Time Value of Money
One of the central concepts, around which the world of finance and investment revolves, is ‘Time Value of Money’ or TVM as it is sometimes called.
The basic premise of this concept is that any amount of money today is valued more than the same amount in the future. Money has the capacity to grow and given that money can earn interest and grow through investments, it is worth more, the sooner you receive it.
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Let us understand this with an example. Vivek wants to renovate his house before Diwali. Since it is April, he has 6 months to save money for the job. The total cost of renovation comes to ₹8 lakh. Vivek can put together ₹6 lakh on his own and plans to take a loan of ₹2 lakh from his friend Sunil.
Sunil is happy to lend the money to Vivek and has offered him a choice of either taking the amount right away or in October, when Vivek needs it. Now, there are two scenarios. If Vivek decides to wait till October, he will immediately need to use it on the renovation. However, if Vivek understands the time value of money, he will take Sunil’s offer of taking the amount right away.
Given that he has six months before he requires the amount, Vivek can invest in short-term debt instruments like a debt mutual fund or even a fixed deposit. Say, the investment earns him an interest of 4% compounded half-yearly, he will have ₹8000 more in October.
Hence ₹2 lakh in April is much more valuable than the same amount in October.
This demonstrates the time value of money. The concept of time value of money helps in determining the future value of investments.