TIME VALUE OF MONEY

We all have heard that ‘time is money’ and we should not waste it! Well, this is one side of the theory, but the other side is that time is an essence in which your money grows. When you make an investment, you always calculate the amount which you will get after a certain span of time to know the incremental value of your money. This incremental value is known as time value of money. For instance, if today I invest $100 for one year and what I get after one year is $111 then $11 represents interest/ return on investment.
Is time value of money equivalent to the return on investment?
For those people who can only bear calculative risk, the return on investment is their time value of money. Example- if Mr. A prefers investing in fixed deposits @8% of return then he will get $108 (in above example) after one year.
But for risk takers, time value of money is more than standard rate of interest. Example- Mr. B has a very balanced portfolio. He invests in highly liquid and risky equity shares along with hybrid and debt funds. His annual rate of return is around 15% because of his portfolio. Today, if he has to invest his money in some fund which is offering 8% of interest, he would be reluctant. This is because time value of money that he is being offered (8%) is lesser than his annual rate of return. While Mr. A would be happy to invest as his expected rate of return is 8% only.
Why time value of money matters to investors?
The money that you are holding in your hand right now can earn interest! Hence, it is important to understand the time value of your money to make investment decisions. There are two areas in which time value of money can be classified:
Present Value of money: Present value of money determines the current value of money when discounted at my expected rate of return. In above example of Mr. A, the current value is $100 which can be determined by discounting $108 @ 8% for one year. Present value of money in absolute terms would be less than future value (108 > 100) as your money is expected to grow.
Future value of money: This means present value + rate of interest for the invested period. You can consider the interest on compound or simple interest method based on the nature of investment.
This matters to investors because any rational investor would prefer to receive money today rather than same amount of money in future. In other words, if I lend $100 to Mr. X, I would like to receive interest at my expected rate of return for the lending term. Receiving $100 after one year from Mr. X is a loss for my portfolio. Despite the equal value at time of disbursement, $100 today has more value as it has a potential to grow every day and the concept of time value of money teaches this.

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