The time value of money concept is a fundamental principle in finance that refers to the idea that the value of money changes over time due to factors such as inflation and interest rates. In other words, a dollar today is worth more than the same dollar in the future because the purchasing power of money decreases over time.
Therefore, understanding the time value of money is essential in making informed financial decisions. In this op-ed, we will explore the concept of the time value of money, and its significance, and provide specific examples to illustrate its application.
The time value of money is calculated using the formula; FV = PV × (1 + R) * T. Here, FV represents the future value of the investment, PV is the present value of the investment, 1 is a constant, R is the interest rate, and T is the number of years. This formula enables us to determine the value of an investment in the future based on the present value of the investment and the expected interest rate. One example of the application of the time value of money is in retirement planning.
Suppose an individual wants to retire in 20 years and wants to have $1 million in savings at retirement, assuming an interest rate of 5%, the individual would need to save approximately $376,889 in today’s dollars to reach their goal. Without considering the time value of money, the individual may underestimate the amount of savings needed to reach their retirement goal. This example illustrates how understanding the time value of money can help individuals make informed financial decisions.
Another example is the use of present value in investment decision-making. Suppose an investor is considering two investment options with different returns. Investment A returns $10,000 in five years, while Investment B returns $15,000 in ten years.
If we assume a discount rate of 5%, we can calculate the present value of each investment. The present value of investment A is $7,791, while the present value of investment B is $9,082. The outcomes of the above present values from both investment options, better inform the investor on the amount of money they want to commit now to yield an expected return in the future.
It is based on the above financial principles that employees, self-employed persons, or any other investment-driven person puts a percentage of their earnings in an investment/pension fund; for instance, monthly SSNIT contributions to enable them to have some amount of savings when they go on retirement. Retirement means you have taken a break from working, but does not mean your expenditures have equally taken a break. People make investment decisions when they are working so that on retirement, they can continue to cater to their needs.
The Government of Ghana on December 5, 2022, launched a Domestic Debt Exchange programme (DDE) to put the country’s debt on a sustainable path and also to meet the conditions for an IMF bailout. As part of the programme, an invitation was extended to domestic bondholders as of December 1, 2022, to voluntarily exchange their bonds for four new sets of bonds maturing in 2027, 2029, 2032, and 2037.
Approximately, GHS137 billion of the domestic notes issued by the government need to be exchanged, including Daakye and Energy Sector Levy Act (ESLA) bonds for a new set of bonds issued by the Government of Ghana. The exchange however excludes all Treasury Bills, bonds, and, notes held by individuals (natural persons).
After the impact assessment by the Finance Ministry, banks, specialised deposit-taking institutions (SDIs), insurance firms, collective investment schemes, pension fund trustees, asset managers, and regulated pension schemes were asked to participate in the debt exchange programme.
What this means is, though individual bondholders are exempted, individuals on the other hand have group investments with these institutions mentioned above will be required to accept some haircuts on their investments in one way or another.
It is common knowledge that some pensioners put their lump sums received from their pension funds in treasury bills and bonds and leave off the interest payments and coupons received from such investments. For instance, a pensioner who is now 70 years is being asked to come and exchange his/her bond for another bond maturing in 2037.
What is the probability that, this pensioner will be alive by 2037 to receive their investments when they finally mature? The other issue worth noting is the time value of money. The bondholders’ investment today will be worth less than the money they will be receiving in the future, as a consequence of inflation and exchange rate volatility.
Will the government factor in inflation in the new interest rate on the new bonds, to make out for the fall in value in the future? The parliament of Ghana is currently working to pass a resolution to exempt pension funds from the debt exchange programme even though the Minister of Finance said it was exempt. Currently a slippery slope, and an unconcluded matter at that.
In conclusion, the time value of money is a fundamental concept in finance and an important principle that helps investors make practical and sound financial decisions. In financial management, we understand there is an element of risk in every investment decision.
Even though government bonds and Treasury Bills are supposed to be risk-free, these times have taught us that, you cannot eliminate entirely the element of risks when making an investment decision. By embracing the risk element in making investments, and understanding the time value of money, one should be conscious to diversify their investment portfolios in order to limit or eliminate the various risks that come with investing.
About the authors
Juliet Ahiagbede is a Chartered Accountant and Chartered Tax Practitioner, with a Masters in Petroleum Accounting and Finance. Juliet has 7+ accumulated years in both internal and external audits. Currently, she is the Lead Consultant of Ceritright Limited.
Kojo Ahiakpa is an agribusiness consultant with Research Desk Consulting Limited. He has a deep understanding of the agribusiness industry and a commitment to helping farmers and agribusinesses to succeed. With his knowledge and expertise, Kojo is able to provide valuable insights and solutions that can help agribusinesses maximise their potential. He is committed to helping the industry grow and thrive, and is dedicated to making a positive impact in the sector.