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Time Value Of Money-The Basics

Posted in Finance Articles, Total Reads: 3258 , Published on May 09, 2012

An in-debateable topic - Whether Money has Time value? Indeed it does. A rupee today isn’t the same as a rupee tomorrow. There are many underlying factors which suggests so.

Firstly, people in general prefer to consume in the present rather than in the future. Thus a rupee today is more valuable than a rupee at a point of time in future. Second, one can make an investment of some capital today & receive returns from it in future, something that in very general terms we call as ‘Interest’. Money invested would grow.

Thirdly, if we talk in economic terms then a rupee today has more purchasing power than it would be in the future in cases an inflationary situation arises. So its very important for us budding managers to understand this fact that money simply lying stationary is going to the dogs & at some point of time in future it might not have any value.

This demands that we make smart investments of excess cash balance in our account. Of course you need to keep sufficiency for the smooth functioning of your operational activities. The challenge is how do you calculate how much to invest elsewhere. But a bigger challenge is where do you invest that surplus? That is one of the key issues today.

The returns that you expect on any investment that you make, i.e. the interest rate/ discount factor is indicative of the risk profile associated with the investment being evaluated. Greater the returns , greater the risk. Its therefore very important for a manager to analyse & take a call as per the requirements of the organization.

But for all of that comparison we need to evaluate & compare the alternatives. The point here is that the returns that we expect is obviously going to be at different points of time in future &  therefore its imperative that we reduce all the same to a common point of time. Generally we bring everything down to their present value.

For this we must know how to scale things up & down , normally referred to as discounting & compounding in financial terms. Remember the compound interest that we studies in our school life. It exactly resembles the same thing from where the base was developed. As Albert Einstein once remarked:- “I don’t know what the seven wonders of the world are, but i know the eighth- compound interest.”

Now consider a situation where one is looking forward to buy a property & he/she knows how much the property would cost 10years hence. Accordingly one can evaluate as to how much one is willing to pay for the same today taking into consideration the returns that he expects out of the same. Here lies the power of CI where in you can judge the present value of money that you would invest on the deal. Its a very powerful tool to analyse & enhance your decision making support criteria.

All investments that we make in real life are small examples of the fact that money indeed has a time value. Had it not been the case people would have simply stocked their money. There are living proofs of businessmen who have gone down due to inefficient planning & strategy as to how & which basket to put their eggs in.

Everything in finances boils down to this one truth – Money has time value. Else there would have been to operational activities, no balance sheets, no CF Statements nothing of any sort. Life runs on this one major key issue. One thing is what we are sure of – the Present. And therefore every sort of evaluation that we do in monetary terms is on the basis of its present value. The risks involved are hge & the stakes keep on going higher & higher.

So dont sit back & keep counting your eggs. Go and trade them in the market.

This article has been auhored by Akhil Kumar Rungta from DOMS IIT Roorkee.

Image: Stuart Miles / FreeDigitalPhotos.net

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