Changing Value of money with time - time value concept

Regularly on television, we see an ad on pension plan, where the lead actor says whether the funds you invest  in the mutual fund today will be enough in future. We can associate the same with our daily life. During my childhood day, a plate of chicken biryani at my favorite restaurant was RS 50(some 10-15 years back). I visited the same restaurant few days back, the price of chicken biryani was Rs 200. So the purchasing power of Rs 200 has reduced from what it was ten years ago and it is much higher than what it will be ten years from now. 10-15 years ago, I would have brought four plates of chicken biryani for Rs 200, but now only one L

In this article, I will try to understand and share, why the purchasing power of money changes with time. We will try to understand the time value of money.  The basic concept behind time value of money is “a given sum of money is more valuable the sooner it is received” due to the potential of earning interest from the money.

Let us take another example. Suppose I had Rs 100 with me and invest it in some government bank under a fixed deposit plan which is giving me almost risk free 10% of interest rate (Please do not ask which bank is offering such interest rate, I have taken 10% for ease of my calculation).

Suppose I invested the money in the fixed deposit for 5 years. The value of the investment at different time will be:

The relation between Present value, future value and the interest rate is as follows:

FV = PV * (1+r)ⁿ

As shown in the calculation above, the future value depends on the rate of interest. Next let us understand how the interest rate is calculated.

Interest rate depends on following factors or components:

a. Risk-Free Rate – A risk free investment is one in which the actual return over a tenure are always equal to the expected return over the period. For e.g.  Government securities can be considered risk free investment and the rate they provide can be considered as risk free rate.

b. Expected Inflation - Inflation refers to the rate at which prices for goods and services rises. Any investment should beat the rate of inflation to make it profit.  

c. Default-Risk Premium – When we invest money in some instrument, we are actually lending money to another party. One component of interest is to consider the capacity of counterparty to repay the investment. This component will be high or low depending on the creditworthiness of the person or entity involved, i.e. what is the probability of the counterparty to default. That is the reason why the bonds of private institutions provide higher interest rates compared to government bonds. Rating provided by rating agency to the instrument is an indication of the risk of default for the instrument.

d. Liquidity Premium- Liquidity of an instrument is considered to be low if the instrument cannot be converted to cash easily. For e.g. Consider there are two bonds, a bond with higher liquidity will have low premium compared to another bond with low liquidity. Higher liquidity means the instrument will be easily convertible to cash and will follow the fair price for the stock. A less liquid instrument should offer a higher interest rate to compensate as liquidity premium.

e. Maturity Premium - Maturity risk premium applies to any investment that pays a fixed rate of interest and has a fixed maturity date. Buying any investment with a longer time to maturity increases the probability that interest rates could rise within the period between today and maturity.

Summarizing the time value of money increases with time based on the interest rate. The future value of any investment depends on the interest rate. Interest rate is directly proportional to risk free interest, increase in inflation rate, and time to maturity of the instrument and the probability of default by the counterparty, and illiquidity in the instrument.