For many people money, means survivability, independence, a new hope, a mean to pursue happiness. Money is the only religion which everyone follows irrespective of religion, caste, sex, etc. and thus everyone knows everything about money or they don’t? What if i say that no one except few handful of people knows exactly what’s the TRUE VALUE OF MONEY. In order to understand True Value of Money, it is important to know the following basic concept relating to TIME VALUE OF MONEY, which is the building block or foundation stone to understand the secrets of money.
WHAT IS TIME VALUE OF MONEY?
Money has time value in that individuals value a given amount of money more highly the earlier it is received. Therefore a small amount of money NOW may be equivalent in value to a larger amount received at a future date.
Time Value of Money is the principles governing equivalence relationships between cash flows with different dates.
The idea of equivalence relationship is relatively simple. For Example. If you pay $1,000 today and receives $900 today itself in exchange for the amount you have paid would you accept that? It is irrational to even ask, no one will accept, however say you will pay $1,000 one year after and will receive $900 now, will you accept it? the answer is yes, because a payment of $1,000 after a year would be less worth to you than paying it write now. This is the power of Time Value.
To understand the concept better in terms of its equation, it is important to understand what is interest rate, present value and future value.
Interest Rate, denoted by r, is rate of return that reflects the relationship between differently dated cash flows. Interest rates can be thought of as Required Rate of Return, Discount Rate and Opportunity Cost.
r= Real risk free interest rate + Inflation Premium + Default risk Premium + Liquidity Premium + Maturity Premium.
Present Value (PV) means the present discounted value of future cash flows: For assets, the present discounted value of the future net cash inflows that the asset is expected to generate; for liabilities, the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities.
Future Value (FV) means the amount to which a payment or series of payments will grow by a stated future date.
EQUATION TO CALCULATE FV for a single cash flow:
FVN = PV(1+r)N
Where, PV = Present Value of the investment
FVN = Future Value of the investment N Periods from today
r = Rate of interest per period
N = Number of Compounding periods
The Fact that present value and Future value are separated in time has following important consequences:
- We can add more amount of money only if they are indexed at the same point in time
- For a given interest rate, the future value increases with the number of periods
- For a given number of periods, the future value increases with the interest rate
The most important point to remember while using the above equation is that N and r must be compatible i.e. they are defined in same time unit.
(1+r)N is also known as future value factor, however, if compounding is more frequent than annual then the said is not future value factor. If compounding is more frequent than annual, then future value formula can be expressed as under:
FVN = PV(1+rs/m)mN
Where, FVN = Future Value of the investment N period from now,
PV = Present Value of Investment
rs = stated annual interest rate or quoted interest rate
N = Number of annual years
m = Number of compounding periods per year.
COMPOUNDING AND ITS RELEVANCE IN TIME VALUE OF MONEY:
In all the above equation, compounding word is often used, but what exactly is compounding? Compounding means the process of accumulating interest on interest.
For example: Say you invested $100 for 2 years at interest rate of 10%, at the end of year 1 year you will receive $10 as interest, assuming the same is reinvested for 1 year at the same interest rate, at the end of year 2 you will receive the following:
Principal amount = $100, Interest for the first year $10, Interest for the second year based on original investment = $10 and Interest for the second year based on interest earned in the first year i.e. $10 x 0.1 = $1.
The said interest earned on interest provides us the first glimpse of the phenomenon known as Compounding.
Time Value of Money and Compounding are inseparable forces, when used simultaneously is quite lethal. The importance of Compounding increases with the magnitude of interest rate.
Thus, Time Value of Money as a principle is equivalent to the principle relating to forces of nature both in terms of complexity and voluminous, by understanding, the above terminology and equation one has the foundation to understand the other principles and theories relating to time value of money.