Understanding the Time Value of Money

Consider the following instances:

A: If someone offered to give you AED 100 now or in a year’s time, you’re likely to take it now, without pausing to think about it.

Why? What’s the difference between AED 100 now and the same amount one year from now; ultimately they’re the same amount, no?

B: If the same person offered you AED 100 now or AED 110 in a year’s time, you would probably give it some thought before deciding.

Why? AED 110 is more money than AED 100, so isn't that the obvious choice?

Though a financial theory, the concept of money value over time, or the Time Value of Money, is applied - consciously and subconsciously - in practical everyday situations. The time value of money is simply the idea that money available at a present time has more value than the same amount at a future date. Going by instance (A) above, you would choose to receive AED 100 now instead of in a year’s time because AED 100 provides more value and utility to you now than it will at a future date. While this seems instinctive and simple enough to understand, instance (B) introduces a slight complexity; how do you decide which is more, between AED 100 now or AED 110 in 12 months? In other words, how do you determine the value of AED 100 over time?

Here are a few factors which affect the value of money over time:

  1. Opportunity Cost: Generally speaking, opportunity cost refers to the alternatives you pass up when you take a decision. Money kept in a savings account, for example, has the potential to earn interest and grow over time. Therefore, in instance (A), the opportunity cost of receiving the AED 100 after a year instead of immediately, is the interest you would have earned if you had received it immediately and kept in a savings account. Let’s look at it a different way; say the interest rate on savings accounts is 20% per annum. AED 100 placed in a savings account today grows to AED 120 in a year’s time. This means that if you lend someone AED 100 today and they pay back the same AED 100 amount after a year, the opportunity cost to you is the interest you would have earned on the money, had you placed it in a savings account instead of lending it out; in this case, AED 20.

  2. Purchasing Power and Inflation: Inflation is the general rise in price of goods and services over a given period. Purchasing power is the ability to buy goods and services, or simply put, the value of a sum of money. If a book that cost AED 50 last year now costs AED 55, this means that the inflation rate for the period is 10%, because the price of book has increased by AED 5, which is 10% of the original price. So now, your AED 50 from last year can no longer buy you your favorite book, meaning that your purchasing power has reduced. Since inflation causes a drop in purchasing power, it is advisable to consider the inflation rate when making financial decisions. Relating this to instance (B), if the inflation rate in the given year is 15% and you agree to receive AED 110 in a year’s time instead of AED 100 today, in actual terms, you have lost AED 5. This is because even though you now have AED 10 more at the end of the year, the cost of goods has increased by AED 15, so you will need AED 5 more to purchase the same things you would have bought the previous year.

  3. Uncertainty: Despite our best efforts, we cannot accurately predict the future 100%. So, when making financial decisions, it is wise to factor in the uncertainty of the future. That said, some investments offer a bit more security than others. A bank offering interest on a savings account is way more secure than lending money to be returned at a future date because your bank’s agreement with you is legally binding and enforceable.

In summary, the value of money perhaps is the actual value and utility it provides. The Time Value of Money is a useful concept to help you determine value and can guide you into making wiser financial decisions.

Disclaimer: All numbers mentioned in this article are hypothetical to explain the concept of Time Value of Money. This is not a prediction or promise of how much the money value will inflate/ deflate in the future.

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Dania Nwizu is a creative entrepreneur based in Lagos, Nigeria. She spends most of her time writing, telling food stories and walking on water.

This article is intended to provide general information about finance and investments and does not replace or should be taken as professional financial advice. The content reflects the view of the author of the article and does not necessarily reflect the views of Citi or its employees, and we do not guarantee the accuracy or completeness of the information presented in the article except information on Citibank N.A. – UAE products referenced herein.
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