Time is Money - Explained Right Here
When you have a choice between 2 receipts, don't only look at the amounts being received. Also look at when you're receiving it.
Congratulations!!! You have won a cash prize! You have two payment options:
A: Receive Rs. 1,00,000 now
or
B: Receive Rs. 1,00,000 in three years. Which option would you choose?
The answer depends on your understanding of the time value of money (TMV).
What Is the Time Value of Money?
Of course you’d choose to receive the Rs. 1,00,00 today.
Why would any rational person defer payment into the future when they could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive.
At the foundational level, the time value of money demonstrates that all things being equal, it seems better to have money now rather than later.
Money you have now is worth more than the identical sum in the future due to its potential earning capacity
Let’s understand the same from this time line:
(Interest rate of 5% p.a. has been assumed)
Option A
Rs. 1 lakh today (i.e. Yr 0) is the present value.
Rs. 1,05,000 is the the future value at the end of year 1 of 1 Lakh invested today
Similarly, Rs. 1,15,762.5 is the the future value at the end of year 3 of 1 Lakh invested today.
Option B
The future value at the end of year 3 for Option B, on the other hand, would only be Rs. 1,00,000 since the same is received only in year 3.
Decision: The 1 Lakh received today has the potential to be Rs. 1,15,762.5 at the end of year 3. Thus, standing at year 3, we would be comparing 1,15,762.5 with 1 lakh received in that year under option B. Since 1,15,762.5 > 1 Lakh, Option A is the preferred choice, standing at year 3.
But we have to make the choice between Option A and Option B today, i.e. Year 0. How do we do that?
Let’s look at the concept of Present Value of Money
If you received Rs. 1,00,000 today, its present value would, of course, be Rs. 1,00,000 because the present value is what your investment gives you now if you were to spend it today. If you were to receive Rs. 1,00,000 in 3 years, the present value of the amount would not be Rs. 1,00,000 because you do not have it in your hand now, in the present.
If Rs. 1,00,000 is received in the future, it’s present value will definitely be something less than 1 lakh today.
In other words, to find the present value of the future Rs. 1,00,000, we need to find out how much we would have to invest today @ 5% p.a. in order to receive that Rs. 1,00,000 in the third year.
Present Value (PV) = Future Value (FV) / (1+r)^n
r = interest rate per period
n = number of periods
W.r.t 1 lakh to be received after 3 years,
it’s value today (PV) = 1,00,000 / (1+0.05)3 = Rs. 86,383.76
Thus, receiving 1 lakh after 3 years is as good as receiving Rs. 86,383,76 today if the earning potential of your money is 5% p.a.
Decision making
Thus, while comparing between option A and B, you’re technically comparing 1 Lakh under option A and Rs. 86,383.76 under option B.
Take Away
You’ve now successfully understood the technical aspects to back your instincts to go with Option A.
Money today is definitely worth more than the same sum received in future.
Hit that 💚 if you learned something today.
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Great read!