Concept of Time Value of Money

Time value of money is one of the most important concepts in finance. It means that the value of a rupee received one year from now is not the same as the value of a rupee received today. In other words most of us would prefer to receive cash sooner rather than later, and to spend cash later rather than sooner, because intuitively we know that money has a time value.

Time value of money can be clearly defined as the relationship between time and value of money. It can be explained through an example. You have the choice of receiving Rs.200 either now one year later, your choice would obviously go for the first alternative you can deposit it in your bank account and earn interest. If suppose interest rate of bank is 10 percent, one year later, the amount will be Rs. 220 in your bank account due to interest. Therefore the current amount is more worth than the future amount. By ignoring the time factor, we cannot take proper decision because with time value of money differs. It plays an important role in financial decision. Thus, in fact of all the concepts used in finance, none is more important than the time value of money.

The question may arise that why the money has the time value. There are various reasons that bring changes in the value of money with the passage of time. These reasons are as follows.

i) Reinvestment opportunity: Money received today can be reinvested to get further return. If the rate of interest is greater than zero, then money has a net productivity over the time, a given sum of money at two points of time does not not have the same value.

ii) Inflation: Inflation brings upward change in the price level with the passes of time. One cannot but same quantity of goods and services in future which can be purchased today. This means the purchasing power of money diminishes with the passing of time, for which everyone needs compensation.

iii) Sacrifice of present consumption: For making investment one must save his earning. Saving from current earning is not possible without sacrificing present consumption and people do not like to sacrifice their present consumption if they do not get reward for it. This is also one of the reasons for the time value of money.

Of the three reasons mentioned above, the most important on is reinvestment opportunity because time preference for money will persists even when there is no uncertainty or inflation. We must, therefore, take into account the timing of cash flows and their amounts to evaluate the financial decision.

Source: Khanal's Business Finance.