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WHY MONEY HAS TIME VALUE

Back in my graduate days, a finance lecturer commenced one of his class with a question, “Will you accept Rs. 10,000 now or after a year?”  The general consensus was ‘now’. The lecturer repeated the question but this time with additional facts, “Will you accept Rs. 10,000 now and deposit in a bank providing 10% annual interest or Rs. 12,000 in a year?” After a moment of silence, we responded with the latter option. This simple exercise opened my eyes to the concept of the time value of money. Regardless of the profession you are in, the time value of money is critical while deliberating on personal or professional concerns regarding finance. It is invariably impossible to ignore this aspect when dealing with loans, investment decisions or simple financial decisions. This article dwells on the fundamental building blocks that the entire field of finance is based on.

CONCEPT OF TIME VALUE

It is the economic principle where a rupee received today is greater than a rupee received in the future. The basic intuition behind this very logic takes us back to the original question -“Will you accept Rs 10,000 now or after a year?” Clearly, the first alternative becomes a viable option for the following reasons:

No Risk: Receiving the money today will eliminate any scope of risk that you have while receiving the money a year later.

Purchasing Power: The purchasing power of money is indirectly linked with inflation. Inflation is the rate of increase of general value of goods and services with the passage of time. Think of any essential commodity and you will comprehend that the value of that very commodity has enhanced. Be it a packet of your favourite chips or even a bar of chocolate, price does increase. Because of inflation, Rs 10,000 can be exchanged for more goods and services now than
Rs 10,000 will in a year.

Opportunity Cost: A rupee received today can be further invested to earn appreciable interest resulting in yield of higher value in the future. On the other hand, a rupee received in the future will not yield interest until it is received. This lost opportunity to earn interest is known as opportunity cost.

From the above factors, we can safely infer that the time value of money can be divided into two fundamental principles:

  • More is better than less
  • Sooner is better than later

With the fundamental connotations explained, let us further explore the two basic techniques in the world of time value of money –compounding and discounting.

COMPOUNDING – MOVING FORWARD

Compounding is a concept explaining moving the money forward with time. It determines the future value of the investment made today. Most readers here will immediately understand the concept of compound growth with an investment of Rs 10,000 today earning a 10% annual interest rate. The investment will return a figure of Rs 11,000 in a year surpassing the original amount invested. The generated amount i.e. principal of Rs 10,000 and interest of Rs 100, will further generate
Rs 12,100 in two years’ time. The initial investment compounds because it earns interest on the principle amount invested along with the earning interest  on interest.

DISCOUNTING – MOVING BACKWARD

Discounting is a concept of moving money backwards in time. It is the process of determining the present value of money to be received in the future. When discoursing the discounted amount, the investment amount is brought back to the present with a rate of interest. For example, if you have to deposit an amount equivalent to Rs 10,000 in one year, what will be the value of the stated amount today with an interest rate of 10%? Taking the following formula into consideration i.e. PV=FV/(1+interest rate), where PV=Present or Discounted Value and FV=Future Value, the amount will be Rs. 9090.90. Corporate houses and businesses alike use this concept when they require purchasing something in the future.

CONCLUSION

The concept of time value of money is the core of finance. Every now and then when an entity initiates something that will result in a future or present payoff, the time value of money is inadvertently taken into consideration. Understanding the time value of money is crucial as our society embarks on becoming a financially savvy society. The next time you are asked any question regarding this concept, attune to your financial brain and respond in an appropriate manner.

By -Vivek Risal