The time value and opportunity cost of money

In financial transactions, you need to consider various costs that impact your returns on investments. There are mainly two costs of money, namely, the time value of money and the opportunity cost of money. Let us understand what these mean.

The time value of money is the assumption that the value of money available now is more than the value of the same amount of money available in future due to the earning potential of the money. Let’s examine this with an example. You have a property to sell and a buyer approaches you with an offer of Rs30lakh, but you may think that this property could fetch you Rs32 lakh and decide to wait for a buyer who will offer that kind of money. After a year or so, you find a buyer who pays you Rs 32 lakh and you sell the property to him. So, have you been financially smart in this deal? Now consider this: If you had sold the property to the first buyer and invested the amount in a fixed deposit at 8% per annum, your interest income would have been Rs 2.40 lakh. So, you have effectively incurred a loss of Rs 40,000 by selling it to the second buyer! This is the time value of money.

The opportunity cost of money is the difference between the value of one option that is given up for another option. Let’s take an example. You have invested Rs 1 lakh in the stock market with the hope that you would be able to get at least 10% return on your investment. You also had the option to invest the amount in fixed deposit that offered interest @ 8% p.a., but you went for the first option. At the end of the year, you find that due to volatile market conditions, the value of your investments had grown to Rs 1,05,000, an appreciation of just 5%. Now, if you had invested Rs 1 lakh in fixed deposit, you would have earned Rs 8,000 on the investment. So, the difference of Rs 3,000 is the opportunity cost of money.