Time Value of Money – How can you use it practically?

We often hear conversations like “I could buy 10 kilograms of rice with Rs.100 15 years ago. Today I hardly get 3 kgs with the same amount”. If you work out the price per kg it was Rs.10 (12 years ago), and currently around Rs.33. Time Value of Money is a simple concept that,  if understood, can direct us towards an easier path to wealth.

This means in 15 years the price of a kg of rice has grown by 2.3 times or by a whopping 230%. This shows that prices have moved up significantly over the years or decades, or shows the trend of ‘inflation’. The value of money gradually reduces or erodes over time, which is due to inflation or rising prices .Time value of money can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases and savings.

For example if the cost of an MBA degree in India in 2009 was an average Rs.3 lakhs per year and if it increases 10% every years, then in 2012 it will be roughly Rs.3.99 lakhs (Rs.3,99,300) per year.

If I give you two options – one to receive Rs.100 today and the other to receive Rs.100 after one year. Which one would you prefer? The first option, because what you receive today has immediate utility.

One rupee today is worth more than one rupee tomorrow.

This is a basic concept holds true universally, although there can be short term blips and exceptions. Lets say Mr. Ramesh works in a bank today as an Assistant Manager and draws a salary of Rs.35,000 per month.

One year later assuming the economic conditions have not changed much and his performance at the bank has been meeting expectations, and keeping all other things constant he will get some salary hike, pushing his income to Rs.40,000 per month.

Even though the bank is getting the same services from Mr. Ramesh and same level of performance, why should they pay more? This is because of erosion in money value. The salary of Rs.40,000 per month after one year is equivalent to Rs.35,000 per month today.

The above example can also be extended to laborers who get daily wages, salary paid to maids, security guards, etc. More money does not mean your value has gone up. You should also take inflation in to account.

Income Outpacing Inflation

Lets say your income has increased by Rs.10,000, however if your expenses also increase by Rs.10,000 you are back to square one (or in the same position). You will really gain only when your income increases by Rs.10,000 and expenses stay the same or go up by less Rs 10,000.

How Compounding Works

Let us assume that Mr.Champaklal a retired teacher in Ahmadabad invests Rs.1,00,000 in a public sector bank in a fixed deposit with a 2 year term. The bank pays cumulative interest at 10% p.a. compounded annually. How much will Mr.Champaklal earn in interest? Try doing some mental arithmetic……

How much did the interest work out to ? Is it Rs.20,000 (Rs.10,000 X 2 years), Wow! You are absolutely wrong! You have just calculated simple interest which remains constant for every year.

The right answer is Rs.21,000. The calculation works as below.

• Interest in Year 1 = Interest on principal investment Rs.100000 X 10% = Rs.10,000
• Interest in Year 2 = Rs.10,000 (interest on principal) + Rs.1000 (10% interest on Rs.10,000)

If the total term were 5 years the interest accrued in your account grows as follows:-

Don’t get blown away by the intricate calculations. To understand it graphically you earn interest on your accumulated principal which is the sum of your original principal plus interest accrued. Every year interest gets added to the principal, thereby boosting the principal amount.

The final amount you get after 5 years is Rs.1,61,051, which means you earn Rs.61,051 over and above your principal. You can also see the patter of interest and total amount below:-

So if you have an amount P and want to invest it for n years at r% interest p.a. then you can simply arrive at the future value or total amount

Future Value = Present Value * (1+r) ^ n

In this case Future Value = Rs.100000 * (1+0.10) ^ 5 = 100000*1.1^5 = Rs.1,61,051.

The total interest will be Rs.1,61,051 – Rs.1,00,000 = Rs.61,051.

To cut the long story short, you are just trying to match current cash flow with future cash flows using a set of variables, which influence the value of money overtime. Compounding occurs when you reinvest interest for the entire term instead of receiving it in cash. This means your interest also starts earning interest.

Discounting – the Reverse of Compounding

Discounting is just the opposite of compounding. In the above example if I just do a contra analysis where I know the future targeted amount (say Rs.2,00,000), and a bank pays 10% interest for a 5 year deposit. How much should I invest today to get the targeted Rs.2,00,000 ?

I can use the above equation FV (Future Value) = PV (Present Value) * (1+r)^n

FV is Rs.200000, r is 10% or 0.1, n is 5 years.

The equation will be 200000 = PV * 1.1^5

Solving this PV works out to Rs.1.24 lakhs (Rs. 124184.26)

I can also use MS Excel function to find my required investment like this. I use the PV (Present Value) function under “Insert Function” in Excel, which pops up a box as shown below.

Here Rate refers to interest rate (10% or 0.1), while “Nper” refers to number of periods (5 years) and FV or Future Value refers to the amount received after 5 years.

Calculating Loan Payments, amounts, etc.

If you want to calculate the EMI for a housing loan of Rs.20 lakhs for a 20 year term with 11.5% interest the procedure would be as follows. You need to choose ‘PMT’ or payment function in excel to calculate this. The process is same as above. However, the inputs change slightly (due to the monthly payment pattern).

The ‘Rate’ is 11.5% p.a, which is converted in to a monthly rate by dividing 11.5% by 12. The ‘Nper’ or number of payment periods is 20 years which is converted in to 240 months (20 X 12). Lastly the Present Value Rs.20 lakhs is the loan amount availed. So your EMI works out to Rs.21,329.

Similarly, you can calculate the possible loan amount given an EMI budget, interest rate and term. There are various permutations and combinations possible which we will not get in to now. This is how you can use some basic finance skills to understand your current and future cash flows. Time Value of Money is one of the most important concepts in today’s financial scenario.

Education on Life Skills

With due respect to all professionals and academicians, one bitter truth is the fact that all the math that we learn in high school and college about trigonometry, calculus, etc is utterly useless.

When was the last time you practically used a trigonometry tool to solve a real life problem or situation? I’m sure you won’t recall even one or two instances unless you are an engineer or technician actually applying these.

Unfortunately, many useful skills are not imparted. The only life skills they teach in colleges are communication skills and a bit of technology.

This is one of the biggest drawbacks of our education system, which is purely intended to prepare us to become employees or workers only. This exactly what Robert Kiyosaki talks about in his “Rich Dad Poor Dad” series of books where he shows how the education system even in developed nations like the USA has only turned smart people in to boring employees.

But offlate, Time value of money is perhaps the most often neglected by private investors, but  you need to consider them all when deciding  whether a particular asset and/or the income it produces is a good investment.

Another proof of this is evident from how MBA’s and PhDs from top educational institutions work for drop outs such as Bill Gates. So its high time you develop those skills which also add value to your life instead of making you another white collar coolie.

You can also read about Robert Kiyosaki’s Cash Flow Quadrant in my article “Demystifying Rich Dad’s Cash Flow Quadrant”.

You can resolve in 2012 to build some life skills which can be as simple as learning to swim or drive to things like investing or writing. Time value of money reflects how  you would rather get a fixed sum of money today then exactly the  same amount in future. The money in the hand now is worth more than the same amount received in years time.

Conclusion – Time Value of Money

Time value of money not only impacts business finance, but also consumer finance and government finance. I’m sure you can definitely improve your personality plus enhance your wealth.

Although you may not become another Bill Gates or Warren Buffet, even if you achieve 1/1000th of what they have done, you would still be a successful personality in your own way.