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A bird in hand is worth two in the bush’ – this adage applies to financial transactions too. Say, someone borrowed a certain amount from you and it is due. Just as you are expecting the money to be credited to your account, you get a call from the borrower saying that he will pay you after 3 months. You are not happy about this. This is because you are aware of time value of money or TVM, albeit subconsciously. In this article, we will discuss the concept of time value of money, also called as present value through the following topics
There is no reason for any rational person to delay taking an amount owed to him or her. More than financial principles, this is basic instinct. The money you have in hand at the moment is worth more than the same amount you ‘may’ get in future. One reason for this is inflation and another is possible earning capacity. The fundamental code of finance maintains that, given money can generate interest, the value of a certain sum is more if you receive it sooner. This is why it is called as the present value.
Basically, the time value of money validates that it is more beneficial to have cash now than later. Say, if you invest a Rs. 100 today – the returns will be more compared to the same investment made 2 months from now. Moreover, there is always a risk that the borrower might delay even more or not pay at all in the future.
The relevance of TVM depends on how much returns you can generate from the capital available. Money has immense growth potential and the more you delay employing this potential, the more you lose the chance to earn on it.
For instance, if a friend or lender gives you two options – to take Rs. 10,000 today or to take Rs, 10,500 next year. Now, even if this promise is from someone or an entity you trust implicitly, chances are more that the second option is a raw deal. With more and more schemes ranging from low-risk to high-risk – tax-saving FDs, ELSS et. – there is a high chance that you can make at least 7% on this sum, which is Rs. 10,700. But if the interest rate offered is less than 5%, then you may consider taking the money next year. So, it depends on the possible returns as per the RBI guidelines or the market.
Present Value is the same as Time Value as elaborated above. It is the money you have currently that is equal to a future one-time disbursal or several part-payments – discounted by a suitable rate of interest. Future Value is the sum of money that any saving scheme with a compounded interest will build to by a pre-decided future date. It applies to both lumpsum as well as recurring investments like SIP.
Based on your financial circumstances at the time, the TVM formula can vary to some extent. Example, in the case of annuity (income) or perpetuity (until death) pension payments, the general formula can have more components. But as a whole, the basic TVM formula is as shown in the image.
FV = PV x [ 1 + (I/ N) ] (N*T)
where, FV is Future value of money,
PV is Present value of money,
I is the interest rate,
N is the number of compounding periods annually and
T is the number of years in the tenure.
For instance, if you invest Rs. 1 lakh for 5 years at 10% interest, the future value of this one lakh will be Rs. 161,051 as per the formula. This formula can help you to analyze different investments over different time periods, enabling you to make optimal and informed financial decisions.
PV is Present value of money, I is the interest rate, N is the number of compounding periods annually and T is the number of years in the tenure. For instance, if you invest Rs. 1 lakh for 5 years at 10% interest, the future value of this one lakh will be Rs. 161,051 as per the formula. This formula can help you to analyze different investments over different time periods, enabling you to make optimal and informed financial decisions.
How often the invested amount compounds too has a huge impact on future value. See how increasing the compounding frequency in the above example make a difference to the earnings.
Monthly: Rs. 164530.89
Quarterly: Rs. 163,861.64
Semi-annually: Rs. 162889.46
Annually: Rs. 161,051
This is where the power of compounding works. It proves that TVM is dependent on interest rate, tenure as well as the number of compounding periods per financial year.
Now that you have grasped the concept of time value and future value, we hope you also understand why it is important to start investing. If you invest with Cleartax Invest, you have handpicked funds from top fund houses presented before you to choose from. They are well-researched and have generated good returns historically. Invest Now.