Question

Explain the concept of time value of money in the context of simple interest. How would you use this in retirement planning

Answer 1

The time value of money is based on the fact that the same amount of money in a different time period has different values. This difference in value is due to the associated time which in turn has value. In an inflationary environment, money erodes its value over time. In case of simple interest, the amount in a certain future year has a lesser value associated today. For eg. if the risk-free rate is 4%, and after 10 years you are bound to get $1000, the today the value of the sum is 1000/(1+10*0.04) = $714.29

This concept can be used in retirement planning when you need to estimate how much amount you need per year and accordingly invest today. For eg. you estimate that after considering inflation, you will need $120,000 after retirement per year which is after 25 years from now, you can invest today accordingly, the amount of money which returns the assured sum after retirment. In short, the present worth of the after retirment amount is calculated to arrive at the current needed investment need.