Imagine you have INR 10 in your hand right now. You can use that money to buy things you like, such as toys or treats. But did you know that the value of that INR 10 can change over time?
Let’s say you decide to keep that INR 10 in a piggy bank for a year. During that year, prices of things you like may increase. This is called inflation. So, when you take out your INR 10 after a year, you may find that the things you could have bought with it before now cost more. In other words, your INR 10 won’t be able to buy as much as it could have when you first saved it.
As time goes on, the value of money tends to decrease because of inflation. This means that the same amount of money can buy less in the future compared to what it can buy today. That’s why it’s important to understand the time value of money.
To make it simpler, imagine if you had a magic power to travel back in time and buy things with your INR 10. You would realize that the things you could buy in the past were much cheaper compared to the prices you see today.
So, the time value of money means that the value of money changes over time, and it’s important to consider this when making decisions about spending or saving.
Let us now properly explain the concept of time value of money:
The concept of the time value of money recognizes that money has a different value at different points in time due to various factors such as inflation, the cost of capital, and interest rates set by central banks. These factors affect the purchasing power of money over time.
Inflation is a measure of how prices of goods and services increase over time. When there is inflation, the value of money decreases because you can buy fewer goods and services with the same amount of money. For example, if the inflation rate is 5%, it means that prices are increasing by 5% each year. Therefore, the purchasing power of INR 100 today would be equivalent to INR 95 next year.
The cost of capital refers to the rate of return required by investors or lenders to invest their capital or provide loans. It represents the opportunity cost of using the money for one purpose rather than another. If the cost of capital is 7%, it means that in order to compensate for the risk and forego alternative investment opportunities, an investor would expect a return of 7% on their investment. This cost of capital affects the present value of future cash flows, as higher rates reduce the present value of future amounts.
Interest rates set by central banks also influence the time value of money. Central banks use interest rates as a tool to control inflation and stimulate or slow down economic growth. When interest rates are low, it becomes cheaper to borrow money and invest, which can stimulate economic activity. Conversely, when interest rates are high, borrowing becomes more expensive, which can slow down economic growth. Changes in interest rates impact the cost of borrowing, investment decisions, and ultimately the value of money over time.
Now let us incorporate the Discounted Cash Flow (DCF) method to discount the inflation adjusted portfolio example and understand what Present Value (Present Purchasing Value of the Future Value of the inflation adjusted portfolio) is.
Let us quickly understand what DCF method is.
DCF stands for Discounted Cash Flow, and it is a financial valuation method used to estimate the present value of an investment or a stream of future cash flows. The DCF method takes into account the time value of money by discounting future cash flows to their present value.
Here’s how the DCF method works:
- Cash Flow Projection: First, you need to estimate the future cash flows expected to be generated by the investment. These cash flows can include revenues, expenses, and other relevant financial metrics, such as net income or free cash flow. Typically, cash flows are projected over a specific period, such as 5 or 10 years.
- Discount Rate: The discount rate is a crucial component of the DCF method. It represents the required rate of return or the opportunity cost of investing in the project being evaluated. The discount rate is often determined by considering factors like the riskiness of the investment, the cost of capital, and the expected return on alternative investments.
- Discounting Cash Flows: Once you have the projected cash flows and the discount rate, you can discount each future cash flow back to its present value. This is done by dividing each cash flow by a factor equal to (1 + discount rate) raised to the power of the corresponding time period. The purpose of discounting is to reflect the fact that future cash flows are worth less than the same amount of money received today due to the time value of money.
- Present Value Calculation: After discounting all the future cash flows, you sum up the present values of each cash flow to determine the total present value of the investment. This total represents an estimate of the current value of the investment or project.
The DCF method is widely used in financial analysis and investment decision-making because it accounts for the time value of money and provides a framework to assess the profitability and value of an investment based on its expected cash flows. It helps to determine whether an investment is worth pursuing by comparing the present value of expected cash flows to the initial cost or investment outlay.
DCF can be calculated through the formula below: (Source: Corporate Finance Institute)
The CFn value should include both the estimated cash flow of that period and the terminal value.
So, in our example of DCF value of an investment portfolio with an initial value of INR 100,000, growing at an average rate of 6%, an average annual inflation rate of 4% with the cost of capital as 7% per year. We will track the real value of the portfolio over a 20-year period.
In this chart, we observe the nominal value of the portfolio, the impact of a 4% inflation rate each year, and the corresponding real value of the portfolio. As the years progress, the nominal value of the portfolio increases due to investment returns or contributions. However, as inflation erodes the purchasing power of money, the real value of the portfolio decreases significantly over time. Now when we discount the value of money by the cost of capital (this is the required rate of return that investors expect to earn relative to the risk of the investment – for assumption assume this to be Risk Free Rate of Return of PPF at 7%.) the present value of the amount after 20-years of investment is highly reduced.
What we find is the Present Value of initial investment of INR 100k in an investment over 20-year time period that gives an annual return of 6% grows to INR 320.71k in absolute value and if it is adjusted to inflation of 4%, the resulting value of the appreciated investment reduces to INR 148.59k. Further if we identify the present value of this inflation adjusted amount, the present value comes out to INR 38.40k.
This means an investment of INR 100,000 in an opportunity that gives 6% annual return, with an inflation of 4% per year and using a discount rate of 7%, the Purchasing Power of future value of INR 320,713 today is equivalent to INR 38,400!
Conclusion:
In conclusion, the time value of money is a fundamental concept in finance that recognizes the idea that the value of money changes over time. It acknowledges that receiving a certain amount of money in the future is not equivalent to receiving the same amount today due to various factors such as inflation, the cost of capital, and the opportunity cost of using money for one purpose over another.
The time value of money highlights that money has a greater value when received sooner rather than later. This is because money can be invested or used for consumption, and there is a cost associated with tying up funds for a specific period. Factors such as inflation erode the purchasing power of money over time, as prices of goods and services increase.
The concept of the time value of money is crucial in financial decision-making, including investment analysis, project evaluation, and financial planning. It allows for the comparison of cash flows occurring at different points in time by discounting future cash flows back to their present value. By considering the time value of money, individuals and businesses can make informed decisions regarding investments, savings, borrowing, and budgeting.
Understanding the time value of money helps individuals and businesses plan for the future, evaluate investment opportunities, and assess the true cost and benefit of financial transactions over time. By considering the time value of money, one can make more accurate and rational financial decisions that take into account the changing value of money over time.
Disclaimer: Article written based on writer’s experience, knowledge and workflow acceleration by Generative AI ChatGPT by OpenAI