If someone made a tempting offer to pay you INR 2 Crore upfront or INR 1 Lakh per month for 20 years, what would you choose? On first thought it may seem like a no-brainer, for anyone with a calculator will quickly punch in the numbers and realize that INR 1 Lakh per month for 20 years will amount to INR 2.4 Crores and that the question would ultimately boil down to whether its INR 2 Crore upfront or INR 2.4 Crore over 20 years? INR 2.4 Crore being numerically greater than INR 2 Crore – for a layman the second option would seem like a better deal.
But what will the “Financially Wise” choose?
They will apply a concept known as the time value of money to understand the implications of the choice.
In simple terms, time value is a concept that the money you have now will be worth more than the identical sum in the future due to its potential earning capacity. Now, the question will slowly morph into – Will INR 2 Crore upfront result into a value greater than INR 1 lakh received per month for 20 years? It is pertinent to note that the same concept of future earning potential has to be applied to 1 lakh that would be received per month and that the calculation will not be just limited to 2 Crore received upfront.
So let’s calculate and see what results we get. For the purpose of calculations, I have assumed the interest rate to be 5.4% per annum which is the current State Bank of India rate for Fixed Deposit for 5- 10 years.
- Future Value of INR 2 Crore received upfront
For the first part of the question, we will analyse the value of INR 2 Crore after 20 years invested at the rate of 5.4% per annum. By using the principle of compound interest – the final amount will be INR 5,72,58,796.
(Please see the excel calculations and the method of calculating the same through our YouTube video – https://youtu.be/XIXEpDOcxRs )
- Future Value of INR 1 lakh per month for 20 years
To estimate what is the future value of INR 1 lakh received per month for 20 years at the end of the said period, we use the Future Value function in excel. It is equivalent to calculating what INR 1 lakh deposited per month for 20 years will amount to after adding the interest component. The result is INR 4,30,56,756.
(Please see the excel calculations and the method of calculating the same through our YouTube video – https://youtu.be/vP4DQ3JSxag)
Now with time weighed in – we can conclude confidently that INR 2 Crore received upfront is of more value than INR 1 lakh received per month for 20 years.
The story doesn’t end here completely. There’s another way to look at it. What if this option is given to someone who wants an arrangement where he received monthly payment (often known as annuity)?
For this we will have to find out what INR 2 Crore upfront translates into, per month, for 20 years. On doing the calculations, we find out that INR 2 Crore upfront will allow us to receive INR 1,36,450 per month for the next 20 years. (Please see the excel calculations and the method of calculating the same through our YouTube video – https://youtu.be/1psBJXcdhoo)
In both the scenarios, INR 2 Crore now is worth more than INR 1 lakh per month for next 20 years. So now we can definitely say that the first option is better than the second option and a bird in hand is worth two in bush (kinda!).
Please note that there are other investment options like the stock market, real estate, bullion etc. which may give higher or lower return on the amount available. However, to do a like to like comparison, we have illustrated this using an example of investment in Fixed Deposit. Also an important point to note here is that a greater amount in hand available upfront can also allow an opportunity to invest in asset classes which a have high unit value at a cheaper cost. In case of receiving the money in instalments, a loan must be arranged to invest in the said asset class which could add on its cost.
The article was first published on The Financial Pandora.