Cash has an important role to play in today’s world. Nowadays, financial literacy and understanding of concepts related to currency are of great importance. One such basic concept is the temporal value of money principle.
What is the concept of time value of money?
The time value of money is the idea that a certain amount of money available now is more valuable than the same amount you will receive in the future. This is due to the fact that money can be invested or used to make a profit, and the sooner you get it, the more opportunities you have to increase its value.
Understanding this principle provides a new perspective for financial planning, investing and assessing various options. Whether it’s a profitable investment or a property buy, accounting for the time value of money may assist you in making the right decision.
Let’s say you are offered two payment options: get $30,000 immediately or wait a year and get $40,000. At first glance, the second option may seem more attractive, but based on the idea of the time value of money, $30,000 received now has more «weight» than the same $40,000 a year from now.
The reason is that the money received today can be invested or used to generate additional income. For example, if you invest this $30,000 at interest, then naturally in a year you will have more money. Thus, the money received «here and now» opens more opportunities for their multiplication.
In addition, the effect of inflation must be taken into account. Since prices rise over time, an amount received later will have less «purchasing power» than the same amount received today. Consequently, for a future payment to be equivalent to an immediate one, it must be increased accordingly.
In general, the time value of money emphasizes that currency received now is more valuable than that which can be purchased in the future. This is due to the potential for growth and alternative uses of funds, as well as the impact of inflation on the buying ability of cash over time.
Future value of money: how to compute?
To determine the future value of money, you can utilize a special formula. It helps you to estimate the amount of cash you will receive after a certain period of time, having deposited a given amount of money now at a certain interest rate.
Let’s return to the example from the previous section. You have decided to get $30,000 immediately. Now you have an opportunity to invest your money at 10% interest.
The formula for testing the future value of the money is as follows:
Future value = Initial amount x (1 + % interest rate)^Number of time periods
We’ll substitute our data:
Initial amount — $30,000
Interest rate — 10% = 0.1
Number of time periods — 1 year
Future value = 30,000 x (1 + 0.1)^1 = 30,000 x 1.1 = $33,000
Also when calculating it is important to take into account the factor of inflation — it can «eat» part of your future savings.
Estimating your future value assists you decide on the right financial choices. You can make a comparison of what is more profitable — getting money now or later — and choose the best option to achieve your goals.
How to check the present value of money?
So, how can you determine whether it’s more beneficial to take money now or wait and get a larger amount later? To do this, you need to estimate the present value of the prospective amount.
Back to our example: get $30,000 immediately or $40,000 in a year. Suppose you can put the money in the bank at 10% per annum. Now let’s calculate the present value of $40,000.
Present value is the amount of money you would have to receive at the present moment in order for it to turn into the amount promised to you after a certain period of time, given the interest rate. In other words, it is the equivalent present value of future cash.
To compute the current value of $40,000 a year from now, a simple formula is used:
Present value = Future amount / (1 + Interest rate)
Substituting our data:
Future amount — $40,000
Interest rate — 10% = 0.1
Current value = $40,000 / (1 + 0.1) = $40,000 / 1.1 = $36,363
It turns out that $40,000 a year from now is equal to $36,363 today at an APR of 10%. Since this amount is greater than the $30,000 offered immediately, it is more profitable to accept the $40,000 in a year.
Thus, having computed the present value of future cash, you can compare different offers and choose the most favorable option for yourself, taking into account the time factor and interest rate.
How capitalization and inflation affect the time value of money
Within the concept of time value of funds, it is important to consider two basic factors that can considerably affect the real cost of your money. These are interest accrual (capitalization) and inflation.
The impact of interest capitalization
Imagine that you have put money in a bank deposit at interest. Every year, the bank charges you interest on the original amount. But there is one nuance: the interest you have earned also starts to generate income. This is capitalization or compound interest accrual.
The more often interest accrues, the faster your deposit grows. Let’s say you deposit $36,363 at 10% APR. If interest is paid once a year, after one year you will have $40,000.
But if the bank applies capitalization every six months, your savings will grow even more — up to $40,302. This is due to the fact that the second half of the interest will be accrued not only on the original amount, but also on the interest that was earned over the first six months.
The calculation can be done using the below formula:
Future amount = Initial amount * (1 + Rate of interest/Number of interest accrual intervals per year) ^ (Number of interest accrual intervals per year * Number of years)
In long-term investment, the periodicity of capitalization is of great importance. Therefore, it is important to consider this factor in financial planning.
Influence of inflation
Let’s imagine another situation. You put money in the bank at 10% APR. However, for this year the cost of products and services has risen by 12% due to inflation. This means that in a year from now you will be able to buy less with the same amount of money than you do now. In fact, your future money has been devalued.
Therefore, when computing the time value of funds, you should always take into account the inflation rate. If it is higher than the interest rate on the deposit, your money loses its real value, even though interest is accruing.
Unfortunately, it is hard to predict inflation accurately for a long time period. Its level can vary greatly over time. But you cannot ignore this factor in order to correctly estimate the future buying ability of your cash.
The time value of money and its importance for investing in crypto assets
The time value of money is important in the crypto industry as well. You often have to decide whether to get money now or later, and where best to invest your digital assets.
For example, you have 5 ETH. You can keep them in your wallet or send them to staking for 5 months at 3% annual interest. According to the concept of time value of money, it is smarter to choose steaking. After 5 months, you will get a little more than 5 ETH as income for that period.
However, you should also pay attention to other investment options for this cryptocurrency. By calculating the time value, you can find the most profitable strategy.
Another situation is buying BTC. Many people think Bitcoin is a deflationary stock with a finite amount of supply. But in reality, the amount of BTC grows to a certain limit because of new coins.
If you have $72,000 to buy BTC now, in terms of time value of money, it would be preferable to spend it right away. A month from now, that $72,000 will be worth much less due to inflation. True, the calculation is complicated by the volatility of the Bitcoin exchange rate.
Conclusion
The time value of money is a basic principle to consider when making trading decisions. Earlier invested money generates higher returns due to the effect of compound interest (capitalization). The earlier you invest, the more time the money will work for you.
For traders, this means the need to enter profitable positions in a timely manner so that capital doesn’t sit idle. Missing a profitable entry point is a lost opportunity to grow funds. Remember, pending trades depreciate over time.
For long-term strategies, such as cryptocurrency staking, you should pay attention to the frequency of rewards. The more often capitalization occurs, the greater the total return will be.
Overall, applying the concept of time value of money to crypto-assets allows traders and investors to more effectively operate their digital holdings and choose profitable trades and strategies with a time horizon in mind.
