Conceptually time value of money means that the value of a unit of money is different in different time periods, The value of a sum of money received today is more than its value received after some time Conversely, the sum of money received in future is less valuable than it is today. In other words, the present worth of a rupee received after some time will be less than a rupee received today, Since a rupee received today has more, value, rational investors would prefer current receipt to future receipts, The time value of money can also IX' referred to as time preference for money.
The main reason for the time preference for money is to be found in the reinvestment opportunities for funds which are received early, The funds so invested will earn a rare of return this would not he possible if the funds are received at a later time. The time preference for money is, therefore, expressed generally in terms of a rate of return or more Popularly as a discount rate.
The expected rate of return as also the time value of money will vary from individual to individual depending, inter alia, on his perception. The time value of money can be illustrated using a simple example.
Suppose, Mr X is given the choice of receiving Rs 1,000 either now or one year later. His choice would obviously be for the first alternative as he can deposit the amount in his saving bank account and earn a nominal "lie of interest, five per cent. At the end of the year, the amount will accumulate to Rs 1.000. In other words, the choice before Mr X is between Rs 1,050 and Rs 1,000 at the end of the year. As a rational person. Mr X should be expected to prefer the larger amount (i.e, Rs 1.050 here). Here we Sly that the time value of money, that is, the rate of interest is five per cent. It may, thus, he seen that future cash flows are less valuable because of the investment opportunities of the present cash flows.
What applies to an individual applies equally, if not in greater measure; to a business firm. It is because business firms make decisions which have ramifications extending beyond the period in which they were taken. For instance, the capital budgeting decision generally involves the current cash outflows in terms of the amount required for purchasing a new machine or launching a new project and the execution of the scheme generates future cash inflows during its useful life. Let us assume that the project cost (current cash outflows) is Rs 10,00,000. To keep the illustration simple, it is assumed that the project has a useful life of only one year in which it is estimated to have cash inflows of Rs 10,80,000 (a) the end of the first year). The project appears to be prima jade acceptable as it adds Rs 80,000 as profit. However, when we take into account a rate of interest, say, of 10 per cent, the earlier conclusion will have to be. revised as, without the project, the sum could have amounted to Rs 11,00,000. Likewise, when the decision is made to raise a loan of Rs 10,00,000 from the financial institution or by issuing debentures, for a period of 10 years, the firm is not only under obligation to meet interest payment as and when it becomes due on the debt at fixed intervals but also must make provisions so that it can repay Rs 10.00,000 when the loan or debentures become due. Thus, time value of money is of crucial significance. This requires the development of procedures and techniques for evaluating future incomes in terms of the present.