Time value of money is defined as the value derived from the use of money over time as a result of investment and reinvestment. Time value of money means that worth of a rupee received today is different from the worth of rupee to be received in future. The preference for money now, as compared to future money is known as time preference of money.
Let me try and explain time preference of money to you with the help of an example. If you are given the choice of receiving ₹ 1,000 today or after one year, you will definitely opt to receive it today than after one year. This is because the value of current receipt of money is higher than the future receipt of the same money. This concept is referred to as time preference of money.
Reasons behind time value of money.
Sacrificing present consumption against future consumption- Individual, in general prefer current consumption to future consumption.
Inflation- In an inflationary period a rupee today has a higher purchasing power than a rupee in the future.
Risk and uncertainty – Future is always uncertain and risky. Outflow of cash is in our control as payments to parties are made by us. There is no certainty for future cash inflows.
Investment opportunities – An investor can profitably employ a rupee received today, to give him a higher value to be received tomorrow or after a certain period of time.
Time value of money is useful for whom?
People who live hand to mouth. These are the people who spend almost everything that they earn each month. They can manage only negligible savings out of their income. For such people, knowledge about the time value of money is just a theory that has no relevance in real life. It is useful for people to whom building wealth is a priority. Such people are always aware of the wrath of inflation on their purchasing power. Hence accordingly, these people judiciously save and also invest their savings. The objective of investing the saved money is to make it grow faster. The growth rate must be faster than inflation. In a growing economy like us, inflation is more rampant and unpredictable. To beat inflation, undertaking risky investments is unavoidable.
Role of time value of money.
Suppose your income was about to arrive in a bank account in Jan’2021. But it reached in June’2021. What is the effect of this delayed payment? The money stays idle for six months. The money neither grew; instead, it became devalued due to inflation.
So we can say that we are fighting two challenges here. First is the battle of cash flows. The earlier we receive the money, the better. Second, to beat the wrath of inflation, we must invest the money wisely.
The concept of time value of money is very fundamental to financial decision making. Any decision which ignores this basic concept is sure to lead to wrong decisions. This concept is often known as the discounting principle. This is of great significance in any decision where the operations are stretched over a period of time, or where we have to make intertemporal choices. The concept of time value of money is based on the premise that lending opportunities always exist and interest rate is positive. It means that if we receive any sum of money at present, we can always lend it and earn some interest in future.
In this way, this amount will become greater than the same sum of money which is to be received at a future date. In other words, we can say that the amount to be received in future has lower worth than the amount to be received now. This is called discounting of the future.
The discounting of the future is done for the time gap between the present and the future and the more distant the future, the greater shall be the extent of discounting. Thus, discounting bridges the gap between the present and the future, and this is done at the prevailing rate of interest and that too at the compound rate.
I’d like to explain the whole process with the help of this example below:
I decided to buy a car in the next 5 years worth 20 lakhs. Now keeping in mind the rising inflation, let’s say the car is going to cost around 25 lakhs.
Suppose the rate of interest is 7 percent per annum. A sum of ₹ 25,00,000 is to be payable after 5 years and we have to find its present worth or present value, we can find it as follows
P=A/ (1+i)t
Where,
Is the present value of money.
Is the future value of money.
Is the rate of interest percentage.
t- Is the time period for which future sum is being calculated.
P=2500000/ (1+.07)5
=2500000/ (1.07)5 =2500000/1.40255
=₹ 1782465.449
Hence, we can say that the discounted value of ₹ 2500000 payable after 5 years is ₹ 1782465.449. In this manner, we can find the discounted value of any sum of money receivable at some future date.
Compounding and discounting are the two sides of the same coin. If present values are carried into the future, it is called compounding and if future values are transferred into present, it is called discounting. Obviously, compounding increases the value, while discounting decreases the same. Both are the consequences of the same concept i.e. ‘time value of money’.
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