K. Treppides & Co Ltd
Defining the principle of the time value of money:
What if a close friend asks today to borrow 1,000EUR with the precondition to repay the exact same amount in five years? Would you take the deal or not?
Let’s imagine a CEO or one of the beneficial owners of a profit making, credit institution with thousands of clients wishing to borrow different amounts of the institution’s money at identical terms as the first scenario, borrowing today and repaying the same amount in five years. Should this qualify as an operating function of the Company?
The minor probability of a positive answer on the first case (based on emotional and psychological grounds) is eliminated at the second case were the scale is expanded in the real economy. Considering that even a school child shouldn’t bother to get into a bargain that has nothing to gain from (in terms of economical profit and/or emotional redemption) the below analysis aims to clarify the underlying fundamental economic principle behind this concept, the Time Value of Money, the theory that indicates that the value of money available at the present time exceeds the identical amount someday in the future. Stripping down this principle the three driving forces that unbalance the future and present equation are: The inflation, the opportunity costs and the risk to reward concept.
To better explain the nature of inflation a real-life case is employed: In the far 1967 around the area of Pittsburg USA, Mr. Jim Delligatti introduces an alteration of the common hamburger and names it Aristocrat. The price of the delicacy was at that time 45 cents of a dollar and could be consumed alone or with the option of a meal (plus fries and soda). More than half a century later with turbulent alternations to the product and the operations of the restaurant producing it, the price increases with a multiple of around X17 and the chain now constitutes one of the most recognized worldwide brands. The Big Mac currently costs $3.99 in the US, were the Big Mac index has been informally adapted as a tool of measuring the purchasing power parity (PPP) between two currencies. Leaving aside the effects of the expansion of the brand and the technical alterations of the product, the main determinant of the price increase is the inflation parameter. Inflation simply putted, is a measure of the general price level of goods and services in the economy over a period. Simplifying further, what drives inflation is the mismatch between supply and demand of those goods and services (cost-push and demand-pull inflation).
Another key determinant of the time value of money is the opportunity cost which describes the basic relationship between scarcity and choice. The opportunity or alternative cost is defined as the difference of benefit achieved between the chosen use of the available money and the hypothetical best use of the same amount. The problem arises due to the lack of consideration of the lost opportunities as opposed to current spending. Take as an example the first paragraph. By lending someone the amount of 1,000EUR, the opportunity to invest the money with the assumed and achievable return of 5% per year is waived. Thus, for the first year, the amount of 50EUR (1,000EUR@5%) can be considered as the opportunity lost due to the choice of interest-free lending since the benefit of the applied choice is zero to the lender. The principle of opportunity cost has daily application to every decision making: buy a car or invest in government bonds? Travel a long journey abroad or save the money in interest bearing deposits? Dine out or make savings? Daily decisions never considered can lead to the theoretical elimination of the opportunity cost if the more profitable choice is made. Nevertheless, it should be highlighted that the above options are considered sounder in pure economic terms.
The third component of the economic principle of the time value of money is the idea of Risk versus Reward. In the Chinese language the ideogram for risk has two components that of danger and that of opportunity. Usually the relationship between risk and return is illustrated through an upward sloping curve. In the investing universe three kinds of participants can be distinguished, the risk-averse, the risk-neutral and the risk-lover category. The return gained from the risk lovers is usually higher than the return gained from risk neutral investor. Even though, it is important to clarify that the differential feature is the level of risk that they tolerate for the same amount of return. In more detail there may be high return investments that risk-averse or even risk-neutral investors cannot approach due to their risk tolerance restriction. For example, investments in cryptocurrencies, derivatives and venture capital may bear higher returns at a higher default probability in oppose to risk-free investments where bear less or sometimes even negative returns (German Government bonds). The factor that links the risk/ reward concept with the time value of money principle is the risk and uncertainty linked with long-term investments. Based on the local expectations theory for longer periods a risk premium (interest) should be adopted in order to compensate the investor for committing the money.
Summing up the above, when someone asks to borrow some money, better be aware of the current inflation index, the best use of that amount and the risk associated to these actions before proceeding to the transaction.
K. Treppides & Co Ltd, the largest independent consulting firm in Cyprus, with established international presence and offices in London and Malta, it offers a full range of legal, tax, accounting, consulting and financial advisory services to international Investors that are operating within a wide range of industry sectors. The company possesses many years of experience and a team of experienced members of staff who remain on hand to assist individuals and businesses throughout the entire investment process, in and through Cyprus.
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