Time Value of Money

The time value of money is the basis of the mathematics of finance determination of the time value of money in financial decision making is extremely important. The objective of wealth maximization much of the subject matter of financial management is future oriented. The financial decision taken day has implications for a number of years i.e. if spreads into the future

Ex Firms have to acquire fixed assets for which they have to pay a certain sum of money to the vendors (cash outflows). The benefits arising out of the acquisition of such assets will be spread over a number of years. In the future till the waking life of the assets.

On the other hand funds have to be procured from different sources such as rising of capital through new issues. Bank borrowings, term loams from financial institutions, sale of debentures & so on. These as well as an obligation to pay interest/Dividend & return the principle in future.

It is on the basis of comparison pf the cash out flows & the benefits (cash inflows) that financial decisions are made for a meaningful comparison. One basic requirement of compatibility is the incorporation of time element in the calculations.

In other words in order to have a logical and meaningful comparison between cash flows and that accrue in different time period. It is necessary to convert the sums of money to a common point of time.

Definition: “Time value of money means that the value of a unit of money of different in different time periods”.

The value of sum of money receive today is more than its value received after some time. The sum of money received in future is valuable than it is today. The present worth of rupee receive after sometime will be less than a rupee receive today.

The main reason for the time preference for money is to be found in the reinvestment opportunities for funds which are received early. The funds so invested will earn a rate of return. This would not be possible if the funds are received at a later time.

The capital budgeting decision s generally involves the current cash outflows in terns of the amount required for purchasing a new machine or lunching a new project and the execution of the scheme generates future cash inflows during its useful life.

Ex: Assume that the project cost (current cash outflows) as Rs.10lakhs. Assume it has a life of only one year in which it is estimated to have cash inflows Rs.10.80lakhs (at the end of first year). This project is acceptable as it adds Rs.80,000 as profit. However when we take into account a rate of interest. Say 10% the earlier conclusion has to be realized as without the project the sum could have amounted to Rs.11lakhs.

If the decision us made to raise at loan of Rs.10lakhs from a financial institution or by issuing debentures for a period of 10 years. The firm is not only under obligation to make interest payment as and when it becomes due on debt of fixed intervals, but also must make a provisions. So that it can we pay Rs.10lakhs when the loan or debenture becomes due. Thus time value of money is of critical significance. This requires the development of processors and techniques for evaluating future incomes in terms of the present.