Time Value of Money

‘Time value of money’ is central to the concept of finance. It recognizes that the value of
money is different at different points of time. Since money can be put to productive use, its
value is different depending upon when it is received or paid.

In simpler terms, the value of a certain amount of money today is more valuable than its
value tomorrow. It is not because of the uncertainty involved with time but purely on
account of timing. The difference in the value of money today and tomorrow is referred to
as the time value of money.

1. Meaning of Time Value of Money

The time value of money is one of the basic theories of financial management, it states that
‘the value of money you have now is greater than a reliable promise to receive the same
amount of money at a future date’.

The time value of money (TVM) is the idea that money available at the present time is
worth more than the same amount in the future due to its potential earning capacity. This
core principle of finance holds that, provided money can earn interest, any amount of money
is worth more the sooner it is received.

The time value of money is the greater benefit of receiving money now rather than receiving
later. It is founded on time preference. The principle of the time value of money explains
why interest is paid or earned? Interest, whether it is on a bank deposit or debt, compensates
the depositor or lender for the time value of money.

2. Concept of Time Value of Money

Important terms or concepts used in computing the time value of money are-

(1) Cash-flow

(2) Cash inflow

(3) Cash outflow

(4) Discounted Cash flow

(5) Even cash flows /Annuity cash flows

(6) Uneven/mixed streams of cash flows

(7) Single cash flows

(9) Future value

(10) Present value

(11) Compounding

(12) Discounting

(13) Effective interest rate / Time preference rate

(14) Risks and types of risks

(15) Uncertainty, and

(16) Doubling Period.

3. Importance of Time Value of Money

The Consideration of time is important and its adjustment in financial decision making is
also equally important and inevitable. Most financial decisions, such as the procurement of
funds, purchase of assets, maintenance of liquidity and distribution of profits etc., affect the
firm’s cash flows/movement of cash in and out of the organization in different time periods.

Cash flows occurring in different time periods are not comparable, but they should be
properly measurable. Hence, it is required to adjust the cash flows for their differences in
timing and risk. The value of cash flows to a common time point should be calculated.

To maximize the owner’s equity, it’s extremely vital to consider the timing and risk of cash
flows. The choice of the risk adjusted discount rate (interest rate) is important for
calculating the present value of cash flows.

For instance, if the time preference rate is 10 percent, it implies that an investor can accept
receiving Rs.1000 if he is offered Rs.1100 after one year. Rs.1100 is the future value of
Rs.1000 today at 10% interest rate.

Thus, the individual is indifferent between Rs.1000 and Rs.1100 a year from now as he/she
considers these two amounts equivalent in value. You can also say that Rs.1000 today is the
present value of Rs.1100 after a year at 10% interest rate.

Time value adjustment is important for both short-term and long-term decisions. If the
amounts involved are very large, time value adjustment even for a short period will have
significant implications.
However, other things being same, adjustment of time is relatively more important for
financial decisions with long range implications than with short range implications. Present
value of sums far in the future will be less than the present value of sums in the near future.

The concept of time value of money is of immense use in all financial decisions.

The time value concept is used

1. To compare the investment alternatives to judge the feasibility of proposals.

2. In choosing the best investment proposals to accept or to reject the proposal for
investment.

3. In determining the interest rates, thereby solving the problems involving loans,
mortgages, leases, savings and annuities.

4. To find the feasible time period to get back the original investment or to earn the
expected rate of return.

5. Helps in wage and price fixation.

4. Reasons for Time Preference of Money / Reasons for Time Value of Money

There are three primary reasons for the time value of money- reinvestment opportunities;
uncertainty and risk; preference for current consumption.

These reasons are explained below:

1. Reinvestment Opportunities:

The main fundamental reason for Time value of money is reinvest ment opportunities.

Funds which are received early can be reinvested in order to earn money on them. The basic
premise here is that the money which is received today can be deposited in a bank account
so as to earn some return in terms of income.

In India saving bank rate is about 4% while fixed deposit rate is about 7% for one year
deposit in public sector banks. Therefore even if the person does not have any other
profitable investment opportunity to invest his funds, he can simply put his money in a
savings bank account and earn interest income on it.

Let us assume that Mr. X receives Rs.100000 in cash today. He can invest or deposit this
Rs.100000 in fixed deposit account and earn 7% interest p.a. Therefore at the end of one
year his money of Rs.100000 grows to Rs.107000 without any efforts on the part of Mr. X.
If he deposits Rs.100000 in two years fixed deposit providing interest rate 7% p .a. then at
the end of second year his money will grow to Rs.114490 (i.e. Rs.107000+ 7% of
Rs.107000). Here we assume that interest is compounded annually i.e. we do not have a
simple interest rate but compounded interest rate of 7%.

Thus Time value of money is the compensation for time.

2. Uncertainty and Risk:

Another reason for Time value of money is that funds which are received early resolves
uncertainty and risk surmounting future cash flows. All of us know that the future is
uncertain and unpredictable. At best we can make best guesses about the future with some
probabilities that can be assigned to expected outcomes in the future.

Therefore given a choice between Rs.100 to be received today or Rs.100 to be received in

The underlying principle is “A bird in hand is better than two in the bush.”

It must be noted that there is a difference between risk and uncertainty.

In a Risky situation we can assign probabilities to the expected outcomes. Probability is the
chance of occurrence of an event or outcome. For example I may get Rs.100 with 90%
probability in future. Therefore there is 10% probability of not getting it at all. In a risky
situation outcomes are predictable with probabilities.

In case of an uncertain situation it is not possible to assign probabilities to the expected

3. Preference for Current Consumption:

The third fundamental reason for Time value of money is preference for current
consumption. Everybody prefers to spend money today on necessities or luxuries rather than
in future, unless he is sure that in future he will get more money to spend.

