Calculating the Time Value of Money

The concept of Time Value of Money can enable you to crystal gaze into the future. You can know the exact figure you may need 30 years later to live the same way as you do today or how much money or assets you will end up with in the future.

Let's look at the two ways you can use the concept of Time

Value of Money to crystal gaze into the future.

Finding out the Future Value

We know that future value is used to find out what your investments today will grow into in the future. It happens due to the power of compounding that follows a simple formula.

FV=PV(1+i)n

Where

FV is the final value

PV is the present value of the investment

i is the annual interest rate and

n is the number of years for which compounding occurs

Following this formula, it is easy to find out the maturity amount for the amount you are investing today, with a certain rate of interest.

Let's see how this formula works with an example.

Say, Sunil got married 5 years back and was blessed with a daughter earlier this year. Sunil has identified 3 key events in his daughter's life for which he needs to invest money namely, school education, higher studies and marriage. He has an idea on the corpus he will need to fund his daughter's school education but is not sure of the amount he will need for her higher studies and marriage.

Let us see how Sunil can find out the future value for higher studies and marriage:

• Higher studies

Any master's degree from a reputed institution in India or abroad, be it a MBA or M.Tech, costs anywhere between Rs. 15-30 lakhs today. Taking an average of Rs. 25 lakh as the amount of higher studies today, Sunil can know what it will cost 20 years into the future by using the above formula.

FV= is the final value or in this case, cost of higher studies after 20 years

PV is the present value or the cost of higher studies today

n is the number of years that will see the cost rise (20 years till his daughter grows up)

i is the annual interest rate.

In this case it will be the rate of inflation by which the cost goes up each year. We will keep it at 9% or 0.09.

Applying the formula, the cost of higher studies after 20 years will be: Rs. 20 lakh (1+0.09)20 that comes to Rs. 1.12 crores.

Thus Sunil, can have an estimated amount for his goal of higher studies for his daughter.

• Marriage

Similarly, to arrive at an estimate for marriage expenses, Sunil can consider the cost of his own wedding 5 years back. Say that amount was Rs. 5 lakh. Assuming that his daughter gets married when she is 28 years old, let us find out how much will it cost in the future.

We know that

FV is the final value or cost of marriage after 28 years

PV is the cost of marriage 5 years back

n is the number of years into the future that is 33 years (28 years + 5 years since Sunil's marriage)

i is the rate at which costs increase each year, i.e. inflation kept at 9% or 0.09

Again applying the formula, the final value will be Rs. 5 lakh (1+0.09)32. Hence we know that the same marriage that Sunil had for 5 lakh, 5 years back, will cost Rs. 71.81 lakh after 28 years!

Therefore, Sunil can safely estimate that he will need 2 crore in 20-22 years for his daughter's higher studies and marriage without any guesswork! It may seem like a staggering amount right now but with regular investments, starting today, Sunil can easily reach this financial goal. Using the SIP calculator, which follows the same compound interest formula, we know that if Sunil invests as little as 20,000 in a diversified equity mutual fund each month, giving an average annual return of 12%, he can easily reach his financial goal of 2 crore in 20 years.

Finding out the Present Value

Say, Sunil also wants to start investing for his retirement when he turns 60 after 30 years. Most of his friends say that Rs. 1.5 crore should be more than enough to lead a comfortable life post retirement. It sounds like a big amount right now but Sunil has no way to find out for sure. Currently, he spends Rs. 45,000 each month. If he goes by what his friends suggest, how does he determine if Rs. 1.5 crore will suffice for his retirement needs. Sunil can use the concept of Present value to determine what the final amount or cash flow to be received in future is worth in today's value or present time.

Using the same compound interest formula, the present value or PV can be determined as

PV=FV[1/(1+i)n] where

PV is the present value

FV is the final value or amount

n is the number of years

i is rate of interest adjusted when finding out the present value.

It is also known as "discount" rate.

Following this formula Sunil can know the present value of 1.5 crore with FV as Rs. 1.5 crore, n as 30 years and i as 9% (inflation rate to be adjusted). Therefore the present value of Rs. 1.5 crore can be given as Rs. 1.5 crore[1/(1+0.09}30] that comes to just Rs. 11.3 lakh in today's value. Now if Sunil needs to spend Rs. 45,000 each month to lead a comfortable lifestyle, then Rs. 11.3 lakhs will last him only for 25 months! That means, maintaining the same lifestyle and taking 9% as inflation or rise of cost each year, Rs. 1.5 crore will last only 2 years for Sunil. He certainly hopes to outlive the corpus! Hence, Sunil can accurately estimate that Rs. 1.5 crore as suggested by his friends, will certainly not be enough to live a comfortable life post retirement. He should ideally look at creating a corpus of Rs. 10-12 crore to lead a comfortable life for 15-20 years post retirement.

Calculating the time value of money enables you to accurately predict the amount you may need and whether it will be enough! This helps you plan in a wise way towards achieving any financial goal.

 

 

The information contained in this document is for general purposes only and not an investment advice. Readers should seek professional advice before taking any investment related decisions.

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