The Science of Money

Einstein In Finance

We all know who Albert Einstein is and we know, too, what is time and what is money.

We know Einstein was the first to propose the Theory of Relativity, which is about time, and we all have heard the saying that “time is money”.

The very concept of Financial Theory – whether savings or investment – is based entirely on the premise of Time Value of Money (TVM). Sounds good to say, doesn’t it?

But before you sleep on me and say that you don’t understand it, well then, let me poke you with a few questions:

Question 1:

I owe you Rp 1 million.

Would you rather I pay you Rp 1 million now or pay you the Rp 1 million in a year?

If you have the money, one year might not matter to you, but it’s most likely you’d prefer to have it now.

Question 2:

You owe me Rp 1 million.

Would you rather pay me Rp 1 million now or pay me Rp 1 a year later? There’s high probability that you’d opt for one year later, after all there’s a reason why you needed to borrow money from me anyway.

But these questions and answers show how the “value” we put on money can change, depending on when we receive it or pay it out – “TIME”.

So the general principle is: We’d rather get our money (or revenue or income) as early as possible and pay our expenses as late as possible. That is the TIME VALUE OF MONEY, a principle which basically says that a certain amount of money, in our case Rp 1 million, changes its “value” to us as “time” goes on.

Let’s try another one:

Question 3:

I owe you Rp 1 million. This time you can choose to have Rp 1 million now, or I will give you Rp 1,200,000 a year later.

Now the choice has become a bit more difficult. You are now weighing up getting an extra Rp 200,000 (20% more) against the following factors:

• What you think you could do with the money now rather than letting me have it for a year?
• What risk you think there is that I won’t pay you at all in one year?
• Is the 20% bonus within a year enough?
• What if I only offered you Rp 1,010,000 in a year’s time (1% more)? I’m guessing you’d take the money now.
• But what if I offered you Rp 2 million in a year’s time (100% more than what you’d get now)? I think you’d let me keep it, right?

So there is certain amount of extra money that you’d want me to give you in a year’s time to make it worthwhile not taking the money now. That percentage of extra money that you want is based on the two points above:

• What else you could do with it? And,
• What risk you think there would be?

In financial terms, we call the rate of extra money that you want (say 20% if I’m giving you Rp 1,200,000 in a year) the Rate of Return or Return of Investment. In other words, it’s how much you’d want per year for letting me keep your money. And the higher the risk you thought I would be in paying, the higher rate you’d want.

So if you assessed me and decided that Mark Castro has a discounting rate of 20% (if not more), you’d want to get at least Rp 1,200,000 in a year, or you’d take the Rp 1,000,000 now. In other words, when you’re investing your money with me, Rp 1,200,000 in a year’s time is worth IDR 1,000,000 now. We have discounted the value of the future money by that same rate (20%) to work out what’s worth now.

Whether you invest it or you’re at the end of it, what you do know is that your money has value in the long run – or should have value at least.

That is also how Credit Card companies look at you.

But we don’t want to go much further with these examples or look too much at how discounting rates are applied. You can learn more about similar topics from our LiveOlive email program. For now we just need to understand the principle that money is worth more to us now than in the future.

Time value of money is about whether you should have the money now or in the future, and how much more you’d want to be getting in the future to make it worthwhile.

The point is, one rupiah today is worth more than one rupiah tomorrow.

So where is Einstein in all this, you might ask?

Ladies, now you know that Time is indeed Relative. When you’re waiting for the money, it’s as if time takes forever. When you’re paying, it’s as if time is fast.

About Asmartrock

N. Mark Castro is the chief political communications strategist for PT AsiaLeads, a political and communications policy-making body based in Jakarta, Indonesia. He is also the Executive Director at the Southeast Asia Consulting Group, an investment advisory company assisting clients roll out their presence for the ASEAN Economic Integration in partnership with government. The views posted here are his own and do not in any way reflect the views of the companies he represents.

Posted on November 12, 2012, in General, Previous and tagged , , , , , . Bookmark the permalink. Leave a comment.

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