Time Value of Money

Suppose Bharat is purchasing some goods worth Rs.100/- today.  We all know that in a year’s time, you would require more than Rs.100/- to purchase the same goods as you have done today.  This is due to the “Rise in Prices”.  This phenomenon is observed constantly in almost all the economies, though the degree of increase would depend upon so many factors and hence it differs from time to time and country to country.

This “increase” in prices is due to the fact that at any given time, more money chases less goods and services.  This means that there exists a gap between “Supply” and “Demand” of goods and services and the degree of price rise directly depends upon the extent of gap.  The more the gap the higher the price rise and vice-versa.  This general increase in prices of goods or services with the passage of time is called “Inflation”.

Inflation in India as a Developing Country:

All Developing Countries experience a fair to heavy dose of Inflation depending upon the Current Growth Rate of the Economy.  Usually, when the economic activity is at its peak in the growth phase in any country, the rate of Inflation tends to be high, as money in circulation increases appreciably and growth in terms of economic activity requires a little time to catch up with.

India, as a developing country is no exception to this phenomenon of “Inflation”.  At present, it is indicated that the rate of Inflation as per “Wholesale Prices Index (WPI) ” is around 9%.

However, in all Developed Economies, the rate of Inflation is measured in terms of “Consumer Prices Index”, which is the correct measure, as consumers do not buy at wholesale prices and that in a country like India, there are any number of intermediaries between wholesale trade and retail trade; usually, the average consumer gets his goods from the retail trade and not the wholesale trade.

What do you mean by “Rate of Inflation of 5%”?

This means on a comparative basis, the difference between prices of a basket of Commodities last year and this year works out to 5%.  Hence, in case there is a reduction in the rate of Inflation, it does not mean that the prices have come down in an absolute sense.  It only means that the rate of increase in price rise of a basket of selected commodities has come down.                                                                                                                                                                                                                                                                                                                                                                              What is the difference between inflation in a Developing Country and a Developed Economy?

Inflation in a Developing Country appears due to the gap between “Supply” and “Demand” of goods and services, whereas, in a Developed Country, this is not the case.

Developed Countries experience, what is known as “Cost Pushed” Inflation.  This essentially occurs because of  “high levels of income”, which pushes up the “Cost of Production”, resulting in Inflation.  This does not necessarily indicate that there is a gap between “demand” and “supply”.

Inflation and Interest Rates:

In any Economy, there is a 4-tier Structure for Rates of Interest as under:

Tier No. I – Rate of Inflation;

Tier No. II – Rate of Interest on Deposits, i.e., Rate of Inflation + Certain % loading depending upon the degree of compensation expected by the Depositors;

Tier No. III – Rate of Interest on Loans, i.e. Rate of Interest on Deposits + Certain % loading depending on the risk perceived in the lending activity by the lender which could be borrower specific and the profit margin of the lender and

Tier No. IV – Rate of return expected by a promoter from Investment in a project = Rate of Interest on Loans + Certain % loading as a reward for the risk incurred by the promoters in the project.

What is “Time Value of Money”?

That with the passage of time, the value of “Present Money” reduces due to “Inflation”is clear to us and this phenomenon is referred to in finance as “Time Value of Money”.

Interest is in fact primarily a Compensation for the loss in value of money due to passage of time. Hence we should familiarise ourselves with terms associated with “Time Value of Money”such as “Compounding and Discounting”.

Compounding:  It is a process by which given a specific present value, at a fixed rate of interest and depending upon the frequency of compounding, the future compounded value can be determined for a specific period.

All of us know this formula to be

F.V. = P.V. (1+ r /100) raised to “n” times, “n” representing the period in number of years.

This presupposes that the periodicity of compounding is yearly.

In case the periodicity of compounding is half-yearly, then the formula would change as follows: F.V. = P.V. (1+ r /200) raised to “2n” times. Similarly, the formula could be amended for quarterly compounding or monthly compounding.

Discounted value:  This is converse to the process of “Compounding”. Just as we know the present value for compounding, we should know the future value for discounting.

This value, when discounted at a given rate of discount, which is usually the rate of return expectation, by a promoter or an investor gives us the present value.

This again depends upon the period for which the discounting is done.  Just as in the case of compounding, in the case of discounting also, the formula which is given below needs amendment for adjusting for a more frequent periodicity of discounting than 1 year.  P.V. = F.V./(1+r/100) raised to the power of “n”, wherein “n” is the number of years.

This discounting is useful for saving a fixed sum at a future date and for evaluating projects, whose cash flows can be determined now for a future date.

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