| How much is your future worth Today ? |
In simple terms, the concept of
Time Value of Money is that, Rs.X in your pocket today is worth more than the promise of a Rs.X tomorrow or at any time in the future, and it's worth less than the Rs.X you had yesterday or any time in the past. This is attributed to the compounding of interest, and this is true, but there are other factors to consider in understanding why money has different values at different points of time.Time value of money is closely related to the concept of Opportunity Cost. Think of that Rs.X in your pocket right now. You have choices about what to do with it. You can spend it, you can invest it or you can put it back in your pocket. This concept of choice is called
opportunity cost, the cost being what you do not choose in favor of what you do choose. Your choices for that Rs.X closely relate to time value. If you spend the amount in purchasing something you want or need then you have that with you now. If you invest it, it will (hopefully) earn a return and will therefore yield more than the amount invested, at some point in the future, depending on how it is invested, for how long and at what interest rate. If you put it back in your pocket, you still have the choice to make in the future, but you have foregone having today whatever you might have purchased, and you have foregone the opportunity to invest it at today's rate.Another factor that relates to the time value of money is
collection risk or credit risk. There is no risk associated with the money you have in your hand now. You possess it and you are the owner of it. You can do what ever you wish to do with it. But there is risk associated with the promise of an amount tomorrow, risk of not getting it or risk of not getting it when you have been promised you will get it. Intensity of the risk associated depends on the source of your promised amount. If the source is your salary that you've received on time for months, there is a low risk that you will not get your amount. If, however, the source is your friend who owes you money and they've never yet paid you back on time, then there's a higher risk that you won't see that amount tomorrow! Generally, collection risk increases with time. This means that a sum owed to you tomorrow has less risk of not being paid than a sum owed to you next year. More things can happen to prevent the future payment in the intervening time.Interest rate risk
is also involved in the concept of Time Value of Money. Market rates fluctuate and the expectation of whether rates will rise or fall can affect loan and investment decisions. If you think that rates are going to increase tomorrow, you could then wait to invest that amount you have with you at a higher rate than you would receive today (though you might lose one day of interest by waiting). If you think rates will decrease, your choice would be to invest the amount today. Today's amount, then, has more value than the one you get tomorrow for another reason, that, if rates increase, and if you don't have the amount with you today, means that the opportunity to invest at the higher rate was lost. As with credit risk, the amount of interest rate risk also increases with time.The longer the period at which payment is expected, the greater is the interest rate risk.Inflation is another factor which has its influence on our choices as to how to spend money. If prices are rising, that amount in your hand will buy less tomorrow than it will today. This doesn't mean that you have to buy everything now, but it should be considered when making choices about what to do with the amount and if it is invested, what return will be needed to keep yourself ahead of rising prices and also compensate for use of the money.
Finally, we come to
interest and its role. Interest acts as a motivating factor for your money and is an incentive to put that amount "to work". It makes your money active and earning, rather than spend it or put it back in your pocket. Loans are the reverse from the borrower's perspective. The interest paid is incentive for the lender to make the funds available as loan funds but it is a burden on the borrower. The interest rate is directly related to each of the risks described above, and results from the fact that money has different value at different points in time. Interest rate is the result of differences in the value of money, not the cause of it. It is a variable in calculation.The value of money differs with time. Its value depends on many factors. So, don't
ignore the value of money associated with time and use your money intelligently keeping in
view all the factors mentioned above.