Time value of money

What it means

The time value of money is the principle that a euro today is worth more than a euro in the future. Money today can be invested to earn interest, while future money is uncertain and its purchasing power is eroded by inflation.

Two basic calculations express it: future value, what today's money will be worth after a number of years at a given rate, and present value, what a sum received in the future is worth today. The second calculation is called discounting.

Compound interest, annuity payments, net present value and business valuation all rest on this principle. The key input is the discount rate, which expresses the required return.

How it works in practice

When comparing offers, a business should convert payments to the same point in time. A 3 % discount for paying upfront pays off if it exceeds the return the company could otherwise earn on the money, or the interest on a loan it would have to take.

In investment decisions, future savings or income are discounted to today's value and compared with the outlay. A project that pays back only after ten years can have a negative value at a higher discount rate.

In accounting the principle applies to long-term receivables and payables, provisions and IFRS leases, where future payments are discounted to present value.

What to watch out for

Ignoring the time value of money leads to wrong decisions, such as overvaluing long-term contracts or instalment sales. A customer who pays a year later is in fact paying less.

The result is very sensitive to the discount rate chosen. Over long horizons a small difference in the rate changes present value markedly, so the rate should be justified and several scenarios tested.