Time value of money deals with equivalence relationships between cash flows with different dates.
Money has time value in that individuals will value a given amount of money more highly the earlier it is received. Therefore, a smaller amount of money now may be equivalent in value to a larger amount receives at a future date.
Consider 3 scenarios below under inflationary environment at 3% inflation rate annually.
Scenario 1 : Paid $10,500 today and received $10,000 one year from now
Scenario 2 : Paid $10,000 today and received $10,000 one year from now
Scenario 3 : Paid $10,000 today and received $10,500 one year from now
Scenario 1 is most unlikely to be accepted by investor as the real value, measure from purchasing power standpoint, eroded by 7.54%
Real value after 1 year = 10,000 / 10,500 / 1.03 = 92.46%
Scenario 2 is unlikely to be accepted by investor as the real value, measure from purchasing power standpoint, eroded by 2.91%
Real value after 1 year = 10,000 / 10,000 / 1.03 = 97.09%
Although the amount of $ is the same today and 1 year later , but inflationary effects eroded purchasing power over time.
Some investors accept scenario 2 as capital preservation or capital protection when link together with an investment product.
Scenario 3 is most likely accepted by investor as the real value, measure from purchasing power standpoint, increased by 1.94%
Real value after 1 year = 10,500 / 10,000 / 1.03 = 101.94%
Scenario 3 increases investor’s purchasing power over time. The interest rate (r) receive in one year will be equal to 5%
Interest rate (r) = (10,500 – 10,000)/10,000 = 5%
Interest rate can be thought of in three ways
Required rate of return, that is, the minimum rate of return an investor must receive in order to accept the investment.
Discount rate, the rate used to discount the future value of the money to reflect the value today. In scenario 3, discount rate is 5%, which will discount $10,500 one year from now to reflect the value as $10,000 today.
Opportunity cost, the value that investors forgo by choosing a particular course of action. In scenario 3, if the investors decided to spend $10,000 today, he would have forgone earning 5% on the money. So, we can view 5% as the opportunity cost of current consumption.
The relationship between value today (term as Present Value, PV) versus future value (term as Future Value, FV), N years from today is
Simple interest : FV = PV [1 + r (N)]
Compounded interest : FV = PV (1 + r)N
Mastery of time value of money concepts and techniques is essential for investment decision as it will determine either the future value of an investment is meeting investment goal set forth in the investment plan to meet future consumption.
