4: Introduction to Time Value of Money (TVM) : Part 2

Components of the TVM

Time Value of Money (TVM): The Time Value of Money is a financial concept that recognizes the idea that money today is worth more than the same amount of money in the future. This is because money has the potential to earn returns or interest over time. The key components of TVM include:

Present Value (PV): Present value represents the current worth of a future sum of money. It's the process of discounting future cash flows back to their equivalent value today.

Future Value (FV): Future value is the amount of money a present investment will be worth at a specified future date, assuming a certain interest rate or rate of return.

Interest Rate (r): The interest rate, also known as the discount rate or rate of return, is the rate at which money grows or is discounted over time. It's a crucial factor in TVM calculations.

Time Period (t): Time period refers to the number of years or periods over which a sum of money will be invested or borrowed. It is an important determinant of the future value or present value of money.

Difference Between Simple Interest and Compound Interest:

Simple Interest: Simple interest is calculated only on the initial principal amount. It does not take into account the interest earned on previously earned interest. The formula for simple interest is: I = P * r * t, where I is the interest, P is the principal amount, r is the interest rate, and t is the time period.

Compound Interest: Compound interest, on the other hand, considers the interest earned on both the initial principal amount and any previously earned interest. The formula for compound interest is: A = P * (1 + r/n)^(nt), where A is the future value, P is the principal amount, r is the annual interest rate, n is the number of times interest is compounded per year, and t is the time period.

Why Individuals Do Not Compound Money Due to Behavioural Issues:

Behavioural economics suggests that individuals often make irrational financial decisions due to various biases and psychological factors. Some reasons individuals may not effectively compound their money include:

Present Bias: People tend to prioritize immediate rewards over future gains. This bias can lead to impulsive spending rather than saving or investing for the long term.

Loss Aversion: People are often more concerned about potential losses than equivalent gains. This fear of losing money may discourage individuals from taking investment risks that could lead to compound growth.

Lack of Financial Literacy: Many individuals are not well-informed about financial concepts like compound interest, which can lead to suboptimal financial decisions.

Procrastination: People may delay making investment decisions, thinking they have plenty of time to save and invest. This delays the benefits of compounding.

The Concept of Compounding and Discounting:

Compounding: Compounding refers to the process of reinvesting earnings or interest on an investment, which leads to exponential growth over time. It allows your money to earn interest on both the initial principal and any previously earned interest.

Discounting: Discounting is the opposite of compounding. It's the process of determining the present value of future cash flows. It involves reducing the value of future cash flows to reflect their worth in today's terms, considering a specific interest rate.

Drawing the Time Line to Understand Compounding and Discounting: A time line is a visual representation that helps in understanding the timing of cash flows in TVM calculations. Here's a simple example:

Compounding: For compounding, you start with the present value (PV) on the left side of the time line, and then you show future values (FV) at various time points to the right, taking into account interest or returns earned at each period.

Example: PV -> FV1 -> FV2 -> FV3

Discounting: For discounting, you start with future values (FV) on the right side of the time line and work backward to calculate their present values (PV) on the left side, using the appropriate discount rate.

Example: FV3 <- FV2 <- FV1 <- PV

These time lines help illustrate how money grows over time with compounding or how future cash flows are valued in today's terms with discounting.

Authored By

Seshadri Krishnaswamy Iyengar

Mentor - StockEazy Financials