The concept of time value of money suggests that the money received at different point of time has different value. The financial manager must appreciate this fact and understand why they are different and how they are made comparable. Therefore, the basic objective of this chapter is to enable the student to calculate present and future value of cash flows and apply these concepts in addressing real life problems.
This chapter begins with fundamental concepts of present value and future value and explains how they are calculated. Then it presents how the pattern of cash flows and required rate of return impact the present value and future value. Finally, different concepts related to interest rates have also been dealt on for their proper uses by the students.
Time value of money is a concept to understand the value of cash flows occurred at different point in time. If we are given the alternatives whether to accept Rs 100 today or one year from now, then we certainly accept Rs 100 today. It is because there is a time value to money. Every sum of money received earlier has reinvestment opportunity. For example, if we deposit Rs 100 today in saving account at 5 percent annual rate of interest, it will increase to Rs 105 at the end of year one. Money received at present is preferred even if we do not have reinvestment opportunity. The reason is that the money that we receive at future has less purchasing power than the money that we have at present due to the inflation. What happens if there is no inflation? Still, many received at present is preferred. It is because most of us have a fundamental behaviour to prefer current consumption to future consumption; money at hand allows current consumption. Thus, (i) the reinvestment opportunity or earning power of the money, (ii) the (risk of) inflation and (iii) an individual's preference for current consumption to future consumption are the reasons for the time value of money.
The concept of time value of money is useful in addressing our real life problems relating to planning for future family expenditure. For instance, if we need Rs 500,000 after the retirement from job in 15 years, the amount we need to deposit at an interest rate every year from now until the retirement is conveniently determined by using the time value of money concept.
Many financial decisions of a firm require a consideration regarding time value of money. In chapter one, we argued that a corporate manager must always concentrate on maximizing shareholders wealth. Maximizing shareholders wealth, to a larger extent, depends on the timing of cash flows from investment alternatives. In this regard, time value of money concept deserves serious considerations on all financial decisions. In the following sections, we present some concepts and techniques to understand time value of money and apply them in financial decision.
Time value of money is a widely used concept in literature of finance. Financial decision models based on finance theories basically deal with maximization of economic welfare of shareholders. The concept of time value of money contributes to this aspect to a greater extent. The significance of the concept of time value of money could be stated as below:
Investment decision is concerned with the allocation of capital into long-term investment projects. The cash flows from long-term investment occur at different point in time in the future. They are not comparable to each other and against the cost of the project spent at present. To make them comparable, the future cash flows are discounted back to present value.
The concept of time value of money is useful to securities investors. They use valuation models while making investment in securities such as stocks and bonds. These security valuation models consider time value of cash flows from securities.
Financing decision is concerned with designing optimum capital structure and raising funds from least cost sources. The concept of time value of money is equally useful in financing decision, specially when we deal with comparing the cost of different sources of financing. The effective rate of interest of each source of financing is calculated based on time value of money concept. Similarly, in leasing versus buying decision, we calculate the present value of cost of leasing and cost of buying. The present value of costs of these two alternatives are compared against each other to decide on appropriate source of financing.
Besides, the concept of time value of money is also used in evaluating proposed credit policies and the firm's efficiency in managing cash collections under current assets management.