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
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
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.