Understanding The Time Value of Money (TVM)
Consider a society that has 0% of inflation and you have 1,000$ in this society. This means that your purchasing power will be static. When your purchasing power is static that means whatever you can buy now, you will be able to buy next year and the year after and so on. Pretty cool uh? But do you think that means 1,000$ now is equal to 1,000$ next year? In this article, I’m going to tell you the answer to this important question which will change your mind in economics. The answer is in the time value of money
Here is the Answer:
Of course NOT! Let me give you an example so you can see why 1,000$ now is not equal to 1000$ next year.
Meet Alex and Max
Let’s say I give Alex and Max 1,000$ now. Alex will save it in his pocket and Max will try to make a business with it. For example, Max will buy a car with it and rent it for 1$ per day. What do you think will happen next year? Tell me in the comments.
After a year passed, Max has 365$ plus his car which worth 1,365$ total, and Alex still has his 1,000$. So obviously this is the time that matters even in an imaginary society that has no inflation. That’s why they say “Time is money”!
But let me go a little bit further, do you think when you buy something that means it’s your for no additional costs?
Of course NOT! you want to see why? keep reading…
It’s All About Time Value of Money
Again try to imagine a house that has no up keeping costs and you buy it for a million dollars. Do you think that’s the end of the story?
If you can make 1$ a day from an initial 1,000$, it means that if you buy a house for a million dollars, you are paying about 1000$ rent for it each DAY! The mathematics is pretty simple:
(Your money / Initial money you need for your business) * (Your business profit)
(1,000,000$ / 1,000$) * (1$) = 1,000$
Now let’s put it all together to make it more clear.
Time Value of Money Once Again
Time value of money is based on how time can effect on money. Because money can make more profit through business. That is the true concept of the time value of money which tells us besides form inflation, time is the key in the value of money.