The best money advice anyone can ever give you is the “time value of money” concept . It is a vital concept in finance. Every financial decision involves the application of this concept directly or indirectly.The calculation of time value involves simple mathematics and it’s easy to calculate. Since this topic is a very important to everyone, we put it down as principle number two.

ENTER-TIME VALUE OF MONEY

The principle is – Rs 100 today is more valuable than Rs 100 a year from now. The reasons for this is quite simple to understand -

• First, since the cost of living goes up , your money will  buy less goods and services in the future .So, today, money has more value or the purchasing power of your money is more
• Second, if you have that money today, you can invest and earn returns.When you receive the money at a future date instead of receiving it today, you lose the interest or profit you would have made, had this money been with you now
• Third, you prefer to have money today since the future is uncertain.

EXAMPLE :

Lets’s assume that you are  25 years old. You have Rs.2500 with you now. You  can either put it in bank FD or buy yourself a new dress. Now, let me further assume that you opt for buying new dress.The reality is that you are spending far more than that Rs 2500. How? Let’s try to calculate the real cost of not investing that money.
FV = pmt (1+i)n
FV = Future Value
Pmt = Payment
I = Rate of return you expect to earn
N = Number of years

HOW TO SOLVE THE EQUATION?

N = Number of years invested - The money you’ve spend on a dress is lost forever. That means,  that  Rs 2500 could have compounded in the bank for atleast 35 years.  How did i get that ’35′ figure? I assumed that you’ll retire at 60 and since you are 25 now, there’s 35  years left. let’s substitute 35 for “n” in the equation.
I= Rate of return expected – The ‘I’ in the formula stands for the expected rate of return. Since  bank fixed deposits would pay around 8% and   stock markets have returned an average of 15 %- 17% ,  Let’s assume you would earn some where in between – an average of 10% rate of return. So, we’ll assume  ’I’ as 10% .

PMT –  is the value of the single amount you want to invest (in this case Rs 2500).
Now substituting the figures, our   formula would be –  FV = 2500 (1+.10)35.
Enter 1.10 into your calculator (this is the sum of 1+.10). Raise this to the 35th power. The result is 28.1024. Multiply the 28.1024 by the pmt of Rs 2500. The result (Rs 70,256 ) is the true cost of spending the Rs 2500 today (if you adjusted the Rs 70256  for inflation of 6 % , it would probably work out to about Rs 9150  That means your real purchasing power would increase approximately 4 fold).
Now,  after realizing the actual cost of spending Rs 2500,   would you prefer to buy a dress for Rs 2500 today or Rs 9150 in the future. The answer is entirely personal.
Once you understand this vital concept,  you would realize that all those bits and pieces of money you spend unnecessarily are costing you thousands in future wealth. This is why time value of money is considered as the central concept in finance.

MORE EXAMPLES..

Future value of money –compounded annually.
You deposit Rs 50,000 for 5 years at 5% interest rate compounded annually. What is the future vale?

• FV= PV ( 1 + i ) ^N
• FV= Rs. 50,000  ( 1+ .05 ) ⁵
• FV= Rs. 50,000  (1.2762815)
• FV= Rs. 63,815.

Future Value of money – Compounded Monthly
You deposit Rs 50,000 for 5 years at 5% interest rate compounded monthly. What is the future value?
(i equals .05 divided by 12, because there are 12 months per year. So 0.05/12=.004166, so i=.004166)

• FV= PV ( 1 + i ) ^N
• FV= Rs. 50,000 ( 1+ .004166 ) ⁶⁰
• FV= Rs. 50,000 (1.283307)
• FV= Rs. 64,165.

GOING BACKWARDS.

Present Value of money – Compounded Annually
You will receive Rs 50,000 5 years from now.  How much money should you get now instead of Rs 50,000 5 years later if the interest rate is 6%?

• (i=.06)
• Rs.50,000 = PV ( 1 + .06) ⁵
• Rs.50,000 = PV (1.338)
• Rs.50,000 / 1.338 = PV
• Rs. 37,370.

Present Value of money – Compounded Monthly

You will receive Rs 50,000 5 years from now.  How much money should you get now instead of Rs 50,000 5 years later if the interest rate is 6% calculated on monthly compounding basis?

• Here , (i equals .06 divided by 12, because there are 12 months per year so 0.06/12=.005 so i=.005)
• FV= PV ( 1 + i ) ^N
• Rs.50,000 = PV ( 1 + .005) ⁶⁰
• Rs.50,000 = PV (1.348)
• Rs.50,000 / 1.348= PV
• Rs. 37,091.

KNOW IT

• A rupee received today is greater than a rupee received tomorrow because money has ‘time value’
• The time value of money is the compensation for postponement of consumption of money. It is the aggregate of inflation rate, the real rate of return on risk free investment and the risk premium.
• ‘Time value of money’ can be different for different people because each has a different desired compensation for postponing the consumption of money.