Basic rule of Time value of Money
“Money received today is worth more than the same money received in the future”
Time Value of Money –
Shareholders of a business make sacrifices by investing funds into the business now, to reap its benefits in the future, either as dividend along the years or increase in share prices in the future. However, the expected future benefits are uncertain and therefore they expect a return on invested capital to compensate for the waiting period. A rational investor will chose to invest the money elsewhere or consume it if he is not adequately compensated.
A similar situation arises in case of acquisition of assets by a firm. A firm requires immediate cash to acquire an asset today but the benefit from the asset will be received in the future. This affects the future cash flow over the life of asset. This leads to the study of time value of money.
While taking financial decisions a financial manager compares the present value of total cash inflows with the total cash outflows associated with a project/proposal to determine its profitability.
Concept of Time Value of Money
The actual worth of money available at present time is more than its worth in the future due to potential earning capacity of money.
Therefore, given a choice of receiving a certain sum of money today or in the future, a rational person will always choose to receive the money now as it has more value today than in the future. This phenomenon is known as time preference of money.
Reasons for Time preference of Money –
- The future is uncertain and involves risk.
- People prefer to satisfy present needs as compared to future goals.
- Due to potential earning capacity of money as the same money can be invested elsewhere and different opportunities can be explored.
Components of Time value of Money –
- Present Value (PV)
- Future Value (FV)
- Interest – Simple or Compound (i)
- Amount (A)
- Annuity – Fixed amount of money received/paid for a particular period of time.
- Time Period – (n)
- Perpetuity – An annuity with infinite time period.
Valuation concepts –
Single cash –
FV = PV (1+i)n
PV = FV ( 1/1+i)n
Annuity –
FV = A { (1+i)n – 1/ i }
PV = A {(1+r)n – 1/ i(1+r)n }
Perpetuity –
PV of Perpetuity = Annual cash flow or installments(A) i
Conclusion – Time value of money encourages a person to receive money now instead of waiting to receive it in the future but his preference to consume money now may change if he is duly compensated for the waiting period.