Meaning of Time Value of Money
The term ‘Time Value of Money (TVM)’ implies that there is a connection between ‘time’ and ‘value of money’. This concept can be explained by a simple question – Would you prefer to receive $100 today or after a year? The answer shall always be obviously ‘today’. Let us understand why we prefer it today. If you receive $100 now, you can deposit it in a bank at say 10% interest rate, a value of your money after a year will be $110. On the other hand, if you opt to receive money after a year, you will get $100. The first option is preferred because, after one year, you are better off by $10. In the current example, the future value of $100 is $110 or the present value of $110 is $100 and $10 is the time value of money for 1 year.
In other words, time value of money is defined as a concept which states that purchasing power of money differs with the passage of time. Normally what we do with money. We either expend or save money. In expenditure, time value of money is understood with inflation and in savings, it has relevance due to interest rates. In our daily routine, from our income, we spend, save, borrow or invest money. Here we shall see how time value of money affects our daily transactions:
Since, inflation is in place, the prices of goods are bound to rise every some days. With the same amount of money today, we can buy more goods than in what we can in future. So, spending today has more value in terms of more amounts of goods compared to future.
We save money to ensure future because it is certain that we will have needs in future but the inflow of money to satisfy those needs is not certain. So, saving money today has value in future in terms of fulfilling our future necessities.
To fulfill our current needs, we borrow money. For example, to enjoy the benefits of a car today, you borrow money and repay it slowly in future.
We opt for an investment of our surplus as we know that investing money will result maximizing the value of our surplus money.
Reasons for Time Value of Money
The question arises is “Why money has time value?” Following are the primary reasons for money changing its value due to a passage of time.
One can control its spending, but he has no control over his income or the inflows. A risk factor is always attached with the inflows. Everyone wants to avoid that risk and prefer cash receipts now.
In this economic trend, the purchasing power of money is falling. Money received today is more useful than money received in future.
Interest Factor Attached with Investment Opportunities
In a simple world where a certain cash amount is received and paid at the later date, the values are different. The link is the ‘Interest Rate’. People invest their savings in the hope of getting a higher value in the near future.
Time value of money is the inevitable to understand the various concept of finance. It is nothing but the difference in the value of money between today and sometime later. It helps us in answering more complicated questions like ‘$100 today or $200, 6 years later’. Primarily the interest rates help us decide such a dilemma provided the cash flows do not have any uncertainty. The concept of present value and future value are very important to solve the corporate financial management problems relating to capital budgeting, investment decisions etc.