Page 38 - DMGT409Basic Financial Management

Unit 3: Time Value of Money

3.1 Meaning of Time Value of Money Notes

“Money has time value” means that the value of money changes over a period of time. The value
of a rupee, today is different from what it will be, say, after one year.
Money has a time value because of the following reasons:
1. Individuals generally prefer current consumption to future consumption.

2. An investor can profitably employ a rupee received today, to give him a higher value to be
received tomorrow or after a certain period of time.
3. In an infl ationary economy, the money received today, has more purchasing power than
money to be received in future.
4. ‘A bird in hand is worth two in the bush’ : This statement implies that, people consider a
rupee today, worth more than a rupee in the future, say, after a year. This is because of the
uncertainty connected with the future.
Thus, the fundamental principle behind the concept of time value of money is that, a sum of
money received today, is worth more than if the same is received after some time.

Example: If an individual is given an alternative either to receive ` 10,000 now or after
six months; he will prefer ` 10,000 now. This may be because, today, he may be in a position to
purchase more goods with this money than what he is going to get for the same amount after six
months.

Time value of money or time preference of money is one of the central ideas in finance. It becomes
important and is of vital consideration in decision making. This will be clear with the following
example.

Example: A project needs an initial investment of ` 1,00,000. It is expected to give a return
of ` 20,000 p.a. at the end of each year, for six years. The project thus involves a cash outfl ow of `
1,00,000 in the ‘zero year’ and cash infl ows of ` 20,000 per year, for six years. In order to decide,
whether to accept or reject the project, it is necessary, that the present value of cash infl ows received
annually for six years is ascertained and compared with the initial investment of ` 1,00,000. The

firm will accept the project only when the present value of the cash inflows at the desired rate of
interest is at least equal to the initial investment of ` 1,00,000.
3.2 Valuation Concepts or Techniques

The time value of money implies that:
1. a person will have to pay in future more, for a rupee received today and
2. a person may accept less today, for a rupee to be received in the future.
The above statements relate to two different concepts:

1. Compound Value Concept
2. Discounting or Present Value Concept

3.3 Compound Value Concept

In this concept, the interest earned on the initial principal amount becomes a part of the principal
at the end of a compounding period.

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