Q.No. 6 Logically explain the concept of "Time Value of Money" in the light of following Case Study: My finance professor told us in his introductory class that the single most important idea in finance is the time value of money. A rupee today is not equal to a rupee tomorrow, he began. He went on to enthrall us with how money would compound over time and how inflation would erode its value. By the end of that course, we knew that financial products were all designed to generate a rate of return after an element of cost over time. What he did not tell us was that the psychological needs of the investor can be exploited to the point where they fail to see the time value of money. Investors love to compare absolute value of the rupee over time. For instance, they are pleased with the fact that '50,000 invested in a house is worth '10 lakh after 30 years. They are mentally comparing both amounts without caring much for the number of years that have passed. The technical detail--that this amounts to just about 10% return per annum--is not something that bothers them. It is common for people to be shocked over how their grandpa ate his breakfast for 2 and travelled in the bus at 25 paisa for a ticket. They rue that things have become so expensive now, without considering the fact that grandpa earned, perhaps, 200. Whether they feel rich or poor are both dependent on their comparison of money values across time, in absolute terms, without any adjustment for the time that has lapsed. Producers and sellers of financial products have used this ignorance to their benefit. They know the math that investors do not know. It serves them well to know that investors fail to calculate return, interest or cost of funds, simply comparing what they gave with what they got. The zero interest finance schemes for buying consumer durables are a play on the ignorance of time value of money. Investors merely add up the amount they have to pay and fail to take into account the fact that they pay administrative charges and advance installments upfront. This amount may be enough to cover the interest that the seller wants to recover. Or, the discount that the customer is willing to give up in order to buy the product in installments ensures that the seller has recovered his money upfront. The eagerness to own something today, and be willing to pay for it tomorrow in smaller installments, also means that most borrowers of home loans do not know is the interest that they are paying. They simply look at the Equated monthly installment (EMI), figure if they can pay it easily from their income, and take the loan. The mental comparison is in nominal terms. Sometimes such product designs based on absolute amounts may work in the favor of investors. For example, a fixed rate home loan can keep the EMI amount constant and small, even as inflation erodes its value over time. The loan thus becomes cheaper to the borrower over time. However, lenders have adjusted the product for this potential loss of revenue. They began to sell floating rate loans when rates had fallen and were poised to move up. The borrowers, who looked at 7-8% rates in early 2000s compared with the double- digit rate of the 1990s, hurried to sign up for the floating rate loans. Soon enough they found the rates going up. As a rule, customers should know that the seller has the antage of market analysis as well as financial acumen for pricing and product design. If bankers are pushing a fixed loan, it should alert the borrowers that perhaps the lender is seeing a fall in interest rates and is keen to lock the investor into a higher fixed rate. The terms of engagement have remained unfair to customers for many financial products. The research of the so-called small investor-friendly saving schemes of finance companies has thrown up several unfair procedures. Many of them simply forfeit all the deposits made by the investors if there is a delay in paying the daily installments of small amounts as committed. Since investors care only about the nominal amount, fraudsters succeed in creating pamphlets which simply show what you give and what you get to be able to mobilise money. Bring in distributors who will sell such propositions for a fat commission, and you can mobilise thousands of crores. Fraudulent schemes offering unreal 20% annual returns are not seen as unrealistic by investors as long as the promises are made in rupee terms. This extends to even a simple thing like charity. Since donors do not ask questions about the money that is used to cover costs and the amount that actually goes into charity, we have call centers earning commissions from cold calling donors. By appealing to their guilt of a good life even as they hear the sad stories about surgeries that need funding, sellers can get people to sign big cheques. (Marks 5)