Understand the time value of money
By James Abola
Most cartoons are supposed to be interesting but I recently saw a really interesting one in a local newspaper. In the cartoon a sweating man was facing two other men who were smiling in a sly way from across the table. One of the smiling guys told the sweating fellow: “We know what you ate from various places. Remember we do not take bribes but you can join our party.”
The lesson from the cartoon is that knowledge is power. The one who knows has control and the one who lacks knowledge also lacks control. Those who have ever ridden a bicycle will appreciate the importance of control. Riding a bicycle that is going down a steep slope without the means and ability to control it can be very unsettling, to say the least.
One of the things to know about money is what is called the time value of money. Academics claim that the time value of money is the foundation for the subject of finance. The good news is that it is not just academic but there are many ways in which the time value of money concept impacts on a person’s personal finance.
You have performed exceptionally at your job and your boss is filled with excitement. The boss calls you to her office and in the presence of the Finance Director, offers you a Shs 1,000,000 bonus with the option of you pocketing it immediately or at the end of the next financial year.
Most of us if given the option will choose to receive Shs 1,000,000 now. After all, 12 months is a long wait. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.
But why is this? A Shs 50,000 note has the same value as a Shs 50,000 note one year from now, doesn't it? Actually, although the note is the same, you can do much more with the money if you have it now: over time you can earn more interest on your money.
If you receive your bonus now, you can put it on an interest bearing account so that in one year’s time it would have grown to a bigger amount. Assuming an interest rate of 10 percent after a year the Shs 1,000,000 would be Shs 1,100,000. That is the positive way to look at it.
The negative way of looking at it is that because the general increase in prices over time, what you can buy with Shs 1,000,000 now may be a lot more compared to what Shs 1,000,000 can get for you in a year’s time. The retail price for a 300ml bottle of soda in May 2006 was Shs 600 while the same quantity of soda sold for Shs 500 in May 2005. So if a long lost friend had made an offer of Shs 500 to buy a bottle of soda for you in May 2005 and you did not take the offer until May 2006 you would be Shs 100 short!
For people involved in business, because of the time of value of money, it is advisable that your clients pay their bills as early as possible. If clients who pay late are not charged interest then that means the business is loosing money every day that passes and the bill is not collected.
Individuals or even institutions that have idle money that is either kept under a mattress or in a latrine or on a current account will also need to rethink. Just to maintain the value of the money you will need to put it on an interest bearing account.
The time value of money concept is also very informative when considering the interest rate you receive on your savings. In general you would want to get a rate that surpasses the prevailing rate of inflation in order to maintain the purchasing power of your money.
When planning for long term needs like college costs or retirement plans, a financial planner will use the principles of time value of money to estimate how much money you need to put aside over time in order to achieve your target. It is not just a matter of establishing the current cost of say college education and assuming that it is the same amount you will be paying in 10 years time. As it is often said the greatest risk in financial planning is the risk of not achieving your goals.
Most cartoons are supposed to be interesting but I recently saw a really interesting one in a local newspaper. In the cartoon a sweating man was facing two other men who were smiling in a sly way from across the table. One of the smiling guys told the sweating fellow: “We know what you ate from various places. Remember we do not take bribes but you can join our party.”
The lesson from the cartoon is that knowledge is power. The one who knows has control and the one who lacks knowledge also lacks control. Those who have ever ridden a bicycle will appreciate the importance of control. Riding a bicycle that is going down a steep slope without the means and ability to control it can be very unsettling, to say the least.
One of the things to know about money is what is called the time value of money. Academics claim that the time value of money is the foundation for the subject of finance. The good news is that it is not just academic but there are many ways in which the time value of money concept impacts on a person’s personal finance.
You have performed exceptionally at your job and your boss is filled with excitement. The boss calls you to her office and in the presence of the Finance Director, offers you a Shs 1,000,000 bonus with the option of you pocketing it immediately or at the end of the next financial year.
Most of us if given the option will choose to receive Shs 1,000,000 now. After all, 12 months is a long wait. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.
But why is this? A Shs 50,000 note has the same value as a Shs 50,000 note one year from now, doesn't it? Actually, although the note is the same, you can do much more with the money if you have it now: over time you can earn more interest on your money.
If you receive your bonus now, you can put it on an interest bearing account so that in one year’s time it would have grown to a bigger amount. Assuming an interest rate of 10 percent after a year the Shs 1,000,000 would be Shs 1,100,000. That is the positive way to look at it.
The negative way of looking at it is that because the general increase in prices over time, what you can buy with Shs 1,000,000 now may be a lot more compared to what Shs 1,000,000 can get for you in a year’s time. The retail price for a 300ml bottle of soda in May 2006 was Shs 600 while the same quantity of soda sold for Shs 500 in May 2005. So if a long lost friend had made an offer of Shs 500 to buy a bottle of soda for you in May 2005 and you did not take the offer until May 2006 you would be Shs 100 short!
For people involved in business, because of the time of value of money, it is advisable that your clients pay their bills as early as possible. If clients who pay late are not charged interest then that means the business is loosing money every day that passes and the bill is not collected.
Individuals or even institutions that have idle money that is either kept under a mattress or in a latrine or on a current account will also need to rethink. Just to maintain the value of the money you will need to put it on an interest bearing account.
The time value of money concept is also very informative when considering the interest rate you receive on your savings. In general you would want to get a rate that surpasses the prevailing rate of inflation in order to maintain the purchasing power of your money.
When planning for long term needs like college costs or retirement plans, a financial planner will use the principles of time value of money to estimate how much money you need to put aside over time in order to achieve your target. It is not just a matter of establishing the current cost of say college education and assuming that it is the same amount you will be paying in 10 years time. As it is often said the greatest risk in financial planning is the risk of not achieving your goals.
Comments
Post a Comment
It helps all of us if you indicate your email address when making a comment.
Thank you. Akamai Global