TIME VALUE OF MONEY

TIME VALUE OF MONEY

TIME VALUE OF MONEY is an important area which one should know if you are associated in the field of finance especially when you are dealing with loans, capital market, investment analysis and other finance-related decisions.

It's a fundamental building block on which the entire finance is built upon.

But, the question is that why does money have TIME VALUE?

TVM is based on the simple principle that a rupee received today has a greater value than a rupee received in the future.

Let's take a simple example to understand this.

Say if you have to choose between taking Rs. 10,00,000 today or after say 50 years.

Which option would you have opted for?

Of course, the first one, right?

There are reasons to justify this-

1. High purchasing power- A sum of money can be exchanged for more goods and services today than 50 years.

for instance 100 years ago, 1000 rupee had a huge value than today.

2. Risks involved- There's a risk involved in getting money back that you already have today.

Say you lend the money to a person for one year and the person goes bankrupt or runs away, you may lose your money.

TIME IS MONEY

  You must have heard your elders say- "Time is money" and frankly speaking, they are right.

Since money has time value, the present value of future cash flows worth less the longer you wait to receive it.
This is why we expect the future value to be greater than present value due to the time value of money.

However, the difference the future and present value depend upon the interest rate and the compounding period.
Moreover, receiving the money quickly also reduces the chances of default.

Compounding and Discounting: A Base for TVM

TVM involves two major aspect - compounding and discounting which helps us in computing future and present value respectively.

It's important to have an understanding of these terms before getting into details of the time value of money.

Compounding

It's process of computing the future value of an investment made today or series of investments made over a period of time.

In simple words, it's about moving your sum of money forward in time.

Say your investment of Rs 1,00,000 at an interest of 10% p.a. will turn into Rs. 1,21,000 in a period of 2 years.

Discounting

It helps in determining the present value of a sum of money or a series of payment to be received in future. It's about moving your money back in time.

Say you will receive a Rs 1,21,000 after 2 years form now, so the present value of it stands at Rs 1,00,000.

Key components of the time value of money

These are the 5 main elements which are very important in solving the time value of money problems.

1. Rate (i)- It is a discount rate or an interest rate which is used in compounding or discounting a sum of money.

2. Periods (n)- It is a total number of periods in the overall time frame which can be weekly, monthly, quarterly, semi-annually, annually and so on.

3. Present value (PV)- It represents a sum total of future cash flows at a present date. It is done by discounting the future cash flows.

4. Future value (FV)- It implies a sum of money to be received at a future date which is obtained by compounding the present cash flow.

5 .Payment (PMT)- It's represents equal periodic payments to be paid or received each period. It's positive value when you receive the payments while it's negative in case you make the payments.

Let’s take a simple time value of money problem to understand more clearly.

Say you went to purchase a television and the shopkeeper gives you a choice to pay either Rs 40,000 now or to opt for five installments of Rs 10,000 at the end of each year for the next five years.

It would be very wrong if you simply add the five installments (i.e. Rs 50,000) and compare it with the alternative (Rs 40,000 today).

You should rather use TVM to determine the present value of the installments and then make a comparison.

Present value computation

n=5

I/Y= 10%

PMT= Rs 10,000

PV= ?

Feed the data into the calculator or spreadsheet and the value comes at Rs 37908.

As you can see that going with the installment option is a better choice.

This is the reason time value of money is so important.