Written by The time value of money (TVM) is a key concept in finance. It tells us that money today is worth more than money in the future.
Why is that? Because money today can be invested and earn interest, making it grow over time.
There are four reasons for the time value of money: inflation, reinvestment opportunities, uncertainty and risk, and preference for present consumption.
Inflation
Inflation is a persistent rise in the average prices of goods and services.
It means that the same amount of money can buy less goods and services over time.
Inflation is a common phenomenon in our economic life that makes money lose its value over time.
Since the inflation rate continues to increase, the money received in the future will be worth less than it is currently.
Consequently, individuals tend to prefer receiving a fixed amount of money at present, either for investment or savings purposes, rather than waiting to receive the same amount in the future when its value will have reduced.
To see this in action, suppose you are offered to either receive N10,000 now or receive the same amount next year.
If the inflation rate is 10%, it implies that the real value of N10,000 that you will receive next year will have reduced to N9,000 at present.
Therefore, it is advisable to receive the N10,000 immediately instead of waiting until next year.
More so, you can invest the N10,000 received today in an investment with higher returns that beat the inflation rate.
Risk or Uncertainty
Another common reality in our economic life is risk and uncertainty.
We live in a world of uncertainty and risks. There are always uncertainty and risk associated with future cash flows.
As a result, people will generally prefer to receive cash now rather than wait for some time in the future, because they can use it or invest it immediately and avoid potential losses or disappointments.
For instance, imagine you have a relative who offers you two options: either receive $200 from him today or receive $200 from him next year.
You would most likely choose the first option because you don’t know if your relative will keep his promise or if something will happen to him or the money at some point in the future.
This shows that individuals value money received today more than money received in the future because of the risks and uncertainties associated with future receipts.
Reinvestment Opportunities
The concept of the time value of money is also explained by the re-investment opportunity that comes with a present sum of money for the holder.
Money today can be invested in various opportunities that offer a return or interest over time.
For example, if someone has N10,000 today, they can invest it in a bank account that pays 5% interest per year. After one year, they will have N10,500 in their account.
However, a sum of money to be received at some time in the future cannot be invested in the same opportunities that are available today.
Therefore, if someone wishes to increase their available cash, the chance to earn, say, N500 on their investment would make them prefer N10,000 now rather than N10,000 in a year’s time.
Preference for Immediate Consumption
Most consumers subjectively prefer to consume goods and services now rather than in the future.
This is called preference for immediate consumption.
There are several possible factors that influence people’s preference for immediate consumption, among which are:
- The urgency of one’s current needs and wants may outweigh the benefits of postponing consumption.
- The uncertainty of future consumption depends on one’s health, life span, income, or availability of goods and services.
- The effect of inflation reduces the purchasing power of money over time and makes future consumption more expensive.
Let’s consider an example. If you have $100 at your disposal today, you may decide to spend it on things like food, clothes, or entertainment – things that bring you utility and satisfaction.
However, if you had to wait a year to receive that same $100, you may not value it as much as you value it today.
This is because your needs and wants may have changed, or you may find that prices have gone up or your income has decreased.
Moreover, people generally prefer to have money now instead of later because money is the means by which they can buy goods and services.
Having money at your disposal now gives you more options and flexibility than having it later.
Conclusion
As a way of concluding, the four reasons for the time value of money concepts are inflation, reinvestment opportunities, preference for immediate consumption, and uncertainty and risk.
