The Time Value of Money (TVM) is a financial concept that says that money is worth more now than in the future. Essentially, TVM implies that a ₹2000 banknote in your possession today holds more value than that same banknote 20 years from now. This is due to both inflation and the potential interest it could have earned over time. For instance, if you stash ₹10,000 in a mattress for three years, you forfeit the additional earnings it could have gained if invested. When retrieved, it will possess even less purchasing power due to inflation.
This is akin to a person aging. As you grow older, you lose some of your energy. Activities that were easy in your 20s can become more challenging in your 40s. Consider hiking a mountain you conquered at 25; though the mountain remains the same, reaching the top demands greater effort, endurance, and determination.
Grasping the concept of TVM empowers you to ensure the value of your money grows over time through prudent investment choices. In this article, we’ll explore what TVM entails, how to compute it, and how it influences investment decisions.
What is an example of Time Value of Money (TVM)?
Imagine you lent Rs 50,000 to a friend who promised repayment in a week. However, a week later, your friend informs you that they can’t return the money for three months. Although they guarantee full repayment in three months, understanding the time value of money changes your perspective.
According to this concept, the money you hold today is more valuable than an equivalent amount in the future. In the above scenario, the value of your loaned money diminishes after three months. So, even though you’ll receive the entire sum, you’re at a loss.
Since money can accrue interest, its value is lower when received in the future. There are two reasons for this:
Inflation diminishes your buying power. If you plan to purchase a TV for Rs 50,000 today, you won’t be able to afford it three months from now due to inflation.
b) Opportunity Cost:
Investing the same money can yield interest, as in a fixed deposit. If you keep it in your pocket or lend it without interest, you miss out on this income opportunity.
Significance of TVM
Understanding the Time Value of Money is vital for investors and retirees aiming to maximize their savings. It is fundamental in comprehending the financial world and can significantly impact your ability to save, invest, and make purchases.
The value of time in money can determine if you can retire comfortably if you haven’t saved enough for your golden years. Depending solely on your pension may not cover all your monthly needs. Recognizing this early and incorporating it into your retirement savings plan will benefit both you and your nest egg.
Investing some of your money today can yield substantial returns. However, it’s crucial to balance potential gains with possible losses, as certain assets carry higher risks. For maximizing TVM, you can go for a smart investment like a Unit Linked Insurance Plan (ULIP). It offers dual benefits of insurance and investment, allowing you to choose from a diverse pool of market-linked funds that generate returns over the long term. ULIPs are the one of the best investment plans if you want to maximise the value of your money over time.
Inflation means people have less money for expenses compared to earlier times. Therefore, making prudent decisions about expenses and spending is crucial.
How is TVM Calculated?
The most basic formula for computing the Time Value of Money takes into account future and present money values, interest rates, compounding frequency, and time duration.
The TVM formula, based on these factors, is:
FV = PV x [1 + ( i / N)] ^ ( N x T)
FV stands for Future value of money
PV stands for Present value of money
i stands for Interest rate
N stands for the Number of compounding periods per year
T stands for Number of years
Not only do interest rates and time periods affect the Time Value of Money (TVM), but so does the number of times the compounding computations are performed every year. Each compounding period increase–daily, quarterly, and monthly–has an immediate influence on the Future Value of Money.
Let us use an example to better comprehend it. Assume you have Rs. 10,000 and an 8% interest rate that is calculated quarterly, monthly, and daily over the course of a year. The Future Value (FV) of money would be different in this instance.
|Compounding Period Formula||Formula||Future Value (FV)|
|Quarterly||FV = Rs. 10,000 x [1+8%/4]^(4*1)||Rs. 10,824|
|Monthly||FV = Rs. 10,000 x [1+8%/12]^(12*1)||Rs. 10,829|
|Daily||FV = Rs. 10,000 x [1+8%/365]^(365*1)||Rs. 10,832|
However, keep in mind that the TVM formula may vary depending on the scenario. For instance, it might involve more or fewer elements for annuity or perpetuity payments. Money’s time value doesn’t account for capital losses or negative interest rates. In such cases, you can determine the Time Value of Money by employing negative growth rates.
Present Value & Future Value of Money
The present value represents money you have today, which is equivalent to a future amount discounted by an appropriate interest rate. It estimates how much to invest now for a specific future value. This implies that the money you receive today can earn returns in the future.
Future value is the sum that grows over a defined period with simple or compound interest. For example, if you invest in a fixed deposit with a 6% interest rate of Rs 1 lakh for a year, the future value will be Rs 1.06 lakh.
Best Investment Plans in India
Developing a strategy to attain financial goals is the primary aim of investment planning. A sound financial investment plan centres on prudent management of investments and savings. Here are some of the best investment plans in India:
- Public Provident Fund (PPF)
It is a low-risk, long-term investment supported by the Indian government, primarily used for retirement planning.
- Unit Linked Insurance Plan (ULIP)
As mentioned earlier, ULIP is a dual-purpose insurance policy that combines life insurance with potential market investments for higher profits. One of the best ULIPs in India is the Wealth Secure+ by Edelweiss Tokio Life Insurance. It is a modern age ULIP with features like systematic withdrawal after the 5-year lock-in period ends, making it perfect as a retirement plan.
- Fixed Deposits (FD)
It is a popular and safe investment choice among Indian investors, offered by banks for a specified term with consistent returns.
The future value of money differs from its present value. This is known as the Time Value of Money, a concept used by businesses to assess future projects and by investors to identify potential opportunities. Simply put, comprehending TVM and how to compute it empowers you to make informed decisions about spending, saving, and investing.