The Concept of Time Value of Money. How it helps us to manage the cash flows wisely?

By Trader Pit

July 8, 2021


Money is the most important of all the things we own in our lives, and it has a way of finding its way into our bank accounts, despite our best attempts to keep it out. But all of us pay for money every day, and we may not even realize just how much. In fact, we don’t even know what money is. Ask a child what money is, and you’ll get a lot of different answers.

Consider the fact that time is the most valuable asset you have, so how do you manage your cash flows? To answer this, we need to understand the concept of money. Before we go any further, let me try to fill you in on the three types of money: -1. Denominated in a currency; -2. That is a medium of exchange; -3. That is a store of value. In the first case, it is easy to understand, the money can be converted into some other currency, which can be used to buy goods and services. In the second case, the money can be used to purchase goods and services, which means that the money can be used to make things more useful to you

In finance, there is a concept that says there is a time value of money. This is one of those concepts that form the basis of all money management.

But before we can understand the time value of money, we need to know who should care about it. In theory, the concept concerns everyone. But in practice, there is a certain percentage of people for whom it makes no difference.

Who are these people? People who live from hand to mouth. These are people who spend almost everything they earn each month. They can only save a small amount from their income. Read: How do you avoid salary dependency?

For these people, the knowledge of the time value of money is nothing more than a theory that has nothing to do with real life. Even if they want to apply this concept in everyday life, they cannot. Why? Because to do this, you must first learn the tricks to saving money.

The concept of the time value of money is useful for whom?

It is useful for people for whom wealth creation is a priority. These people always know how inflation affects their purchasing power. As a result, they save and invest their savings wisely.

The purpose of investing the accumulated money is to make it grow faster. The growth rate must be higher than the inflation rate. In a growing economy like ours, inflation is higher and more unpredictable. To beat inflation, risky investments are inevitable.

The role of the time value of money

In this scenario, the time value of money now also plays a role. How do you do that? After all, the faster the revenue flows into our pockets, the faster we can invest and grow it.

For example, suppose that in January 2021 income is due on a bank account. However, it was not reached until June 2021. What is the effect of this postponement? The money remains uninvested for six months. Money did not increase, but was devalued by inflation.

So we can say that we face two challenges. The first is a cash flow battle. The sooner we get the money, the better. Second: To beat the wrath of inflation, we need to invest wisely in a risky proposition. The goal is to achieve a higher profit.

What is the time value of money?

The time value of money is a financial concept that states that the value of money decreases over time. It’s simple: The 100 million rupees are worth more now than in a year’s time. Why? After all, the money that is available today can be invested and will therefore generate cash flow in the future.

The above infographic symbolizes the time value of Rs 100 crore. Assuming that money can grow at 10% per year, the value of money is given after the first, second and third year. How should the above figures be read? For example, Rs 100 today is equivalent to Rs 133 in three years.

What is the advantage of this concept for us? To understand the essence of this usage, let’s look at two examples.

Example #1

Suppose you want to buy a house worth Rs. 1.0 million. This is a new facility that is expected to be completed within the next three years. The proposer has proposed two payment options (see below). You want to know which payment term is best for you.

To simplify the calculation, let us assume that you have Rs 1.0 crore in bars. This means that you will not opt for a bank loan. So from a cash flow perspective, your chance of maturity date 1 is right there. Now let’s see if payment term 2 is reasonable or not. How do you check it?

Before we start the calculations, we need to answer a little question. What return on investment can you achieve over a period of 3 years? Let’s assume your answer is 8.5% per year.

What happens if you invest Rs. 1.0 million in such an investment option? In the next three years, a fund of 1.0 million rupees will become a fund of 1.28 million rupees.

Let’s try to understand what’s going on. You have selected the second payment period. So you haven’t paid anything for the property today. Instead, you invest your savings (Rs. 1.0 million) at an annual interest rate of 8.5%. They will have Rs 1.28 crore for the next 3 years.

What happens after the third year? You can pay Rs 1.25 crore for the property. After the payment, you will have 3 lakhs as remaining money. Therefore, the second payment term is more advantageous for you.

Examine the matrix below to determine the size of the case that occurs at different performance levels. As you can see, with an investment return of less than 8.0% per year, the duration of the first payment is preferable.

This is the first example of using the concept of the time value of money, which has allowed us to discover which payment alternative is best.

Example #2

Suppose there is an investment plan that asks you to immediately invest Rs. 1.0 million. Once invested, it will generate cash flow from the seventh year. The cash inflow is 36 lakhs in years 7, 8, 9, 10, 11, 12, 13, 14 and 15 (36 lakhs x 9 = Rs 3.24 crore).

At first glance, it seems reasonable to turn 1 million rupees into 3.24 million rupees in 15 years. But how can you be sure? How can you determine whether or not it is worth investing in this investment plan?

Start again by answering the question. What is your guaranteed investment income from alternative investments (over the next 15 years)? Let’s assume your answer is 11% per year.

To evaluate an investment plan, we need to calculate the present value (PV) of all future cash flows. The calculation of the present value can be done by determining an appropriate discount rate. What would the discount rate be? It will be 11% per year, as assumed above.

At this discount rate, the investment plan is buyable if the PV of all future cash flows is more than Rs 1.0 million.

How do you calculate the present value (PV)? This can be done using the PV formula in Excel. The PV formula in Excel is as follows:

Now let’s use the PV formula and calculate the present value of all future cash flows that will occur in 9 years, as above.

The above calculation shows that the sum of the present values of all future cash flows amounts to 106.6 million euros. A discount rate of 11% per annum has been established. Since the net present value is higher than the investment amount, the investment plan must be taken into account.

[P.Note: Thanks to the investment plan, your money has gone up – 1.0 crore has become 1.06 crore].

Supplement

The time value of money is best used to calculate the present value of future cash flows (as in Example 2). The more the cash flows are spread out, the more complex the present value calculations become.

I would suggest a simpler way to evaluate an investment plan with complex cash flows. We can use the XIRR formula in Excel to perform the calculations.

How do you do that? First, determine how much investment income you can safely earn with your preferred investment option. Let’s assume it’s 12% a year.

Once this is done, we can start plotting all future cash flows (as shown below). This creates an Excel spreadsheet to calculate the return on investment (ROI) using the XIRR formula.

Finally, we can compare the calculated profitability of the investment plan with your safe return. If an investment plan’s XIRR is higher than your assumption of a safe return, then that plan is worth investing in.

To estimate intrinsic value, it is best to use the concept of the time value of money. The method we can use for this calculation is the discounted cash flow (DCF) method.

Frequently Asked Questions

What is the concept of time value of money?

The concept of time value of money is the idea that money has a certain value at a certain time. This value changes depending on the time period.

Why is the concept of time value of money is important?

The time value of money is the idea that money today is worth more than the same amount of money in the future. This is because money in the future is worth less because it could be invested, saved, or spent.

Why is the concept of time value of money important in studying financial management?

The concept of time value of money is important in studying financial management because it helps you understand how to make the most of your money.

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About the author

Trader Pit

A yogi who like Finance and Technology. I have been in Indian Stock market for over 12 years now as financial analyst, portfolio manager, trader. Now, I focus on Yoga, Financial Education & Long term investing. 

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