The Importance of Time Value of Money: Why It Matters for Your Finances
10 Oct 2024
Importance of Time Value of Money
Understanding the time value of money (TVM) is essential for anyone involved in investing, financial planning, or major life goals like retirement, education, or home buying. A firm grasp of TVM can enhance both investment strategies and personal savings, thus achieving the financial goals.
Concept of Time Value of Money
- TVM refers to the idea that Rs 100 today is worth more than Rs 100 in the future owing to inflation reducing purchasing power.
- Owing to Opportunity Cost, money received today can be invested, yielding returns, which is lost if received later. Delaying investment means missing out on compounding growth and the opportunity to maximize returns.
Illustration of Future Value
Assume Rs. 10,00,000 invested at a 7% return over 2 years to arrive at the
Future Value (FV) of this amount.
Formula:
FV = PV×(1+Interest Rate)^Number of Periods
Given:
- Principal (P) = Rs 10,00,000
- Interest rate (r) = 7% compounded annually
- Time (t) = 2 years
- Future Value (FV) = Rs 11,44,900
So, the future value of Rs 10,00,000 after 2 years at 7% interest will be
Rs 11,44,900
Illustration of Present Value
Suppose you want to know the present value of Rs 10,00,000, you will receive
in two years, assuming growth of 7% annually.
Formula:
PV = FV / (1 + Interest Rate)^Number of Periods
Given:
- Future Value (FV) = Rs 10,00,000
- Interest rate (r) = 7% = 0.07
- Time (n) = 2 years
- Present Value (PV) = Rs 8,73,437.42
So, the present value of Rs 10,00,000 at a discount rate of 7% over 2 years will
be Rs 8,73,437.42
Why Time Value of Money Matters
• Opportunity Cost :
Money today can be invested for potential growth.
• Inflation Impact :
It helps account for inflation, ensuring money's future value is considered, not just its nominal value.
• Investment Decisions :
It aids in comparing investments by factoring in time while choosing various investments and thus making a right choice
• Retirement Planning :
Early contributions grow over time, making TVM essential in deciding when and how much to save for retirement.
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