Time Value of Money: Meaning, Benefits, Concept, Formula, Examples, and When to Use
With IDR 200 thousand in the past you could shop for more goods than now. This situation is an example of the time value of money.
This situation occurs because the value of the money you have now may change or even decrease in the future. One way to overcome these changes is with long-term investment.
Therefore, in this article you must learn in full about the time value of money from various concepts to calculation formulas.
Understanding Time Value of Money
Time value of money is a financial concept where the current value of money may decrease in the future. This reduction in value is caused by time, fluctuations in bank interest, and inflation.
Investopedia illustrates this concept with the following case example. If you are offered IDR 5 million now or in two years, it would be better to accept the money now.
Even though the amount of Rp. 5 million will not change in the next two years, the value and goods it can buy will decrease. This is caused by the factors mentioned above.
Therefore, by receiving IDR 5 million now, you can increase its value by investing. That way, you will receive additional money from the investment.
Benefits of Time Value of Money
Maybe you think that time value of money is a bad thing, but that's not always the case. Here are some ways to take advantage of this:
- Become a guide for determining the investment amount.
- Knowing when you should use money and for what.
- Knowing what investment instruments will be profitable in the future.
- Helping you choose the right savings product, for example deposits.
- Take into account the money you will have in the future with a financial plan.
- Regarding business, you can calculate production and innovation budgets.
- Calculate your profit opportunities in the future.
Time Value of Money concept
Summarized from MasterClass, based on changes in time and ways of looking at the value of money, there are three concepts of time value of money, namely:
Present value
Present value is the amount of money you need to invest now to get a certain profit in the future. Briefly the current value of money. This amount also serves as a benchmark for the amount of interest you will receive after investing.
Future value
Future value is a prediction of the amount of profit you will get based on a certain interest rate and duration. Briefly the future value of money. For example, based on present value, you invest IDR 100 million. By calculating high interest rates, you will get greater profits/future value.
Annuities
An annuity is additional income that you receive consistently over a certain period of time. For example, if you own a boarding house business, every month you will receive an annuity in the form of rent.
Time Value of Money Formula and Examples
To calculate the time value of money, you can calculate it based on each concept. Beforehand, you must understand the following terms:
- FV = future value/future value of money
- PV = present value/current value of money
- r = interest rate
- n = time period
After understanding the terms, here are the formulas and examples of calculations, citing BankRate:
Present value (PV) calculation formula and example
The present value formula is PV = FV / (1 + r)ⁿ.
Example of PV calculation: You have a savings target of IDR 25,000,000 within 3 years. You decide to create a deposit account with an interest rate of 10% annually. Based on the formula above, the calculation is:
PV = 25,000,000 / (1 + 10%)3
PV = 25,000,000 / 1.331
PV or money you have to prepare now = IDR 18,782,870
Formula and examples of future value (FV) calculations
The formula is FV = PV x (1 + r)ⁿ.
Example of calculating future value: if you save a deposit in a bank of IDR 15,000,000 with an interest rate of 10% annually. You have a plan to keep it for 3 years.
First year FV: 15,000,000 x (1+0.10) = 15,000,000 x 1.10 = IDR 16,500,000
Second year FV: 16,500,000 x 1.10 = Rp. 18,150,000
Third year FV: 18,150,000 x 1.10 = IDR 19,965,000
With the calculations above, it can be concluded that the total profit you will get in three years is IDR 4,965,000.
When should Time Value of Money calculations be used?
We recommend that you use time value of money calculations in the following situations:
- When you are considering whether to buy or rent a house, and the amount needed between the two.
- When calculating the amount of insurance premium you want to take and the investment amount.
- When starting an investment, including choosing an instrument, the initial investment amount, and the investment period.
- When considering buying a car, motorbike or other valuable items.
- When considering paying debt/credit or investment first with an annual bonus.
- When your company wants to acquire a smaller company.
- When your company wants to buy new equipment for production.
By understanding the time value of money, you can estimate the benefits of the money you have now if invested correctly.
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