Inflation


Before we get into Investing and Stock Market at all, we need to get our basics right. Its important to understand what is Inflation and time value of money. So to make good  money, understating the concept of money and its value is the right foundation. 


Inflation is when the prices of goods and services increase over time, and the value of money decreases.

Example:
Imagine a candy bar costs ₹10 today. If inflation happens at 10% per year, next year, the same candy bar might cost ₹11. Your ₹10 from today won't be enough to buy it anymore.

So, inflation means your money doesn't stretch as far as it used to. It’s like your money is losing some of its buying power.

In simple terms, you need more money to buy the same things.


Time Value of Money

The time value of money is a core principle of finance. We prefer to receive money today rather than the same amount of money in the future because a sum of money, once invested, grows over time. For example, money deposited into a savings account earns interest. Over time, the interest is added to the principal, earning more interest. 


Story of two friends and a Business Opportunity

Pia and John are two friends with a keen interest in business. They both want to start a small business, but they need some initial capital to get started. Pia has a certain amount of money saved up, while John does not yet have the funds. However, John promises Pia that he will have the same amount of money within a year, when he expects to receive a bonus from work.
  • One day, they both come across a great business opportunity. Pia is able to invest her money immediately, taking advantage of this opportunity, while John has to wait until he receives his bonus next year.
  • Pia is in a better position because she can invest her money right away. By investing now, she can start earning profits, gaining experience, and potentially growing her business. Over time, these benefits can accumulate, leading to a successful venture.
  • John, on the other hand, has to wait a year to invest his money. This delay costs him opportunities to earn profits, gain experience, and grow his business. Additionally, by the time he will be ready to invest, the same opportunity might not be available, or the market might have changed.
  • This simple story highlights the key idea behind the Time Value of Money: a dollar in hand today is worth more than a dollar in the future because you can use it to generate more value over time. By having money now, you can invest it, earn returns, and take advantage of opportunities that may not be available later. This is why it's important to understand the value of money today and the potential costs of waiting. In other words, a delayed payment is a missed opportunity.

Simply put, knowing what TVM is, can help you make sound decisions about how you spend, save and invest.


Food for thought: If you as an investor can choose between two projects: A or B, both are identical projects except that Project A promises a Rs 15 Crores cash payout in year one, whereas Project B offers a Rs 15 Crores cash payout in year five, which project would you choose? 


Time value of money indicates that

A unit of money obtained today is worth more than a unit of money obtained in future
There is no difference in the value of money obtained today and tomorrow
A unit of money obtained today is worth less than a unit of money obtained in future
None of the Above

Why is it important to consider the Time Value of Money when planning for retirement?

Because future expenses are likely to be higher due to inflation
Because future expenses will be lower than today
Because investment opportunities decrease with age
Because retirement accounts cannot earn interest

Which factor does NOT affect the Time Value of Money?

Interest rate
Time period
Inflation
Cost of living


Interest

Interest is the cost of borrowing money or the return on investment for lending money. When you borrow money, you pay interest to the lender. When you lend money, you earn interest. This Interest compensates for the time value of money.



Broadly there could be two types of interest:

  • Simple Interest and Compound Interest


1. Simple Interest

Simple Interest is calculated on the principal amount (the original amount of money) only. The formula for calculating simple interest is:
  • Simple Interest (SI)=P×R×T
Where:
  • P = Principal (the initial amount of money)
  • R = Rate of interest per year (in decimal form, so 5% becomes 0.05)
  • T = Time period (in years)

Example: Suppose you invest Rs 1,000 at an interest rate of 5% per year for 3 years.
  • P=1000 
  • R=0.05
  • T=3

Simple Interest = 1000×0.05×3= Rs.150

So, the simple interest earned is Rs 150.


Compound Interest

Compound Interest is calculated on the principal amount and also on the interest that accumulates over previous periods. The formula for compound interest is:
  • A=P(1+R/n)^nT
Where:
  • A = The future value of the investment/loan, including interest
  • P = Principal amount (the initial amount of money)
  • R = Annual interest rate (in decimal form)
  • n = Number of times that interest is compounded per year
  • T = Time the money is invested or borrowed for, in years

The compound interest is then:
Compound Interest (CI)=A−P

Example: Suppose you invest Rs 1,000 at an annual interest rate of 5%, compounded annually for 3 years.
  • P=1000 
  • R=0.05 
  • n=1 
  • T=3
  • A=1000(1+0.05/1)^1×3 =1000(1+0.05)^3 =1000(1.05)^3 =1000×1.157625 =1,157.625
So, the amount after 3 years is Rs 1,157.63 (rounded to two decimal places).

Compound Interest = 1,157.63 − 1,000 = Rs 157.63
So, the compound interest earned is Rs 157.63.

Under Compound interest, we calculate Interest on Interest as well.
  • Simple Interest is calculated on the principal amount only.
  • Compound Interest is calculated on the principal amount and the interest that accumulates on it over time.



    • Present & Future Value

    1. Future Value (FV) with Compound Interest

    The Future Value formula calculates the value of an investment at a specific point in the future, given a present sum, an interest rate, and a number of periods.

    𝐹𝑉=𝑃𝑉×(1+r)*t where
    • FV: Future Value
    • PV: Present Value (initial investment or principal)
    • r: Interest rate per period (as a decimal, e.g., 0.05 for 5%)
    • t: Number of periods (e.g., years)
    This formula helps determine how much an investment will be worth after a certain number of periods at a given compound interest rate.

    2. Present Value with discounting

    The Present Value formula calculates the value today of a sum of money to be received in the future, given a discount rate and a number of periods.

    PV= FV/(1+r)^ t  where
    • PV: Present Value (what a future sum is worth today)
    • FV: Future Value (the future sum)
    • r: Discount rate per period
    • t: Number of periods (e.g., years)
     
    This formula is useful for understanding how much a future sum is worth in today's terms, considering the expected rate of return or discounting.

    Practice Question: 
    Suppose you are promised to receive Rs 2,000 in 5 years from now. If the expected annual discount rate is 6%, what is the present value of this future amount? In other words, how much is this future sum worth today, considering the discount rate?

    Solution:

    To find the present value, we use the below formula:

    PV= FV/(1+r) ^t 

    • FV (Future Value): Rs 2,000 (the future amount to be received)
    • r (discount rate): 6% per year, or 0.06 in decimal form
    • t (number of periods): 5 years

    Now plug the values into the Present Value formula:
    𝑃𝑉=2,000/(1+0.06)^5 = Rs. 1,494.52


    The present value of Rs 2,000 to be received in 5 years at a discount rate of 6% is approximately Rs 1,494.52. 


    Food for thought ?
    Thus, if someone offers you 1,700 today or Rs.2,000 after 5 years, what will you choose ??

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