TIME VALUE OF MONEY

-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
(Fernando, J. (2021).
- money received in present is of higher worth than money to be
received in the future as money received now can be invested and it
can generate cash flows to enterprise in future in the way of interest
or from investment appreciation in the future and from reinvestment
(Vaidya, D).
Importance of Time Value of Money
Time value of money (TVM) is the most fundamental and important
concept in finance. This concept basically means that money you have
at hand is worth more than the money that will be available in the
future / after some time. In other words, a dollar is worth more today
than if you were given it in the future. And, this is so because of the
time gap, the uncertain future, the impact of inflation, and so many
other financial and economic factors. The TVM concept serves as the
basis for many other financial concepts and also helps in decision-
making. The age-old proverb “one bird in hand is more than two in the
bush” confirms this fact to the point. This concept is better understood
and the importance of time value of money in financial decision-
making is therefore crucial for all of us.

Importance of Time Value of Money

The basic idea and underline of this concept is very simple. Time Value
of Money means that we should always prefer to get the funds /
money now rather than getting it in the future, but this is subject to
the overriding caveat that other things are the same.

The future is uncertain, and even if someone promises to pay you

fixed interest in the future, it is still risky, so in order to make a
decision on which option to choose, we need to establish a relationship
between the present and future cash flows. This would definitely help
us make a better and more calculated decision. And, at this point, in
deciding the preferred option, the TVM concept comes in handy. It
helps us to clearly understand and bridge the gap between the present
value (PV) and future value (FV) of the money under consideration.
TVM bridges the gap between the two with the help of a discount rate.
PV, FV and discount rate are the three components of TVM. Together,
these three components help in almost all types of financial decision
making

Yes, TVM helps bridge the gap between PV and FV, but why bridging
this gap is important? The following points will help explain this, and
they will also explain the importance of time value of money:

Time Value of Money and Compounding

The compounding effect is perhaps the most important application of
the TVM concept. In compounding interest investment, apart from
yearly interest on the principal, interest is also calculated on earlier
years’ interest. In other words, the investor earns interest on the
principal, as well as on all the interest on previous years. Various
authors and experts have already called compounding the ninth
wonder of the world; interest on interest has a spiralling impact on the
funds. So, in order to get the maximum benefit, you have to stay
invested for a long time and enjoy the benefits of compounding.

For example, to understand and appreciate the compounding concept,

suppose a bond pays a 5% return on $1,000 over five years, in which
case the bondholder receives $50 per year, or $250 over five years.

Now, suppose you put the same amount into a deposit account with
the same interest rate at maturity. In this case, your annual interest
rate continues to increase with each year / period. In the first year, we
receive $50 in interest, but in the second year, the interest amount
will increase to $52.50 and so on for all subsequent years. This is
because you also earn interest on the unpaid interest of the previous
year. The unpaid interest portion is treated as principal which
continues to earn interest until maturity. After five years, the final
payout is $1,276.

The reason why you got more money in the second case is the
duration of your investment or the fair value of your money.
Financial Management And Time Value of Money
Since the money is worth more now than the same money in the
future, TVM is therefore important for financial management. You can
always use the funds to make an investment and receive interest.
However, when investing you must take into account the opportunity
costs.

Opportunity costs exist wherever options are available. Opportunity

costs are therefore the benefit or interest that one forgoes when one
prefers one investment over another. Or, to put it simply, opportunity
costs are the next best available and preferred investment. Therefore,
when deciding on an investment, one should consider its opportunity
costs. Opportunity costs are a TVM concept and help in decision
making.

Capital Budgeting And Time Value of Money

TVM is very useful in capital budgeting as it helps management to get
an idea of their cash flows. In capital budgeting, we discount the
future cash flows to their present value to determine whether the
project is worthy of investment or not.

When a company plans to make investments, for example in

machinery, to take over another company, etc., it wants to get an idea
of whether that investment will pay off or not. Or companies need to
know whether the cash flows from the investment are sufficient to
recoup at least the initial outlay. The TVM helps a business in deciding
and analyzing this aspect with the use of a discount rate.

