Time value of money is the benefit of having money now rather in the future. Having money in hand today allows you to invest it and potentially earn some level of return on that money. For example, money deposited into a savings account has the potential to earn interest over time. Money invested in the stock market has the potential to earn a return and grow in value over time.
There are a number of calculations that fall under the umbrella of the time value of money.
Future value
The future value calculation takes a rate of return of and a period of time into future and calculates the value that a sum of money at the end of that time period.
The future value formula tells you the value of a sum of money after it’s been invested with a set rate of interest (or an assumed rate of return) over a period of time including the number of times per year the interest is paid. Future value is a calculation best done using an online calculator, a financial calculator, or a spreadsheet using the formula for future value.
Using the tool on Calculator.net, you can determine that the future value of $1,000 with a 6% rate of interest with 10 compounding periods is $1,790.85.
Another variable to consider is whether you want to calculate the future value of a single sum of money from point A to point B over time, or if you will be adding to the initial sum at regular intervals. In other words, will you be adding to your initial investment? Most future value calculators offer the option to add periodic payments to your initial investment and have those factored into the calculation.
Present value
Present value is the current value of some future value or sum of money. The present value considers the time period (number of periods) in the future plus the rate of return earned on that money.
Present value allows you to determine how much you would need to invest in order to have your money grow to $1,000 ten years from now assuming your earned 6% on those funds. The answer, or the present value would be $558.39.
Internal rate of return (IRR) and net present value (NPV)
IRR and NPV are used in capital budgeting by businesses looking to evaluate the potential return on a capital expenditure like the purchase of a major piece of machinery, an investment in a new business venture, etc.
IRR and NPV can also be used to evaluate a perspective investment of most any type as well.
Net present value is the difference between the present value of an investment project’s cash inflows and the project’s various outflows. As an example, a capital project will typically have at least one initial cash outlay. After that, there will be a series of cash inflows which could take the form of cost savings, or cash flow from increased product sales or some other source.
To calculate the net present value, you need to factor in the initial investment. Let’s look at a hypothetical project with an initial outlay of $100,000 and inflows in years 1-5 of $50,000 in each of these years. Let’s also say that the discount rate, the desired rate of return for the project, is 5%.
Using an online calculator at the site CalculateStuff.com, the net present value of these inflows and outflows is $116,174. This indicates that the estimated cash inflows from this investment exceed the estimated costs of doing the project.
To illustrate the impact of the discount rate used, raising the discount rate to 10% in this example would decrease the net present value of the cash flows to $89,539. An increase in the discount rate to 15% would lower the net present value to $67,608.
Clearly the higher the discount rate, or hurdle rate as it’s sometimes called, the lower the net present value of the project cash flows will be.
This can be a good way to evaluate the performance of an investment you are considering. While you can’t know the returns that an investment will provide, net present value could be used to evaluate an initial investment against anticipated cash inflows over time from dividends on a stock, ETF, or mutual fund. You could then factor in a desire sale price at some point in the future for the investment as a terminal cash inflow.
An investor might vary the discount rate and the anticipated cash flows to see how changing these variables would impact the net present value.
Internal rate of return could be considered NPV’s “first cousin.” It looks at the same cash inflows and outflows from a capital project or an investment, and the calculates a discount rate that results in an NPV of zero.
Why would we want to do this and what does it tell us? Looking at our hypothetical investment or project, a $100,000 initial investment with positive cash inflows for five years of $50,000 per year yields an IRR of 41.04%. If you raise the initial investment to $300,000 but leave the cash inflows as the same $50,000 per year for the five years, the IRR on the project drops to -5.79%.
IRR can be useful for looking at various investment alternatives you may be considering. As an investor you can play with the initial amount you might invest, and ongoing cashflows while you own the investment, such as dividends or capital gains distributions and then projected proceeds from the sale of the investment. This is a tool that lets you vary any or all of these inputs to see the impact of these scenarios on your IRR.
Another way to use IRR is to do a post-mortem on an investment you already hold or have sold. You could look at your initial investment, the ongoing cash flows you have received and then either the inflow from your actual selling price on the investment or the selling price you would receive based on the current market price.
As an example, let’s look at a $10,000 investment in a mutual fund. Over the five years you held it you had the following inflows and outflows:
Year 0: -$10,000 initial investment
Year 1: $500 in dividend and capital gains distributions
Year 2: $600 in dividend and capital gains distributions
Year 3: $400 in dividend and capital gains distributions
Year 4: $500 in dividend and capital gains distributions
Year 5: $17,250 in dividend and capital gains distributions, plus proceeds from the sale of the mutual fund.
The IRR here was 15.03%. This can be used to compare this investment holding against other alternatives that you may be considering.
The bottom line: The time value of money is an important concept whether or not it is actually quantified. All things being equal, a dollar today is worth more than that same dollar received at some point in the future.
