Time Value of Money
Time Value of Money is a concept that recognizes the relevant worth of future cash flows arising as a result of financial decisions by considering the opportunity cost of funds.
Money loses its value over time which makes it more desirable to have it now rather than later.
There are several reasons why money loses value over time. Most obviously, there is inflation which reduces the buying power of money.
But quite often, the cost of receiving money in the future rather than now will be greater than just the loss in its real value on account of inflation. The opportunity cost of not having the money right now also includes the loss of additional income that you could have earned simply by having received the cash earlier. Moreover, receiving money in the future rather than now may involve some risk and uncertainty regarding its recovery. For these reasons, future cash flows are worth less than the present cash flows.
Time Value of Money concept attempts to incorporate the above considerations into financial decisions by facilitating an objective evaluation of cash flows from different time periods by converting them into present value or future value equivalents. This ensures the comparison of 'like with like'.
The present or future value of cash flows are calculated using a discount rate (also known as cost of capital, WACC and required rate of return) that is determined on the basis of several factors such as:
|● Rate of inflation||Higher the rate of inflation, higher the return that investors would require on their investment.|
|● Interest Rates||Higher the interest rates on deposits and debt securities, greater the loss of interest income on future cash inflows causing investors to demand a higher return on investment.|
|● Risk Premium||Greater the risk associated with future cash flows of an investment, higher the rate of return required by an investors to compensate for the additional risk.|
Consider a simple example of a financial decision below that illustrates the use of time value of money.
Time Value of Money principle is used extensively in financial management to incorporate the financial impact of the timing of cash flows in business decisions.
In order to apply the time value of money principle in complex financial decisions, you need to familiarize yourself with the detailed understanding and calculation of the following key topics:
- Cost of capital (also referred to as WACC and required rate of return);
- Present value of cash flows
- Future value of cash flows
These topics will be covered in detail later.