Concept Time value of money refers to the potential that money has to change in value over a period of time. The change in the value is due to the re-investment of returns over time. This ability of money to earn makes the money in hand today more valuable than the same amount of money received on a future date. Inflation has the opposite effect on the time value of money. Money left idle loses value over time. The purchasing power of a sum of money reduces over time because inflation makes goods and services more expensive. Compounding and DiscountingRe1 received today is worth more than Re1 received in the future because the Re1 can be invested to earn returns. If the rate at which money will earn interest is known, then the money in hand today can be translated into its equivalent amount in the future. This is known as compounding or calculating the future value. Similarly, the present value of money receivable in the future can be calculated by discounting it to today’s value. The rate that is used to compound or discount could be the rate of inflation, market interest rate or any other applicable rate. Impact on Investments Time value of money helps investors decide how much to invest now to meet a future goal. Or it helps an investor decide the sufficiency of an amount to be received in future to meet the needs of the investor by discounting it to today’s value. The impact of compounding or discounting on the value of money depends upon the rate that is used and the period for which the valuation is being made. Higher the rate and longer the period, higher will be the future value and lower the present value. Time value of money helps in making decisions between spending and investing for individuals and between pay-out and plough-back for companies.
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