How the value of money changes over time

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

18 July 2021

Leonard Mwangi sent this question which, I think, disturbs many people: “What is the right way to calculate the payback period of an investment while accounting for the time value of money? If I purchase a property at Sh5 million and the monthly rent is Sh35,000, what will be the payback period if the average inflation rate is 5% over the years?”

Before crunching the numbers, it is important to clarify the concept of time value of money. On several occasions in this column, I have stated that money has no value unless you spend it; that the value is in what you spend it on! This is what makes the difference between the wealthy, the rich and the poor. The wealthy have a lot of property, the rich have a lot of money and the poor have neither.

Suppose you have sh1,000 today; you might be able to buy 100 pencils with it at the price of Sh10 each. In that case, the value of Sh1,000 is 100 pencils. What about in five years’ time? Will Sh1,000 be enough to buy 100 pencils? Chances are that it won’t.

The reason is that, due to inflation, the price of pencils will most likely be higher, perhaps about Sh13 each [assuming Leonard’s 5 per cent inflation rate prevails]. In such a case, the Sh1,000 will buy just 77 pencils. Cleary, in the five years, the value of Sh1,000 will drop from 100 pencils to 77.

Now, at Sh10 each, the total cost of 77 pencils today is Sh770. This means that, if you keep Sh1,000 under the mattress for five years, you will only be able to buy goods whose current cost is Sh770. Thus, you would be better off to spend Sh770 on the goods today [non-perishable ones, like pencils] and keeping the remaining Sh230 for your daily expenses. (This is what the wealthy do.)

Unfortunately, because of society’s fixation on money, most people will see this as a situation where the value of 100 pencils has increased from Sh1,000 to Sh1,300. But that is the wrong way to look at it. The truth is that the value of the pencils is not the money you spend on them but what you do with them. These are the same pencils; they will write same length of lines even five years from now. So, their value will not change!

With that concept explained, we are now ready to tackle Leonard’s question. More on that next week.