In our fast-paced world, it’s natural to want instant access to money. We often crave immediate gratification, whether it’s for buying the latest gadget, treating ourselves to a fancy dinner, or taking that dream vacation. But have you ever paused for a moment to think about the long-term value of your money?
In this blog post, we’ll explore why understanding the future value of your money is crucial. We’ll break down the concept of future value in simple terms and show you how it can impact your financial decisions.
The Context
Several factors can make it feel like you’re never able to have enough money, such as limited income, inflation, lifestyle creep, and unforeseen expenses.
These challenges can make it difficult to save or invest in the future. If you had the choice between receiving ₹100 today or the same amount in five years, which would you choose?
Most people would choose to receive the money immediately, rather than wait for it in the future. This preference is often due to a desire for immediate gratification, as well as the understanding that the value of money can change over time and may be worth more in the present. This idea also helps investors to save for goals that are set far into the future.
What Is the Time Value Of Money?
The time value of money is the concept that money is worth more in the present than in the future. It is based on the idea that a person would rather have a given amount of money now rather than later, all else being equal because they can use it to generate income or take advantage of investment opportunities.
For example, if someone is offered the choice between receiving ₹100 today or receiving ₹100 one year from today, they will typically choose to receive the ₹100 today because they can earn interest on it, invest it, or use it to meet their current needs. On the other hand, if someone is offered the choice between giving up ₹100 today or giving it up one year from today, they will typically choose to give it up one year from today because they will have had the opportunity to use it and benefit from it in the meantime.
This concept is important in finance because it helps to determine the present value of future cash flows, such as the expected returns on investment. It is also used in the calculation of interest rates and the analysis of financial instruments, such as bonds and annuities.
Choices & The Probabilities
Your choices and the probabilities of their outcomes are two important factors to consider when making decisions. Your choices represent the different options available to you, while the probabilities of their outcomes refer to the likelihood of each option happening. Understanding both of these elements can help you make informed decisions that align with your goals and priorities.
Imagine that your employer offers you a choice between receiving a bonus of ₹1.2 lakh now or receiving ₹10,000 per month for the next 12 months. In this situation, a financially literate person would consider the time value of money and weigh the potential for growth against the stability of recurring payments. It is important to consider the possibility of your employer going bankrupt or you losing your job, as this could impact your ability to receive future payments.
Additionally, the current value of the currency, taking into account factors such as inflation and the potential to earn interest, may be higher than its value in the future. Therefore, it may be more beneficial to choose to receive the bonus now rather than waiting for future payments.
The Time Value of Money & Your Goals
The time value of money is an important concept to consider when planning for long-term goals such as retirement because time can have a significant impact on the amount of money you need to save to retire comfortably.
If you don’t consider the time value of money, you may find that your savings fall short of your projected needs. It’s important to set clear financial goals and to understand the projected value of money in the future so that you can make informed decisions about your retirement planning.
Additionally, it may be necessary to consider other sources of income, such as dividends or rentals, to supplement your savings to fully cover your living expenses in retirement.
Time is a valuable resource when it comes to financial planning, so it’s important to start thinking about your retirement goals against TVM’s perspective early on to give your savings the best chance of success.
The Time Value of Money & Your Investments
Investing capital now has the potential to generate growth through compound returns over time. For example, if you invest ₹1.0 lakh in a stock that has the potential to earn a 10% annual return, the value of your investment will increase to ₹1.10 lakh in the following year.
If you wait to invest the same amount in the same stock the following year, you will miss out on the opportunity to earn the additional ₹10,000 on your original principal. This is known as opportunity cost.
It is important to carefully consider the potential risks and rewards of an investment before making a decision, as timely investment decisions can greatly impact your financial future.
The Time Value of Money & Purchasing Power
Inflation is a measure of the loss of purchasing power over time, which means that the same amount of money will be able to buy fewer goods and services in the future. For example, if the price of one liter of petrol was ₹30 in the 2000s and you wanted to purchase ₹1000 worth of fuel, you would be able to buy 33 liters.
If over time the price of petrol increases to ₹96 per liter 20 years later, and you still want to buy ₹1000 worth of fuel, you would only be able to purchase 10 liters. This illustrates how time depreciates the purchasing power of money over time, as the same amount of money can buy only less in the future.
Time Value of Money In Theory
Theoretically, the time value of money (TVM) formula is a financial concept that shows the relationship between the present value of a sum of money and the future value of that same sum of money. It is based on the idea that money received in the future is worth less than money received today, due to the opportunity cost of not being able to use the money immediately.
The TVM formula can be used to calculate the present value (PV) of a future sum of money or the future value (FV) of a present sum of money. While it makes sense to apply the TVM equation on an Excel sheet, the formula for calculating PV is as follows:
PV = FV / (1 + r)^n
Where:
»PV is the present value (the amount of money you have now)
»FV is the future value (the amount of money you will have in the future)
»r is the discount rate (the rate at which you discount the future value of the money
»n is the number of periods (the number of years, months, etc. that you are considering)
For example, if you have ₹100 that you will receive in one year, and the discount rate is 10%, the present value of that ₹100 would be:
PV = 100 / (1 + 0.1)^1 = ₹90.91
The formula for calculating FV is as follows:
FV = PV * (1 + r)^n
Where:
»FV is the future value (the amount of money you will have in the future)
»PV is the present value (the amount of money you have now)
»r is the interest rate (the rate at which your money will grow over time
»n is the number of periods (the number of years, months, etc. that you are considering)
For example, if you have ₹100 now, and the interest rate is 10%, the future value of that ₹100 after one year would be:
FV = 100 * (1 + 0.1)^1 = ₹110
Conclusion
The time value of money is a concept that is used to compare the value of money at different points in time. Understanding the time value of money is important because it can help you make informed decisions about financial matters, such as how to invest your money or how much to borrow.
It can also help you understand the long-term impact of financial decisions, such as the opportunity cost of choosing one investment over another or the total cost of borrowing money. Thank you for reading and we hope you found this article helpful.
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