What is Time Value of Money .
Background:
We may have heard from our parents, teachers and elders since our childhood that “Respect time as time is money”. We may be considering this as a good piece of advice and sometime we may have challenged. How can time is considered as money but let me tell you that this piece of advise may be for our better future however it is a basic principle in Finance Management for any enterprise or economy in the world . You may think what is Time Value of Money and how it affects our life,business, economy . We will try to provide answers to these questions in this post and also provide reference to present value and future value for better understanding of subject .
Time Value of Money :
Let us start with an example. I am giving you a choice , if someone gives you Rs.100 today or Rs.100 after end of 1 year , which is better ? Yes, you are right that you will always prefer today. You can take this Rs.100 and investment in Fixed Deposit for one year and can earn @ 7% p.a. .
This FD interest of 7% p.a. can be considered as opportunity cost as one can earn 12% p.a. also if he is having good knowledge of Mutual fund, share market or other legitimate investment sources .
Inflation and Time Value of Money:
Time Value of Money equally applies to inflation . e.g. If you are buying one particular item @ Rs.100 today , you may have to pay Rs.105 to buy the same product after 1 year . It means inflation rate is 5% p.a. and Purchasing power is reduced by 5% . If you keep hard cash with you instead of investing the same , it will also result in reduction in real value of Money.
Real Rate of Interest:
Every quarter , Indian economist,government and other stake holders keep close eyes on meeting of Monetary Policy Committee( MPC) . Any reduction in interest rate has positive impact on lending rate . Cost of borrowing will reduce however RBI while taking decision on interest rate cut , inter alia consider inflation rate into account . This is because , people should get real rate of interest and not nominal rate of interest. In above example , we can see that one can get 7 rupees after one year however due to inflation he will get real interest of Rs. 2 only (7-5). This is pre-tax return .
Present Value(PV) , Future Value(FV) and Net Present Value (NPV)
With same example one will get Rs. 107 after one year . Rs.100 is present value and Rs.107 is future value .
In Finance Management , timing of cash flow is very important . If finance manager is preparing business plan for 5 years , he has to apply discounting factor for all five years cash flow to get Net Present value. Net Present value is difference between Cash inflow and Cash Outflow .Cost of Equity or Cost of Debt or Weighted Average Cost of Capital (WACC) can be considered for discounting factor .
Objective of this post is to provide clarity on What is Time Value of Money , other terms are explained in short for reference . Hope you have liked this post . Do visit our website again and give your valuable feedback in comment section .
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