Time is money, we know. In fact what comes for free in this world? Nothing.
Time is one of those rearrest of rare things which is not present in abundance in this world. We have only 24 hours in the day.
Anything which is scarce becomes expensive.
Hence, time is one of those things which becomes expensive with every passing day.
Money is also one of those essentials which is not present in abundance in this world. Only very few people have ample amount of money to boast.
Combination of time and money becomes even more scarce. How?
Let’s take a small example. Suppose your account gets credited with your salary on first of every month. If somebody will ask you to lend him your money, on the first day itself, would you do it?
Probably not. Because on the first day of the month you need to pay the bills, fees, salaries, etc. Majority people in this world do not have excess cash to lend it to somebody else. Their income and expenses are almost balanced.
It becomes very difficult for a common man to lend money to others.
Now suppose, you know that not enough money is available in this world for lending. But ‘you’ have some spare cash that can be used for lending.
Knowing that the money for lending is a scarce resource, you would not like to lend your money for free. Instead, you will ask for interest.
The period (time) for which you will lend your free money, will decide how much interest you will earn. The longer will be the time period, larger should be the interest earned.
This process of earning interest on the lended money proves that time is money.
When we put our savings in bank, don’t we earn interest? Yes.
By putting our savings in the form of bank deposits, don’t we earn higher interest? Yes.
When we invest our money in stock market for long term, don’t we expect very high returns compared to deposits? Yes.
These are all examples confirming that time is money. If one decides to part away with his money for a certain period of time, he/she is liable to earn interest on it.
Why banks pay interest?
Banks pay interest for two reasons. First, they know that money is a scarce resource. Secondly, they also know that money not lended to them could be invested elsewhere to earn returns.
What does it mean?
It means, banks assume that, if we do not use their fixed deposit to park our money, we may use this money to invest in stocks (example). These stocks in turn can give us an average annual returns of say 12% per annum.
Banks also knows that stock investing is risky. But keeping money in the bank (fixed deposit) is not risky. Hence they offer an interest of 8% per annum on fixed deposits.
Though 8% per annum is less then stocks return of 12% per annum, but still people will take it as fixed deposit’s are less risky (very safe).
This a logical compromise between return and risk.
In simple language, banks pay interest so as to compensate us to part away with our money. Because during this period, when our money is locked in fixed deposit, we are not able to use this money.
This is what is called as time value of money or ‘time is money’.
Banks pay interest to adjust for inflation?
No, banks do not pay interest to compensate for inflation. Neither they pay interest as the invested money is at some risk.
Interest payment by the banks is neither due to inflation or due to investment risk.
Consider a situation similar to what is present in Europe. In Europe there are economies where inflation rate is almost zero. There are also multinational banks operating in Europe, which offer almost zero risk conditions.
Even in these economies, if the money is kept in the bank as deposits, it will still earn interest.
Why interest is paid? Because there is time value attached with the money.
And that is why we say time is money.
Mr. Bank, if you want me to lend you my savings for some period (even when inflation is zero), then you will have to compensate me with interest, because time is money.
If time is money, then interest rates across banks must be same, right?
Banks pay interest to compensate for lending and not using that money for certain period of time.
If this is the only factor which decides interest rate, then interest rates offered by all banks must be same. But in reality this is not true.
Why there are different rates offered by different banks?
The influence of ‘inflation and risk’ is also there on the interest. Lets see how…
If the inflation rate prevailing in the economy is higher, in this case the lenders would expect higher interest rates on their deposits.
In case the lenders assumes that the risk associated with his lended money is higher, in this case as well he will expect higher interest.
A bank like SBI, which is the biggest bank run by Indian government, the risk of loss associated with it is very low. Hence SBI can offer low interest on deposits.
Whereas in case of smaller banks, to attract depositors, they are forced to offer higher interest rates (than SBI).
Why this is so?
Because depositors find options like SBI, ICICI Bank etc as safer options. But higher interest rates offered by smaller banks make them equally attractive for potential depositors.
So, it is true that inflation and risk also decides the quantum of interest earned on the deposits. This is the reason why we have several range of interest rates prevailing in the market.
What the ‘time value’ does to our ‘money’?
It is this time value of money which has initiated the concept called the power of compounding.
What the time value does to our money is to make it grow with time.
The formula that express the growth of money with time is as below:
Future Value (FV) = Present Value (PV) x (1+r)^t
r = interest rate (5)
t = time period for which the money stays invested (years)
To understand the concept of ‘growth of money’ with time, we shall see a simple example.
Suppose an amount of Rs.5,000 invested in bank deposit yielding interest a rate of 8% per annum. What will be the growth of money with time (1 year, 2 years, 3 years).
PV = Rs.5,000
t = 8% p.a.
1) FV (1 year) = 5,000 x (1+8%)^1 = 5,400
2) FV (2 years) = 5,000 x (1+8%)^2 = 5,832
3) FV (3 years) = 5,000 x (1+8%)^3 = 6,298
Money only grows with time? No…
If money is not suitable invested, its purchasing power actually reduces with time.
This also happens as time is money.
