Question

Explain how you could use time value concepts to adjust things like your spending, investment, and savings goals for the future.  

Answer 1

Time Value of Money is the concept that the same amount of money is worth more today than tomorrow. It can be explained using its 4 determinants:

1. Consumption Preference

Consumption preference comes out of need for consumption. For example if a certain sum of money is required today for consumption, it will be prefered today more.

2. Uncertainty of future

The future is always uncertain. Nobody knows what will happen in the future. So it is better to consume now rather than consume in the future if the current consumption rate is more. People would like to compensate for uncertain future cash flow against certain cash flow.

3. Inflation of the economy

Inflation is related to the purchasing power of money. With time the purchasing power of money is decreased. If there is higher inflation then the required rates of return of investors are higher. For a higher inflationary economy, consumers prefer current consumption rather than future consumption.

4. Investment opportunity

Time value of money considers the idea of reinvestment that is if an investment generates cash inflow periodically then this periodic return can be reinvested which will generate a higher return. If the cash flow comes now, it can be invested and generate additional cash flow, therefore whatever may be the cash flow now. The future cash flow is more than its present cash flow.

How to use time value concepts to adjust things like your spending, investment, and savings goals for the future:

Lets try to understand this using examples.

Say you have a certain amount with you today, but you know that next month you will require more than this amount for spending/consumption requirements. In such a situation, someone familiar with TVM concepts would block these funds in an investment, in such a way that they recieve interest on it, enough to make the amount equal to your future consumption requirements. This essentially involves getting compensated for the risk taken in investing and inflation.  

Similarly, if you have requirement of funds, say, for education in 10 years, you will find avenues where the face value of your money increases in 10 years, therby making the intrinsic value of your money equal to (or more than) the present value. This is how you plan your finances to meet your future requirements and goals using the concepts of TVM.