Time Value of Money

According to the correct definition, time value of money is "the value generated from the usage of money over time as a result of investment and reinvestment." The phrase "worth of a rupee obtained today is dissimilar from the worth of rupee to be received in future" refers to the time value of money. The time value of money is the preference for money now over money in the future.

The fact that the value of one rupee in the present is not equivalent to the value of one rupee at the end of one year, at the end of the second year, and so on, determines the value of the entire collection of financial decisions (whether financing decisions or investment decisions).In other words, we cannot assume that the value of rupee remains same or constant. This is known as ‘Time Value of Money’.????

In simple terms, Time Value of Money principles says that the value of money to be received on a particular date is more than the same sum of money to be received on a later date.

Contents in this article

• An Overview of Time Value of Money
• Introduction to Time Value of Money
• Concept of Time Value of Money
• Top 4 Importance of Time Value of Money

An Overview of Time Value of Money

Time value of money is most important amongst all the concepts and principles used in the field of financial management. The main Crux of time value concept is that money has a time value. A rupee to be received a year from now is not worth as much today as a rupee to be received immediately. At Least two factors contribute to the time value of money.

• First, the purchasing power of the rupee directly decreases over time when there is inflation. Therefore, future rupees will be worth less than they are now if inflation continues as predicted.
• Second, any sort of expenditure carries opportunity costs, which once more depreciates future rupees relative to their current value. Opportunity costs arises because a rupee now can be profitably invested and as a result will be worth more than a rupee in the future.

Time Value of Money – Introduction

Understanding the temporal worth of money is crucial and helpful when making financial decisions. The primary goal of financial management is to maximize shareholder wealth. This is superior to profit maximization because, among other things, the former takes into account the time of benefits received, whilst the latter overlooks it. The financial management must make the proper decisions on funding, investments, and dividends in order to achieve this. The financial management should consider the "time factor" when making these decisions., for example:

1. When interest on funds raised will have to be paid.
2. When return on investment will be received.
3. Whether it will be received on a consistent basis.

All of this necessitates that the financial managers be familiar with the many notions of valuation, such as compound value, annuity, present value, etc. All of these ideas are fundamentally predicated on the idea that money has a temporal component, which implies that a rupee now is worth significantly more than a rupee tomorrow. When comparing the value of money that will be received in the future and money that will be obtained in the distant future, the time value of money theory also holds true. The value of a given sum of money to be received on a specific date is greater than the same sum of money to be received on a later date, according to TVM principles.

Concept of Time Value of Money

The value of one rupee today differs from the value of one rupee at the end of the first year or at the end of the second year, which is the basis for the entire set of financial decisions (whether financing decisions or investment decisions). In other words, we cannot rely on the rupee's value staying constant. This concept is called "Time Value of Money."

When making financial decisions, it is crucial to understand the value of time. A financial choice made today will have effects for several years. Every financial decision includes comparing the cash inflows and outflows (outlays and investment costs) (benefits or earnings after tax but before depreciation). In order to provide an accurate comparison, the two sets of flows must be strictly comparable.

The inclusion of time components in calculations is one fundamental criterion for comparability. To put it another way, it is important to translate the amounts of money to similar points in time in order to make a logically relevant comparison between cash flows that accrue across various time periods. The business may make actions that undermine its goals if the timing of cash flows is not taken into account

‘Time Value of Money’ signifies that the value of a sum of money received today is more than its value receivable after some time. This may be due

1. risk, i.e., uncertainty associated with future receipts or
2. inflation causing the decline in purchasing power of money or
3. reinvestment opportunities for funds received early.

It might be claimed that the risk element connected to receiving money in the future could be abolished or decreased to a greater extent through appropriate guarantees, insurance against default, etc., making the likelihood of default (not receiving money in the future) relatively improbable. Consequently, the time value of money is rendered meaningless.

The worth of money now and tomorrow may be presumed to be the same if it is thought that there is no inflation in the economy, in which case the time value of money likewise loses relevance.

Despite these two extreme hypotheses, a rupee received now would be preferred to a rupee received tomorrow (i.e., in the future), as it can be invested and will have a higher value (this is due to the fact that the rupee invested will fetch some interest). Future cash flows are only assumed to be less valuable than the present ones in the case of early reinvestment possibilities. Funds received today would earn a rate of return which may not be possible in case they are received later.

Typically, the time value of money is stated as a rate of return or as a discount rate. Understanding the mathematical concepts of compounding and discounting is key to comprehending the temporal value of money. Any type of financial decision must consider these ideas.

Time Value of Money – Top 4 Importance

In the financial decisions, the time value of money holds great importance. It is now the most significant principle in finance and economics. There are certain valid reasons for this state of affairs. Few are:

(1) Inflation

The rupee today has a larger purchasing power than the rupee in the future due to inflationary conditions. As a result, those who must receive money seek to do so as soon as possible, while those who must pay it try to put off doing so.

(2) Uncertainty

Individuals and businesses prefer to get revenue now rather than receive the same amount in the future because the future is unpredictable. They worry that the party making the payment might miss it because of insolvency or another issue.

(3) Preference for present?Consumption

People prefer current consumption to future consumption due to both uncertainty and inflationary conditions. They do not want to reduce current spending in order to save for the future consumption.

(4) Opportunities for reinvestment

Real returns can be produced with the use of money. Individual business concerns reinvest the funds at a specific pace in order to generate a return.

Therefore, when making financial judgments, a financial manager of any business concern cannot neglect the idea of time worth of money; otherwise, his decisions will be invalid and inaccurate as well.