Time Value of Money

Financial Dictionary -> Investing -> Time Value of Money

Imagine that a carton of Oregon Strawberry costs $10, and you invest $5 in a company that makes the produce. The investment yields and you capitalize this amount in a year. Then, you buy a $10 carton of ice cream and your $5 investment has the same time value of money as the $10 of the future. This explanation was given by Martin de Azpilcueta of the School of Salamanka, who never tasted the Oregon Strawberry. However, Martin is the person who coined the idea of the time value of money. If he was still alive at present, he might have invested his $5 wisely. He may have predicted the huge success of Microsoft, Google, or other large companies, investing in their establishment. Such decision would definitely buy much more than an ice cream. (He might have purchased an island of ice-cream. The latter statement does not advocate the purchase of Iceland, iceberg, iced island or ice cream producing entity, unless the investor feels a compelling necessity to do so).

Generally speaking, the idea of the time value of money is that the value of the funds available at present exceeds the future value of the same sum. This fact is attributable to the potential earning capacity of money because they can earn interest for the investor. Any amount of money is worth more if it is received as early as possible.

Let us now consider the future value of your $5, or "how to buy an island made of ice cream". You decide to invest a five dollar banknote at a simple annual rate of 5 per cent. Then, the future value of your money at the end of the first year will be established if you multiply the principal amount of $5 by the interest rate of 5%, and then add the estimated interest to the principal amount (= $5.25/end for the 1st year) . For any number of years, you may calculate the future value of the expected amount by the following formula: the initial amount is multiplied by the exponent on the number of years intended for investment, including the annual interest rate. To put it shortly, the Future Value of an Annuity (FVA) represents the future value of payments (the annuity), if we assume that the payments will be invested at a certain interest rate. Besides FVA, some additional calculations relate to the estimation of the time value of money, such as the present value, the present value of an annuity, and the present value of perpetuity.