Time value of money

The time value of money (English time value of money, TVM) is a central part of the financing and capital budgeting, and financial mathematics and is based on the return of the money. If today the bank leaves an amount of money, this amount will be paid back in one year, plus interest. If you only get the same amount but in a year, you have to waive the interest.

In simple terms means the time value of money so that the money we have today is worth more than the money we will have in the future: " A Euro today is better than a euro in a year. "

This preference is due primarily to the uncertainty about future payments that is created by default and inflation: the money we have today is safe while it is not sure that we get the money back in the future or how much we can buy with it.

Future Value of Money ( end value )

To find out how much 100 euros pa today in six years at an interest rate of 5% are worth, use the following formula:

Today's value of future income (present value)

To find out how much 100 euros are worth today in six years at an interest rate of 5 %, use the following formula:

This means that you would have to invest at the present time the amount of € 74.62 at an interest rate of 5 % in order to come to the age of 6 to 100 € final value ( end value ).

Investment Appraisal

In capital budgeting, the importance of this concept is particularly clear. In the static method, the fair value is completely ignored, which can make only incomplete statements about the value of an investment and lead to the so economically wrong decisions.

One can illustrate this relationship ( dynamic method ) using a simple example, comparing the payback method (static method ) and the net present value method. Suppose there are the following two projects to choose from, and they have the same risk and uniform, at the opportunity cost of capital ( discount rate ) of 10%:

Both projects have the same payback period, ie the capital invested in both investment at the same time the asset ( repaid ). So you are the same sense because it does not matter at what time and in what amount the repayments as long as the entire back flow occurs at the same time. However, if the time value of money involved ( the sooner the payment, the better) it is clear that Project B is more economic sense, since it has the higher net present value (present value of the discounted cash flows ). Project A is completely reject the view of the net present value method due to the negative value.

Application

The fair value as a universal concept for the evaluation of cash flows is the basis for all modern finance, including all public finances and the banking and insurance businesses. It finds application in the same commodity and securities trading as well as for simple interest calculation problems, the project cost accounting using the discounted cash flow method, and countless more.