The Concept of Time Value of Money
The Concept of Time Value of Money
What is time value of money? The simple concept of time value of money is that the value of money received at different time periods is different. The value of money received today is more than the value of the same amount received at a future date.
A rational human being, if given a choice of receiving Rs. 1000 today or after one year, will definitely choose to receive the money today. This is because he considers the receipt of money today more valuable than the future receipt of money after one year.
This phenomenon of considering present cash flows more valuable than the future cash flows is known as the time preference for money or the time value of money.
Reasons for time value of money: There are three main reasons for which we consider the money received today more valuable than that received in the future.
1) Risk: The future is always uncertain and involves risk. A person can never be sure of receiving cash in the future and hence would prefer to receive it today.
2) Preference for consumption: People use money to satisfy their needs by buying food, clothes, shelter and so on. The present needs are considered more urgent than the future ones. Hence, we need money today in order to satisfy our urgent needs as we are uncertain about the future.
3) Investment opportunities: Money has time value because there are opportunities available to invest it and enhance it in the future by earning interest, premium, dividend and so on.
Techniques involved in time value of money: There are two techniques for adjusting the value of money according to the time. 1) Compounding technique which is used to measure the future value of present cash flows. 2) Discounting technique which is used to measure the present value of future cash flows.
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