Superphysics
The Time Value of Money as an Effect of the Force of Capital
November 3, 2023 2 minutes • 298 words
Table of contents
The time value of money states that a dollar today is worth more than a dollar tomorrow. This is due to a few key reasons:
- Potential to Earn Interest
If you have money now, you can invest it and earn interest or returns. A dollar tomorrow misses out on this growth opportunity.
- Inflation
Over time, inflation reduces the purchasing power of money. A dollar today buys more than it will in the future due to rising prices.
- Risk
There’s always a chance you won’t receive the promised future sum of money due to unforeseen circumstances. Money in hand is more certain.
Practical Example
Imagine you have two options:
- Receive $100 today.
- Receive $105 in one year.
Even though $105 seems like more, the time value of money tells us that $100 is actually worth more today.
This is because you could invest the $100 and earn interest, making it worth more than $105 after a year.
In a year, due to inflation, $105 might not buy the same things $100 does today.
Key Formula
Time Value of Money calculations often rely on these concepts:
| Concept | Meaning |
|---|---|
| Present Value (PV) | The value of a sum of money today |
| Future Value (FV) | The value of money at a specific point in the future, considering potential growth |
| Interest Rate (r) | The rate of return you can earn on an investment |
| Time (t) | The number of periods (e.g., years) involved |
Time Value of Money is a cornerstone of finance. Understanding it is crucial for:
- Investment Decisions: Comparing potential investments to decide which ones will earn the most money over time.
- Retirement Planning: Calculating how much you need to save today to have enough money in the future.
- Loan Evaluations: Analyzing the true cost of borrowing money, considering the interest paid over time.
