Question

Explain the concept of time value of money, including compounding and discounting. Consider how time value of money applies to personal life.

Answer 1

Time Value of Money:

If we have the option of receiving $200 today, or $200 a year from now, we will choose to get the money now.

There are several reasons for our choice to get the money immediately.

1. Use the money and spend it on basic human needs such as food and shelter.

2. We can use the $200 to buy clothes, books, or transportation.

3. We can invest the money that we receive today, and make it grow.

Thus, the $200 we receive a year from now may not buy the same amount of goods and services that $200 can buy today. and there is the uncertainty of not receiving the money at all after waiting for a year. People are risk-averse, meaning, they do not like to take unnecessary risk. To avoid the uncertainty, or the risk of non-payment, we would like to get the money as soon as possible.

Compounding is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest and the process continues till n number of periods we choose.

Discounting is the process to convert the future value of a sum of money to its present value.

So, in our personal life, we need to see the value of time value of money and should invest our income by weighing all the options available and the choose the options which are giving us more benefits using this time value of money concept.