PFRDA

Time Value of Money

One of the most fundamental concepts in finance is that money has a “Time Value”.

Time value of money is the idea that it is not just the absolute value of money that is important, but when it will be received or paid that determines its value. Receiving Rs.100 today or one year later is not the same because the money in hand today has the potential to earn returns and grow to a higher value one year hence. With each passing period (day/ week/ month/ year etc.) the value of the absolute money keeps on reducing due to its potential earning capacity (read about Return).

Present Value

It is the amount that you are willing to pay today in order to get a cash flow in future.

Present value is the current worth of a future sum of money or stream of cash flow given a specified rate of return. Future cash flows are discounted at the discount rate; the higher the discount rate, the lower the present value of the future cash flows.

Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they are earnings or obligations.

Number crunching to understand PV

For simplicity sake, let us assume the discount rate as the rate of Inflation, then

The present value (PV) of Rs.10,000 received today is Rs.10,000.
The PV of Rs.10,000 received after one year when the inflation is 8%?

(PV) =

Rs.10,000/(1+8%)

= Rs.9,259.

What this final figure of PV = Rs.9,259 means that a sum of Rs.10,000 today would buy you goods worth Rs.9,259 one year hence i.e. the same amount of absolute money has lost its purchasing power.

Future Value

Refers to the value of present cash flow received at a future date.

The future value (FV) is the value of a current asset at a specified date in the future based on an assumed rate of growth over time. It is in fact related to the concept of PV (Present Value). Simply put, the calculation of ones future corpus is determined on the basis of FV.

FV = PV X (1+r)ⁿ

Where,
FV= Future Value
PV= Present Value
r= rate of return (also expressed interest rate per period expressed as decimal)
n= periods of compounding

Number crunching to understand FV

For simplicity sake, let us assume the rate of return is 10% and the amount invested is Rs.10,000, then FV of the said amount received after 1 year is

The FV of Rs.10,000 received after one year when the rate of return is 10%?
FV= Rs.10,000 X (1+10%) X 1 = Rs.11,000
Similarly, the FV of Rs.10,000 received after 5 years when the rate of return is 10% per annum?
FV= Rs.10,000 X (1+10%)5 = Rs.16,105.10

Importance of Inflation and Time Value of Money in Retirement Planning

In planning for long term goals, like retirement, an understanding of time value of money is essential to make the right saving and investment decisions.

The cost for the same expenses will be higher in retirement than the current cost because of inflation. The effects of inflation puts upward pressure on the sum of money required to meet expenses in retirement and hence the absolute sum required in ones retirement corpus would be higher.