Time Value of Money

You must have heard “Time is Money”, but do you know what is Time Value of Money? No… then blame the economists. I guess economists love to twist the common sense language into incomprehensible mumbo-jumbo to confuse the common junta.

(Picture courtesy Sam Fox)  Okay, here is another way to look at the this terminology: If you are offered 10,000 INR today or after one year, what will be your pick? Easy, huh. Only a nut-head would choose the later. But why? Well because money “NOW’ can be invested to earn more money later, or it can be utilized right now for any material gratification or who knows what will happen one year later!! What-ever the reason, everyone attaches some “time value” to the money.

                                                        

 

There are basically two reasons why people attach time value to money :

• Possibility of growing the money over a period of time
• Possibility of purchasing less in the same money over a period of time 

This simple concept becomes extremely complicated when we start applying this to practical situations. Here are some examples, where this concept is utilized:

1) How much is the present value of 100Rs paid after a year?

2) What is the monthly payment of a mortgage of Rs 200,000 at annual rate of 6% for 10 years?

3) If the investment scheme promises 10% annual interest, in how many years my present money of Rs 100 will get doubled?

4) In a different way,how much rate of interest should a scheme have if I need to double my money of Rs 100 in 5 years?

5) If I invest Rs 1000 for 20 years at 7% rate of interest, what is the final future value discounted back to its value today?

6) You are planning to retire in twenty years. You'll live ten years after retirement. You want to be able to draw out of your savings at the rate of Rs10,000 per year. How much would you have to pay in equal annual deposits until retirement to meet your objectives? Assume interest remains at 9%.

7) If you get payments of Rs 15,000 per year for the next ten years and interest is 8%, how much would that stream of income be worth in present value terms?

8) How much would you pay for an investment which will be worth Rs 60,000 in three years? Assume interest is 5%.

9) You are considering the purchase of two different insurance annuities. Annuity A will pay you Rs16,000 at the beginning of each year for 8 years. Annuity B will pay you Rs12,000 at the end of each year for 12 years. Assuming your money is worth 7%, and each costs you Rs75,000 today, which would you prefer?

10) You deposit Rs17,000 each year for 10 years at 7%. Then you earn 9% after that. If you leave the money invested for another 5 years how much will you have in the 15th year?

All these and many more questions can be answered correctly if you understand the concept of time value of money. If you are mathematically inclined, visit the wiki page or check out this video.