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FIN 101

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Q2. Briefly discuss the Time Value of Money concept?   

Answer 1

Time Value of Money (TVM) is the effect of application of interest. An amount received today is worth more than the same amount received on a future date. Because the money received or paid today will earn interest for the interim period and will grow in volume during that period. Inversely, the amount received or paid on a future date is equivalent to a lesser amount today, the difference being interest during this period.

Major applications of TVM are in the following:

Present Value (PV) is today’s equivalent of a sum received or paid on a future date. This is the future sum, net of interest during the interim period. Since interest fetches interest applicable for earlier period (compound interest), interest reduced from the future sum, for arriving at the present value, is the interest compounded at specified intervals.

Future Value (FV) is the amount to be received or paid on a future date, so as to be equivalent to today’s worth. In other words, it is the amount today plus interest for the intervening period. For FV also, interest is calculated with compounding at the specified intervals.

Compound interest is the amount of interest with ‘interest on interest’. For example, for a loan or deposit for one year, if compounding is to be done at monthly rests, interest is calculated at the end of every month and added to the principal so that interest for next month is calculated on the combined sum (principal and interest for the earlier month) and so on. At the same time, simple interest is amount of interest calculated for the whole period, at the nominal rate, on the principal. Here, interest is not calculated on the amount of interest accrued earlier.

Uniform Payment Series (Annuity) is the arrangement in which a lump sum amount is repaid, together with interest, in fixed installments. As all the installments together is equivalent to principal plus interest, the entire amount gets exhausted on completion of the specified annuity payments.

TVM is based on the following assumptions:

1. Periodical payments are again invested and such investments generate income at the same rate uniformly, for the period investment

2. Rate of interest is constant throughout the term of assessment

3. There is no difference in interest rates based on term structure- Yield curve is flat

4. Periods or time intervals are of uniform length

5. Annuities are discrete, certain and at uniform fixed intervals.

In actual situations, these assumptions usually do not hold good. Interest rates may vary over a period of time. Re-investment may attract interest rates higher or lower than the one applied for assessment. Periodical amounts might undergo changes due to defaults. Also, time intervals may undergo changes due to various reasons including credit risk.

Most of these limitations can be overcome by breaking down the investment plan into several pieces so that the combined result will suit to the sum various possible deviations. For example, annuities can be made for smaller amounts of varying terms. Single deposits can be broken into several small deposits of different terms. In the case of assumption regarding flat yield curve and uniform interest rates, which are not likely in real-life, rate of interest can be adjusted to suit to the outcome of possible changes.