Time value of money(TVM) is one of the most important part of financial management. To understand this concept, let’s take an example..suppose that your client who owes you 1000$ gives you an option that either he can pay you this money today or after 3 months. Obviously you would be more interested in getting this amount today because an amount of cash available today is more valuable than the same amount of money available in future. But why so..?
The reason is simple… money earns interest over time, so it has the potential to grow over time. So, if you get 1000$ today and invest it somewhere or deposit it in a bank, you would get more than 1000$ after 3 months. Because the amount invested earned you interest. Hence the money that you have today is worth more than the same amount of money that you will receive in future.
For example, you have 1500$ in hand today. You deposited it in a bank for 6 months,which gives you interest at 3% p.a. So after 6 months, along with the original amount you would get interest also which is calculated as under:
So the amount you get back after 6 month is 1522.5$.
The concept of time value of money helps us to determine the amount of money we need to invest today given the amount of money that we want to receive in future. It also helps us to know the future value of the money that we have today. with a good knowledge of TV, we can compare various investment options available and choose the most profitable one. It can help us solve problems related to finance, savings, loans, mortgages, instalments, annuities etc.