Basic Concept of Time Value of Money
Money has time value. A rupee today is more valuable than a year hence. It is on this concept “the time value of money” is based. The recognition of the time value of money and risk is extremely vital in financial decision making. If the timing and risk of cash flows is not considered, the firm may make decisions which may allow it to miss its objective of maximising the owner’s welfare by maximising the Net Present Value.
Thus, we conclude that time value of money is central to the concept of finance. It recognizes that the value of money is different at different points of time. The difference in the value of money today and tomorrow is referred as time value of money.
Reasons for Time Value of Money: Money has time value because of the following reasons:
- Risk and Uncertainty: Future is always uncertain and risky. Outflow of cash is in our control as payments to parties are made by us. There is no certainty for future cash inflows. Cash inflows is dependent out on our Creditor, Bank etc. As an individual or firm is not certain about future cash receipts, it prefers receiving cash now.
- Inflation: In an inflationary economy, the money received today, has more purchasing power than the money to be received in future. In other words, a rupee today represents a greater real purchasing power than a rupee a year hence.
- Consumption: Individuals generally prefer current consumption to future consumption.
- Investment opportunities: An investor can profitably employ a rupee received today, to give him a higher value to be received tomorrow or after a certain period of time.
For example, if an individual is given an alternative either to receive Rs 10,000 now or after one year, he will prefer Rs 10,000 now. This is because, today, he may be in a position to purchase more goods with this money than what he is going to get for the same amount after one year.
EXAMPLE 1: A project needs an initial investment of ₨1,00,000. It is expected to give a return of ₨20,000 per annum at the end of each year, for six years. The project thus involves a cash outflow of Rs 1,00,000 in the ‘zero year’ and cash inflows of ₨20,000 per year, for six years. In order to decide, whether to accept or reject the project, it is necessary that the Present Value of cash inflows received annually for six years is ascertained and compared with the initial investment of Rs 1,00,000.
The firm will accept the project only when the Present Value of cash inflows at the desired rate of interest exceeds the initial investment or at least equals the initial investment of Rs 1,00,000.
EXAMPLE 2: A firm has to choose between two projects. One involves an outlay of Rs 10 lakhs with a return of 12% from the first year onwards, for ten years. The other requires an investment of Rs 10 lakhs with a return of 14% per annum for 15 years commencing with the beginning of the sixth year of the project. In order to make a choice between these two projects, it is necessary to compare the cash outflows and the cash inflows resulting from the project. In order to make a meaningful comparison, it is necessary that the two variables are strictly comparable. It is possible only when the time element is incorporated in the relevant calculations. This reflects the
need for comparing the cash flows arising at different points of time in decision-making.