$100 today and $100 1 year from now are not worth the same. Today’s $100 is worth more. This is the concept of time value of money. From the point of view of finance, the value of money received in the future changes as time changes. This change in value of money over time is called time value of money.
Example: James has $1,000 cash. According to the time value of money concept, $1,000 now is not worth the same as $1,000 a year from now. Let’s say the interest rate is 10%, if James deposits his $1,000 in a commercial bank, one year later the bank will pay him $1,100.
In the light of above discussion, it can be said:
a) Money received now is more valuable than money received in the future;
b) Deposited money can be invested in return;
c) The reason for the difference between present money and future money is its value.
Basically, the time value of money relates to the decrease or increase in the value of money over time.
If a person is given a choice between receiving a certain amount of cash now or same amount of cash in the future, he will prefer receiving cash now to receiving the same amount of cash in the future. This is called time preference for money.
Example: A person is asked to accept $10,000 now or $10,000 after 1 year. 2 of these options, he would definitely prefer receiving $10,000 today.
Factors of time preference for money are discussed below.
a) Uncertainty: Future is always uncertain so any person gives more priority to present money. He may not get money in future. Moreover, it cannot be said that he will be alive in the future or not.
b) Consumption Preference: Most people prefer present consumption than future consumption. This is mainly because the current consumption of items or services is essential; there is a risk of not being able to consume those items or services in the future due to illness, death, inflation.
c) Investment Opportunity: Most people prefer present cash than the future cash. That is because he can invest the present cash to increase the future cash received. Example: Investing $10,000 now at 10% will yield more than $10,000 after 1 year, so getting $10,000 now is preferred.
d) Inflation: The increase in the price of a good or service is called inflation. Of course, the future value of a good or service will be higher than the current value. As a result, purchasing power decreases. Most people prefer current cash receipts to avoid risk as purchasing power declines.
Importance of time value of money
Determining the present value and future value of cash flows is essential for a business to make sound financial decisions.
1. Opportunity Cost: When investing in one project, you have to give up the opportunity to invest in another project. Then it is called opportunity cost of investment in finance. Opportunity cost is calculated using the time value of money formula. Example: Want to buy land in New York where the value of the land doubles in 5 years. In this case, a simple procedure known as Rule 72 can be used to decide. If the money doubles, dividing 72 by the term shows the result of the interest rate. Again, dividing 72 by the interest rate gives the term. The value of land doubles in 5 years. So, the interest rate is (72/5) or 14.4%. So, purchasing land is better than depositing money in XYZ bank.
2. Borrowing Decision: Before taking a loan from a bank or any institution for business or personal needs, one has to consider the ability to repay the installments of the loan. Due to variations in loan tenure, the installment amount varies. For example, in case of 5-year and 10-year loans, the installment amount will not be the same. Again, the installments can be for different periods, such as annual, semi-annual, monthly, etc. In all these cases, the installment amount is different. The concept of time value of money can be used to determine the number of installments for various term loans, and due to lack of proper planning in this regard, many times the business goes bankrupt if it cannot pay the interest or principal of the loan. Because it is mandatory for the institution to repay the loan amount.
3. Evaluation of Project’s Investment: Money is invested in investment projects for the long term. Present value and future value of money are not the same. A company has decided to purchase new machines to increase its production, whose lifespan is 15 years. The purchase price of the machine is $1,000,000. In this case, the cash flow obtained from this investment project in the next 15 years should be compared with the purchase price by multiplying it by a barter rate and converting it to the present value. If the present value of future cash flows is greater than the purchase price, the project is accepted. Here, present value estimation is an important technique for estimating the time value of money that can be used to make investment decisions.
4. Growth Rate Determination: Let’s say ABC Company’s sales in 20xx were $500,000, and two years later they grew to $800,000. In this case, the sales growth rate can be determined using the concept of present or future value of money.
More Resources
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