Understanding and Harnessing the Time Value of Money Concept!

Updated: Apr 27, 2018

Tags: #discountcashflow, #Netpresentvalue, #Timevalueofmoney, #financialmodels, #hospitalitycode, #DCF, #NPV, #TVM

In this series of articles, I will cover key financial models and this is the second article on the subject. I will cover three related concepts; Discounted Cash Flow, Net Present Value and Time Value of Money.

Time value of money concepts are the cornerstone of modern finance

Definitions of Time Value of Money and Discounted Cash Flow

The time value of money (TVM) is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received.

Martin de Azpilcueta of School of Salamanca (1491 – 1586), also known as Doctor Navarrus is the inventor of Time Value of Money Concept.

In modern finance, time value of money concepts plays a central role in decision support and planning. When investment projections or business case results extend more than a year into the future, it is important to see the time value of money impact on long-term projections and therefore, we need to see cash flows in both with discounting and without discounting forms.

Discounted cash flow DCF is an application of the time value of money concept—the idea that money to be received or paid at some time in the future has less value, today, than an equal amount actually received or paid today.

The time value of money (TVM) is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity

One of the reasons we are reviewing DCF and TVM together is the interlink between the concepts. When we analysing Discounted cash flow analysis DCF, the two-time value of money terms is the key;

  • Present value (PV) is what the future cash flow is worth today.

  • Future value (FV) is the value that actually flows in or out at the future time.

The DCF calculation finds the value appropriate today—the present value—for the future cash flow. A £100 cash inflow that will arrive two years from now could, for example, have a present value today of about £95, while its future value is by definition £100.

Discount Cash Flow (DCF) can be an important factor when evaluating or comparing investments, action proposals, or purchases.

Is Time Value of Money Real Value?

Time value of money concepts are easier to understand when explained together and I will try to do it as easier as possible.

Let’s accept it, when we all here “Time Value of Money” the first time, it sounds like fiction and comparing to the cold, serious and calculated face of Finance it feels unreal.

Having the use of money for a specific period of time has a value that is tangible, measurable, and real

Time Value of Money as a concept has two separate applications; discounted cash flow and interest paid for a loan.

DCF – Discounted Cash Flow; the discounting lowers the present value (PV) of future funds. What future money is worth today is called its present value (PV) and what it will be worth in the future when it finally arrives is called not surprisingly its future value (FV). Present value, in other words, is discounted below future value.

There are three factors impact future value (FV) of our today’s money;

  1. Inflation; inflation over time reduces the buying power of money.

  2. Risk; money you have today is real but future is less certain which creates a risk factor

  3. Opportunity; if you invest your money today, you could get a better return somewhere in the future. The money you will not have until a future time cannot be used now.

What is Cash Flow Stream and How does it work with different Discount Rates over time?

A series of cash inflows or outflows coming at different future times, the series is called a cash flow stream