Time value of money will make you smart

Time is the most valuable and scarce resources that human being always wanted to utilize in the best possible way. As a result, today’s internet is flooded up with loads of time management apps and guidebooks to help you and me to accomplish more in less time. In this post, We are not going to discuss time management tools. Instead, we will be focusing on the next resource that human mind perceives as scarce and important which is money.

Technically, You cannot call money as scares resource because you can print money as much as you want, but doing so will degrade its purchasing power in proportion with the new currency printed and circulated in the market.

This post on time value of money will help people to understand that  receiving Rs. 100,000 today and Rs. 100,000 after one month is not same.

What is time value of money?

In this article, we will discuss the most basic and important concept of finance, which is time value of money. The entire financial world revolves around the conceptual axis of the time value of money.  In layman’s language, ‘Time value of money’ is the change of the value of money in relation to the time.

Let’s take an example, If you deposit Rs. 100,000 in a saving account offering 4% interest per annum, you will receive Rs. 1,04,000 at the end of one year. You may think that you earned a return, but it is not so. your money did not earn any return. If you consider an inflation rate of 7%, then you made a loss of 3% on your deposit. You earned a return in terms of interest on saving but, market inflation eats it up and left you with 3% net loss. You should know that bank always offers an interest rate on saving account which is lower than the inflation rate.

Understanding Present Value and future value

Time value of money is standing upon two broad pillars namely future value concept and present value concept. Suppose, you have Rs. 1,00,000 in your hand. If the current inflation rate remains at 7%, then the future value of Rs. 1 Lac has to become be Rs. 1,07,000 after one year to maintain it’s current purchasing power. It implies that you will be losing the purchasing power if you do not generate a minimum return of 7% on your investment.

Alternatively, present value is the value as on today of an amount receivable in future. Let’s say, you will receive Rs. 1,05,000 after one year from your customer. The prevailing inflation rate is 7%, then the purchasing power of Rs. 1,05,000 receivable after one year is equivalent to Rs. 98,131 receivable as on today.

You can calculate the future value just by compounding the principal amount with the appropriate interest rate for the desired period. You can take inflation rate, or rate of return on a risk-free investment as discount rate. However, a risk premium may be added with risk free rate to arrive at  appropriate discounting rate. Similarly, you can calculate the present value of a future inflow by dividing the sum with the appropriate discounting factor. you can use these two calculators to calculate future value and present value just by clicking the links.

What is an Annuity?

The next important concept related to time value of money is annuity. Understanding this concept will help you to find out better project amongst alternative projects. Let’s understand what is annuity. Annuity is a stream of periodic cash flows receivable in future for a defined periods. We will take the help of an example to understand this better.

Assume that you started a home tuition batch. You are going to teach one student for a whole year, and he is going to pay you Rs. 2,000 on monthly basis. The risk-free interest rate prevailing in the market is 6% p.a. Now, we will find out the present value of the future stream of cash flows. To calculate this, you have to find out two things namely risk-free monthly interest rate and present value annuity factor.

Risk-free monthly interest rate can be found out by dividing 6% with 12, and Present value annuity factor can be computed by preparing an annuity table.

You have to multiply the monthly cash flow with the Present value annuity factor to find out the present value of the future cash flows. You can find the present value of an annuity just by clicking on this link.

You can use this concept to evaluate future projects, investments, and many more things. While evaluating projects or investment alternatives, You need to compare the present value or the future value of the project or investment, and invest in the one which offers more in terms of present value.

Save money with TVM concept

This concept will also help you to determine which project is better in terms of expenditure. Here, you will discount your periodic cash outflow(for example, EMI for car, house etc.) instead of inflow to find out the present value of cash outflow. In case, cash inflow and outflow both exist, then you have to compute the present value of cash inflow and out flow separately, and then find out net cash inflow or outflow by deducting one from another. The project or investment which offers maximum Discounted Net Cash Flow is the best option.

Let me know your experience in the comment section how time value of money helps you to take better financial decision.

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About KOUSHIK DAS

I am Koushik Das, and I live in Kolkata, India. I am a passionate personal finance blogger at iplancash.com
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