Understanding Time Value Of Money And Its Application In Finance

Concept of Time Value of Money

Discuss about the Time Value of Money.

Time value of money is the concept which establishes the reasons for difference in the value of the money today and in the future period. It states that a sum of money is worth more if received today than at some other time (Adelaja, 2015). This concept will be better understood with the help of an example. Mr. X has $10 today, if he invests this sum for a period of 6 month, then he would receive $12 at the expiry of the stated period. The difference between $10 and $12 is due to earning capacity of the money, which is called time value. The major principle in finance states that if money has the capacity to earn interest, then the amount which is received first is of more worth. Few reasons for which money has time value are as follows:

• Risk: given an option to receive $100 today or after 1 year, a person would accept today. It is so because it eliminates the risk factor, removes uncertainty of not receiving money some time.
• Inflation: more goods can be purchased today then after 1 year. This is so because he inflation rate increases and declines the purchasing power of money.(Bierman & Smidt, 2010)
• Opportunity cost: money received today can be invested to earn interest income. Whereas if amount is received after a year we will lose the interest for one year.

The process which helps to calculate of value present value of money which is to be received in future if called discounting. Discounting cash flow technique is one of the major components in security pricing and investment decision. (Peterson & Fabozzi, 2012)

The most important tool in time value of money is interest rate. It is the most important factor on which whole of the application of this concept depends. It is important that the investor calculate his required rate of properly, else the whole result may conclude to something else. Calculation of this rate of return is the crucial part; it depends on lot of conditions and assumptions. (Rivenbark, Vogt, & Marlowe, 2009) Change in any of the condition may result in calculation of wrong return. This is one of the greatest limitations of time value of money.

Time value of money helps calculate the worth of securities. It helps investor decide the maximum price they should pay for a given security, so that they can earn their desired rate of interest. When an investor invests a sum in a security, he is promised by the company that he would earn interest income on this principle amount. The worth of money which is invested today should be minimum present value of incomes which the investor is to receive in future. Therefore, by discounting the future cash flows from a security, we get the maximum price of the security which the investor should be willing to pay. (Seitz & Ellison, 2009) It not only calculates the value of securities, it also helps calculate the value of business which helps investor analyse the worth of the company. Concept of time value of money helps reduce arbitrage opportunities.

Discounting Cash Flow Technique and Its Significance in Security Pricing and Investment Decision

The following example will help understand this concept better. Say there is a security A which is expected to earn $50 annually for 5 years and at the end of year 5, it will also redeem the face value of $1000. Given the required rate of return is 11%, how much an investor should invest today. For this we need to calculate the present value of the cash flows:

Year	Cash Flows	PV factor @11%	PV of Cash Flows
1	50	0.9009	45.05
2	50	0.8116	40.58
3	50	0.7312	36.56
4	50	0.6587	32.94
5	1050	0.5935	623.12
Total	778.25

Therefore given the required rate of return of 11%, the investor should not invest more than $778.25 today.

Time value of money helps in taking investment decisions. Capital budgeting is one of most used financial tool which helps the investor in making decisions. Suppose we are provided with two opportunities for investment, both these have same cash flows but the timing of these cash flows is different. Time value of money will help analyse the present value of these cash flows and help the investor decide which the better option is. (Shapiro, 2007) There are other tools in capital budgeting like discounted pay back, internal rate of return, etc, which assist in decision making. The option with the higher present value of net inflows should be opted for maximum returns. But this also has few limitations. As discussed earlier, a rate is required to discount the cash flows. Calculation of this rate for capital budgeting is one of the most complex steps. Wrong calculations will lead to wrong results and losses.

The following example will help understand this concept better. Let say, we have two projects, K and L. following are the cash flows from both the projects:

Cash Flows from Project K	Cash Flows from Project L
Year	Cash Flows	Year	Cash Flows
0	-50000	0	-40000
1	10000	1	8000
2	15000	2	16000
3	17000	3	17000
4	16000	4	16000
5	20000	5	11000

We see that the net cash flow from both the project is $28000. Given a rate of return of 7%, we will calculate the present values of cash flows from both the project in order to evaluate the better option.

Cash Flows from Project K
Year	Cash Flows	PV factor @7%	PV of Cash Flows
0	-50000	1.0000	-50,000.00
1	10000	0.9346	9,345.79
2	15000	0.8734	13,101.58
3	17000	0.8163	13,877.06
4	16000	0.7629	12,206.32
5	20000	0.7130	14,259.72
			12,790.49
Cash Flows from Project L
Year	Cash Flows	PV factor @7%	PV of Cash Flows
0	-40000	1.0000	-40,000.00
1	8000	0.9346	7,476.64
2	16000	0.8734	13,975.02
3	17000	0.8163	13,877.06
4	16000	0.7629	12,206.32
5	11000	0.7130	7,842.85
			15,377.89

Therefore we see that the present value of cash flows from Project L is higher than that of project K, so we should opt for project L.

Adelaja, T. (2015). Capital Budgeting: Investment Appraisal Techniques Under Certainty. Chicago: CreateSpace Independent Publishing Platform .

Bierman, H., & Smidt, S. (2010). The Capital Budgeting Decision. Boston: Routledge.

Peterson, P. P., & Fabozzi, F. J. (2012). Capital Budgeting. New York, NY: Wiley.

Rivenbark, W. C., Vogt, J., & Marlowe, J. (2009). Capital Budgeting and Finance: A Guide for Local Governments. Washington, D.C.: ICMA Press.

Seitz, N., & Ellison, M. (2009). Capital Budgeting and Long-Term Financing Decisions. New York: Thomson Learning.

Shapiro, A. C. (2007). Capital Budgeting and Investment Analysis. New Jersey: Wiley.