BTL 710 - Time Value of Money

 

The Banking Tutor’s Lessons

BTL 710                                                                          03-10-2024

Time Value of Money

The time value of money (TVM) is the concept that a sum of money is worth more now than the same sum will be at a future date due to its earnings potential in the interim.

This is a core principle of finance. A sum of money in the hand has greater value than the same sum to be paid in the future. This is because money can grow only through investing. An investment delayed is an opportunity lost.

The time value of money is also referred to as present discounted value.

The formula for computing the time value of money considers the amount of money, its future value, the amount it can earn, and the time frame.

Investors prefer to receive money today rather than the same amount of money in the future because a sum of money, once invested, grows over time. For example, money deposited into a savings account earns interest. Over time, the interest is added to the principal, earning more interest. That's the power of compounding interest.

If it is not invested, the value of the money erodes over time. If you hide Rs1,000 in a mattress for three years, you will lose the additional money it could have earned over that time if invested. It will have even less buying power when you retrieve it because inflation has reduced its value.

For example, you have the option of receiving Rs 10,000 now or Rs10,000 two years from now. Despite the equal face value, Rs 10,000 today has more value and utility than it will two years from now due to the opportunity costs associated with the delay.

In other words, a payment delayed is an opportunity missed.

TVM depends not only on the interest rate and time horizon but also on how many times the compounding calculations are computed each year.

Time Value of Money and Opportunity Cost

Opportunity cost is key to the concept of the time value of money.

Money can grow only if it is invested over time and earns a positive return.

Money that is not invested loses value over time. Therefore, a sum of money that is expected to be paid in the future, no matter how confidently it is expected, is losing value in the meantime.

The concept of the time value of money can help guide investment decisions.

For instance, suppose an investor can choose between two projects:

Project A and Project B. They are identical except that Project A promises a Rs 1 lakh cash pay-out in year one, whereas Project B offers a Rs 1 lakh cash pay-out in year five. The pay-outs are not equal. The Rs 1 lakh payout received after one year has a higher present value than the Rs 1 lakh pay-out after five years.

The time value of money is the central concept in discounted cash flow (DCF) analysis, which is one of the most popular and influential methods for valuing investment opportunities.

It is also an integral part of financial planning and risk management activities.

Pension fund managers, for instance, consider the time value of money to ensure that their account holders will receive adequate funds in retirement.

The time value of money is used to make strategic, long-term financial decisions such as whether to invest in a project or which cash flow sequence is most favourable.

The time value of money helps decision-makers select the best option.

Time value of money equalizes options based on timing, as absolute dollar amounts spanning different time spans should not be valued equally.

Businesses often use time value of money to compare projects with varying cash flows. Businesses also use time value of money to determine whether a project with an initial cash outflow and subsequent cash inflows will be profitable. Companies may also be required to use time value of money principles for external reporting requirements.

Individual investors use time value of money to better understand the true value of their investments and obligations over time. The time value of money is used to calculate what an investor's retirement balance will be in the future.

Determining the Time Value of Your Money

There are five factors in a TVM calculation. They are:

1. Number of time periods involved (months, years)

2. Annual interest rate (or discount rate)

3. Present value (what you currently have in your pocket)

4. Payments (If any exist; if not, payments equal zero.)

5. Future value (The rupee amount you will receive in the future)

Difference between Present Value and Future Value

Present value is the time value of money for a series of cash flow that calculates the value of the money today.

For example, if you want to find the value of Rs 1,000 to be received one year from now or the value of Rs 2,500 to be received each month for the next two years, you are trying to find the present value.

Alternatively, future value is time value of money concept of finding the value of a series of cash flows at a point in time in the future. You'd be calculating the future value if you want to know what your Rs 500 may be worth in 10 years. You'd also be finding the future value if you want to find out what your retirement balance will be if you contribute Rs 250 every month for 10 years.

Payback Period

The payback period refers to the amount of time it takes to recover the cost of an investment or how long it takes for an investor to hit breakeven.

Opportunity cost

Opportunity cost represent the potential benefits that an individual, investor, or business misses out on when choosing one alternative over another.

The concept of time value of money refers to the fact that money say Re. 1 received today is different in its worth from Re. 1 received at any time in future. In other words money received in future is less valuable than the money received today. The time value of money helps in converting the different rupee amounts arising at different points of time into equivalent  values of a particular point of time. These equivalent values can be expressed as future values or as present values, By compounding technique the present value can be converted into a future value and by discounting method future value can be converted to present value. For this we make use of rate of interest or discount factor. Both can be calculated for a single amount and an annuity.

Sekhar Pariti

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