Let us take an example, Your father gives you two options – to get Wagon R today on your
20th birthday OR to get Wagon R on your 21 st birthday which is one year later.

Which one would you choose? Obviously you would prefer Wagon R today rather than one
year later. So every rational person has a preference for current consumption. Those who
save for future, do so to get higher money and hence higher consumption in future.
In the above example of a car if your father says that he can give you a bigger car, say
Honda City on your 21 st birthday, then you may opt for this option if you think that it is
better to wait and get a bigger car next year rather than settling for a small car this year.

Thus we can say that the amount of money which is received early (or today) carries more
value than the same amount of money which is received later (or in future). This is Time
Value of Money.

9. Risk and Return Analysis

What is risk?

Risk is the variability which may likely to accrue in future between the expected returns and
the actual returns. So, the risk may also be considered as a chance of variation or chance of
loss.

Types of Risk:

Risk can be classified in the following two parts:

1. Systematic Risk or Market Risk:

Systematic risk is that part of total risk which cannot be eliminated by diversification.
Diversification means investing in different types of securities. No investor can avoid or
eliminate this risk, whatsoever precautions or diversification may be resorted to. So, it is
also called non diversifiable risk, or the market risk.

This part of the risk arises because every security has a built in tendency to move in line
with the fluctuations in the market. The systematic risk arises due to general factors in the
market such as money supply, inflation, economic recession, industrial policy, interest rate
policy of the government, credit policy, tax policy etc. These are the factors which affect
almost every firm.

[Link] Risk:

The unsystematic risk is one which can be eliminated by diversification. This risk represents
the fluctuation in returns of a security due to factors specific to the particular firm only and
not the market as a whole.

These factors may be such as worker’s unrest, strike, change in market demand, change in
consumer preference etc. This risk is also called diversifiable risk and can be reduced by
diversification. Diversification is the act of holding many securities in order to lessen the
risk.
The effect of diversification on the risk of a portfolio is represented graphically in the
below figure:

The above diagram shows that the systematic risk remains the same and is constant
irrespective of the number of securities in the portfolio as shown by OA in the above
diagram and is fixed for any number of securities.

For only security it is OA & for 20 security also it is OA. However, the unsystematic risk is
reduced when more and more securities are added to the portfolio. As from the above
diagram we can see that earlier it was OD & by increasing the number of securities it
decreases to C.

10. Methods of Risk Management

Risk is inherent in business and hence there is no escape from the risk for a businessman.
However, he may face this problem with greater confidence if he adopts a scientific
approach by dealing with risk. Risk management may, therefore, be defined as adoption of a
scientific approach to the problem dealing with risk faced by a business firm or an
individual.

Broadly, there are five methods in general for risk management:

i) Avoidance of Risk

A business firm can avoid risk by not accepting any assignment or any transaction which
involves any type of risk whatsoever. This will naturally mean a very low volume of
business activities and losing of too many profitable activities.

ii) Prevention of Risk

In case of this method, the business avoids risk by taking appropriate steps for prevention of
business risk or avoiding loss, such steps include adaptation of safety programmes,
employment of night security guard, arranging for medical care, disposal of waste material
etc.

iii) Retention of Risk

In the case of this method, the organization voluntarily accepts the risk since either the risk
is insignificant or its acceptance will be cheaper as compared to avoiding it.

iv) Transfer of Risk

In case of this method, risk is transferred to some other person or organization. In other
words, under this method, a person who is subject to risk may induce another person to
assume the risk. Some of the techniques used for transfer of risk are hedging, sub-
contracting, getting surety bonds, entering into indemnity contracts etc.

v) Insurance

This is done by creating a common fund out of the contribution (known as premium) from
several persons who are equally exposed to the same loss. Fund so created is used for
compensating the persons who might have suffered financial loss on account of the risks
insured against.

11. Types of Investors

There are three types of investor which may be classified as:

a) Risk Averse

Under this category those investors appear who avoid taking risk and prefer only the
investments which have zero or relatively lower risk. These investors ignore the return from
the investment. Generally risk averse investors are – Retired persons, Old age persons and
Pensioners.

b) Risk Seekers

Under this category those investors are nominated who are ready to take risk if the return is
sufficient enough (according to their expectations). These investors may be ready to take –
Income risk, Capital risk or both.

c) Neutrals

Under this category those investors lie who do not care much about the risk. Their
investments decisions are based on consideration other than risk and return.

What is return?

Return is the amount received by the investor from their investment. Everyone needs high
returns over invested amounts. Each and every investor who invests or wants to invest their
amount in any type of project, first expects some return which encourages them to take risk.

Risk and Return Trade Off:

The principle that potential “return rises with an increase in risk”. Low levels of uncertainty
(low risk) are associated with low potential returns, whereas high levels of uncertainty (high
risk) are associated with high potential returns. According to the risk-return tradeoff,
invested money can render higher profits only if it is subject to the possibility of being lost.
Because of the risk- return tradeoff, you must be aware of your personal risk tolerance when
choosing investments for your portfolio. Taking on some risk is the price of achieving
returns; therefore, if you want to make money, you can’t cut out all risk. The goal instead is
to find an appropriate balance – one that generates some profit, but still allows you to sleep
at night.

We can see this in the following figure:

Risk and return analysis emphasizes over the following characteristics:

(i) Risk and Return have parallel relations.

(ii) Return is fully associated with risk.

(iii) Risk and return concepts are basic to the understanding of the valuation of assets or
securities.

(iv) The expected rate of return is an average rate of return. This average may deviate from
the possible outcomes (rates of return).