As investors it is of some importance and interest for us to have an understanding of the time value of money. And to appreciate the reasons why a unit of money, let us say the Indian Rupee, today has more value than it would have a year or two later.
You would appreciate that in addition to consuming this money in the present, the investor may consider applying this money through the various investment avenues and instruments available to him to enable a positive return to him sometime in the future. In addition, the influence of inflation would reduce the purchasing power of this unit of money with the passage of time.
To put the above in perspective, the investor would invest his money along with the accompanying exposure to risk in the expectation of a positive return in the future, which may be a few months or a year later. A part of this return on investment would provide for the reduction in the value of the unit of money during the investment period.For purposes of comparison amongst the various investment avenues and their accompanying instruments and factors of risk, the investor would be obliged to either "compound" to ascertain a future value of the money applied or invested today; or he would "discount" a future money amount to its present day value. The former is usually applied in an upward trending market, while the latter in a downward trending market and a combination of the two may be applied in a sideways trending market.
A time line may be applied when the cash flows occur at different points over time. Further, these cash flows may be both positive or negative which would signify a cash inflow and a cash outflow, respectively. It would also be appropriate for the investor to differentiate between compound interest and simple interest; as in the former the income, profit and/or interest earned after a period of time is reinvested along with the initial investment into the future; while in the case of the latter the income, profit and/or interest is not reinvested but consumed at the point of cash inflow or thereafter. The investor would realize that over a period of time his return on investment would be much higher if he were to be able to compound his investment along with the income he is able to generate through his investments.The interested investors would further seek the formulae for the future value of a single amount, for the concept of the doubling period by applying the rule of 72 and ascertaining the growth rate.
Now, the concept and process of discounting is the inverse of compounding; the formula for which may be obtained by appropriately adjusting the same for the purpose. Here the investor is seeking to discover the present value of a monetary amount to be received in the future. Discounting may be done for a single amount as well as for a cash flow stream over a period of time.
An investor would undertake this exercise to assess his present position as well as what lies ahead in the future for him, given the various mathematical tools he may chose to apply to ascertain the same. This would also help the investor discover a monetary amount he would be required to save annually or over a period of time to meet cash outflow requirements pertaining to purchases (like house, car and other consumer durables) and also their interest cost he would be obliged to provide for in the future. This would lead the investor to create a sinking fund to provide for these constant and periodic cash outflows in the present and in the future. However, the present cash outflows would not be required to be discounted as they would occur in the present.
The concept of the time value of money may also be utilized towards ascertaining a loan amount an investor is able to take, while assessing the affordability of the monthly installments. On the other hand, he may also apply these mathematical tools to determine a loan amortization amount and the periodicity of its repayment, while also finding the appropriate accompanying interest rate. In addition to this, the investor may also utilize these mathematical tools to ascertain the present value of a growth annuity or a perpetuity; and also be able to differentiate between a stated interest rate versus an effective interest rate.An understanding of the time value of money would give the investor an insight as to what he is really up against when he invests the financial resources he may have under management in the various investment avenues and financial instruments he may have access to and chose to invest in.