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Thursday, June 1, 2017

Time Value of Money (TVM)

What is Time Value of Money?

Time Value of Money (TVM) is the concept that the value of the same amount of money available today is worth more than the value in future with the same amount of money receive. The main reason is because of INFLATION, where the value of the money is reduced in time. In other word, your purchasing power is reduced with the same amount of money comparing today and 10 years later. 






Why Understand Time Value of Money is important?

Simply because time is money! You want to fully utilize your time and money to make more money. The value of your money is decreasing every single day when you waste/procrastinate by letting them do nothing in your pocket. So what you do with the money you have NOW is utterly important! Time Value of Money can be better understand with the basic formula of calculating future value.





How to Calculate Future Value of Money?

Future value of money can be calculated by using these variables, namely present value, interest rate and number of periods. Looking at the formula, by increasing any of these variables, the future value of money will be increased too and vice versa. Which is why you have to start invest early, so that your number of periods is bigger and future value will be greater too. Greater return (interest rate) will yield higher future value too, so keeping in your pocket, keeping in bank and keeping in investment make a big difference as well!  



Example?

If you won a lottery (forget about the tax or whatsoever) and you are given a choice to choose:
Option A : Receive RM1mil now
Option B : Receive RM1mil 5 years later
Which one would you choose?

Obviously, the answer would be A, you want it now since Option B doesn't give you any extra incentive. And the same RM1mil probably not enough to buy you the same house or same land or same car or anything 5 years later because of inflation. So this is easy to choose, what about....




Option A : Receive RM1mil now
Option B : Receive RM1.5mil 5 years later
Which one would you choose?

Now, this is tricky! But actually not if you understand Time Value of Money. 

Step 1 - Find out the interest rate (return, r)
By moving around the future value formula above, we will get the number of period formula as per below. Do you feel familiar with this formula? Yes, this is indeed the same as Annualized Return where I have posted about it in previous post (read here). Simply go to Online Finance Calculator (click here) and key in all the values, you will find the Interest Rate/Annualized Return is 8.447%

PV = RM1mil, FV = RM1.5mil, n = 5, find r?



Step 2 - What will you do with the money?
Now the question is simple, what will you do with the money if you receive it now. If you are going to take the RM1mil now and put in your home (with 0 interest) or put in fixed deposit (around 4%), then you might as well choose Option B. Let's not forget that you may want to include inflation into your calculation as well. So bottom line, 8.447% should be your benchmark, unless you can beat the benchmark of 8.447%, otherwise you should always choose Option B, you want it later



If you won a lottery, probably these are not in your mind...
I bet most of you will be thinking how to spend it all away. Which is why according to National Endowment for Financial Education, about 70% of lottery winners actually end up broke within a few years. (Read here)

Well, nothing wrong with that, it's natural to want to spend money on nice things once you receive a huge amount of money. But if you do not have a proper financial plan, even for millions of dollar, you can easily lose track of how much you have spent until it is too late to realize.  


So remember, if you happen to win a lottery or receive a big inheritance, regardless of Option A or Option B, remember to hire #YourFinanceDoctor to ensure that you can spend part of the money yet keeping the rest of them to generate more money for you!  😉😉😉

2 comments:

  1. Really dont understand about financial. But i do understand the value of money now reduce. Oh Malaysia!

    ReplyDelete
  2. its such a good example by choosing option A or B :D

    ReplyDelete

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