The time value of money is the idea that a particular sum of money right now is more than the same amount in the future. This finance principle tells us that any sum right now is more than the equal sum in the future. This is because it can earn interest. The money you have right now has the potential to grow and expand. For example, 100 rupees now have more value than the same amount after 10 years. In this article, we will
Time Value Of Money
The time value of money is that a sum of money right now has a greater value in the future. It means that the purchasing power of that sum, say 100 rupees, has gone down in the future comparing to that in the past. This might be due to various reasons like inflation. Inflation is the increase in prices of goods and services in a particular economy.
It means that the value of money depreciates over time due to a change in the level of prices. Another factor that contributes to increasing purchasing power is interest rates. For example, if we invest 500 rupees now, its value would grow in the future, say to 700 rupees more than 200 rupees. This extra 200 rupee is the interest we have received. Thus investment beats inflation over some time.
Importance Of Time Value Of Money
Time value of money is a topic of great importance both in personal finance and for investors. For personal finance, the time value of money helps in:
i. Better planning of loans.
ii. It helps a consumer in his daily business and banking decisions.
iii. It also helps calculate the future returns of a fixed deposit or any other investment made by a person.
Time value of money is of great importance to an investor, provided the money can earn interest. The sooner you get, the more revenue you generate.
For An investor Or A Business Firm:
- It helps to identify misconceptions relating to a project.
- It helps in calculating the future cash flow of a business firm.
- It helps a business firm to make apt decisions relating to finance and plot out its future.
Terms Relating To The Time Value Of Money
1. Purchasing Power
Purchasing power is the financial capacity to buy goods and services. The purchasing power of 100 rupees now is more than the equal sums of purchasing power in the future. The same hundred rupees would have brought more goods or services 10 years back.
2. Opportunity Cost
The time value has an opportunity cost. For example, if you invest 10,000 rupees in savings account for buying a car. You are sacrificing the same interest you would have got if you had invested the same in a small-cap mutual fund. Likewise, you are investing some amount in your education for, say, 3 years. You could have gone for a job and earned some money instead. You invest in education, hoping you would earn more after 3 years. It is choosing an alternative over the other for a potential gain.
3. Compound Interest
It is a type of interest in which the final amount is estimated based on the initial amount invested. The idea of investing money is great because it generates interest. The 100 rupees you invest now will grow to 105 rupees next year. The interest is now calculated for 105 rupees and not 100 rupees. This is compound interest. Interest can be compounded monthly or daily, and this is continuous compounding. You get a small growth each day and thus can grow your investment with time.
Formula To Calculate The Time Value Of Money
Before knowing the formula to calculate the time value of money, we need to know some terms used in its formula.
PV: this means present value; this is the current value you have.
I: this is the rate of the growth rate of interest. This is the rate at which your present value will grow.
N: this is the number of times the interest compounds. This is calculated yearly.
FV: this is the future value of the investments made.
T: this is the number of years taken into account.
The formula to calculate future value (FV) is given as:
FV= PV × [1+i/n] ^ (n×t)
Using the above formula, we can calculate the future value.
Let’s look at an example where you have 5000 rupees. The interest amount can be taken at 5% per annum for the next two years. The future value of 5000 rupees is calculated as
FV=5000RS. × (1+5%/1) ^ (1×2) = 5,512.50 RS.
The formula can also be used to find the present value (PV) of the amount to be received in the future period. This can be achieved by dividing the future value instead of multiplying the present value. This would be given as:
FV= PV× [1+i/n] ^ (n×t)
FV÷ [1+i/n] ^ (n×t) =PV
PV= FV÷ [1+i/n] ^ (n×t)
We can now calculate the present value of money to be received in the future. We can take an example of someone paying you 1000 rupees now and paying 1100 rupees in the future, say 1 year from now. Take the interest rate at 5 percent. We want to know what present value would be equal to the future value of 1100 rupees or how much money you would need to have 1100 rupees in the future. The answer can be calculated using the formula.
PV= FV÷ [1+i/n] ^ (n×t)
Substituting the values, we get
PV=1100÷ [1+5%/1] ^ (1×1) =1047 RS.
Thus from the above example, we understood that with a return of 5 percent yearly, you should receive 1047 rupees now to have the future value of 1100 rupees in 1 year.
Time Value Of Money Examples
You are in a dealership to buy a new car; the car costs 1800000 rupees. There are 2 schemes available for buying the car.
1. The dealer asks you to pay 1600000 now, giving a discount of 200000 rupees.
2. Buy the car at its original cost that is 1800000, with a 36-month loan having a market interest rate of 4% per year.
Which option is cheaper among the two options?
The answer is the 1st option. In the second option, you are paying 200000 rupees more.
Let us see another example; if someone offers a choice of 1000 rupees now and 1200 rupees in the future, what would you choose? We know that 1000 rupees now are greater but what about 1200 rupees after 5 years. Let us see if we invest 1000 rupees now with an interest of 5 percent. In 1 year, we would have earned 50 rupees in interest. So now we have 1050 rupees after 1 year. If we again invest 1050 the next year, the interest would get compounded. That is, it increases. By the end of the 5th year, we would have had 1276 rupees. We can see that 1000 rupees now would be better than 1200 rupees after 5 years.
1. What is the time value of money?
2. Cite an example of the time value of money?
3. What is the future value of money?
4. What is the difference between the future value of money and the present value of money?
5. What are the 2 key factors that play a role in determining the time value of money?
6. How can the time value of money be relevant to investors?
7. How does time value compare the cash flow recorded at different periods of time?
8. How are the interest rate and inflation-related?
9. What do you mean by discounting?
10. What is the rule of 72?
11. What are the reasons to support the concepts of the time value of money?
- An amount invested has the power to earn interest over time.
- Money is subjected to inflation.
- The purchasing power of cash lessens with time.
12. What does the time value of money tell us?
Time value of money is one of the most important concepts in financial planning. It helps in calculating the risk of inflation. It is always better to invest early. The amount you have now will not have the same purchasing power in the future. By investing, you overcome inflation and thus can improve or grow the purchasing power of the sum. With investing you, have to bear some risk to outpace and beat inflation. We have to always keep in mind that money now has much more value than the same amount in the future period. Those who don’t consider the risk of inflation may end up in a loss.