Understanding Time Value of Money (TVM)
Created on 17 Apr 2021
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Change is the only constant, they say. Unfortunately, that rule applies to money as well. The time value of money is going to make the clock tick whether we like it or not. This will cause our money to depreciate as time passes. In short, something costing you a rupee today will cost you twice or even thrice in the years to come. Without realizing this, most of us still keep our money well stored in our cupboards and safety lockers.
Now a majority of us will be wondering what should be done in order to escape its clutches. Luckily we have the answers that you are searching for.
Time value of Money – In detail
A bar of chocolate which was priced at 100 is now costing you around Rs 200 approximately. In the same lines, a rupee today is a lot better than the same rupee tomorrow. Let's take another example. Say you lent your friend some Rs 1000 to meet his expenses. After a month, he is offering you two options
- Where you will receive your money today
- Where you will be receiving the money tomorrow
While your instinct pushes you to choose the first option, financially also the first one seems to be a sound choice. Because in the case of the second option, your purchasing power will be reduced than in the case of the first one. Apart from this, other reasons why a rupee in the future is a bad option and why you shouldn't be picking that are as follows:
- Inflation happens to be one of the crucial reasons why getting back the money today is important. Something that is worth 1000 today is going to be 2000 tomorrow. Whether you make an effort to increase the value of your money or not, inflation is going to climb new heights.
- Secondly, because of the fact, the future is unstable and uncertain. Though it is your friend to whom you have lent your money, there is no underlying promise that the money invested will reach you at a future period. There is a risk of default and depreciation in the value.
- Finally, the opportunity cost of selecting such an option. Opportunity cost is the value of the next best opportunity foregone. By choosing the second option, you will be forgoing the opportunity to invest your money under which its value will increase. Hence, option (b) will be a lot costlier than you think as days pass by.
So time value of money, by definition, claims that owning a rupee today is better than the same tomorrow or at a future date.
Invest! Invest! Invest!
Yes, you got it right. In order to protect your money and to make it grow, investing seems to be the best way. Furthermore, it puts your ideal cash into work, assisting you in fetching a greater sum in the days to come. Also, it helps you in reaching your goals and financial objectives faster. Investing is one of the proven ways to combat the growing inflation rates and keep on with them.
Concepts of the time value of money
The two most important concepts when it comes to 'Time value of Money' are as follows -
- Present value of money
- Future value of money
From the very terms we can understand, present value is the value of money in hand. But on the other hand, the future value is the value of your money at a future date. Say, for instance, you invested 1000 today. So the future value of the same might be 1500, or more or less; you can just second-guess.
Present value is mostly used by companies to understand if a project is worth investing in or not. Apart from that, it also helps them arrive at better investment decisions. Future value helps investors in drafting an investment plan for themselves.
Having understood what the time value of money is, let us scan through the methods utilized in order to calculate the same.
Similar to the case of compound interest calculation, compounding utilizes the present value of investment to calculate the future value of the money. For example, you have 10,000, and you want to know how much this will amount to in a period of 2 to 3 years, provided that you have invested your money, then the compounding technique will be useful. And the formula to calculate the time value of money under this method is:
Future Value (FV) = PV (1+R)^N
PV is the present value
R is the rate of return
N is the number of years
You want a 2 lakh in a period of two years. You are planning to get a car with that amount. So you want to know the present value which you have to invest in order to get that amount then. Hence, discounting technique is the one you should be using. The formula to calculate the same is mentioned below:
Present value (PV) = FV/ (1+R)^N
FV is the future value
R is the rate of return
N is the number of years
To sum up
Today you have got another powerful reason as to why you should be investing and let the money do the work. Having got a clear picture as to what time value of money is, it is important you act to save your money. No matter how big or small your paycheck is, if you can chart out firstly your savings and then your spendings beforehand, you'll always have enough to invest.
The next thing to do will be to put your money into good investment avenues that you properly understand. Do your research, invest your money and reap the benefits in the years to come.
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