Explained: Time Value of Money and the

Idea of Compounding
1. Time Value of Money

Firstly, I would like to discuss the concept of the time value of money. So, I will try to
explain this concept by giving an example. In this example, let us assume that there are
3 options as mentioned below.

1. ₹ 100 2 . ₹ 108 3 . ₹ 118

An event is organized by RBI to understand people’s financial knowledge and thinking.
In this event, three people were invited namely Crypteshwar, Rupani and Dollarium.
They were provided with three options to choose from. In the first option, a person can
grab the opportunity of taking 100 rupees now. In the second option an individual can
get a higher amount of 108 rupees, but only after one year. The third option will give
the person the highest amount of 118 rupees but he has to wait for two years.

• Rupani instantly chooses the 3rd option because, on the face of it, it is the highest amount
one can get among all the available 3 options.
• Dollarium chooses the 2nd option because he doesn’t want to wait for a long period of
2 years and is happy getting 108 Rupees after a year.
• Crypteshwar chooses the 1st option because he knows the time value of money, which
we will be discussing afterwards.
• Now, the question that arises here is, who has made the most prudent decision
financially?
→ The soundest decision is made by Crypteshwar by choosing the 1st option of taking 100
rupees without wasting any time. The rationale behind this is that, suppose a bank gives
us 10 per cent interest per year and if we simply put 100 rupees in a bank account now.
So, after 1 year, we will be making 110 rupees from that initial 100 rupees which is
more than the 2nd option of getting 108 rupees after a year. Furthermore, after 1 more
year, that initial 100 rupees will become 121 rupees, which is even more than the 3 rd
option of getting 118 rupees after 2 years.

1
→ Crypteshwar will be in a better position than Rupani and Dollarium because he knows
the concept of the “time value of money”.
→ Hence, the Time value of money is the idea that money is more valuable when it is
received closer to the present because of the money’s potential earning capacity.
• Here, I simply gave the example of depositing money in a bank but there are many other
avenues also, like investing in shares, cryptocurrency and fixed deposit (FD) etc, which
will give us much more profit than savings account in a bank.
• We can also understand it more clearly by the concept of opportunity cost. This concept
speaks about the potential benefits one misses out on when choosing one alternative
over another. For example, Manoj instead of continuing with his studies invests the
money in a business. So, he misses out on his higher education, which would have
increased his earning prospects. This is similar to the example that we took earlier,
Rupani and Dollarium by choosing the option of receiving money after a year and 2
years respectively diminished their chance of making money by getting it as soon as
possible.
• The coding that works behind the concept of the time value of money is that money
can earn compound interest.

2. Idea of Compounding
By the process of compounding, our money/investment will give us returns on the
initial principal as well as on the accumulated interests from previous periods.
It is not similar to linear growth, where we receive interest only on the principal amount.
This concept of compound interest works on both assets as well as liabilities. On one
hand, it increases our profits and on the other hand, it also has the capacity of increasing
our burden of liabilities by charging interest on the principal and unpaid interest too.
Example: - If we put 10,000 rupees in an account and on that amount, we are getting a
5 per cent Rate of interest annually. So, after 1 year the total amount in our account will
rise to 10,500 rupees. In the 2nd year, we earn on both the original principal (10,000)
and 500 of the 1st year’s interest, resulting in making our total amount 11,025 rupees.
In this way, after ten years the amount will rise to 16, 288 Rupees.
The equation which we can use to calculate the future value of the money which we
possess now is:

FV = PV * (1 + r) n
Where, FV= Future Value, PV = Present Value, r = rate of interest & n = no. of periods.