TIME VALUE OF MONEY

Time Value of Money



Time Value of Money

The Time Value Of Money

This study examines the key financial management concept of the time value of money (TVM). Time Value of Money (TVM) is an important concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities. (Mcmenamin, 2001)

The sooner cash flows are expected to be received, the more valuable they are, and conversely the later they are expected to be received, the less valuable they are. There is thus a negative or inverse relationship between the timing of cash flows and their value: as the time before receipt increases the value declines. The timing of cash flows therefore directly affects their value and this is what we mean by the time value of money concept.

Financial managers constantly have to make decisions based on the time value of money concept, whether it is decisions about in which projects the firm should invest its capital resources, or about how the firm should raise the capital resources necessary for its activities. Such decisions can only be made effectively and lead to an increase in the value of the firm if the financial manager has a sound understanding of the time value of money concept.

The time value of money concept is thus extremely relevant to both investment and financing decisions. Not just to the investment and financing decisions of the firm, but also at a personal level for us all. For example, whether you are buying a house, joining a savings scheme, or providing for a future pension, the time value of money affects them all and consequently your personal wealth.

The time value of money of necessity involves some mathematical manipulation and for students who are less mathematically inclined these calculations may seem at first intimidating. However, do not be deterred, as with a little effort and practice they will soon become clear. The time value of money is such a fundamentally important concept in financial management that making an effort to grasp its principles now will yield its rewards later.

The Timing Of Cash Flows

Most of us will instinctively appreciate that, 'a dollar today is worth more than a dollar tomorrow'. In other words most of us would prefer to receive cash sooner rather than later, and to spend cash later rather than sooner, because intuitively we know that money has a time value.

There are a number of reasons. First, there is less risk associated with the $1,000 if it is to be received today, $1,000 to be received one year from now is much less certain—a bird in the hand as the proverb goes. Second, there is what economists call personal consumption preference, most people prefer to spend or consume now rather than at some less certain time in the future. (Mcmenamin, 2001)

The third, and perhaps the most relevant for our purposes, is that there always exists alternative investment opportunities: you can decide to ...