How is Time Value of Money Affected by Interest?

How is Time Value of Money Affected by Interest?
  • Opening Intro -

    Time value of money means having a dollar today is worth more than having it in the future.

    This is usually related to factors such as inflation and interest.

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If we look at the equation:

FV = PV (1 + r)^n

  • Where FV = Future value of USD
  • PV = Present value of USD
  • r = Interest
  • n = Time in years

Now let us substitute it with a time of 2 years, a present dollar value of USD $1, and an interest rate of 10%

FV = 1 (1 + 0.10)^2
= 1 x 1.1^2
= 1 x 1.21
= 1.21

This means that the work done to earn USD $1 today will be equal to USD $1.21 in the future.

Now the work done today earns you a USD for the number of man hours you invested in it.

Circulation of money starts from the State Bank. Any employer who has a Savings bank account will reap the profits from interest in addition to his actual income. This is because all banks add profits to their customers’ accounts by income generating activities, which also includes receiving interest on loans.

Actual income here means income received against man hours. Whereas, the interest is the income received as fees against a loan. This fee is an extra expense over the actual loan, and this is just money generated from money, and there are no man hours invested. In other words you can say that the bank charges the loanee a fee for lending him money over a certain period of time.

Now lets look at it in terms of time. If a bank accepts only USD $1 against a loan of USD $1 plus asks for a share in the profit generated from the loan, or asks for the original amount in case of loss, then there will be no change in the time value of money.

Let us take an example:

Example

A person named A is the first person who took a loan from a lender without interest. At that time the value of USD was $1. He is asked to share 10% of the profit generated from this loan, or return the original amount, in case of loss.

Now let us look at the scenario of profit.

Let us assume the person A generates 35% profit from his loan.

This means on USD $1 he generates USD $0.35.

His profit is 35 cents on USD $1.

He has to return USD $1 plus 10% of $0.35, which is $1 + $0.035 = $1.035

In this case the FV of USD = 1.035 X 1 = $1.035. Let us assume this profit is generated over a period of two years. Still it will vary for every loanee depending on how much they worked during that period.

There are a lot of other factors, such as, which market did the loanee target to earn revenue. Their demographics, likes, interests etc.

Conclusion

In short future value of money is dependent on both foreseen and unforeseen circumstances.

Considering the money lended earns a profit by fair means, it will not lose worth over time.

Asking for a fixed rate of return over a loan despite of loss, triggers unfair circulation of money, such as loanee lending the money to another in exchange for higher interest or the loanee raising the prices of his goods to earn a fixed amount of profit.

In the above scenario the time value of money has increased as the worth of money has increased with time. We can also look at the other scenario, where the person A suffers from loss. Follow our blog to find out what change it will bring to the time value of money in such case.

This leads to inflation especially in regions where the prices of consumer goods are not in control of the government, and a vendor is allowed to raise the prices to his liking.

Image Credit: Pixabay

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Categories: Money Management

Comments

  1. liurouwan
    liurouwan 15 August, 2018, 23:16

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