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Financial Plan – Concepts & Factors for Success
What is the time value of money?
You have won 10 lakh in a lottery. Given a choice, would you take the 10 lakh as a lump sum in one shot immediately? Or would you prefer to receive it in equal yearly installments of 1 lakh over the next 10 years?
If you are like most people, you will have taken the money immediately. And this is the right decision. This is because of the Time Value of Money (TVM) which is basically the power of compounding.
FV = PV x (1+R)^ n
FV: Future Value
PV: Present Value
R: rate of return
N: Number of time periods for which the money is invested
Money that is available today is worth more than money available at a later date, because you can invest it and earn a return / interest on it. So, for example, if you had 10 lakh available today, and you invested it into a 1 year Bank Fixed Deposit offering 7.50% in compounding mode, then in 1 year your money would be worth 10.77 lakhs.
The money you save and invest is the Present Value in your equation.
R is the available market rate of interest – this is not in our control – available investments offer certain approximate rates of return, and what you can do is choose your investment instrument carefully.
The only factor in your control is your N. You can increase your investing time horizon. The earlier you start investing, the higher will be your N, and the greater will be your money’s Future Value.
Power of Compounding is the Eighth Wonder of World – Albert Einstein