the present value of the benefits of a particular decision and compare them with the opportunity costs of other alternative decisions.

Capital Budgeting: A company can decide to put their funds in a particular investment that earns interest, but they must consider the opportunity costs of foregoing other investment options. It is important to choose an investment that earns higher net present value from future expected cash flows.

Personal Finance Decisions: Another importance of time value of money is that it helps individuals to make informed personal finance decisions. Individuals can use their knowledge in TVM to make financial decisions and achieve their financial goals. An individual can also use TVM to evaluate two or more investment options. For example, a company may provide interest on savings such that if you deposit $8,000 today, you will get 8,800 after one year. This investment option looks good because you get $800 on top of what you saved. However, you need the time value of money concept to help you decide whether this savings option is really good for you. If the present value of the future amount you expect is less than the current amount you have, then that investment is not worth it.

Investing and Inflation: The TVM concept is important for making investment decisions. When deciding to invest, one needs to consider several factors including opportunity cost, risk, and inflation. Prices of goods rise over time due to inflation, so the amount of money one has today is worth much more than the same amount in the future. Therefore, it is important to invest money owned now instead of letting them stay idle in the bank. But then, investors must consider alternative investment options that give more returns.

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