In the financial world, this discount rate is used to discount and

determine the present value of expected future cash flows. This
discount rate depends on several factors, such as the ongoing interest
rate, risk level, expected return, and more. Arriving at a discount rate
is a difficult task. Of course, it becomes easy to arrive at the present
value of all future cash flows once you are done with the discount rate.
However, once you have it, you can easily determine the present value
of future cash flows.
 Personal Finance Decisions And Time Value
of Money
The importance of time value of money is not only for corporate
decision-making, but also on a personal level. Knowing the TVM
concept will help you see the financial impact of every financial
decision you make. It would help you plan your financial goals and
help you meet financial challenges. It would also help you compare
and evaluate two or more investment options.

For instance, someone asks you to lend him $5000 now for $5,500 a
year later. At first glance, it seems like an attractive investment
option, as you get an extra $500. However, you need to consider the
TVM to get the real picture. If the PV of the future amount is smaller
than the current amount, then this investment is not worth it. And if
the PV of the future amount is more, then you should opt for this
investment.
You can also use the TVM concept when buying insurance. Almost all
of us blindly trust what our brokers say, that after n years we would
get x times as much if we now invest y amount now. However, you
can always use the TVM concept to evaluate an insurance proposal.
And can very well understand what rate of interest the insurance
company will be giving out on your investment during the term of the
insurance. The offer of giving an X-time return looks quite attractive
on the face of it. However, once we try to look at the present value
and rate of return, the attraction is sometimes over.

Other real-life applications of TVM that you can easily apply in your
daily life include:

 If you are planning to buy a property and then rent it out, the
TVM concept can help you determine the rental amount you
should charge.
 If you are planning to buy a property in the future and want to
know how much to save, then TVM can also help.

Personal Finance Decisions And Time Value of

Money
The importance of time value of money is not only for corporate
decision-making, but also on a personal level. Knowing the TVM
concept will help you see the financial impact of every financial
decision you make. It would help you plan your financial goals and
help you meet financial challenges. It would also help you compare
and evaluate two or more investment options.

For instance, someone asks you to lend him $5000 now for $5,500 a
year later. At first glance, it seems like an attractive investment
option, as you get an extra $500. However, you need to consider the
TVM to get the real picture. If the PV of the future amount is smaller
than the current amount, then this investment is not worth it. And if
the PV of the future amount is more, then you should opt for this
investment.
You can also use the TVM concept when buying insurance. Almost all
of us blindly trust what our brokers say, that after n years we would
get x times as much if we now invest y amount now. However, you
can always use the TVM concept to evaluate an insurance proposal.
And can very well understand what rate of interest the insurance
company will be giving out on your investment during the term of the
insurance. The offer of giving an X-time return looks quite attractive
on the face of it. However, once we try to look at the present value
and rate of return, the attraction is sometimes over.

Other real-life applications of TVM that you can easily apply in your
daily life include:

 If you are planning to buy a property and then rent it out, the
TVM concept can help you determine the rental amount you
should charge.
 If you are planning to buy a property in the future and want to
know how much to save, then TVM can also help.
 Investing and Time Value of Money
 Because of inflation, prices will rise over time. And the value of
the available money will decrease over time. Therefore, the
money you have is worth more today than in the future.
Therefore, it is very important that you invest the money instead
of keeping it in yourself or in a normal bank account. And, the
TVM helps you make the better investment decision based on the
following factors:
 Inflation – it is the continuous rise of the price level. The
money in your pocket has more purchasing power today than in
five years thereafter. Therefore, an appropriate investment can
only maintain or increase the value of your money over time.
 Risk – the future is uncertain, so you may lose some or all of
your money in the future, but you can reduce your risk by
investing it right now.
 Investment Opportunity – There are many ways and options
in which you can invest your money. However, you lose the
opportunity if you wait to invest your money. Any delay will lose
the value of your money.
  Final Words
 The time value of money is a straightforward concept with many
applications in the real world. It helps to explain the power of
time financially and helps you achieve your financial goals and
find suitable investment opportunities.
 FAQs
 1. How is Time Value of Money important to investors?

 Time Value of Money plays a crucial role in investment decisions.

The investor evaluates the present value of future cash inflows
and compares this with the current cash outflows to estimate the
additional return that can be expected from this investment over
time in terms of current period.
 2. Why is the value of present dollar is more than
future`s?
 The value of the dollar in the present is higher than it will be in
the future because of inflation. Due to inflation, the value of
money / purchasing power of the dollar decreases. Today, one
dollar has more purchasing power than tomorrow.

