Summary: Time Value of Money
The concept of compounding is deeply embedded in our everyday life, and this calls for our attention to understand the basics of time value of money. Important to note, the concept of time Value of Money asserts that value of a dollar received today is more than the same amount of dollar received at a future date. Stated simply, a dollar today cane invested in a return generating asset, and at future period, the investor will get additional interest on the money invested. Stated below are some of the reasons as why money has time value:
a)Risk and Uncertainty:
Future is always certain and an investor is always skeptical regarding the amount of cash inflow he will receive. Therefore, he will always prefer to have cash now rather than waiting for some time period.
b)Power to offset inflation:
In an inflationary environment, money received today safeguards the purchasing power of the investor than the money received in future. In other words, a dollar earned today has a greater real purchasing power.
c) Preference for present consumption:
Even if we assume that there is no inflation and the prices are stable as dollar spent today purchase exactly the same quantity of goods in the future date also, even then, the investor will prefer to spend the amount today. Henceforth, in order to induce the investor to postpone his consumption, he will always demand compensation in the form of interest rate.
d)Investment Opportunity:
Sooner is the dollar amount received, better it is for the investor as he can invest the same to gain higher value tomorrow.
Therefore, the central theory of time value is that the money carries the power of compounding and no investor will offer his savings until he is offered premium for bearing the risk of assuming future cash flows. For instance, if a firm borrows funds from the bank, it is under the obligation to repay the principal and the interests in the future period and this interest is the premium which will be paid to the bank for bearing the risk of investment. Similarly, if the equity investor invests his savings in stock of a firm, he expects to be compensated in the form of dividends and/or capital appreciation. Therefore, the recognition and understanding of the concept of time value of money is extremely critical in our everyday life as these factors will help us in understanding our financial needs and thus shape our investment decisions. Every investor must understand the timing and risk of cash flows associated with his investments, because if he ignore those factors, he will miss his investment objectives.Thus, we conclude that the time value of money is central to the concept of finance and since money has a capacity to produce returns, every investor should learn more about the concept of time value of money and how the power of compounding can help him achieve his investment goals.
Application: Deciding for Retirement
Even though the concept of Time Value of Money(TVM) has widespread applications in the field of personal finance, however, the one that I am interested in is its utility in retirement planning. Even though I am a young individual, but considering my personal experiences, financial planning is one important task practiced by each member of my family. Therefore, since I will be starting by career in two years from now, I will use the concepts of time value of money in planning my retirement related financing and how I want to receive the money post my retirement life. Below I have discussed the scenario in my mind and also the TVM methodology to solve it:
Scenario:
Assuming that I want to start planning for my retirement after 10 years of my enrollment at job, i.e. at 35 years, I start making my own saving towards the retirement fund, which will be maturing 25 years later, i.e. when I attain the age of 60 years. I expect to earn 12.5% during the time I keep saving for 25 years until my retirement and then 10% thereafter. Now, I need to know, how much money I should invest in the retirement fund so that I am able to withdraw $25000 beginning of every year post my retirement for 30 years.
Applying TVM concept:
Even though I have selected a complex scenario here, however, the objective here was to showcase the applicability of TVM even under such situation.
Important to note, in the above scenario, first we will determine the amount that must be deposited in the retirement account at the end of year 25 in order to fund the 30-year retirement life, during which I expect a payment of $25000 beginning of every year. Next, I will need to determine the annuity payment that must be made to accumulate the required amount. Below I have discussed these two steps in detail using the concepts of TVM:
Step 1: Calculating the required amount to meet the retirement withdrawals
The required amount here will be the present value of $25000, 30-year annuity due at the beginning of year 26(end of year 25). Therefore, using the following commands in the financial calculator( in the beginning mode),we calculate the PV:
N= 30, I/Y= 10, PMT= -$25000, PV= $234240
Adding first annuity payment here to get $234240+ $25000= $259,240. Therefore, I will need $259,240 at the end of year 25.
Step 2:
Now, since I know the amount I will need to accumulate by the time I retire, all I need to know is the annual annuity payments that must be made to accumulate required amount over 25 years in order to determine the annual payment I need to make according to my retirement needs. Therefore, using the following commands in the financial calculator( in the ending mode),we calculate the PV:
N= 25, I/Y= 12.5, FV= -$259240, PMT+ $1800.02
Therefore, my calculations show that I must deposit $1800.02 every year for the next 25 years in order to accumulate $259,240. With this amount, I will be able to withdraw, $25000 per year for 30 years post my retirement.
Henceforth, using the concept of the time value of money, I was able to determine the amount of saving I need to make every year to reach my retirement goals. It is also considerable that every calculation related to the time value of money must be made by analyzing the timing of cash flows and the required rate of interest and its compounding frequency.For instance, in the above scenario I discussed, payment was set in the beginning mode while the frequency of compounding was annual.
References
Damodaram, Aswath. Time Value of Money. New York: New York University, 2012.
