As a business owner, you have to be familiar with the term “Time Value of Money“. If there is an inflation in an economy, which means banks are paying certain rate of interest for your cash, and money is losing its value along the time, then we start talking about the time value of money.
Time value of money results from the concept of interest. So if the interest rate is 0% (no interest), the money will keep its same value along the time.
Let’s start with a simple example. I have $100.00 bill in my hand, and what will be the value of this $100.00 bill next year same time? You may say, it will be $100.00 , it is a piece of paper. But it doesn’t work this way in real life. I can go to the nearest bank, and maybe get 10% interest for keeping this $100.00 in a saving account for one year. So next year this time, I can go to the bank, and get $110.00 cash back. Therefore within 10% interest rate environment, my $100.00 cash has earned a total of $10.00 within 1 year, and now I have $110.00 instead of $100.00.
This simple example clearly explains the time value of money. In business life, we deal with cash every day. We have to be very familiar with the time value of money. Otherwise we may, as managers, make wrong decisions, and as a result, our companies may lose money.
Time Value of Money Main Formula
FV= PV (1 + i )^n
FV = Future Value
PV = Present Value
i = the interest rate per period
n= the number of compounding periods
Example: What is the future value of $50 in 3 years if the interest rate is 5%?
FV= PV ( 1 + i ) ^3
FV= $ 50 ( 1+ .05 )^3
FV= $ 50 (1.157625)
The time value of money serves as the foundation for all other notions in finance. So before starting advanced finance topics, it’s for best to study time value of money, simple interest, compound interest, present and future value of money and annuities.
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