To understand the concept, lets assume that you and your friend has Rs.500,000 as spare cash. You decide to invest this money in mutual funds for next 10 years, on which you are likely to earn a return of 16% per annum.
But your friend, considering the risk involved with mutual funds investments, decided to keep the cash in the locker of his home.
What happens after 10 years?
Your money grew as we know that time is money (power of compounding):
PV = Rs.500,000
(P.N: today five lakh rupees can buy a Maruti Swift car – Petrol)
t = 16% p.a.
FV (10 year) = 500,000 x (1+16%)^10 = 22,00,000
Your friends money did not grow at all as he chose to earned zero interest:
PV = Rs.500,000
t = 0% p.a.
FV (10 year) = 500,000 x (1+0%)^10 = 500,000
After 10 years, you have Rs.22,00,000 as spare cash. You can use this amount to buy nice sedan like Honda City.
But your friend has only Rs.500,000. Using this money he can probably afford only a car like Maruti Alto.
So what this example proves?
It proves that if money is not invested suitably, with time the purchasing power of money reduces.
Hence, to make up for the lost purchasing power, it is essential to utilize the power compounding investment returns by investing money.
The concept of ‘Present Value’ of Money
This is one of the most useful derivative of the concept of time value of money.
Lets first do some calculations, before theoretical understanding of the concept of present value.
Suppose you are finalizing a deal for your home. You have two potential buyers, each having different price offers.
The first one is offering you Rs.50,00,000 as 100% down payment.
The second one is offering Rs.25,50,00 in first year and Rs.26,50,000 in second year.
Which offer is more lucrative for you?
If one doesn’t know the concept of ‘present value’, the second offer looks more lucrative as it is giving Rs.200,000 extra compared to the first buyer.
But lets use the present value concept to see which offer is more lucrative.
PV = Future Value / (1+r)^t
FV = Rs.50,00,000
r = 8.5% p.a. (discounting rate)
t = 0 years (down payment)
PV = 50,00,000 / (1+8.5%)^0 = Rs.50,00,000
1) Down payment (Rs.25,50,000)
FV = Rs.25,50,000
r = 8.5% p.a. (discounting rate)
t = 0 years (down payment)
PV1 = 25,50,000 / (1+8.5%)^0 = Rs.25,50,000
2) Second payment (Rs.26,50,000)
FV = Rs.26,50,000
r = 8.5% p.a. (discounting rate)
t = 1 year
PV2 = 26,50,000 / (1+8.5%)^1 = Rs.24,42,000
Total PV = PV1 + PV2 = 25,50,000+24,42,000 = 49,92,000
So you can see that, prima facie though the second offer was looking more lucrative, but after application of the “Present Value” concept, the first offer is looking better.
Present value of first offer is Rs.50,00,000
Present value of second offer is Rs.49,92,000
Why this difference?
This difference is caused as time is money.
In case of second offer, Rs.26,50,000 is received only after lapse of 1 year. Rupees twenty six lakhs fifty thousand received after 1 year is valued less than its face value.
Rs.26,50,000 after one year values only Rs.24,42,000.
Hence first offer is better than the second offer.
So now, lets try to define in words, what is present value of money…
Applying the concept called “time is money”, we know that the purchasing power of a rupee/dollar reduces with time.
So a dollar in hand today is worth more than a dollar in hand tomorrow.
Suppose you get a dollar after one year. Applying a discounting rate of 8.5% per annum, the dollar to be received after 1 year from today will be worth only $0.92 as on today. Means its present value will be only $0.92.
Present value is the current value of future cash flows.
In order to calculate current value (present value) of future cash flows, one must use a suitable discounting rate.
In implementing the concept of the present value, the discounting rate considered for calculation is very critical.
Higher discounting rate will mean that present value will be deflated.
Lower discounting rate will mean that present value will be inflated.
Selecting a right discounting rate is necessary.
What discounting rate you should consider?
The discounting rate will vary from person to person. A person who has capability to generate higher return on his invested spare cash, can consider high discounting rate.
A person who has capability to generate only low return on his invested spare cash, must consider lower discounting rate.
What decides ones capability to generate high/low returns?
Ones investment know-how and risk taking ability decides potential future returns.
Warren Buffett, can even consider the discounting rate as high as 20% per annum. Why? Because he has potential to generate 20% returns. He is the worlds BEST stock investor.
But “WE” must select discounting rates more conservatively. Our investment know-how is limited, as our risk taking ability.
So what to do? How to know OUR suitable discounting rate?
Ask yourself this question; how much return on investment I can generate for myself?
Take more risks, higher returns can be generated.
Creating a balance between risk and return is key.
As a common men, we cannot take high risks with our hard earned money. For common men, a risk premium of 1-2% is suitable.
Apply this formula and get your potential return on investment (ROI):
ROI = 6.5% + 2% = 8.5% per annum.
For us a discounting rate of 8.5% per annum is suitable to calculate the present value of our future cash flows.
Disclaimer: All blog posts of getmoneyrich.com are for information only. No blog posts should be considered as an investment advice or as a recommendation. The user must self-analyze all securities before investing in one.