The money available at the present time is worth more than the same amount in the future since it has the potential to earn returns. Consider the following options, assuming there is no uncertainty associated with the cash flow:
- Receiving Rs.500 now.
- Receiving Rs.500 after one month.
All HNI investors would prefer to receive the cash flow now, rather than wait for a month, though the amount to be received has the same value. This preference is attributed to the following reasons:
- Instinctive preference for current consumption over future consumption.
- Ability to invest the Rs.500 in the equity cash market and earn a return so that it grows in value to more than 500 after one month.
Clearly, Rs.500 available now is not equivalent to Rs.500 received after a month. The value associated with the same sum of money received at various points on the timeline is called the time value of money. The time value of money received in earlier periods as compared to that received in later time periods will be higher. Since most decisions in finance involve cash flows spread over more than one year, the time value of money is a key principle in financial decision-making.
Since money has time value, it is not possible to compare cash flows received in different time periods.
Consider the above example: suppose the Rs.500 received now is placed in a one-month bank deposit yielding 6.5 % p.a. After a month, the value would grow to Rs.500.54. If an investor has to opt for receiving Rs.500 after a month, then he needs to be compensated by Rs.0.54, the amount that has been foregone by waiting for a month. The two options will be equivalent from the investor’s point of view if the option is to receive Rs.500 now or Rs.500.54 after one month.
Thus the rate of return should also be adjusted for time value; this rate converts future flows into present flows and vice versa.
When time values are taken into account, the following points need to be noted:
- Future inflows are discounted by a relevant rate to reach their present value; this rate is known as the discount rate.
- Present inflows are increased at a relevant rate to reach their future values: this rate is known as the compound rate.
- The more in the future a cash flow is, the lower its value at the current time. Rs.500 available after one month is more valuable than Rs.500 available after one year, which is better than Rs.500 available after 5 years.
- The higher the discount rate, the lower the present value of future cash flows. A higher rate means that investors have to forego more returns by opting for future cash flows.
In any time value situation the important parameters are:
- Cash inflows or outflows: These could be either in the form of single period cash flow or in the form of an annuity or a stream of uneven cash flows.
- Rate of interest: Also known as compounding rate or discount rate
- Time Period: This may be annual or any other fraction thereof d. Frequency of cash flows, which may or may not be fixed
Financial problems involving time value of money are usually concerned with calculating one of the above parameters. 24 Carat Financial Services is the best stock cash intraday tips provider that extends accurate and reliable calls for a balanced or positive financial status.