The concept of time value of money suggests that the money received at different point of time has different values. The financial manager must appreciate this fact and understand why they are different and how they are made comparable.
Time value of money is a concept to understand the value of cash flows occurred at different point of time. If we are given the alternatives whether to accept $ 100 today or one year fro now, then we certainly accept $ 100 today. It is because there is a time value to money. Every sum of money received earlier has reinvestment opportunity. For example, if we deposited $ 100 in saving account at 5% annual rate of interest, it will increase to $ 105 at the end of one year. Money received at present is preferred even if we do not have reinvestment opportunity. The reason is that the money that we receive in future has less purchasing power than the money that we have at present due to the inflation. What happens if there is no inflation? Still, money received at present is preferred, it is because most of us have a fundamental behavior to prefer current consumption to future consumption. Thus, i) The reinvestment opportunity or the earning power of the money, ii) the risk of inflation, and iii) an individual’s preference for current consumption to future consumption are the reasons for the time value of money.
The time value of money concept is useful in addressing our real life problems relating to planning for future family expenditure. For instance, if we need $ 50,000 after the retirement from job in 15 years, the amount we need to deposit at interest every year from now until the retirement is conveniently determined by using the time value of money concept.
Many financial decisions of the firm require a consideration regarding time value of money. The corporate manager must always concentrate on maximizing shareholders wealth. Maximizing shareholders wealth, to a larger extent, depends on the timing of cash flows from investment alternatives. In this regard, time value of money concept deserves serious considerations on all financial decisions.
Significance of Time Value of Money Concept
Time value of money is a widely used concept in literature of finance. Financial decision models based on finance theories basically deal with maximization of economic welfare of shareholders. The time value of money concept contributes to this aspect to a greater extent. The importance or significance of the time value of money concept could be stated as below:
1. Investment Decision
Investment decision is concerned with the allocation of capital into long-term investment projects. The cash flow from long-term investment occur at different point in time in the future. They are not comparable to each other and against the cost of the project spent at present. To make them comparable, the future cash flows are discounted back to present value.
The time value of money concept is useful to securities investors. They use valuation models while making investment in securities such as stock and bonds. These security valuation models consider time value of cash flows from securities.
2. Financing Decision
Financing decision is concerned with designing optimum capital structure and raising funds from least cost sources. The concept of time value of money is equally useful in financing decision, especially when we deal with comparing the cost of different sources of financing. The effective rate of interest of each source of financing is calculated based on time value of money concept. Similarly, in leasing versus buying decision, we calculate the present value of cost of leasing and cost of buying. The present value of costs of two alternatives are compared against each other to decide on appropriate source of financing.
Besides, the time value of money concept is also used in evaluating proposed credit policies and the firm’s efficiency in managing cash collection under current assets management.