What do you understand by Time Value of Money? Discuss its relevance in Financial decision making?

The recognition of time value of money and risk is extremely vital in financial decision-making. If the timing and risk of cash flows is not considered, the firm may make decisions that may allow it to miss its objective of maximizing the owner’s welfare. Rupee today is of worth more than a rupee tomorrow. Most individuals value the opportunity to receive money now higher than waiting for one or more periods to receive the same amount. Time preference for money is an individual’s preference for profession of a given amount of money now, rather than the same amount at some future time.

Three reasons may be attributed to the individual’s time preference for none:

● Risk

● Preference for consumption

● Investment opportunities

The time value of money is generally expressed by an interest rate. This rate will be positive even in the absence of any risk. It may be therefore, called the risk-free rate.

In reality, an investor will be exposed to some degree of risk. Therefore, he would require a rate of return, called risk premium, from the investment, which compensates him for both time and risk. Thus, the required rate of return will be,

Required rate of return = Risk free rate + Risk premium.

The required rate of return may also be called opportunity cost of capital of comparable risk. The interest rates account for the time, value of money, irrespective of an individual’s preferences and attitudes.

The recognition of the time value of money and risk is extremely vital in financial decision-making. A rupee today is worth more than a rupee tomorrow. A choice of having Rs. 75,000 today is much more attractive than Rs. 1,00,000 after five years because present is certain than future. You could invest Rs. 75,000 in the market and earn return on this amount. On the other hand, Rs. 1,00,000 at the end of five years would have less purchasing power due to inflation. The time value of money concepts will unravel the mystery of such choices which all of us do face in our daily life. Most financial decisions, such as the purchase assets or procurement of funds, affect the firms’ cash flows in different time periods. For example, if a fixed asset is purchased, it will require an immediate cash outlay and will generate cash inflows during many future periods. Similarly, if the firm borrows funds from a bank or from any other source, it receives cash now and commits an obligation to pay cash for interest and repay principal in future periods.

Therefore, recognition of time value of money is very important and a good understanding of it constitute 90% of finance sense

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