The Time Value of Money is a fundamental financial concept. According to this theory, money has more value in the present than in the future. One of the most important reasons is that money can expand if we invest it. However, investing later results in a loss of opportunity cost.
If we think about it practically, every investor wants money now rather than later. The money he receives now can be invested and will grow in the future. On the other hand, if he receives the same amount of money in the future, he will incur opportunity cost.
Practical Applications of Time Value of Money
• Capital Recovery or Amortization
• Sinking Funds
• Deferred Payments
To understand it, we can use a simple example. If we deposit money in a bank, we can be certain that it will earn interest over time. In three years, the same money we deposited today will have grown.
Similarly, as time passes, it will continue to grow. This is the power of compounding money over time. However, if we do not invest our money and instead hold it in cash, it will erode and there will be no growth. Take a $100 bill and put it in a drawer. Open it after 5 years. What will you see? Either it is eroded or the same.
However, if you thought about depositing it in a bank at the time, this $100 would be worth $150 or perhaps more. You squandered money that could have been saved.
Furthermore, this $100 will buy you less after 5 years than it did previously. The reason is inflation. As inflation takes hold, purchasing power erodes. Inflation devalues the currency.
Let us look at another case. Assume you have the option of taking $1,000 now or $1,000 in a year. What are your plans? There may be differing viewpoints. But, in reality, $1000 now will be more beneficial. After two years, it is worth more than $1000.
You can get a lot more out of that $1000 now than you can in the future. In a nutshell, we might say, “If you are expecting a delayed payment, you have missed a chance.”
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Impact of Compounding on It
We learned before that the power of money grows when is compounded. What does the term “money compounding” mean? If money is not invested, it loses its worth. Compounding is caused by the temporal worth of money.
In layman’s terms, compounding is the accumulation of interest or other growth in money that occurs over time when money is invested. A simple example- Suppose you have $1000 and you invest it for 20 years at the rate of 10% per annum.
After 20 years $1000 will become $6727. It is compounding. The interest gets added each year for 20 years at 10% until $1000 becomes $6727. What happens if you remove the interest compounded? Then $1000 will remain $1000 only.
Reasons for People’s Time Preference for Money
The Time Value of Money provides people with insights on what is best for them. Everyone, whether an individual or a business, has the right to priorities their time and money. Some of the reasons why people have such preferences are listed below.
Many people prefer to consume in the moment rather than in the future. It is due to their currency demands and desires for goods and services.
Another factor could be a psychological fear that they would be unable to purchase a particular commodity or service in the future.
This threat can be caused by disease, a lack of funds, or death. They may even believe that the product will be discontinued in the future. As a result, one of the reasons why people develop a time preference for money is consumption.
There are numerous appealing investment alternatives for folks who like to have cash immediately rather than later. Because of investment options, they develop a temporal preference for money.
The best example is the one given above, in which you have the option of taking $1000 now or in two years.
People feel relieved now that they have money. There is always the possibility that you will run out of money in the future. A company’s debt collection cycle should be as short as possible.
They have no idea when the debtor goes bankrupt and the money is lost. It is preferable not to sell on credit. Because of these uncertainties, people develop a temporal preference for money.
If the economy is experiencing inflation, the money you have now is always worth more than the money you will have in the future. The basket of products and services that you can buy now with money will always be greater than the basket of goods and services that you can buy hereafter.