One of the most fundamental concepts in economics is the time value of money. It’s the idea that money has value based on how long it will take to earn that money back.
For example, if you have $100 that you need to spend in two months, you would rather spend that $100 today than wait two months and have it worth only $98.08. In other words, The Concept Of time value of money is important because it determines how much we want to spend on something right now versus how much we want to save for later.
The concept of the time value of money
The time value of money says that 100 rupees now and 100 rupees a year later do not carry the same value.
Suppose the interest rate is 10 percent, which means if you deposit 100 rupees in Sonali Bank now, the bank will give you 110 rupees next year. So the current 100 rupees and the next year’s 110 rupees carry the same value according to the time value.
The importance of time value of money
Every business decision involves the inflow and outflow of money. In order to make the right decision, it is necessary to determine the current and future value of these inflows and outflows.
As a result considering the importance of time value of money can be said:
A) Opportunity Expenditure:
If you invest money in one project, you have to give up the opportunity to invest money in another project. Which is called the opportunity to invest in financing.
Thus the amount spent on this opportunity can be determined by applying the time value formula of money.
For example, The value of land in your area doubles in 10 years. On the other hand, let’s take the interest rate of Sonali Bank as a saver at 6 percent. If you buy land, you can’t keep money in Sonali Bank, so the opportunity cost of buying land is 6%.
A simple and fairly accurate method in this regard is known as ‘Rule 72’. If the money is doubled, the interest rate is obtained by dividing 72 by maturity, and by dividing 72 by the interest rate, the maturity is obtained. Since the value of land doubles in 10 years.
So the interest rate is (72/10) or 8.2%. So it is reasonable to keep money in Sonali Bank without buying land.
B) Project evaluation:
Long-term project evaluation involves comparing the current cost of the project with the future revenue. In this lesson, we have learned that the present value and future value of money are not equal.
So we can’t make long-term project evaluation decisions without bringing future potential income to current prices.
C) Borrowing decision:
The ability to repay installments has to be considered before taking a loan from a bank or any financial institution. The amount of installment varies depending on the different repayment periods of the loan.
For example 5 year term or 6-year term loan installments will be different, but also short term such as: annual, monthly, etc. In that case, also the amount of installment will be different. By determining the time value of money, we can calculate different term installments of different amounts of loan and decide accordingly how much money will be suitable for the business of borrowing in repayable installments in what type of term.
In the absence of such a plan, many businesses go bankrupt because they have to verify their repayment capacity before taking out a loan. Keep in mind that repaying the loan is mandatory, failing which the business goes bankrupt.
Time value formula of money
In the example above, we know that if the interest rate is 10 percent, it carries the same value of Rs 100 now, Rs 110 next year, and Rs 121 two years later. These 100 rupees are called the present price and 110 and 121 rupees are called the future price.
Future prices and annual compounding
If the present value is known, the future value can be found using formula 1.
Annual term
Formula 1:
Future Price (FV) = Current Price (1+ Interest Rate)
^yearly expiration
Here FV is the Future Value
The present 100 rupees is the future value of 1 year later
= 100 (1 + 0.10)^ 1
= 100 × 1.10
= 110 rupees
The present 100 rupees is the future value of 2 years later
= 100 (1 + 0.10)^ 2
= 100 × 1.21
= 121 rupees
The process used in the above example to determine the future value is called the compounding method.
It is to be noted here that after one year, the future price of Rs 110 is Rs 100 and the interest is Rs 10 at 10%. In the same way, if the interest is 10 rupees more in the second year, the future price in the second year should be 120 rupees but the future price in the second year is 121 rupees.
This is because at the beginning of the second year the principal is taken as 110 rupees and in the second year, the interest at the rate of 10% is 11 rupees. Thus, the process of charging the first-year interest on the second-year principal over the second-year interest is called the compounding method.
In the compounding method, the future price is determined by charging interest on the interest rate every year. That is, the interest that is paid on the principal is called compound interest. But in the case of simple interest, only the interest on the principal is calculated.
Current prices and Annual Discounts
If the future value is known, the present value can be determined according to formula 2. The element that was multiplied in formula 1 will be divided here. This is called discounting process.
Formula No. 2:
Current Price = Future value / (1 + interest rate)^ Expiration
For example: current price of 100 rupees after 1 year
(PV) = 100/(1+10)^1
= 100/(1+.10)^1
= 90.91 rupee
The discounting method is used in the above example to determine the current price. In contrast, the current price is determined each year by dividing the future interest rate by the interest rate. So, if your friend pays 100 rupees after 1 year, his current value of 8 rupees is 90.91 rupees. The difference in the value of money between the present and the future is usually due to the interest rate.
The present and future value of one-time cash flows are calculated using compounding and discounting methods through a few examples:
Example-1: What will be the future value of 100 rupees at the rate of 10% after 5 years?
According to the formula: 1:
Here, the current price (PV) = 100 ruppe (PV=Present Value)
Interest rate (i) =10%
Duration (n) = 5 year
Future Price (FV) =?
FV = PV (1+i)^n
In the formula,
FV = 100 (1 + .10) ^5
= 100 × (1.10) ^5
= 100 × 1.610
= 161 rupees
Concept: The current value of 100 rupees, if the interest rate is 10%, carries the same value as 161 rupees after 5 years.
Conclusion:
As you can see, understanding the concept of the time value of money is important in making decisions. It plays a vital role in how much income we earn and how much work we will be able to do with our current savings. In case you are looking for ways to improve your finances, then consider investing some of your money into getting an education that can help improve your career prospects.
In this way, you will not only get better job opportunities but also make wiser financial choices in the future as well!
