TIME VALUE OF MONEY

Utkarsh Tewari
MBA -47
Definition

 Time Value of Money is a concept that recognizes the relevant worth of

future cash flows arising as a result of financial decisions by considering
the opportunity cost of funds.
Concept

 Money loses its value over time which makes it more desirable to have it now
rather than later.
 There are several reasons why money loses value over time. Most obviously,
there is inflation which reduces the buying power of money.
 But quite often, the cost of receiving money in the future rather than
now will be greater than just the loss in its real value on account of inflation.
The opportunity cost of not having the money right now also includes the loss
of additional income that you could have earned simply by having received
the cash earlier. Moreover, receiving money in the future rather than now
may involve some risk and uncertainty regarding its recovery. For these
reasons, future cash flows are worth less than the present cash flows.
What is does?

 Time Value of Money concept attempts to incorporate the above

considerations into financial decisions by facilitating an objective evaluation
of cash flows from different time periods by converting them into present
value or future value equivalents.
 This ensures the comparison of 'like with like'.
The present or future value of cash flows are
calculated using a discount rate that is
determined on the basis of several factors -
● Rate of Higher the rate of inflation, higher the return that investors
inflation would require on their investment.

Higher the interest rates on deposits and debt securities,

● Interest Rates greater the loss of interest income on future cash inflows
causing investors to demand a higher return on investment.

Greater the risk associated with future cash flows of an

● Risk Premium investment, higher the rate of return required by an
investors to compensate for the additional risk.
Example

 Suppose that you have earned a cash bonus for an outstanding performance at
your job during the last year.
 Your pleased boss gives you 2 options to choose from:
 ● Option A: Receive $10,000 bonus now
● Option B: Receive $10,800 bonus after one year
 Further information which you may consider in your decision:
- Inflation rate is 5% per annum.
- Interest rate on bank deposits is 12% per annum.
 Which option would you choose?
Considerations-

 Although in absolute terms Option B offer the higher amount of bonus, Option
A gives you the choice of receiving bonus one year earlier than Option B. This
can be beneficial for the following reasons:
 To start with, you can buy more with $10,000 now than with $10,800 in one
year's time due to the 5% inflation.
 Secondly, if you receive the bonus now, you could invest the cash in a bank
deposit and earn a safe annual return of 12%. in contrast, you stand to lose
this interest income if you choose Option B.
 Thirdly, future is uncertain. In worst case scenario, the company you work for
could become bankrupt during the next year which would significantly reduce
your chances of receiving any bonus. The probability of this happening might
be remote, but there would be a slim chance none the less.
 Option A is preferable as it has the highest
future value.

Future Value Future Value

Option A
Option B
Bonus $10,000
Bonus $10,800
($10,0
Interest
$ 1,200 00 x Interest
Income - *
12%)
Income

($10,0
$11,200 after 1 00 + $10,800 after
Future Value
year $1,200
Future Value
1 year
)
Based on the present values, Option A is
preferable as it has the highest present
value.
Present Value Present Value
Option B
Option A
Bonus $10,000 Bonus $10,800
Interest
1.0 *
Income Interest (1 ÷ [1 +
0.8928
Income 0.12] )
($10,
Present
$10,000 000 x
Value
1.0) ($10,800
Present Value $9,642*
x 0.8928)