What concept states that an amount of money or cash in the present day is worth more than receiving the amount in the future?

Income based valuation relies heavily on a concept called the time value of money.

In previous courses we've touched on this topic, but in this lesson, I'm going to explain the time value of money in a lot more detail.

The time value of money concept simply states that money available at the present time is worth more than the same amount in future due to its potential earning capacity.

So in effect, any amount of money is worth more the sooner it is received.

To illustrate this point more clearly, let's say I have $10,000 and I want to lodge it in a savings account with an interest rate of 3%.

The US Government guarantees this investment, so in effect it’s risk free.

Next year, my $10,000 will be worth $10,300, and not the original amount, so my money today is worth more than the equivalent amount in a year's time.

The equation that governs this investment is $10,000 multiplied by one plus the interest rate is equal to $10,300.

If I now divide both sides by 1 plus R, I'll get an equation for present value.

$10,000 is my present value, $10,300 is my future value, and R is called the discount rate.

This equation allows me to convert future cash flows into their present day value.

It’s called discounting and is the fundamental basis for income based valuation.

Now let's take another example of a $12,000 payment I am due to receive in two years.

I'd like to know how much this is worth in the present day.

For payments two years away, we simply discount twice.

So our equation this time round will be our answer is equal to $12,000, which is our future value, multiplied by one, divided by one plus R, all to be squared, because the payment is two years away.

To find the correct answer, we must just decide on a discount rate.

If I’m guaranteed this money in two years, then 3% or the risk free rate, seems like a reasonable value for R.

So if I put this into the equation, I'll see that in today's money, my future payment is worth $11,311, but how should I account for this payment if it’s a lot riskier and it's not quite guaranteed? Well, a safe dollar is worth more than a risky dollar, so in our equation we'll either have to increase the discount rate or decrease the future value.

I don't want to change the future value, because that's still the same, so to account for riskiness we'll increase the discount rate.

So if I recalculate our present value for a 15% discount rate, you'll see that we now have a much lower present value of $9,074.

And this is how the time value of money accounts for risk.

If we have a future payment that's quite risky, we simply increase the discount rate, which will lower the present day value of this future payment.

The examples we’ve taken so far are for single payments that are going to be received in the future.

However, most investment projects involve multiple future payments.

In the next lesson, we'll build a model in Excel that will calculate the present value of 10 future cash flows for a wind farm that’s for sale, and still has 10 years of operating life remaining.

The time value of money concept is the basis of discounted cash flow analysis in finance. The discounted cash flow allows for the accumulation of expected interest earned on a sum.

Discounting cash flow is one of the core principles of small business financing operations. It has to do with interest rates, compound interest, and the concepts of time and risk with regard to money and cash flows.

Key Takeaways

• The time value of money is the concept that money you have in hand today is worth more than money you'd get in the future.
• There are four main types of cash flows related to time value of money:Future value of a lump sum, future value of an annuity, present value of a lump sum, and present value of an annuity.
• Tables, financial calculators, and spreadsheets are good tools for calculating time value of money.

Underlying Principle of Time Value of Money

The underlying principle is that the value of $1 that you have in your hand today is greater than a dollar you will receive in the future. Conversely, the time value of money (TVM) also includes the concepts of future value and present value.

For example, if you have money in your hand today, you can save it and earn interest on it, or you can spend it now. If you don't get it until some point in the future, you lose the interest you could earn, and you can't spend it now.

When calculating the future value of money locked up in an investment, you must have a way to consider both the potential compound interest you could get by holding the investment and the risk of losing value over time to inflation or to a failed investment due to market conditions.

Using Time Value of Money in Small Business Finance

Time value of money formulas is used to calculate the future value of a sum of money, such as money in a savings account, money market fund, or certificate of deposit. It is used to calculate the present value of both a lump sum of money or a stream of cash flows that you'll receive over time.

If cash flows are scheduled to be received in the future from a company's investment, such as an investment in a building or piece of equipment, time value of money is used to calculate the present value (the value now) of those cash flows.

Types of Cash Flows for TVM Calculations

There are four major types of cash flows for TVM calculations:

• Future value of a lump sum
• Future value of an annuity
• Present value of a lump sum
• Present value of an annuity
  

Note

Calculating the time value of money will include the use of discounted cash flows.

Future Value of a Lump Sum

The calculation for the future value of a lump sum is used when a business wants to calculate how much money it will have at some point in the future if it makes one deposit with no future deposits or withdrawals, given an interest rate and a certain period of time. Calculating future value is also called "compounding."

Future Value of an Annuity

The calculation for the future value of an annuity is used when a business wants to calculate how much money it will have at some point in the future if it makes equal, consecutive deposits over a period of time, given an interest rate and a certain period of time.

Present Value of a Lump Sum

The calculation for the present value of a lump sum is used when a business wants to calculate how much money it should pay for an investment today if it will generate a certain lump sum cash flow in the future, given an interest rate and a certain period of time. Calculating the present value is also called discounting.

Present Value of an Annuity

The calculation for the present value of an annuity is used when a business wants to calculate how much money it should pay for an investment today if it will generate a stream of equal, consecutive payments for a certain time period in the future, given an interest rate and a certain period of time.

Ways to Calculate TVM

Each TVM calculation has a formula that you use to find the time value of money. The more complicated the calculation gets, the more unwieldy the formula gets.

Time Value of Money Factor Tables

Using TVM tables will basically give a method for using financial calculators and spreadsheet programs. Certain professional exams and some college professors still rely on the time value of money tables. The tables are a series of multipliers that are derived from the appropriate time value of money formula to make time value of money calculations easier.

Financial Calculators

Financial calculators were designed specifically for TVM calculations. There are five keys that you will need for these calculations.

• The N key is used for the number of time periods.
• The I/Y% key is used for interest rate per period.
• The PV key is used to enter present value which must be entered as a negative number only by using the +/- key.
• The PMT key is used in an annuity problem if you have a series of equal, consecutive payments. Otherwise, it is 0.
• The FV key is the future-value variable you are solving for which will, of course, change based on your inputs for the other variables.

Spreadsheet

Spreadsheet apps like Microsoft Excel and Google Sheets are ideal for the time value of money calculations as well as most other financial calculations.

Other Methods

There are many types of time value of money calculations that small businesses use in their financing operations. Some of them include solving for the interest rate, solving for the number of years, solving for the present value of ordinary annuities and annuities due, solving for the future value of ordinary annuities and annuities due, solving for annuity payments, and solving for the present value of irregular cash flow streams.

Also, companies apply these concepts as a component of other financial procedures like calculating net present value, profitability index, internal rate of return, and other capital budgeting procedures that make a small business successful.

Frequently Asked Questions (FAQs)

What is time value of money?

Time value of money is a principle that states money you have now is worth more than the money you get in the future. For example, you can invest money you have now and, in theory, earn a return over time.

How do you calculate the time value of money?

You can calculate the time value of money by identifying the cash flow you want to analyze, then using a spreadsheet or financial calculator equation that takes into account time period, interest during that time period, present value or annuity payments, and future value.

What do you call a concept that states an amount of money today is worth more than that same amount in the future?

What is the concept of time value of money?

What is the present value of money concept?

Why present money is worth more than in the future?