VARIABLES

➢ Present value (PV) - This is your current starting amount. It is the

money you have in your hand at the present time, your initial
investment for your future.
➢ Future value (FV) - This is your ending amount at a point in time in
the future. It should be worth more than the present value, provided it
is earning interest and growing over time.

➢ The number of periods (N) - This is the timeline for your

investment (or debts). It is usually measured ➢ Interest rate (I) - This
is the growth rate of your money over the lifetime of the investment.
It is stated in a percentage value, such as 8% or .08. Source:
https://humjiinvestor.com/what-is-time-value-of-money-and-
discounting/ FV = PV x [ 1 + (i / n) ] (n x t)

➢ Payment amount (PMT) - These are a series of equal, evenly-spaced

cash flows.in years, but it could be any scale of time such as quarterly,
monthly, or even daily.

FV = PV x [ 1 + (i / n) ] (n x t)

Money is not worth the same

through time
If I were to ask you to choose – 1) receive $1,000 now or 2) receive
$1,000 next year, which would you choose? You would choose 1),
because it is more ‘immediate’. How does the fact that you are
receiving money sooner make it a better option? One way to explain is
that if I take the $1,000 now, I can deposit it in the bank and earn
interest. Next year, I will have slightly more than $1,000. This makes
choice 2) a poorer option because in option 1) I have $1,000 + interest.
In option 2), I only have $1,000.

This is essentially the time value of money. The principle is that

money now is worth more than money in the future. Having money
now creates increased options for you which can lead to more money
in the future.

Relevance to investing –
“Discounting”
Time Value of Money is very relevant to investing. If you buy a stock
which is earning income right now, it is more valuable than a stock
which makes the same income in the future. This is the same concept
as our example above. However, the companies you invest in aren’t so
simple. They don’t just earn money this year or in the future.
Typically, companies earn income over many years, not just in one
year. Using the time value of money, we know that each year’s
income is worth more than the next year’s income.

Since time value of money uses a math formula to determine what

each year’s income is worth, we can find out what each year’s income
is worth today. To do this, we use a concept called discounting. The
easiest way I know to explain this is with an example.
Discounting example

Suppose the bank gives 1% interest rate and your company/stock

earned $1,000 for 3 years.

As you can see, the 3 years of $1,000 cash is not worth $3,000. It is
actually worth slightly less ($2,940.99). Year 1’s $1,000 income can
be generated by putting $990.10 in the bank today and earning 1% in a
year. Therefore year 1 $1,000 income is worth $990.10 today. The
following year’s $1,000 can be generated by putting $980.30 in the
bank for 2 years. Therefore, year 2 $1,000 income is worth $980.30
today. You can extend this logic infinitely into the future.

As you may have noticed, discounting is just a process of making

sense what future money is worth today. This is extremely relevant for
investing because different companies generate future cash flow
different.

For example, a traditional big bank like DBS / JP Morgan can

generate cash immediately because it’s business is already set up and
running. It will generate income today, tomorrow, next month and in
the future years. Therefore, what these banks earn is discounted less
because the cash is immediately available. In contrast, a futuristic tech
company trying to achieve commercial space travel (e.g. SpaceX) can
only generate cash in the very, very distant future. If SpaceX starts
generating income in 2050, you need to discount it for 29 years (to
2021, i.e. today).

Discounting for stock investment

Now, with stock investments, you don’t discount with the bank’s
interest rate. Discounting for stocks is a bit more complicated.
Companies are funded by shareholders like you contributing money
(equity) and bank loans (debt). As shareholders you might want
returns of say 10% and banks may want 3% interest on their loans.
Therefore, your discounting needs to account for both of these.

I won’t go through the math here, but this is a concept which is

important for doing the discounted cash flow analysis, which is
arguably the only “objective” valuation for any stock. Any company’s
value is the present value of its future cash flows, discounted
appropriately. In the example I just made up, the company is worth
$2,940.99 because my discount rate is 1%.

Conclusion
I do realize this post is kind of theoretical and seems to discuss
discounting as an abstract concept. In future posts, I will be posting
some valuations of specific stocks which will utilize discounting to
determine the ‘correct’ stock price. This post hopes to just help you
understand what discounting is and how you can use it for investing.