Understanding Time Value of Money - Never been easy before

Let's build a scenario,.

Which would you prefer,… 10,000 dollars today or 10,000 dollars tomorrow?

Let me take the liberty of answering at your part. 'Obviously 10,000 dollars today'.

See, you have already realized that there is a 'Time value of Money!!!'.

Now let's start cracking.

Why is time such an important element in your decisions anyway?

Again taking liberty, "Time allows you the opportunity to postpone consumption and earn interest".

But what is interest? I am interested in Kelly, you mean that interest?

Well, you got it. But let's just replace 'Kelly' with 'Money'. Who isn't interested in money anyway? And why would someone give up on their interest (in this case money)?

This is where our minds just start working fine and we keep on thinking. Well!! If I am giving up on my interest for the time being I should be getting something better, which is money upon money.

So, now you know that Interest is something that you charge for the privilege given to the other party.  In above case, you let go Kelly and in returned doubled her. Sounds good?

But how many ways are there to double? That's a seriously loaded question.

 

Types of Interests:-

Simple Interest

Interest paid (earned) on only the original amount, or principal, borrowed (lent). 

• Assume that you deposit $1,000 in an account earning 7% simple interest for 2 years.  What is the accumulated interest at the end of the 2nd year? 

oOpps!!

Don’t panic.

It's very simple.

Step 1: Find 7% of $1000, which is $70.

Step 2: Double the amount. That is to say, $70x2= $140

(2, is the Number of years).

But what if I ask you what is the Future Value? i;e What will you get after 2 years.

Well, future value in this case is:

            Future value = Principal amount + Simple interest

                                 = 1000 + 140 = $1140

Talking about future value, But what should be the Present Value?

I guess, the borrowing amount or the amount lent otherwise known as Principal Amount.

So, here comes the most important question, how do we derive the formula from above question.

Let's see what elements we dealt with.

        Simple Interest= Principal Amount x Interest Rate x Number of Years

More professionally you can also write it as;

            I = P x R x T

Note:- Don't panic if you see a different formula than this one. There are some other scary formulas but the underlying rules are the same and trust me it works.

Compound Interest

Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent). 

• Assume that you deposit $1,000 at a compound interest rate of 7% for 2 years.

What now?

For the First year

Interest= $1000 x 7% = $70

Future Value (FV) = $1000 + $70= $1070

Well, now as shown in previous example, you earned $70 interest on your $1,000 deposit over the first year. This is the same amount of interest you would earn under simple interest.

Now the tricky part comes in the second year. Remember the word compound? Well, it does compound, have a look.

For the Second year

Interest  = $1070 x 7% =  $74.9

Future Value (FV) = $1070 + $74.9= $1,144.9

We can do the first and second year in just one simple step and for that we will have to use a formula.

            Compound Interest =  P (1 + r)ⁿ

Where:

P = Principal Amount

r = Interest rate

n= Number of years

Now, we are done with both types of interest.

In conclusion, now we know that it is only the present value and future value of an amount/investment/capital/project that we are so concerned about, but why? Because that is, our time value of money and we are very much concerned about that, accepting $1000 today is more beneficial or tomorrow.

I hope you understood the matter. That's for now.!