Time value of money (TVM) is the concept that an amount of money is worth more now than the same amount will be in the future because of its earning potential in the interim. The time value of money is a root principle of finance. An amount of money in hand is worth more than the same amount to be paid in the future. It is also called present discounted value. Let us have a look at the Time value of money in financial debt under IBC.
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Financial Debt
As per Section 5(8) of the Insolvency and Bankruptcy Code 2016 (“IBC“), “financial debt” is defined as debt, together with any interest, which is paid in consideration for the time value of money. In Orator v. Samtex, the Supreme Court clarified that an interest-free loan would be considered a financial debt, thus resolving the question of whether an obligation to pay interest is necessary to create a financial debt.
However, at least one observer noted that the Supreme Court did not address the question of whether the loan in the given case was made against consideration for the time value of money. This is a fair finding considering the earlier decisions of the Supreme Court in Pioneer and Jaypee Infratech both of which elaborated on the meaning of “time value of money”. This article offers an explanation as to why the Supreme Court may have avoided the “time value of money” analysis.
A form of the time value of money
The form of the time value of money is not defined anywhere in the code. The time value of the code can take many forms. This is usually in the form of interest on the principal amount borrowed, for example. However, it can also be from the point of view of the evaluation of the financial lender’s investment.
In Pioneer Urban Land & Infrastructure Limited & Anr v. Union of India, it was held that the acceptance of a flat in return for investing money in a project was held to be the time value of money and hence the home buyers were termed as finance lenders. The Supreme Court held that the time value of money is not only the regular or timely return received over the duration of the amount but also the value gained by the buyer who pays the deposit. It was further clarified that the time value of money does not necessarily require an amount in addition to the principal. Some form of benefit to the lender is required as a return for the provision of money.
Importance of the time value of money
Whether you are managing your own finances or determining your investment strategy, TVM is an important concept to understand. One critical factor is inflation—an effect that causes everything to become more expensive over time. A McDonald’s (NYSE:MCD) hamburger cost just $0.15 in 1970. Fast forward 50 years, a burger will cost a dollar or two, depending on where you live. Your $0.15 was worth a lot more half a century ago than it is today. But what can counter the negative effects of inflation? Investing.
TVM can help your money keep up with – even exceed – the rate of inflation, as interest and investments build value over time. Let’s say you earn $1 per $100 in your high-yield savings account (yielding 1% per year). Next year you will earn $1.01 because the first $1 in interest you earned is now also earning interest. The same concept works in investing. If your $100 earns 10% in year 1 (increasing the value of your portfolio to $110), you’ll earn $11 in year 2 if you earn another 10% (since the first $10 also earns 10% in value). It may not sound like much in the early stages, but compounding really adds up.
Use of time value of money used in the finance
We would be hard-pressed to find a single area of finance where the time value of money does not influence the decision-making process. The time value of money is a central concept in discounted cash flow (DCF) analysis, which is one of the most popular and influential methods of valuing investment opportunities. It is also an important part of risk management activities and financial planning. For example, pension fund managers take the time value of money into the account to ensure their account holders receive adequate funds in retirement.
What effect does inflation have on the time value of money?
The value of money commutes over time and there are several factors that can affect it. Inflation, which is a general rise in the prices of goods and services, has a negative impact on the future value of money. That’s because when prices go up, your money only goes so far. Even a slight increase in prices means that your purchasing power is decreasing. So that dollar you earned in 2015 that you kept in your piggy bank buys less today than it would have then.
How does the time value of money affect debt?
What the debt is for, how much debt you owe, and how long the debt will be outstanding are all factors to consider. If the interest rate on the debt is particularly high, it may make more sense to start paying it off as aggressively as possible so that you can get rid of it as quickly as possible.
If the debt is forgiven or written off at some point (such as a UK student loan), only minimum payments may be necessary and you can focus on building an emergency fund or investing the money.
Before going into debt (e.g. with a credit card) it is worth considering whether;
- the extra payments (plus interest) you’ll have to pay for it are worth it compared to what you bought.
- you are comfortable enough to give up the amount of interest you could have earned on the money if you had invested it instead.
- getting the thing you want to buy is more important or in line with your overall financial goals compared to saving or investing money.
How do you calculate the time value of money?
The time value of money takes several things into account when calculating the future value of money, including the present value of money (PV), the number of compounding periods per year (n), the total number of years (t), and the interest rate (i). You can use the following formula to calculate the time value of money: FV = PV x [1 + (i/n)] (n x t).
Final words
The future value of money is not the same as today’s dollars. And the same goes for money from the past. This phenomenon is known as the time value of money. Companies can use it to assess the potential for future projects. And as an investor, you can use it to pinpoint investment opportunities. Simply put, knowing what TVM is and how to calculate it can help you make the right decisions about how you spend, save and invest.
